Financial Reporting Developments: Issuer’s accounting for debt and equity financings

Financial reporting developments

A comprehensive guide

Issuer’s

accounting for

debt and equity

financings

(before the adoption of ASU 2020-06,

Accounting for Convertible Instruments

and Contracts in an Entity’s Own Equity)

August 2023

To our clients and other friends

The accounting for the issuance of debt and equity instruments is among the more complex areas of

US GAAP. That complexity is caused not only by the sophistication of financial instruments and features,

but also the patchwork of accounting guidance that has evolved over time. Consider convertible debt.

Issuers can account for convertible debt in up to five different ways, depending on the instrument’s terms.

This publication is designed to provide you with a road map to help you analyze the accounting for the

issuance of debt and equity instruments, including specific transactions. Subsequent accounting

considerations are also included. The appendices provide further insight into the accounting literature

on specific parts of the analysis.

Given the variety of instruments and potential features, an instrument’s terms should be fully understood in

order to properly apply the accounting guidance. Moreover, accounting for the issuance of debt and equity

instruments often requires significant judgment based on the individual facts and circumstances. While this

publication includes our views and interpretations on many practice issues, other views may also be acceptable.

In August 2020 the Financial Accounting Standards Board (FASB or Board) issued Accounting Standards

Update (ASU) 2020-06.

ASU 2020-06 eliminates the beneficial conversion feature and cash conversion

models in Accounting Standards Codification (ASC or Codification) 470-20 that require separate

accounting for embedded conversion features in convertible instruments.

The guidance also eliminates some of the conditions that must be met for equity classification under

ASC 815-40-25. The guidance also requires entities to use the if-converted method to calculate earnings

per share (EPS) for all convertible instruments in the diluted EPS calculation and include the effect of

potential share settlement (if the effect is more dilutive) for instruments that may be settled in cash or

shares, except for liability-classified share-based payment awards.

For public business entities other than smaller reporting companies as defined by the Securities and Exchange

Commission (SEC) as of 5 August 2020, ASU 2020-06 is currently effective. For all other entities, it is

effective for annual periods beginning after 15 December 2023 and interim periods therein. Early

adoption is permitted, but an entity must adopt the guidance as of the beginning of a fiscal year.

This edition of our publication does not reflect the amendments issued in ASU 2020-06. Therefore, it

should be used only by those entities that have not yet adopted ASU 2020-06. Entities that have adopted

ASU 2020-06 should refer to our Financial reporting developments (FRD) publication, Issuer’s accounting

for debt and equity financings (after the adoption of ASU 2020-06, Accounting for Convertible Instruments

and Contracts in an Entity’s Own Equity).

We hope this publication helps you understand and apply the accounting for the issuance of debt and equity

instruments. As always, EY professionals are available to answer any questions you may have.

August 2023

ASU 2020-06, Debt — Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging — Contracts in

Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity.

 
Financial reporting developments Issuer’s accounting for debt and equity financings  |  i 
Contents 
Overview ................................................................................................................... 1 
1  Debt and equity financings ..................................................................................................... 1 
2  Accounting considerations ..................................................................................................... 1 
2.1  Identifying all freestanding financial instruments ............................................................ 2 
2.1.1  Combining freestanding financial instruments ....................................................... 2 
2.2  Distinguishing liabilities from equity (ASC 480) ............................................................... 4 
2.2.1  Debt .................................................................................................................... 4 
2.2.2  Stock ................................................................................................................... 5 
2.2.3  Equity contracts ................................................................................................... 5 
2.3  Derivatives and embedded derivatives (ASC 815) ........................................................... 5 
2.3.1  Debt and stock ..................................................................................................... 6 
2.3.2  Equity contracts ................................................................................................... 6 
2.3.3  Embedded derivatives and bifurcation .................................................................. 7 
2.4  Contracts (or features) in an entity’s own equity (ASC 815-40)........................................ 8 
2.5  Accounting for convertible instruments (ASC 470-20) .................................................... 9 
2.5.1  Cash conversion guidance .................................................................................... 9 
2.5.2  Beneficial conversion feature guidance ................................................................. 9 
2.6  Classification and measurement of redeemable securities (ASC 480-10-S99-3A) .............. 10 
2.7  Allocation of proceeds ................................................................................................. 10 
2.7.1  SEC staff’s view on allocation of proceeds when the fair value of a 
liability exceeds net proceeds received................................................................ 12 
3  Navigating the transaction documents .................................................................................. 12 
3.1  International Swaps and Derivatives Association contracts ............................................ 13 
4  How to use this publication ................................................................................................... 14 
Debt ........................................................................................................................ 15 
1  Overview and general descriptions of types of debt ............................................................... 15 
1.1  Debt terminology ........................................................................................................ 15 
1.2   Common types of debt instruments.............................................................................. 16 
1.2.1   Convertible debt ................................................................................................ 16 
1.2.2   Zero-coupon bond .............................................................................................. 17 
1.2.3   Term-extending debt .......................................................................................... 17 
1.2.4   Share-settled debt ............................................................................................. 17 
1.2.5   Indexed debt ...................................................................................................... 17 
1.2.6   Exchangeable debt ............................................................................................. 18 
1.2.7  Inflation-indexed debt ........................................................................................ 18 
1.2.8   Perpetual debt ................................................................................................... 18 
1.2.9   Increasing-rate debt ........................................................................................... 18 
1.2.10  Tax increment financing entity (TIFE) (added August 2023) ................................. 18 
2  Issuer’s initial accounting for debt instruments (including flowchart) ....................................... 19 
2.1  Box A — Debt instruments accounted for at fair value .................................................... 20 
2.2  Box B — Identifying embedded features ........................................................................ 20 

Contents 
Financial reporting developments Issuer’s accounting for debt and equity financings  |  ii 
2.3  Box D and Boxes D1, D2 and D3 — Evaluating embedded features for bifurcation ............. 21 
2.3.1  Unit of analysis .................................................................................................. 21 
2.3.2  Meaning of ‘clearly and closely related’ ............................................................... 22 
2.3.3  Identifying the host contract in a debt instrument ............................................... 22 
2.3.4  Definition of a derivative instrument ................................................................... 23 
2.4  Box D(A) and Boxes D1, D2 and D3 — Evaluating embedded conversion options.............. 23 
2.4.1  Determining whether a conversion option is clearly and closely 
related to the debt host instrument..................................................................... 23 
2.4.2  Determining whether a conversion option meets the definition of a derivative ...... 24 
2.4.3  Exceptions from derivative accounting ................................................................ 24 
2.4.3.1  Meaning of ‘indexed to issuer’s own stock’ .................................................. 25 
2.4.3.2  Meaning of ‘classified in stockholders’ equity’ ............................................. 25 
2.4.4  Contingently convertible debt ............................................................................. 26 
2.4.5  ‘Time value make-whole’ features ....................................................................... 27 
2.4.6  Share-settled debt ............................................................................................. 29 
2.4.7  Debt that is convertible into shares of a subsidiary or the parent .......................... 29 
2.4.8  Conventional convertible debt ............................................................................ 30 
2.4.9  Conversion options with a strike price denominated in a currency 
other than the issuer’s functional currency ......................................................... 31 
2.5   Box D(B) and Boxes D1, D2 and D3 — Evaluating embedded redemption 
(put and/or call) features ............................................................................................. 31 
2.5.1  Determining whether put and call features are considered clearly 
and closely related to the debt host instrument ................................................... 32 
2.5.1.1  Application of ASC 815-15-25-26 and the double-double test ..................... 33 
2.5.2  Meaning of ‘involve a substantial premium or discount’ ........................................ 35 
2.5.3  Determining whether put and call features meet the definition of a 
derivative subject to derivative accounting.......................................................... 36 
2.6   Box D(C) and Boxes D1, D2 and D3 — Evaluating other potential embedded features ....... 36 
2.6.1  Contingent interest features ............................................................................... 36 
2.6.2  Interest make-whole features (updated August 2023) ......................................... 38 
2.6.3  Term-extension features .................................................................................... 39 
2.6.4  Debt indexed to inflation and other variables (indexed debt) ................................ 39 
2.6.5  Participating mortgages ..................................................................................... 40 
2.6.6  Increasing-rate debt ........................................................................................... 41 
2.6.7  Debt denominated in a currency other than the issuing entity’s 
functional currency ............................................................................................ 41 
2.6.8  Sales of future revenues ..................................................................................... 41 
2.7   Box E — Bifurcation of a single embedded derivative ...................................................... 43 
2.7.1  Option-based embedded derivatives ................................................................... 43 
2.7.2  Forward-based embedded derivatives ................................................................. 43 
2.7.3  Financial statement classification ....................................................................... 43 
2.8   Box F — Non-bifurcated features and conversion options ............................................... 44 
2.9   Boxes G, H and I — Cash conversion options .................................................................. 44 
2.10  Boxes J, K and L — Beneficial conversion features and contingent 
beneficial conversion features ..................................................................................... 45 
2.11  Boxes M and N — Debt issued at a substantial premium where the 
conversion option is not accounted for separately......................................................... 46 
2.12   Box O — No accounting is required for the conversion option ......................................... 47 

Contents 
Financial reporting developments Issuer’s accounting for debt and equity financings  |  iii 
2.13   Box P — Temporary equity classification of the equity component 
separated from convertible debt .................................................................................. 47 
3   Costs and fees incurred upon debt issuances ......................................................................... 47 
3.1   Presentation of debt issuance costs ............................................................................. 48 
3.1.1   Debt issuance costs related to revolving credit arrangements .............................. 48 
3.2   Fees paid to lenders .................................................................................................... 49 
4   Subsequent accounting and measurement ............................................................................ 50 
4.1   General ...................................................................................................................... 50 
4.2   Debt instruments for which the fair value option is elected ............................................ 50 
4.2.1   Debt with an inseparable third-party credit enhancement that is 
measured at fair value for accounting or disclosure purposes .............................. 51 
4.3   Debt instruments for which the fair value option is not elected ...................................... 51 
4.3.1   Premiums, discounts and debt issuance costs ..................................................... 52 
4.3.1.1  Effective interest method .......................................................................... 52 
4.3.1.2  Determining the expected life of a debt instrument ..................................... 54 
4.3.1.3  Amortization for cash convertible instruments ........................................... 54 
4.3.1.4  Amortization of instruments with beneficial conversion features ................. 54 
4.3.2  Paid-in-kind interest ........................................................................................... 54 
4.3.3   Embedded features not bifurcated from the host debt instrument........................ 55 
4.3.3.1  Embedded derivative reassessment ........................................................... 56 
4.3.3.2  Subsequent bifurcation.............................................................................. 57 
4.3.4   Embedded features bifurcated from the host debt instrument as a 
derivative and classified as an asset or liability .................................................... 57 
4.3.5   Embedded conversion features separated from the host debt 
instrument and classified as a component of equity ............................................. 58 
4.3.5.1  Cash conversion features .......................................................................... 58 
4.3.5.2  Beneficial conversion features ................................................................... 58 
4.3.5.3  Application of ASC 480-10-S99-3A ............................................................ 59 
5   Debt extinguishment and conversions ................................................................................... 59 
5.1   Extinguishment of liabilities ......................................................................................... 59 
5.1.1   Measurement of debt extinguishments ............................................................... 60 
5.1.2  Extinguishment of debt with a beneficial conversion feature ................................ 60 
5.1.3   Extinguishment of cash convertible debt ............................................................. 61 
5.1.4  Extinguishment of debt with a previously bifurcated conversion option ................ 61 
5.1.5  Transition from a primary to a secondary obligor ................................................ 61 
5.1.6  Classification of debt extinguishment gains or losses ........................................... 61 
5.1.7  Debt extinguishments with related parties ........................................................... 62 
5.2  Conversion of convertible debt instruments .................................................................. 62 
5.2.1  Conversion pursuant to the original terms of convertible debt 
under the general conversion guidance ............................................................... 63 
5.2.2  Conversion of debt with a bifurcated conversion option ....................................... 63 
5.2.2.1  Conversion of debt with a conversion feature initially 
bifurcated and subsequently reclassified into equity ................................... 63 
5.2.3  Conversion pursuant to the original terms of convertible debt that 
contain beneficial conversion features ................................................................ 64 
5.2.4  Induced conversions of general convertible debt ................................................. 64 
5.2.5   Induced conversions of convertible debt under the cash conversion guidance ...... 64 

Contents 
Financial reporting developments Issuer’s accounting for debt and equity financings  |  iv 
6  Troubled debt restructurings and debt modifications ............................................................. 64 
6.1  Troubled debt restructurings ....................................................................................... 66 
6.1.1  Scope of the troubled debt restructuring guidance in ASC 470-60 ....................... 66 
6.1.2  Distinguishing a troubled debt restructuring from a modification or exchange ...... 67 
6.1.2.1  Debtor experiencing financial difficulties .................................................... 68 
6.1.2.2  Creditor granting concession ..................................................................... 69 
6.1.3  Debtor’s accounting for a troubled debt restructuring ......................................... 70 
6.1.3.1  Full satisfaction of a payable through transfer of assets or equity interest ... 70 
6.1.3.2  Modification of terms in a troubled debt restructuring ................................ 72 
6.1.3.3  Combination of types including partial satisfaction ..................................... 74 
6.1.3.4  Contingent payments and payments based on variable interest rates .......... 76 
6.1.3.5  Notes payable ‘on demand’ or with prepayment provisions ......................... 78 
6.1.3.6  Costs incurred in connection with troubled debt restructurings ................... 78 
6.2  Modifications or exchanges of debt instruments ........................................................... 78 
6.2.1  General .............................................................................................................. 78 
6.2.2  Scope of the debt modification guidance in ASC 470-50 ...................................... 79 
6.2.2.1  Contemporaneous exchange of cash between the same debtor 
and creditor from issuance of new debt and satisfaction of an 
existing debt by the debtor ........................................................................ 79 
6.2.2.2  Debtor with an irrevocable offer to redeem a debt instrument 
at a future date ......................................................................................... 80 
6.2.3  Determining whether debt instruments are substantially different ....................... 80 
6.2.3.1  Performing the cash flow test involving exchange of noncash 
consideration ............................................................................................ 81 
6.2.3.2  Performing the cash flow test when debt instruments are 
prepayable prior to maturity ...................................................................... 81 
6.2.3.3   Illustrations — 10% cash flow test ............................................................... 82 
6.2.4  Modifications or exchanges of convertible debt instruments ................................ 87 
6.2.4.1  Modifications or exchanges involving convertible debt 
instruments with a conversion option that is bifurcated .............................. 89 
6.2.4.2  Modifications or exchanges involving convertible debt instruments 
that contain a separately classified equity component ................................ 90 
6.2.5  Accounting for debt modification or exchange and fees paid and costs incurred ... 92 
6.2.5.1  Accounting for fees and costs when principal is partially repaid 
or prepaid ................................................................................................. 93 
6.2.6  Effect of third-party intermediary’s involvement ................................................. 94 
6.2.7  Loan participations and loan syndications ........................................................... 95 
6.2.8  Modification of line-of-credit arrangements ......................................................... 95 
6.2.9  Modifications of credit facilities ........................................................................... 96 
6.2.10  Modifications or exchanges involving public debt issuances ................................. 97 
6.2.11  Transactions between or among creditors ........................................................... 97 
7  Classification and presentation ............................................................................................. 97 
7.1   Classification of debt with contractual maturity greater than one year ........................... 98 
7.1.1   Due on demand loan arrangements .................................................................... 98 
7.1.2   Debt that becomes callable upon covenant violations .......................................... 98 
7.1.2.1  Covenant violation at the balance sheet date (or prior to the 
issuance of financial statements) ............................................................... 99 

Contents 
Financial reporting developments Issuer’s accounting for debt and equity financings  |  v 
7.1.2.1.1   Covenant violation at balance sheet date (or prior to 
the issuance of financial statements) but a waiver has 
been obtained for a period greater than one year ............................ 100 
7.1.2.1.2  Covenant violation has not occurred at the balance 
sheet date (or prior to the issuance of financial 
statements) but violation probable within next year ......................... 101 
7.1.3  Debt in default financial statement disclosure ................................................... 102 
7.1.4  Settlement of long-term debt shortly after the balance sheet date ..................... 102 
7.2  Subjective acceleration clauses .................................................................................. 104 
7.2.1   Long-term debt with subjective acceleration clauses ......................................... 104 
7.3   Classification of short-term obligations expected to be refinanced on a 
long-term basis ......................................................................................................... 105 
7.3.1   Demonstrating ability via actual refinancing ...................................................... 105 
7.3.2   Demonstrating ability via a financing agreement ............................................... 106 
7.3.2.1  Demonstrating ability via a standby credit agreement ............................... 106 
7.3.2.2   Demonstrating ability through potential alternative source of financing ..... 106 
7.3.2.3   Refinancing agreement that contains subjective acceleration clause ......... 106 
7.3.3   Amount to be excluded from current liabilities .................................................. 107 
7.4   Revolving credit agreements ..................................................................................... 108 
7.4.1   Classification of long-term revolver ................................................................... 108 
7.4.2   Classification of short-term revolver ................................................................. 109 
7.5   Lock-box and ‘springing lock-box’ arrangements in revolving credit agreements ............ 109 
7.5.1   Lock-box arrangements .................................................................................... 109 
7.5.2   Springing lock-box arrangements ..................................................................... 110 
7.6   Classification of convertible debt instruments ............................................................. 110 
7.7   Classification of increasing-rate debt .......................................................................... 111 
Common shares, preferred shares and other equity-related topics ............................ 112 
1  Overview ........................................................................................................................... 112 
1.1  General description of common and preferred shares ................................................. 112 
1.2  Share terminology .................................................................................................... 112 
1.3  Common types of stock instruments .......................................................................... 113 
1.3.1  Par value stock ................................................................................................ 113 
1.3.2  No par value stock ........................................................................................... 113 
1.3.3  Treasury stock ................................................................................................. 113 
1.3.4  Perpetual preferred stock ................................................................................. 113 
1.3.5  Convertible stock ............................................................................................. 113 
1.3.6  Redeemable stock ............................................................................................ 114 
1.3.7  Mandatorily redeemable stock .......................................................................... 114 
1.3.8  Increasing-rate preferred stock ........................................................................ 114 
1.3.9  Restricted shares ............................................................................................. 114 
1.3.10  Nominal stock issuances ................................................................................... 115 
1.4  Additional paid in capital and retained earnings .......................................................... 115 
2  Issuer’s initial accounting for stock instruments (including flowchart).................................... 115 
2.1  Box A — Mandatorily redeemable stock ....................................................................... 117 
2.2  Box B — Stock settled in a variable number of equity shares ......................................... 117 
2.3  Boxes C and D — Liability classification for stock .......................................................... 118 
2.3.1  Shares that represent legal form debt ............................................................... 118 

Contents 
Financial reporting developments Issuer’s accounting for debt and equity financings  |  vi 
2.4  Box E — Identifying embedded features....................................................................... 118 
2.5  Box F — Recognition at issuance ................................................................................. 119 
2.5.1  Stock subscription ............................................................................................ 119 
2.5.2  Stock issued to nonemployees (including customers) ......................................... 119 
2.6  Boxes G and H — Evaluate the nature of the host contract............................................ 120 
2.6.1  Defining the host contract ................................................................................ 120 
2.6.1.1   Weighing terms and features ................................................................... 120 
2.7  Box I and Boxes I1, I2 and I3 — Evaluating embedded features for bifurcation ............... 124 
2.7.1  Unit of analysis ................................................................................................ 124 
2.7.2  Meaning of ‘clearly and closely related’ ............................................................. 125 
2.7.3  Definition of a derivative instrument ................................................................. 125 
2.8  Box I(A) and Boxes I1, I2 and I3 — Evaluating embedded conversion options ................. 126 
2.8.1  Determining whether a conversion option is clearly and closely 
related to an equity host instrument ................................................................. 126 
2.8.2  Contingently convertible stock.......................................................................... 126 
2.8.3  Share-settled stock .......................................................................................... 126 
2.9  Box I(B) and Boxes I1, I2 and I3 — Evaluating embedded redemption 
(put and/or call) features ........................................................................................... 127 
2.9.1  Determining whether put and call features are considered clearly 
and closely related to an equity host instrument ................................................ 128 
2.9.2  Determining whether put and call features meet the definition of a 
derivative subject to derivative accounting........................................................ 128 
2.9.3  Exceptions from derivative accounting .............................................................. 129 
2.9.3.1  Meaning of ‘indexed to issuer’s own stock’ ................................................ 129 
2.9.3.2  Meaning of ‘classified in stockholders’ equity’ ........................................... 130 
2.9.4  Stock of a consolidated subsidiary that includes redemption rights .................... 130 
2.10  Box I(C) and Boxes I1, I2 and I3 — Evaluating other potential embedded features ........... 131 
2.10.1  Exchange features ........................................................................................... 131 
2.10.2  Rights offering features.................................................................................... 131 
2.10.3  Indexed dividends ............................................................................................ 132 
2.10.4  Shareholders’ rights plans (Poison pills) ............................................................ 132 
2.11  Box J — Bifurcation of a single embedded derivative .................................................... 133 
2.11.1  Option-based embedded derivatives ................................................................. 133 
2.11.2  Forward-based embedded derivatives ............................................................... 133 
2.11.3  Financial statement classification ..................................................................... 133 
2.12  Boxes K and L — Non-bifurcated features including conversion options and 
redemption features.................................................................................................. 133 
2.13  Boxes M, N and O — Beneficial conversion features and contingent 
beneficial conversion features ................................................................................... 134 
2.14  Box P — Temporary equity classification ..................................................................... 135 
3  Share issuance costs .......................................................................................................... 135 
4  Selected guidance on subsequent accounting and measurement .......................................... 136 
4.1  General .................................................................................................................... 136 
4.2  Stock that is classified as a liability due to the provisions of ASC 480 ........................... 136 
4.3  Stock that is classified in equity .................................................................................. 136 
4.3.1  Premiums, discounts and issuance costs ........................................................... 137 
4.3.2  Embedded features not bifurcated from an equity host instrument .................... 137 
4.3.2.1  Embedded features reassessment............................................................ 138 

Contents 
Financial reporting developments Issuer’s accounting for debt and equity financings  |  vii 
4.3.2.2  Subsequent bifurcation............................................................................ 139 
4.3.3  Embedded features bifurcated from an equity host instrument as a 
derivative and classified as an asset or liability .................................................. 139 
4.3.4  Beneficial conversion features .......................................................................... 139 
4.3.5  Stock that is classified in permanent equity ....................................................... 140 
4.3.6  Stock that is classified in temporary equity........................................................ 140 
4.3.7  Stock classified in equity (temporary or permanent) that becomes 
mandatorily redeemable subsequent to issuance ............................................... 140 
4.4  Capital restructuring ................................................................................................. 141 
4.5  Accounting for dividends ........................................................................................... 141 
4.5.1  Cash dividends ................................................................................................. 143 
4.5.2  Noncash dividends ........................................................................................... 143 
4.5.3  Liquidating dividends ....................................................................................... 143 
4.5.4  Stock dividends ................................................................................................ 143 
4.5.5  Dividends on stock instruments classified as a liability ....................................... 144 
4.5.6  Dividends on stock classified in temporary equity .............................................. 144 
4.5.7  Fixed-rate dividends ......................................................................................... 144 
4.5.8  Variable-rate dividends..................................................................................... 145 
4.5.9  Increasing or decreasing rate preferred stock ................................................... 145 
4.5.10  Paid-in-kind dividends ....................................................................................... 147 
4.5.11  Participating dividends ..................................................................................... 148 
5  Share repurchase and conversions ..................................................................................... 148 
5.1  Repurchase of stock .................................................................................................. 148 
5.1.1  Treasury shares ............................................................................................... 149 
5.1.1.1  Common stock purchased above fair value ............................................... 150 
5.1.1.2  Shares escrowed in connection with an IPO .............................................. 151 
5.1.1.3  Excise tax on stock repurchases (added August 2023) .............................. 151 
5.1.2  Redemption of preferred stock ......................................................................... 151 
5.1.2.1  Extinguishment of preferred stock with a beneficial conversion feature ..... 152 
5.1.3  Repurchase of redeemable shares issued by a subsidiary ................................... 152 
5.1.4  Purchases of parent’s stock by a subsidiary ....................................................... 153 
5.2  Conversion of convertible stock instruments .............................................................. 153 
5.2.1  Conversion pursuant to the original terms without a beneficial 
conversion feature ........................................................................................... 153 
5.2.2  Conversion pursuant to the original terms with a beneficial conversion feature .. 153 
5.2.3  Induced conversions of convertible stock .......................................................... 153 
6  Modifications or exchanges of stock instruments ................................................................. 154 
6.1  Modifications or exchanges of common stock instruments .......................................... 154 
6.2  Modifications or exchanges of preferred stock instruments ......................................... 154 
6.2.1  Determining whether an amendment of an equity-classified preferred 
share is an extinguishment or modification ....................................................... 155 
6.2.1.1  Amendments to equity-classified preferred stock instruments 
due to reference rate transition (added September 2022) ........................ 156 
6.2.2  Accounting for modifications of equity-classified preferred shares that 
are not extinguishments ..................................................................................... 157 
6.2.3  Liability-classified preferred shares that are modified ........................................ 158 
7  Financial presentation and disclosure .................................................................................. 158 

Contents 
Financial reporting developments Issuer’s accounting for debt and equity financings  |  viii 
Equity contracts .................................................................................................... 160 
1  Overview and general description of equity contracts .......................................................... 160 
1.1  Common types of equity contracts ............................................................................. 160 
1.1.1  Equity option ................................................................................................... 160 
1.1.2  Equity forward ................................................................................................. 162 
1.1.3  Variable share forward ..................................................................................... 163 
1.1.4  Prepaid forward purchase ................................................................................ 163 
1.1.5  Accelerated share repurchase .......................................................................... 163 
1.1.6  Equity collar ..................................................................................................... 163 
1.1.7  Call spread transaction ..................................................................................... 164 
1.1.8  Prepaid written put option ................................................................................ 164 
1.1.9  Puttable warrant .............................................................................................. 165 
1.1.10  Tranched preferred share financing .................................................................. 165 
1.1.11  Contracts settled in the stock of a consolidated subsidiary ................................. 165 
1.1.12  Share lending arrangement .............................................................................. 165 
1.1.13  Unit structures ................................................................................................. 165 
2  Issuer’s initial accounting for freestanding equity contracts (including flowchart) .................. 166 
2.1  Box A — Equity contracts within the scope of ASC 480 ................................................ 166 
2.1.1  Equity contracts with more than one component ............................................... 168 
2.1.1.1  Component requires or may require transfer of assets 
(ASC 480-10-25-8 through 25-13) .......................................................... 169 
2.1.1.2  Component requires delivery of a variable number of shares 
(ASC 480-10-25-14) ............................................................................... 169 
2.1.2  Puttable warrants and warrants on redeemable shares ...................................... 170 
2.1.3  Forward purchase contract............................................................................... 170 
2.1.4  Variable share forward ..................................................................................... 170 
2.1.5  Range forward ................................................................................................. 171 
2.2  Box B — Equity contracts indexed to the issuer’s own stock .......................................... 172 
2.2.1  Adjustments affecting an equity contract’s settlement amount, 
including antidilution and down round provisions ............................................... 173 
2.2.2  Equity contracts executed in ISDA forms ........................................................... 174 
2.3  Box C — Equity contracts and the definition of a derivative ........................................... 175 
2.4  Box D — Equity contracts not indexed to the issuer’s own stock and not 
meeting the definition of a derivative ......................................................................... 175 
2.5  Box E — Equity contracts classified in equity ................................................................ 176 
2.5.1  Equity contracts executed in ISDA forms ........................................................... 177 
2.5.2  Equity contracts issued in registered form ........................................................ 177 
2.5.2.1  Meeting the settlement in unregistered shares criterion for 
registered warrants ................................................................................. 178 
2.5.3  Warrants issued in a PIPE transaction ............................................................... 179 
2.6  Boxes F and G — Equity contracts not meeting equity classification guidance ................ 180 
3  Issuance costs ................................................................................................................... 180 
4  Subsequent accounting and measurement .......................................................................... 180 
4.1  Equity contracts subject to ASC 480 liability classification ........................................... 181 
4.1.1  Measurement of a physically settled forward contract ....................................... 181 
4.2  Equity contracts classified as equity pursuant to ASC 815-40 ...................................... 181 

Contents 
Financial reporting developments Issuer’s accounting for debt and equity financings  |  ix 
4.3  Equity contracts that meet the definition of a derivative and do not 
receive an exception from derivative accounting and equity contracts 
indexed to the issuer’s shares but failing the equity classification guidance................... 182 
4.4  Equity contracts that are not derivatives and also not indexed to the 
entity’s own shares ................................................................................................... 182 
4.5  Reclassification of equity contracts ............................................................................ 182 
4.6  Modification of equity contracts ................................................................................. 183 
4.6.1  Modification of equity-classified contracts ......................................................... 183 
4.6.1.1  Modification or exchange of certain equity-classified written call 
options (after the adoption of ASU 2021-04) (added September 2022) .... 183 
4.6.2  Modification of equity contracts classified as assets or liabilities ........................ 184 
4.6.3  Modification of equity contracts resulting in a reclassification ............................ 184 
5  Settlement/termination...................................................................................................... 185 
Selected transactions ............................................................................................ 186 
1  Debt (or preferred share) exchangeable into common stock of another issuer ....................... 186 
1.1  Overview and background ......................................................................................... 186 
1.2  Analysis .................................................................................................................... 187 
1.2.1  At issuance ...................................................................................................... 187 
1.2.2  Subsequent accounting .................................................................................... 188 
1.2.2.1  Exchangeable debt .................................................................................. 188 
1.2.2.2  Bifurcated derivative ............................................................................... 188 
1.2.2.3  Investment in MNO .................................................................................. 188 
1.2.3  At maturity ...................................................................................................... 189 
1.3  Exchangeable preferred shares .................................................................................. 189 
2  Unit structures (updated September 2022) ......................................................................... 189 
2.1  Overview and background ......................................................................................... 189 
2.1.1  Unit structure — Debt instrument ...................................................................... 190 
2.1.1.1  Analysis .................................................................................................. 190 
2.1.2  Unit structure — Convertible preferred stock ..................................................... 192 
2.1.2.1  Analysis .................................................................................................. 193 
3  Auction rate securities (including failed reset auctions) ........................................................ 195 
3.1  Overview and background ......................................................................................... 195 
3.2  Analysis .................................................................................................................... 196 
3.2.1  Entities sponsoring trusts or SPEs issuing ARSs ................................................ 196 
3.2.2  Considerations when auction fails ..................................................................... 196 
3.2.2.1  Penalty interest ....................................................................................... 196 
3.2.2.2  Extinguishing or modifying ARSs .............................................................. 197 
3.2.2.3  Balance sheet classification ..................................................................... 197 
3.2.2.4  Bidding on borrower’s own ARSs .............................................................. 198 
4  Remarketable put bonds .................................................................................................... 198 
4.1  Overview and background ......................................................................................... 198 
4.2  Analysis .................................................................................................................... 199 
5  Share lending arrangements............................................................................................... 201 
5.1  Overview and background ......................................................................................... 201 
5.2  Analysis .................................................................................................................... 201 
5.2.1  Scope .............................................................................................................. 201 
5.2.2  Classification of share lending arrangements as equity ...................................... 202 

Contents 
Financial reporting developments Issuer’s accounting for debt and equity financings  |  x 
5.2.3  Initial measurement ......................................................................................... 202 
5.2.4  Accounting for counterparty default ................................................................. 203 
5.2.5  Earnings per share ........................................................................................... 203 
5.2.6  Disclosures ...................................................................................................... 203 
6  Trust preferred securities ................................................................................................... 203 
6.1  Overview and background ......................................................................................... 203 
6.2  Analysis .................................................................................................................... 204 
7  Warrants for redeemable shares ......................................................................................... 204 
7.1  Overview and background ......................................................................................... 204 
7.2  Analysis .................................................................................................................... 205 
7.2.1  Applicable guidance ......................................................................................... 205 
7.2.2  What makes a share ‘redeemable’ ..................................................................... 206 
7.2.2.1  Mandatorily redeemable securities ........................................................... 207 
7.2.2.2  Contingently redeemable securities ......................................................... 207 
8  Tranched preferred share issuances ................................................................................... 208 
8.1  Overview and background ......................................................................................... 208 
8.2  Analysis .................................................................................................................... 208 
8.2.1  Freestanding or embedded ............................................................................... 209 
8.2.2  Accounting for a freestanding future tranche right or obligation ........................ 210 
8.2.3  Accounting for an embedded future tranche right or obligation ......................... 211 
9  Accelerated share repurchase transactions ......................................................................... 212 
9.1  Overview and background ......................................................................................... 212 
9.2  Analysis .................................................................................................................... 214 
9.2.1  ASC 480 considerations ................................................................................... 215 
9.2.2  Contracts in an entity’s own equity (ASC 815-40) ............................................. 215 
9.2.3  Effects on EPS as a potential participating security under ASC 260 .................... 216 
9.2.4  Illustration (added September 2022) ................................................................ 217 
9.3  Collared ASRs ........................................................................................................... 218 
9.3.1  Accounting for collared ASRs ........................................................................... 219 
10   Equity contracts on noncontrolling interests ........................................................................ 221 
10.1  Overview and background ......................................................................................... 221 
10.2  Analysis .................................................................................................................... 222 
10.2.1  Road map for initial classification of equity contracts over NCI ........................... 223 
10.2.2  Is the equity contract embedded in the NCI or freestanding? ............................. 224 
10.2.2.1  Equity contracts considered embedded .................................................... 225 
10.2.2.2  Equity contracts considered freestanding ................................................. 226 
10.2.3  Equity contracts deemed to be financing arrangements ..................................... 226 
10.2.4  Application of the redeemable equity guidance ................................................. 227 
10.2.4.1  Measurement and reporting issues related to redeemable 
equity securities (updated September 2022) ............................................ 227 
10.2.5  Earnings per share considerations .................................................................... 231 
10.2.6  Examples of the presentation of NCI with equity contracts issued 
on those interests ............................................................................................ 232 
10.2.7  Redeemable or convertible equity securities and UPREIT structures .................. 237 
10.2.8  Redeemable NCI denominated in a foreign currency .......................................... 238 
10.2.9  Illustrative examples of equity contracts on NCI ................................................ 238 

Contents 
Financial reporting developments Issuer’s accounting for debt and equity financings  |  xi 
11  Registration rights agreements........................................................................................... 245 
11.1  Overview and background ......................................................................................... 245 
11.2   Analysis .................................................................................................................... 246 
12  Overallotment provisions (or ‘greenshoes’) ......................................................................... 247 
12.1  Overview and background ......................................................................................... 247 
12.2  Analysis .................................................................................................................... 248 
12.2.1  Freestanding or embedded ............................................................................... 248 
12.2.2  Evaluating greenshoes as ASC 480 liabilities ..................................................... 249 
12.2.3  Evaluating greenshoes as derivatives ................................................................ 249 
12.2.4  Exceptions available for greenshoes meeting the definition of a derivative ......... 250 
12.2.5  Accounting for greenshoes determined to be derivatives ................................... 250 
12.2.6  Application of the SEC staff’s longstanding view on written options .................... 251 
13  Pre-funded (‘penny’) warrants (added September 2022) ...................................................... 251 
14  Preferred equity certificates, convertible preferred equity certificates .................................. 252 
15  Liabilities with an inseparable third-party credit enhancement .............................................. 252 
15.1  Overview and background ......................................................................................... 252 
15.2  Analysis .................................................................................................................... 252 
15.2.1  Scope .............................................................................................................. 252 
15.2.2  Measuring liabilities with third-party credit enhancement................................... 253 
16  Convertible debt with call spread ........................................................................................ 256 
16.1  Overview and background ......................................................................................... 256 
16.2  Analysis .................................................................................................................... 256 
16.2.1  Unit of account ................................................................................................ 256 
16.2.2  Classification ................................................................................................... 257 
16.2.3  Allocation of proceeds ...................................................................................... 258 
17  Prepaid written put option .................................................................................................. 259 
17.1  Overview and background ......................................................................................... 259 
17.2  Analysis .................................................................................................................... 260 
17.2.1  ASC 480 considerations ................................................................................... 261 
17.2.2  Definition of a derivative .................................................................................. 261 
17.2.3  Classification of the hybrid instrument .............................................................. 262 
18  Advanced bond refunding .................................................................................................. 262 
18.1  Overview and background ......................................................................................... 262 
18.2  Analysis .................................................................................................................... 263 
18.2.1   Legal defeasance of the issuer .......................................................................... 263 
18.2.2   Transfer of cash to the trust ............................................................................. 263 
19  Classification and disclosure of certain trade accounts payable transactions 
involving an intermediary (updated August 2023) ............................................................... 264 
19.1  Overview and background ......................................................................................... 264 
19.2  Analysis .................................................................................................................... 264 
19.2.1  Balance sheet classification (updated August 2023) .......................................... 264 
19.2.2  Statement of cash flow presentation ................................................................. 269 
19.2.3  Disclosure considerations ................................................................................. 269 
19.2.3.1  Disclosure about supplier finance program obligations (after 
the adoption of ASU 2022-04) (added August 2023) ................................ 269 
19.2.3.1.1  Overview ........................................................................................ 269 
19.2.3.1.2  Scope ............................................................................................. 270 

Contents 
Financial reporting developments Issuer’s accounting for debt and equity financings  |  xii 
5.19.2.3.1.3  Disclosures ..................................................................................... 270 
5.19.2.3.1.4  Effective date and transition ........................................................... 271 
5.19.2.3.2  SEC staff disclosure guidance on supplier finance programs ...................... 271 
5.19.3  Purchasing cards ...................................................................................................... 271 
5.20  Joint and several liabilities.................................................................................................. 272 
5.20.1  Overview and background ......................................................................................... 272 
5.20.2  Scope ....................................................................................................................... 272 
5.20.3  Recognition and measurement .................................................................................. 272 
5.20.4  Disclosures ............................................................................................................... 273 
5.21  Breakage for certain prepaid stored-value products ............................................................. 274 
5.21.1  Recognition and measurement .................................................................................. 274 
5.21.2  Disclosures ............................................................................................................... 275 
5.22  Credit facilities issued with warrants ................................................................................... 275 
5.22.1   Overview and background ......................................................................................... 275 
5.22.2   Analysis .................................................................................................................... 276 
5.22.2.1   Identify the freestanding financial instruments (step 1) ..................................... 277 
5.22.2.2   Analyze each freestanding financial instrument (step 2) .................................... 278 
5.22.2.2.1   FCA considered embedded ...................................................................... 279 
5.22.2.2.2   FCA considered freestanding ................................................................... 281 
5.22.2.2.3   FCA considered a loan commitment ......................................................... 281 
5.23  Bridge loans ...................................................................................................................... 282 
5.23.1   Overview and background ......................................................................................... 282 
5.23.1.1   Variable-share settlement ................................................................................ 282 
5.23.1.2   Additional settlement features.......................................................................... 283 
5.23.2   Analysis .................................................................................................................... 284 
5.23.2.1  ASC 480 considerations ................................................................................... 285 
5.23.2.2  Embedded derivatives ...................................................................................... 285 
5.23.2.2.1  Variable-share settlement features .......................................................... 285 
5.23.2.2.2  Fixed-share conversion features .............................................................. 286 
5.23.2.2.3  Combination of variable-share and fixed-share settlement features ........... 287 
Appendices 
A  Distinguishing liabilities from equity ......................................................................... A-1 
A.1  Summary and overview ....................................................................................................... A-1 
A.2  Background and prior accounting ........................................................................................ A-1 
A.3  Scope of ASC 480 ............................................................................................................... A-3 
A.3.1  Obligations ................................................................................................................ A-5 
A.3.2  Freestanding financial instruments ............................................................................. A-6 
A.3.2.1  Identifying ‘nonsubstantive or minimal’ features ................................................. A-6 
A.3.2.2  Determining whether an instrument is freestanding ........................................... A-6 
A.3.3  Definition of issuer’s shares (including shares of subsidiaries) ....................................... A-7 
A.3.4  Prohibition against combining separate contracts ........................................................ A-8 
A.3.5  Instruments not within the scope of certain classification, measurement 
and disclosure provisions ............................................................................................ A-9 
A.3.5.1  Scope exception for certain mandatorily redeemable shares of 
nonpublic companies .......................................................................................A-11 
A.3.5.2  Scope exception for certain mandatorily redeemable 
noncontrolling interests ..................................................................................A-12 

Contents 
Financial reporting developments Issuer’s accounting for debt and equity financings  |  xiii 
A.3.6  Contingent consideration in a business combination................................................... A-12 
A.3.7  Share-based compensation ....................................................................................... A-13 
A.4  Mandatorily redeemable financial instruments — recognition and measurement ................... A-14 
A.4.1  General applicability ................................................................................................. A-15 
A.4.1.1  Contingently or optionally redeemable shares ..................................................A-16 
A.4.1.2  Contingently redeemable shares that become mandatorily redeemable ............A-17 
A.4.1.3  Non-substantive or minimal features in otherwise mandatorily 
redeemable instruments ..................................................................................A-17 
A.4.2  Recognition and measurement ................................................................................. A-18 
A.4.2.1  Accounting for costs to issue mandatorily redeemable shares ..........................A-19 
A.4.2.2  Accounting for modifications or exchanges of mandatorily 
redeemable shares ..........................................................................................A-19 
A.5  Obligations to repurchase an entity’s own shares by transferring assets — 
recognition and measurement ........................................................................................... A-19 
A.5.1  General applicability ................................................................................................. A-22 
A.5.1.1  Freestanding financial instruments composed of more than one option 
or forward contract embodying obligations to transfer assets ...........................A-22 
A.5.1.2  Freestanding warrants and other similar instruments on shares 
that are redeemable ........................................................................................A-23 
A.5.2  Recognition and measurement ................................................................................. A-23 
A.5.2.1  Physically settled forward contracts to purchase shares ...................................A-23 
A.5.2.1.1  Forward contracts on noncontrolling interest ..........................................A-24 
A.5.2.2  Other contracts embodying obligations to repurchase an entity’s own shares ....A-25 
A.5.2.3  Reassessment of contracts ..............................................................................A-25 
A.6  Certain share-settled obligations — recognition and measurement ....................................... A-26 
A.6.1  General applicability ................................................................................................. A-27 
A.6.1.1  Monetary value does not change .....................................................................A-27 
A.6.1.2  Monetary value is based on something other than the issuer’s equity shares ......A-28 
A.6.1.3  Monetary value moves in the opposite direction as value of the issuer’s shares ...A-29 
A.6.1.4  Freestanding instruments with more than one option or forward 
contract embodying an obligation ....................................................................A-29 
A.6.1.5  Determining predominance .............................................................................A-30 
A.6.2  Recognition and measurement ................................................................................. A-31 
A.6.2.1  Share-settled debt ..........................................................................................A-31 
A.6.2.2  Other share-settled obligations ........................................................................A-31 
A.7  Presentation, earnings per share and disclosure ................................................................. A-31 
A.7.1  Presentation ............................................................................................................ A-31 
A.7.2  Earnings per share (for mandatorily redeemable instruments and 
physically settled forward purchase contracts) .......................................................... A-33 
A.7.3  Disclosures .............................................................................................................. A-34 
A.8  Frequently asked questions ............................................................................................... A-35 
A.9  Summary of application of ASC 480 to specific instruments ................................................ A-56 
B  Contracts in an entity’s own equity .......................................................................... B-1 
B.1  Summary and overview ....................................................................................................... B-1 
B.1.1  Overall process for considering ASC 815-40 ................................................................ B-1 
B.1.2  Overview of ASC 815-40 ............................................................................................ B-2 
B.2  Scope of ASC 815-40 ......................................................................................................... B-3 

Contents 
Financial reporting developments Issuer’s accounting for debt and equity financings  |  xiv 
B.3  The indexation guidance (ASC 815-40-15) ........................................................................... B-7 
B.3.1  Introduction ............................................................................................................... B-7 
B.3.2  Step 1 — Evaluating exercise contingencies .................................................................. B-7 
B.3.3  Step 2 — Evaluating the settlement amount ................................................................. B-9 
B.3.3.1  Fixed strike price, number of shares and fixed monetary amount ...................... B-10 
B.3.3.2  Adjustments solely based on non-levered inputs to a fixed-for-fixed instrument .. B-11 
B.3.3.3  Application of Step 2 to an instrument denominated in a foreign currency .......... B-14 
B.3.3.4  Application of Step 2 when payoff is based on stock of consolidated subsidiary .. B-15 
B.3.3.5  Application of the indexation guidance to contracts that do not 
meet the definition of a derivative ................................................................... B-16 
B.3.3.6  Interaction of the indexation guidance with other authoritative guidance .......... B-16 
B.3.4  Illustrative examples of the indexation guidance ........................................................ B-16 
B.3.4.1  Application of Step 2 to instruments with down round features ......................... B-25 
B.4  The equity classification guidance (ASC 815-40-25) ........................................................... B-28 
B.4.1  Introduction ............................................................................................................. B-28 
B.4.2  Evaluation of the basic settlement features within a contract ..................................... B-29 
B.4.3  Evaluation of any additional provisions that could require net cash settlement ............ B-31 
B.4.4  Additional considerations necessary for equity classification ...................................... B-33 
B.4.4.1  Settlement permitted in unregistered shares .................................................... B-34 
B.4.4.2  Entity has sufficient authorized and unissued shares ........................................ B-37 
B.4.4.3  Contract contains an explicit share limit ........................................................... B-39 
B.4.4.3.1   Multiple share limits................................................................................ B-41 
B.4.4.4  No required cash payment if entity fails to file timely ........................................ B-41 
B.4.4.5  No cash-settled ‘top-off’ or ‘make-whole’ provisions ......................................... B-42 
B.4.4.6  No counterparty rights rank higher than shareholder rights .............................. B-43 
B.4.4.7  No collateral required ...................................................................................... B-44 
B.5  Initial measurement, subsequent balance sheet classification and measurement, 
and derecognition ............................................................................................................. B-44 
B.6  Reclassification of contracts .............................................................................................. B-48 
B.6.1  Allocation of shares to contracts for reclassification ................................................... B-49 
B.6.2  Partial reclassification .............................................................................................. B-49 
B.7  Illustrations ...................................................................................................................... B-51 
B.8  Disclosures for contracts in an entity’s own equity .............................................................. B-54 
B.9  Frequently asked questions ............................................................................................... B-55 
C  Accounting for cash convertible instruments ............................................................ C-1 
C.1  Summary and overview ....................................................................................................... C-1 
C.2  Background and scope ........................................................................................................ C-1 
C.2.1  Scope of the cash conversion guidance for instruments that are settled in 
shares on redemption ................................................................................................. C-4 
C.3  Accounting model ............................................................................................................... C-4 
C.3.1  Recognition ............................................................................................................... C-4 
C.3.2  Initial measurement ................................................................................................... C-5 
C.3.2.1  Estimating the fair value of the liability component ............................................. C-8 
C.3.2.2  The nonconvertible debt borrowing rate ............................................................ C-9 
C.3.2.3  Expected life ..................................................................................................... C-9 
C.3.3  Transaction costs ..................................................................................................... C-10 
C.3.4  Subsequent measurement ........................................................................................ C-10 

Contents 
Financial reporting developments Issuer’s accounting for debt and equity financings  |  xv 
C.3.5  Derecognition .......................................................................................................... C-12 
C.3.6  Modifications and exchanges .................................................................................... C-13 
C.3.7  Induced conversions ................................................................................................. C-15 
C.3.8  Deferred taxes ......................................................................................................... C-16 
C.4  Presentation, disclosure and earnings per share ................................................................. C-16 
C.4.1  Presentation ............................................................................................................ C-18 
C.4.2  Disclosures .............................................................................................................. C-18 
C.4.3  Earnings per share ................................................................................................... C-19 
C.5  Frequently asked questions ............................................................................................... C-19 
D  Beneficial conversion features ................................................................................. D-1 
D.1  Summary and overview ....................................................................................................... D-1 
D.2  Scope ................................................................................................................................. D-1 
D.3  Recognition and initial measurement ................................................................................... D-4 
D.3.1  Beneficial conversion feature that is accounted for at inception .................................... D-4 
D.3.1.1  Commitment date ............................................................................................. D-7 
D.3.1.2  Determination of the effective conversion price ................................................. D-7 
D.3.1.3  Fair value considerations in calculating the intrinsic value of a BCF ..................... D-8 
D.3.1.4  Income tax consequences .................................................................................. D-9 
D.3.2  Contingent beneficial conversion features (including conversion options 
with variable prices and contingencies) ....................................................................... D-9 
D.3.2.1  Contingent conversion options that reduce or reset the conversion 
price, or where the option does not permit the issuer to compute 
the number of shares to be issued ................................................................... D-12 
D.3.2.2  Contingent conversion options that were initially out of the money ................... D-12 
D.3.2.3  Conversion options with continuous resets....................................................... D-13 
D.3.2.4  Instruments involving a multiple-step discount ................................................. D-14 
D.3.2.5  Interaction of contingent BCFs with the indexation guidance in ASC 815-40 ..... D-14 
D.3.3  Other recognition and initial measurement matters.................................................... D-15 
D.3.3.1  Paid-in-kind interest or dividends ..................................................................... D-15 
D.3.3.2  Issuance of convertible instruments in satisfaction of 
nonconvertible instruments ............................................................................. D-16 
D.3.3.3  Beneficial conversion features in convertible instruments issued in 
exchange for goods and/or services ................................................................. D-17 
D.3.3.4  Issuance of warrants exercisable into convertible instruments .......................... D-18 
D.3.3.4.1  Equity-classified warrant ........................................................................ D-19 
D.3.3.4.2  Liability-classified warrant ...................................................................... D-20 
D.3.3.5  Measurement of a BCF in convertible instruments convertible into 
common stock and other equity instruments deliverable upon conversion ......... D-20 
D.4  Subsequent measurement ................................................................................................. D-21 
D.4.1  Accretion and amortization of discount resulting from BCF ........................................ D-21 
D.4.1.1  Contingent beneficial conversion features ........................................................ D-22 
D.4.1.2  Accretion of instruments involving a multiple-step discount .............................. D-23 
D.4.1.3  Instruments that become mandatorily redeemable at a premium 
upon termination of the conversion feature ..................................................... D-23 
D.5  Derecognition ................................................................................................................... D-24 
D.5.1  Conversions ............................................................................................................. D-24 

Contents 
Financial reporting developments Issuer’s accounting for debt and equity financings  |  xvi 
D.5.2  Extinguishments ...................................................................................................... D-24 
D.5.2.1  Extinguishments of convertible debt ................................................................ D-25 
D.5.2.2  Extinguishments of preferred shares ............................................................... D-25 
D.5.3  Modifications or exchanges of convertible debt instruments ....................................... D-26 
D.6  Presentation and disclosure .............................................................................................. D-27 
D.6.1  Balance sheet .......................................................................................................... D-27 
D.6.2  Disclosures .............................................................................................................. D-27 
D.7  Frequently asked questions ............................................................................................... D-27 
E  SEC guidance on redeemable equity instruments ...................................................... E-1 
E.1   Summary and overview ....................................................................................................... E-1 
E.2   Scope ................................................................................................................................. E-2 
E.2.1  Applicability to public companies ................................................................................. E-2 
E.2.2  Items within the scope of ASC 480-10-S99 ................................................................. E-3 
E.2.3  Noncontrolling interests ............................................................................................. E-3 
E.2.4  Equity-classified instruments potentially settleable in shares ........................................ E-3 
E.2.4.1  Conversion features in preferred stock .............................................................. E-3 
E.2.5   Freestanding financial instruments classified as assets or liabilities ............................... E-4 
E.2.6   Freestanding derivatives and hybrid instruments classified in stockholders’ equity .............. E-5 
E.2.7  Equity instruments subject to registration payment arrangements................................ E-6 
E.2.8  Share-based payment awards ..................................................................................... E-6 
E.2.9   Convertible debt instruments that contain a separately classified equity component ...... E-7 
E.2.10   Consideration of ‘deemed liquidation’ provisions .......................................................... E-8 
E.2.11   Redemptions covered by insurance proceeds .............................................................. E-9 
E.2.12  Redemptions limited to proceeds from sale of equity and exchanged for a 
permanent equity security .......................................................................................... E-9 
E.2.13  Certain equity securities held by an ESOP .................................................................... E-9 
E.3   Classification .................................................................................................................... E-10 
E.3.1   Convertible debt instruments that contain a separately classified equity component .... E-11 
E.3.2  Noncontrolling interests ........................................................................................... E-12 
E.4   Measurement ................................................................................................................... E-13 
E.4.1  General ................................................................................................................... E-13 
E.4.1.1  Initial measurement ........................................................................................ E-14 
E.4.1.2  Subsequent measurement ............................................................................... E-15 
E.4.1.2.1  Securities that are currently redeemable ................................................. E-15 
E.4.1.2.2  Securities that are not currently redeemable but probable of 
becoming redeemable in the future .......................................................... E-15 
E.4.1.2.2.1  Events that prevent an instrument from becoming redeemable ....... E-16 
E.4.1.2.2.2  Securities that are redeemable upon a majority vote by 
shareholders ................................................................................. E-16 
E.4.1.2.2.3  Securities with multiple redemption features 
(added August 2023)..................................................................... E-16 
E.4.1.2.2.4  Redeemable host equity contract with bifurcated derivatives 
(added August 2023)..................................................................... E-17 
E.4.1.2.2.5  Securities that are redeemable by the issuer and the holder 
(added August 2023)..................................................................... E-18 
E.4.1.2.3  Securities that are not currently redeemable and not 
probable of becoming redeemable in the future ....................................... E-18 

Contents 
Financial reporting developments Issuer’s accounting for debt and equity financings  |  xvii 
E.4.1.2.4  Assessing whether an instrument is ‘probable of becoming redeemable’... E-18 
E.4.1.2.5  Accounting for the adjustments to temporary equity ............................... E-18 
E.4.2  Noncontrolling interests ........................................................................................... E-19 
E.4.3  Convertible debt instruments that contain a separately classified equity component ............ E-20 
E.4.4  Share-based payments and employee stock ownership plans ...................................... E-21 
E.4.5  Reclassifications between temporary equity and permanent equity ............................ E-22 
E.5   Earnings per share ............................................................................................................ E-23 
E.5.1  Preferred securities issued by a parent (or a single reporting entity) ........................... E-25 
E.5.2  Common securities issued by a parent (or a single reporting entity) ............................ E-25 
E.5.3  Noncontrolling interests issued in the form of preferred securities .............................. E-26 
E.5.4  Noncontrolling interests issued in the form of common securities ............................... E-26 
E.6   Disclosures ....................................................................................................................... E-27 
E.7   Frequently asked questions ............................................................................................... E-28 
F  Summary of important changes ............................................................................... F-1 
G  Glossary ................................................................................................................. G-1 
H  Abbreviations used in this publication ...................................................................... H-1 
I  Index of ASC references in this publication ................................................................ I-1 
 

Contents

Financial reporting developments Issuer’s accounting for debt and equity financings | xviii

Notice to readers:

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Financial reporting developments Issuer’s accounting for debt and equity financings | 1

1 Overview

1.1 Debt and equity financings

Companies raise capital by issuing debt and equity instruments, which can take many forms. Frequently,

companies offer several debt and equity instruments in a single transaction, which may include additional

elements, such as warrants or conversion features, to meet investors’ demands. Most of those transactions

are designed with a focus on tax, EPS and other financing and financial reporting considerations.

The combination of instruments and features increases the complexity of the accounting analysis both at

issuance and on an ongoing basis.

1.2 Accounting considerations

An issuer’s accounting for debt and equity depends on the instruments issued. For an option or forward on the

issuer’s own shares (generally referred to in this publication as “equity contracts”), the analysis focuses on

whether the equity contract should be classified as an asset or liability, which is generally adjusted to fair value

through earnings each reporting period, or as equity, which is not subsequently remeasured. In contrast, the

analysis for shares or debt requires consideration of whether the instrument contains embedded features

(e.g., puts, calls, conversion options) that may require separate accounting. In addition, despite their form,

shares may need to be classified as a liability or under SEC rules as temporary (mezzanine) equity. If the

securities issued are convertible into common stock, the issuer is required to evaluate whether a portion of the

issuance proceeds should be allocated to a separate component in equity.

To evaluate the accounting considerations, issuers may want to consider the following questions:

• Which instruments are being issued?

• Are there any rights or obligations that should be considered a freestanding financial instrument?

• Should the instrument(s) issued be classified as an asset or liability or in equity?

• Should the entire instrument, or part of the instrument, be carried at fair value through earnings?

• Are there embedded features, such as conversion, put or call options, that require separate accounting?

• What are the accounting considerations if the instrument is convertible into the entity’s own

common stock?

• How does the SEC staff’s guidance on redeemable securities affect the instrument’s classification?

Notably, only rights and obligations that are contractually binding may require accounting recognition.

For example, a forward contract that allows both the issuer and the investor to terminate the arrangement

without any penalty or recourse to recover damages would not be a binding contract that requires

accounting recognition. Consultation with legal counsel is often necessary to determine whether an

arrangement is contractually binding.

This section provides a high-level summary of the key accounting considerations for debt and equity

transactions, including general overview of the guidance.

1 Overview

Financial reporting developments Issuer’s accounting for debt and equity financings | 2

1.2.1 Identifying all freestanding financial instruments

When companies issue multiple instruments to the same counterparty in a single transaction (e.g., debt

and warrants), it isn’t always clear what is a freestanding instrument (e.g., detachable warrant) and what

is an embedded feature (e.g., a conversion option). In addition, a freestanding instrument may be evaluated

differently than an embedded feature with the same economics (such as a written put option). Moreover,

US GAAP may dictate the accounting for the feature, regardless of where it is documented (such as

certain registration rights in connection with a convertible instrument issuance).

The first step in evaluating the accounting for debt and equity instruments is to identify all freestanding

financial instruments. Freestanding instruments should first be separately analyzed and accounted for,

and then evaluated to determine whether embedded features, if any, within those instruments should be

bifurcated or accounted for separately.

ASC 480 defines a freestanding financial instrument as a financial instrument that is entered into

(1) separately and apart from any of the entity’s other financial instruments or equity transactions or

(2) in conjunction with some other transaction and is legally detachable and separately exercisable. In

contrast, ASC 815 defines embedded derivatives as implicit or explicit terms that affect some or all of

the cash flows or the value of other exchanges required by the instrument in a manner similar to a

derivative instrument.

The determination of whether an instrument is freestanding or embedded in another instrument involves

understanding both the form and substance of the transaction and may involve substantial judgment.

For example, a single legal agreement may consist of multiple instruments, such as preferred stock with

tranche rights. If a party to a contract is able to separately transfer each instrument within the contract to

a third party, that instrument is generally considered legally detachable. However, if an instrument can be

separately transferred only with the consent of the counterparty, further analysis should be performed.

We generally view an instrument as not legally detachable if the contractual terms require consent of all

parties. That is, no party has the unilateral right to separately transfer. However, the legal detachability

criteria may be met if the contract specifies that consent cannot be unreasonably withheld.

The specific document in which a term or feature is described is not determinative when evaluating

whether that term or feature is considered freestanding or embedded. Moreover, an instrument is not

necessarily freestanding just because it is documented in a separate contract. Similarly, rights and

obligations documented in a single agreement may be treated as separate freestanding instruments.

The accounting should generally follow the contractual terms, not the intent of the parties. In certain

cases, legal counsel may need to be engaged to interpret the contractual terms.

Factors to be considered in making this determination include whether:

• The instruments were issued separately or concurrently and in contemplation of each other.

• The rights, obligations or instruments can be separated, including consideration of any

transferability provisions or restrictions in the legal documents constituting the transaction.

• The exercise of one instrument results in the termination of the other instrument (e.g., through

redemption, simultaneous exercise or expiration).

1.2.1.1 Combining freestanding financial instruments

Issuers may find that, in certain circumstances, the economic substance of multiple freestanding financial

instruments may suggest that accounting for them on a combined basis is more appropriate.

1 Overview

Financial reporting developments Issuer’s accounting for debt and equity financings | 3

ASC 480 prohibits the combination of any freestanding financial instrument within its scope with any other

instruments unless required by ASC 815 (in which case they would become a derivative and generally would

be accounted for at fair value). The FASB prohibited combining an instrument within the scope of ASC 480

with any other instrument to avoid the inadvertent or planned circumvention of the requirements of

ASC 480. For example, combining an instrument that is otherwise a liability within the scope of ASC 480

(e.g., a written put) with another freestanding instrument (e.g., a share) might (1) cause a freestanding

instrument to be considered to be embedded in another instrument and therefore not within the scope of

ASC 480 (as that guidance applies only to freestanding instruments), (2) change the reported amount of

the liability or (3) change the required measurement method.

ASC 815 prohibits separating a single contract meeting the definition of a derivative into separate

components to circumvent the derivative guidance. Therefore, ASC 815-10-15-9 states that the

following indicators should be considered in the aggregate and, if present, cause separate transactions

to be viewed as a unit:

• The transactions were entered into contemporaneously and in contemplation of one another.

• The transactions were executed with the same counterparty (or structured through an intermediary).

• The transactions relate to the same risk.

• There is no apparent economic need or substantive business purpose for structuring the transactions

separately that could not also have been accomplished in a single transaction.

Illustration 1-1: Forward contracts with the same counterparty to purchase and sell shares

Entity A enters into a forward contract to purchase 1,000,000 shares of Entity B’s stock in six months

for $5 per share. Simultaneously, Entity A enters into a forward contract to sell 900,000 shares of

Entity B’s stock in six months for $5 per share. The purchase and sale contracts are both with Entity B.

There is no market mechanism to facilitate net settlement of the contracts and both contracts require

physical delivery of Entity B’s shares in exchange for the forward price. On a gross basis, neither

contract is readily convertible to cash because the market cannot rapidly absorb the specified quantities

without significantly affecting the share price (e.g., the trading volume for Entity B’s shares is currently

about 100,000 shares daily). However, on a net basis, Entity A has a forward purchase contract to

buy 100,000 of Entity B’s shares, a quantity that can be rapidly absorbed by the market and thus is

readily convertible to cash.

In this example, if the transactions were entered into with the same counterparty, executed

simultaneously, relate to the same risk and there is no clear business purpose for structuring the

transactions separately, the two forward contracts should be combined and accounted for as a

derivative because the structured transaction circumvents the application of derivative accounting

pursuant to ASC 815.

As a result of the FASB’s conclusion in ASC 480, the decision to combine two instruments that are issued

contemporaneously should be made under the following framework:

• Combine two instruments if required under ASC 815, then evaluate the combined instruments under

ASC 480 and ASC 815.

• If both (1) ASC 815 does not require the combination of the two instruments and (2) one of the

instruments is within the scope of ASC 480, do not combine the two instruments.

• If both (1) ASC 815 does not require the combination of the two instruments and (2) neither of the

instruments is within the scope of ASC 480, evaluate the instruments using the basic concepts

around combination.

1 Overview

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The basic concepts related to combination were discussed pre-Codification in Emerging Issues Task

Force (EITF) 02-2, When Certain Contracts That Meet the Definition of Financial Instruments Should Be

Combined for Accounting Purposes. That Issue provided considerations in determining whether separate

transactions should be combined for accounting purposes and were based on various models for

combining instruments, including the guidance in ASC 815-10-25-6. While those concepts were very

similar to those in ASC 815-10-25-6, the third criterion was modified somewhat to require not only that

the separate transactions or contracts being evaluated share at least one underlying, but also that

changes in that underlying (holding the prices of all other underlyings constant) result in at least one

substantially offsetting change in fair value for those transactions or contracts.

The EITF did not complete work on the issue, but the SEC staff observer did note that the SEC staff would

continue to challenge the accounting for transactions for which it appears that multiple contracts have

been used to circumvent US GAAP. As a result, judgment is required given the particular facts and

circumstances to determine if freestanding contracts should be combined for accounting purposes.

In practice, having sufficiently different settlement dates may indicate that the instruments relate to

different risks and thus provide support for separate accounting for the two instruments.

Determining whether two or more contracts should be combined is a matter of facts and circumstances

requiring the use of professional judgment.

1.2.2 Distinguishing liabilities from equity (ASC 480)

ASC 480 distinguishes liabilities from equity for certain freestanding financial instruments. The guidance

requires liability classification for the following three types of instruments:

• Mandatorily redeemable shares

• Instruments other than an outstanding share that, at inception, embody, or are indexed to, an

obligation to buy back the issuer’s equity shares that could require the transfer of assets

• Instruments that embody a conditional obligation, or shares that embody an unconditional obligation,

to issue a variable number of the issuer’s equity shares and at inception, the monetary value of the

obligation is based solely or predominantly on:

• A fixed value known at inception (e.g., an obligation to deliver shares with a fair value at

settlement equal to $1,000)

• Variations in something other than the fair value of the issuer’s equity shares (e.g., an obligation

to deliver shares with a fair value at settlement equal to the value of one ounce of gold)

• Variations that move in the opposite direction to changes in fair value of the issuer’s shares

(e.g., net share settled written put options)

1.2.2.1 Debt

Debt is classified as a liability because of its legal form. However, certain debt instruments may fall within

one of the categories in ASC 480. For example, share-settled debt that requires the issuer to settle the

instrument by delivering a variable number of shares with a then-current fair value equal to the principal

amount of the debt would also be a liability pursuant to ASC 480. Debt instruments are usually carried at

amortized cost, unless an election is made pursuant to one of the fair value options provided in ASC 815

and ASC 825.

1 Overview

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1.2.2.2 Stock

Companies may issue preferred stock that is mandatorily redeemable for cash or other assets. ASC 480

requires mandatorily redeemable financial instruments to be classified as liabilities. Shares are mandatorily

redeemable pursuant to ASC 480 if it is certain that the issuer will redeem those shares by transferring

cash or other assets. That certainty would exist if the issuer is required to redeem the shares on a

contractual maturity date or upon an event that is certain to occur (e.g., upon the death of the investor).

Shares that are optionally redeemable or convertible into another class of shares before a mandatory

redemption date are not considered mandatorily redeemable pursuant to ASC 480 because the redemption

is not certain.

Shares that require settlement in a variable number of another class of shares upon a mandatory settlement

date, with a monetary value of the settlement obligation equal to a fixed or predominantly fixed amount,

may also require liability classification pursuant to ASC 480. An example of such instrument is share-

settled preferred stock.

1.2.2.3 Equity contracts

Forwards, options or warrants should be carefully evaluated pursuant to ASC 480. Certain contracts

that may require the issuer to transfer assets (e.g., cash) in exchange for its own shares are liabilities

(or sometimes assets) pursuant to ASC 480. One example is a physically settled written put option that

may require the issuer to pay cash in exchange for its shares upon the holder’s exercise. A less obvious

example is a warrant on conditionally redeemable preferred shares. Upon the exercise of the warrant,

the holder is entitled to preferred shares that may require the issuer to transfer assets upon redemption.

Equity contracts can also fall within ASC 480 if they require, or may require, the issuer to transfer a

variable number of shares and the monetary value of the shares does not expose the holder to risks and

rewards similar to those of an owner. For example, the value of a net share settled written put option to

the holder increases as the share price declines, which is inversely related to the issuer’s equity shares,

and therefore, requires liability classification.

An equity contract that is accounted for pursuant to ASC 480 should still be evaluated pursuant to

ASC 815 to determine whether it also meets the definition of a derivative, in which case the related

derivatives disclosures should also be made.

Refer to Appendix A for a comprehensive discussion of ASC 480.

1.2.3 Derivatives and embedded derivatives (ASC 815)

Freestanding financial instruments that are not within the scope of ASC 480 should be evaluated pursuant

to ASC 815. Those instruments may either be derivatives themselves or may contain embedded features

that would be derivatives if freestanding. Those instruments or embedded features that are bifurcated and

accounted for separately should be accounted for as derivatives and measured at fair value continuously.

To be a derivative pursuant to ASC 815, an instrument must be a financial instrument or other contract

(or embedded feature) with all of the following characteristics:

• One or more underlyings. An underlying is a variable whose changes are observable or otherwise

objectively verifiable and whose movements cause the cash flows or fair value of the financial

instrument or other contract to fluctuate. Examples of an underlying include a share price, an

interest rate, a commodity price and the occurrence or nonoccurrence of an event.

1 Overview

Financial reporting developments Issuer’s accounting for debt and equity financings | 6

• One or more notional amounts or payment provisions or both. While the underlying is the variable,

the notional amount is a quantity that determines the size of the change caused by the movement of

the underlying. Notional amounts are, for example, the number of underlying shares or the number

of barrels of crude oil. A payment provision is an alternative to a notional amount in which the contract

specifies a fixed or determinable settlement amount to be made if the underlying behaves in a specified

manner. The underlying and the notional amount determine the amount of settlement, and in some

cases, whether or not a settlement is required.

• No initial net investment or an initial net investment that is smaller than would be required for other

types of contracts expected to have a similar response to changes in market factors. Derivatives do

not require the parties to the contract to initially invest in, own or exchange the underlying asset or

liability. In fact, there is usually no exchange of cash (or a relatively small amount) at the date that two

parties enter into a derivative contract. The initial net investment in a hybrid instrument should not

be considered the initial net investment in an embedded derivative.

• Net settlement provisions through (1) implicit or explicit terms, (2) a market mechanism outside the

contract or (3) delivery of an asset that, because the delivered asset is readily convertible to cash,

puts the recipient in a position not substantially different from net settlement (a gross settlement

that is economically equivalent to a net settlement). Net settlement is a one-way transfer of an asset,

usually cash or shares, from the counterparty in a loss position to the counterparty in a gain position

that settles the obligation. For example, a warrant that permits a cashless exercise is considered a

contractual net settlement, regardless of whether the underlying stock is readily convertible to cash.

In contrast, a gross settlement involves an exchange, whereby Party A transfers cash to Party B, and

Party B transfers an asset to Party A. To be a derivative, the contract must either explicitly permit

net settlement or place the receiving party in a position that is essentially equivalent to net settlement.

The nature of a share underlying a contract or feature can affect the assessment of net settlement.

For example, publicly traded shares of a company are generally considered readily convertible to

cash unless the market for the shares is not active and the number of shares to be exchanged (given

the smallest increment available for conversion) is large relative to the daily trading volume of the

underlying shares. However, if the underlying is a share in a private company, the contract or feature

may not meet the net settlement criterion.

1.2.3.1 Debt and stock

Debt and stock generally do not meet the definition of a derivative because they typically require a

payment in cash (or other assets) equal to the fair value of the debt or stock at inception. However, debt

and stock may be hybrid instruments that contain embedded features (e.g., conversion option, puts or

calls) that require bifurcation (refer to section 1.2.3.3 below).

1.2.3.2 Equity contracts

Options or forwards issued by private companies may not meet the net settlement criterion when those

equity contracts require physical settlement because the underlying shares usually are not freely

transferrable and thus not deemed readily convertible to cash. In contrast, a warrant that requires

physical settlement in shares of a public company that allows the recipient of those shares to easily sell

them in the market without affecting the price would put the holder in a position not substantially

different from a holder of a warrant net settled in cash.

An equity contract that is accounted for pursuant to ASC 480 should still be evaluated pursuant to

ASC 815 to determine whether it also meets the definition of a derivative, in which case the related

derivatives disclosures should also be made.

1 Overview

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1.2.3.3 Embedded derivatives and bifurcation

While a financial instrument may not meet the definition of a derivative in its entirety, it may contain

contractual terms that function similar to a derivative. Debt and stock often contain embedded features

that require additional analysis. Debt and stock containing embedded features are referred to as hybrid

instruments, which should be analyzed to determine whether any of the embedded features should be

bifurcated (i.e., accounted for separately). The most common embedded derivatives in debt and stock

instruments are conversion options, puts, calls and other interest rate features.

ASC 815-15-25-1 requires an embedded derivative to be bifurcated if all three of the following conditions

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 US GAAP with

changes in fair value reported in earnings as they occur.

• A separate instrument with the same terms as the embedded derivative would be considered a

derivative instrument subject to derivative accounting (the initial net investment for the hybrid

instrument should not be considered to be the initial net investment for the embedded derivative).

After identifying, evaluating and concluding on which features (e.g., conversion option, puts, calls, other

embedded features) require bifurcation, a single derivative comprising all the bifurcatable features

should be separated from the host instrument. ASC 815 requires that the derivative be initially measured

and recorded at fair value and the residual value assigned to the host contract.

Embedded derivatives may be broadly categorized as one of the following:

• Option-based embedded derivatives — A feature where one party (the holder of the option) has a

gain and the other party (the writer of the option) has a loss at exercise. This is referred to as an

asymmetrical payout profile. The writer of the option receives a premium for assuming the risk

of loss and the holder of the option pays a premium for having the option, often in the form of an

adjustment to the interest rate or other terms of the instrument. Examples of option-based embedded

derivatives are conversion options, redemption features (puts and calls) and interest rate caps and

floors. Some options require explicit exercise by the holder (such as conversion options and

redemption features) and others require automatic exercise (such as interest rate caps and floors).

• Forward-based embedded derivatives — A feature where either party can have a gain, with the other

party having a loss depending on whether the underlying (market prices or rates) is above or below the

price or rate stipulated in the contract. This is referred to as a symmetrical payout profile. When the fair

value of the underlying equals the stipulated price or rate at settlement, neither party has a gain or

loss. A forward-based embedded derivative requires performance on both sides, as opposed to one

party having the right to force performance. An example of a forward-based embedded derivative

would be a mandatory conversion feature, where the debt must settle in a fixed number of shares at

maturity. Embedded forward-based features are generally less frequent than option-based features.

The initial measurement of a bifurcated derivative depends on whether the embedded derivative is

option-based or forward-based. Generally, an option-based embedded derivative is bifurcated based on

the stated terms documented in the hybrid instrument, while a forward-based embedded derivative is

separated from the host contract based on terms that result in the fair value of that forward-based

embedded derivative generally being equal to zero at the inception of the hybrid instrument.

Examples throughout this publication assume that an option-based embedded derivative is bifurcated at a fair value other than

zero. Alternative methods for bifurcating option-based features may exist based on the specific facts and circumstances.

1 Overview

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Refer to sections 2.4 and 3.3 of our FRD publication, Derivatives and hedging, for further guidance on the

definition of a derivative and bifurcation of embedded derivatives.

1.2.4 Contracts (or features) in an entity’s own equity (ASC 815-40)

If an instrument (or embedded feature) is indexed to, and potentially settled in, the issuer’s own stock,

ASC 815-40, Derivatives and Hedging — Contracts in Entity’s Own Equity, should be applied to determine

whether:

• The freestanding instrument (or embedded feature) that meets the definition of a derivative qualifies

for the exception from derivative accounting pursuant to ASC 815-10-15-74(a).

• The freestanding instrument that does not meet the definition of a derivative (e.g., some private

company contracts) should be classified in equity.

Examples include freestanding equity contracts, such as warrants and forward contracts, as well as embedded

conversion options in debt or preferred shares and embedded puts or calls in preferred or common shares.

ASC 815-40 states that contracts should be classified as equity instruments (and not as an asset or

liability) if they are both:

• Indexed to its own stock (ASC 815-40-15)

• Classified in stockholders’ equity in its statement of financial position (ASC 815-40-25)

ASC 815-40-15 outlines a two-step evaluation to determine whether an instrument (or embedded

feature) is indexed to the issuer’s own stock. The first step is to evaluate any contingent exercise

provisions. If an exercise contingency is an observable market or index unrelated to the issuer, the

instrument would not be considered indexed to the issuer’s own stock.

The second step requires an analysis of provisions that could change the instrument’s settlement

amount. In general, the instrument (or feature) must settle in an amount based on an exchange of a fixed

amount of cash (or principal amount of debt) for a fixed number of shares. Frequently, equity contracts

or equity-linked features contain provisions that require adjustment to the terms upon certain events

(e.g., tender offer, delisting, merger, acquisition). Those provisions should be carefully analyzed under

the second step, as there are a number of exceptions to the general concept.

ASC 815-40-25 provides guidance to determine whether an instrument that is indexed to the issuer’s

own stock should be classified in equity. That determination depends heavily on how the instrument

settles and whether an acceptable form of settlement is entirely within the control of the issuing entity.

The basic principle underlying the equity classification guidance is that instruments that require net cash

settlement (or the issuer can be forced or presumed to net cash settle) are assets or liabilities and those

that require settlement in shares (or the issuer can choose a form of settlement that involves either party

transferring shares) are equity instruments.

ASC 815-40-25 includes other detailed conditions that must be met for equity classification. Those

conditions focus on whether the issuer will have the ability, in all cases, to effect the settlement in

shares. Otherwise, net cash settlement is presumed and equity classification is not permitted.

Freestanding equity-classified instruments are initially measured at fair value (or allocated value). Subsequent

changes in fair value are not recognized as long as the contract continues to be classified in equity. In

contrast, if a freestanding instrument that was indexed to the issuer’s own stock fails the requirements for

equity classification, it should be classified as an asset or liability and is initially measured at fair value. The

equity classification guidance specifies that subsequent changes in fair value are recorded in earnings.

Embedded derivatives that meet the requirements of ASC 815-40 (i.e., are indexed to the entity’s own

stock and classified in stockholders’ equity) should not be bifurcated.

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Refer to Appendix B for a comprehensive discussion of the equity classification guidance.

1.2.5 Accounting for convertible instruments (ASC 470-20)

Convertible instruments (primarily convertible debt and convertible preferred stock) should be further

analyzed when the embedded conversion feature is not bifurcated pursuant to ASC 815, including

ASC 815-40, because there may be further accounting for the conversion option.

1.2.5.1 Cash conversion guidance

The cash conversion guidance in ASC 470-20, Debt — Debt with Conversion and Other Options, should be

considered when evaluating the accounting for convertible debt instruments (this includes certain

convertible preferred stock that is classified as a liability) to determine whether the conversion feature

should be recognized as a separate component of equity. The cash conversion guidance applies to all

convertible debt instruments that upon conversion may be settled entirely or partially in cash or other

assets where the conversion option is not bifurcated and separately accounted for pursuant to ASC 815.

The cash conversion guidance requires the issuer to separately account for the liability (debt) and equity

(conversion option) components of the convertible debt instrument in a manner that reflects the issuer’s

nonconvertible debt borrowing rate. To do that, the issuer allocates the proceeds from issuance to a

liability component based on the fair value of the instrument excluding the conversion option (but

including any other embedded features present in the instrument) and the residual to a component

classified in equity.

The difference between the principal amount of the debt and the proceeds allocated to the liability

component is subsequently amortized as interest expense. The equity component is not subject to

subsequent remeasurement. The issuer should reassess the conversion option at each reporting date

to determine whether it continues to qualify for equity classification pursuant to ASC 815-40.

Refer to Appendix C for a detailed discussion of the cash conversion guidance.

1.2.5.2 Beneficial conversion feature guidance

A conversion option that is not bifurcated as a derivative pursuant to ASC 815 and not accounted for

as a separate equity component under the cash conversion guidance should be evaluated to determine

whether it is beneficial to the investor at inception (a beneficial conversion feature (BCF)) or may become

beneficial in the future due to potential adjustments (often referred to as a contingent BCF). The BCF

guidance in ASC 470-20 applies to convertible stock as well as convertible debt. Recognition of a BCF

typically results in higher interest or dividend charges over the life of the instrument.

A BCF is defined as a nondetachable conversion feature that is in the money at the commitment date. An

option is in the money if its effective exercise price (i.e., conversion price) is less than the current fair

value of the share. For purposes of measuring a BCF, the effective conversion price should be based on

the proceeds received or allocated to the convertible debt instrument (including embedded derivatives).

The BCF guidance requires recognition of the conversion option’s in-the-money portion (the intrinsic

value of the option) in equity, with an offsetting reduction to the carrying amount of the convertible

instrument. The resulting discount is amortized as interest expense or as a dividend (depending on

whether the convertible instrument is debt or stock) over either the life of the instrument (if a stated

maturity date exists) or to the earliest conversion date (if no stated maturity date).

A convertible instrument may contain conversion terms that change upon the occurrence of a future

event or as a result of adjustment provisions. A subsequent change to the conversion ratio or conversion

price may trigger the recognition of an additional BCF.

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Refer to Appendix D for a comprehensive discussion on accounting for BCFs.

1.2.6 Classification and measurement of redeemable securities (ASC 480-10-S99-3A)

Public entities should consider the SEC staff’s guidance (included in ASC 480-10-S99, SEC Materials) when

evaluating the accounting for redeemable shares classified as equity. That guidance addresses the balance

sheet presentation (temporary or “mezzanine” equity versus permanent equity) and measurement of

equity classified shares that are redeemable for cash or other assets in any of the following ways:

• At a fixed or determinable price on a fixed or determinable date

• At the option of the holder

• Upon the occurrence of an event that is not solely within the control of the issuer

ASC 480-10-S99-3A, SEC Staff Announcement: Classification and Measurement of Redeemable Securities,

requires classification outside of permanent equity for redeemable instruments for which the redemption

triggers are outside of the issuer’s control. Therefore, it is important that redemption features within

those instruments are carefully analyzed to assess the effect on the instrument’s classification. The

assessment of whether the redemption of an equity security could occur outside of the issuer’s control

should be made without regard to the probability of the event or events that may result in the instrument

becoming redeemable.

ASC 480-10-S99-3A provides guidance that may require subsequent remeasurement of equity instruments

classified outside of permanent equity. The measurement requirements vary depending on whether the

instrument is (1) currently redeemable or (2) probable of becoming redeemable in the future. The

subsequent remeasurement, if required, may affect the issuer’s EPS.

This guidance also applies to the equity component of convertible debt or shares of a subsidiary

(noncontrolling interests (NCI)). ASC 480-10-S99-3A provides specific classification and measurement

guidance on those instruments.

Freestanding equity contracts that are classified in equity pursuant to ASC 815-40 are not subject to the

SEC staff’s guidance on redeemable securities because, if the instruments were redeemable on a specified

date or upon the occurrence of an event that is not in the issuer’s control, they would not meet the

conditions in ASC 815-40 to be classified in equity.

Refer to Appendix E for a comprehensive discussion of the SEC staff’s guidance on redeemable equity securities.

1.2.7 Allocation of proceeds

When multiple instruments are issued in a single transaction, the total proceeds from the transaction

should be allocated among the individual freestanding instruments identified. The allocation occurs after

identifying (1) all the freestanding instruments and (2) the subsequent measurement basis for those

instruments. The subsequent measurement basis helps inform how the proceeds should be allocated.

After the proceeds are allocated to the freestanding instruments, those instruments should be further

evaluated for embedded features that may need to be bifurcated or separated.

Generally, proceeds may be allocated based on one of the following methods:

• Fair value method — The instrument being analyzed is allocated a portion of the proceeds equal to its

fair value, with the remaining proceeds allocated to the other instruments as appropriate.

• Relative fair value method — The instrument being analyzed is allocated a portion of the proceeds based on

the proportion of its fair value to the sum of the fair values of all the instruments covered in the allocation.

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Financial reporting developments Issuer’s accounting for debt and equity financings | 11

• Residual value method — The instrument being analyzed is allocated the remaining proceeds after an

allocation is made to all other instruments covered in the allocation.

If debt or stock is issued with detachable warrants, the guidance in ASC 470-20-25-2 (applied by analogy

to stock) requires that the proceeds be allocated to the two instruments based on their relative fair

values. This method is generally appropriate if debt or stock is issued with any other freestanding

instrument that is classified in equity (such as a detachable forward contract) or as a liability but not

subject to subsequent fair value accounting (such as a detachable forward contract to purchase shares —

accounted for under an accretion model in ASC 480).

We understand that the FASB staff and the SEC staff believe that a freestanding instrument issued in a

basket transaction should be initially measured at fair value if it is required to be subsequently measured

at fair value pursuant to US GAAP, with the residual proceeds from the transaction allocated to any

remaining instruments based on their relative fair values.

The following is a general outline of the application of the allocation methods to certain combinations

of instruments:

Instruments issued and subsequent measurement model

Allocation methodology

Instrument A — not at fair value

Instrument B — not at fair value

Relative fair value basis of both instruments

Instrument A — at fair value

Instrument B — not at fair value

Fair value to Instrument A and residual value to

Instrument B

Instrument A — not at fair value

Instrument B — not at fair value

Instrument C — not at fair value

Relative fair value basis of all instruments

Instrument A — at fair value

Instrument B — not at fair value

Instrument C — not at fair value

Fair value to Instrument A with residual allocated to

Instruments B and C on relative fair value basis

Instrument A — at fair value

Instrument B — at fair value

Instrument C — not at fair value

Fair value to both Instruments A and B with

residual allocated to Instrument C

The amount of proceeds allocated to an instrument may affect the initial accounting for the instrument.

For example, a redemption feature (put or call) in debt is an embedded derivative that may require

bifurcation based in part on the existence of any premiums or discounts on the debt host. Likewise, the

determination of whether a BCF exists may be strongly influenced by any discount on the instrument.

Therefore, the allocation of proceeds is usually performed prior to completing the accounting analysis for

each instrument.

If the sum of the fair values of the individual instruments being issued and the issuance proceeds are

significantly different, there may be little or no proceeds allocated to the instrument(s) that are not

subsequently measured at fair value. In that case, the issuer should challenge (1) the valuation of the

individual financial instruments and (2) whether there are additional rights or obligations requiring

separate accounting.

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1.2.7.1 SEC staff’s view on allocation of proceeds when the fair value of a liability exceeds net

proceeds received

At the 2014 AICPA National Conference on Current SEC and PCAOB Developments,

the SEC staff

discussed the allocation of proceeds received for the issuance of a hybrid instrument (e.g., convertible

debt), when the fair value of financial liabilities required to be measured at fair value (e.g., an embedded

derivative) is greater than the net proceeds the issuer received. The SEC staff noted that;

“… [W]hen reporting entities analyze these types of unique fact patterns, they should first, and most

importantly, verify that the fair values of the financial liabilities required to be measured at fair value

are appropriate under Topic 820. If appropriate, then the reporting entity should evaluate whether the

transaction was conducted on an arm’s length basis, including an assessment as to whether the parties

involved are related parties under Topic 850. Lastly, if at arm’s length between unrelated parties, a

reporting entity should evaluate all elements of the transaction to determine if there are any other

rights or privileges received that meet the definition of an asset under other applicable guidance.

In the fact patterns analyzed by the staff, we concluded that if no other rights or privileges that require

separate accounting recognition as an asset could be identified, the financial liabilities that are required

to be measured at fair value (for example, embedded derivatives) should be recorded at fair value with

the excess of the fair value over the net proceeds received recognized as a loss in earnings.

Furthermore, given the unique nature of these transactions, we would expect reporting entities to

provide clear and robust disclosure of the nature of the transaction, including reasons why the entity

entered into the transaction and the benefits received.

Additionally, some people may wonder whether the staff would reach a similar conclusion if a transaction

was not at arm’s length or was entered into with a related party. We believe those fact patterns require

significant judgment; therefore, we would encourage consultation with OCA in those circumstances.”

Although the SEC staff did not address transactions with related parties, we generally believe the

accounting for the excess of the fair value of a financial liability over proceeds received will depend on

the individual facts and circumstances. In some cases, it may be appropriate to record the excess in

retained earnings (e.g., dividends to a particular class of equity holders).

1.3 Navigating the transaction documents

A thorough understanding of the transaction and the terms of each instrument is required to determine

the appropriate accounting for debt and equity transactions.

The primary legal agreements that specify the terms of debt and equity arrangements may include: a

promissory note or indenture (for debt), the articles of incorporation or a certificate of designation (for

stock) and an International Swaps and Derivatives Association (ISDA) contract (for equity contracts).

There may also be ancillary agreements to the transaction, such as securities purchase agreements,

shareholders’ agreements, investors’ rights agreements, share lending agreements and registration

rights agreements. Those agreements specify other contractual terms related to the transaction that

may affect the accounting evaluation (e.g., terms that would be considered freestanding financial

instruments or embedded in the primary instruments issued).

Hillary H. Salo, 2014 — Refer to the SEC website at http://www.sec.gov/News/Speech/Detail/Speech/1370543610129.

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A transaction may also include a registration statement, prospectus and prospectus supplement

(generally public transactions) or an offering memorandum (generally private transactions). Those

documents may contain summary information about the instruments being issued and their contractual

terms. While those documents may be helpful to understanding the transaction, they do not establish the

legal rights and obligations related to the instruments being issued.

The review of the executed agreements should focus on the terms that establish the rights and

obligations of the parties to the arrangements, especially those terms related to cash flows or other

consideration exchanges, including terms that:

• Establish amounts to be paid or received

• Identify events that trigger additional payments or receipts

• Identify events that cause the timing of a cash flow or consideration exchange to change

• Relate to any value flows, such as conversion options, including the conversion ratio, events that

trigger or delay a conversion, and the events that cause a conversion ratio to be adjusted

• Require or may require an action from either the issuer (e.g., registration of securities, maintenance

of registration statements, right or obligation to issue more securities in the future) or the investor

(e.g., right or obligation to purchase more securities in the future)

1.3.1 International Swaps and Derivatives Association contracts

Equity contracts can be documented in different forms. However, many transactions are documented in

ISDA contracts.

ISDA, a trade organization of participants in the market for over-the-counter financial instruments, has

created standard ISDA documentation for financial instruments. The documentation for a single ISDA

equity contract usually consists of:

• Master Agreement — Describes the overall relationship between the issuer and the counterparty and

contains terms applicable to any future transactions. A single Master Agreement may support

several individual transactions, each documented by a specific ISDA confirmation.

• Equity Derivatives Definitions — Provide a common set of contract terms and terminology to

standardize the documentation process. The definitions are periodically updated (e.g., the 2011

definitions) and past versions (e.g., the 2002 definitions) may still be referenced in a current transaction.

• Confirmation — Specifies the terms of an individual transaction, including which elections from within

the Master Agreement or Equity Derivatives Definitions are being selected or modified. The terms

of the instrument are provided in the ISDA Confirmation, which makes references to the Master

Agreement and Equity Derivative Definitions.

When using ISDA contracts, all three together form the contractual terms and should be analyzed under

the relevant accounting guidance.

The terms of the ISDA documentation should be carefully considered in light of the indexation and equity

classification guidance discussed in section 1.2.4. Any adjustment and settlement provisions and early

termination provisions should be carefully reviewed because they may have a significant effect on the

classification of the instrument. At the beginning of the analysis, the ISDA confirmation should be

reviewed to determine which adjustment and settlement methods described in the Master Agreement

and Equity Derivatives Definitions have been elected for the particular equity contract. Those methods

should be traced through all of the documents and definitions to identify the triggers for termination or

adjustment and how it is settled.

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1.4 How to use this publication

This publication is intended to serve as a reference tool to assist issuers in accounting for debt and equity

transactions at issuance. Selected subsequent accounting considerations are also included. This publication

has been divided into sections based on the basic instrument types as follows:

• Section 2 — Debt

• Section 3 — Common shares, preferred shares and other equity-related topics

• Section 4 — Equity contracts

• Section 5 — Selected transactions

Sections 2 through 4 provide guidance for determining an issuer’s accounting for the type of instruments

covered in the section. Common structures and features are included throughout the sections. Flowcharts

are also provided to help in navigating the accounting framework.

Section 5 includes a discussion of some common but more complex debt and equity transactions observed

in the market. Examples include unit structures, remarketable put bonds, accelerated share repurchases,

equity contracts on noncontrolling interests, warrants for redeemable shares and convertible debt with

call spread.

The appendices supplement the sections and provide a detailed discussion of the key accounting

considerations discussed in the flowcharts. The guidance in the appendices generally addresses various

instrument types.

Financial reporting developments Issuer’s accounting for debt and equity financings | 15

2 Debt

2.1 Overview and general descriptions of types of debt

Debt is an amount owed for funds borrowed. While debt can have many different features, the debtor

typically agrees to repay the lender the amount borrowed (the principal) plus interest (a return on the

borrowed funds). Principal may be paid back over time or at maturity. Interest is generally paid at fixed

intervals over a specified period of time, but it may accrue over time on the unpaid principal balance,

resulting in a single payment of principal and interest in the future at maturity. A contractual agreement,

generally a note (if borrowed from a bank or other intermediary) or an indenture (if borrowed under a

security or bond offering to multiple investors), establishes the terms of the obligation.

2.1.1 Debt terminology

The following terms are generally used when discussing debt:

• Principal (par amount or face amount) — The amount to be repaid at the maturity date or over time.

(Frequently, the principal amount equals the initial gross proceeds before considering debt issuance costs.)

• Coupon — The periodic interest payments the issuer must make to the debt holder. (The payments

can be monthly, quarterly, semiannually, annually or any other negotiated frequency.)

• Coupon rate or stated interest rate — The predetermined interest rate used to calculate the coupon

payments on the debt. (These rates are often expressed as a fixed percentage of the principal amount

or are variable based on a market index (London interbank offering rate (LIBOR) or a US Treasury rate)

plus a fixed spread that is generally based on the creditworthiness of the issuer (and any related

collateral) at issuance. In some cases, the spread over the referenced rate may adjust over time.)

• Maturity — A defined date on which the issuer must repay the debt’s principal amount

• Issue price — The price at which investors buy the debt when it is first issued

• Premium and discount — Part of the issue price that is in excess of (premium) or less than (discount)

the par amount

• Accreted or carrying amount — The issue price increased or decreased by the unamortized premium

or discount and unamortized issuance costs

Debt that is not convertible is sometimes referred to as “straight debt” or “term debt.” Debt may be

convertible into another instrument (typically shares) during its life.

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2.1.2 Common types of debt instruments

2.1.2.1 Convertible debt

Convertible debt provides the investor with the ability to convert the debt into equity securities (common or

preferred) of the issuer (or sometimes a subsidiary of the issuer or the issuer’s parent), usually at some

predetermined ratio. The debt includes a conversion option (or forward in the case of mandatorily

convertible debt), which is an embedded written call option (or forward sale) on the underlying shares by

the issuer to the investor. Convertible debt is considered to be a hybrid instrument because it contains an

embedded feature (i.e., a conversion feature).

While most convertible debt instruments provide the investor an option to convert, certain convertible debt

requires the holder to convert the instrument into the underlying equity security either on or before a

specified date or upon the occurrence of certain events (e.g., completion of the issuer’s initial public offering

(IPO) or receipt of stockholders’ approval of the conversion). Those securities generally provide investors with

higher yields than optionally convertible instruments to compensate the holders for the fact that conversion

may be required when the shares to be received are worth less than the principal amount of the notes.

Similar to typical nonconvertible debt, convertible debt generally includes a principal amount, coupon

and maturity date. Convertible instruments contain the following elements related to the embedded

conversion option:

• Conversion price — The price at which a convertible debt instrument can be converted into the

underlying equity security

• Conversion rate (or conversion ratio) — The number of underlying equity securities to be received by

investors at the time of conversion for each fixed dollar value of convertible debt (principal value of

each note/conversion price)

• Parity value (or conversion value) — The as-converted value of each note (current underlying equity

security trading price multiplied by the number of shares into which the debt is convertible)

• Conversion spread — The amount by which the parity value of the convertible debt exceeds the

accreted value (sometimes referred to as conversion premium)

Conversion terms vary by instrument, but they historically have taken several forms (including Instruments

A, B and C that were described previously in EITF 03-7, Accounting for the Settlement of the Equity-Settled

Portion of a Convertible Debt Instrument That Permits or Requires the Conversion Spread to Be Settled in

Stock (Instrument C of Issue No. 90-19), before being superseded):

• Classic convertible debt — Upon conversion, the issuer must satisfy the obligation entirely in shares

based on the fixed number of shares into which the debt is convertible.

• Instrument A — Upon conversion, the issuer must satisfy the obligation entirely in cash based on the

conversion value.

• Instrument B — Upon conversion, the issuer may choose to satisfy the entire obligation in either stock

or cash in an amount equal to the conversion value.

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Financial reporting developments Issuer’s accounting for debt and equity financings | 17

• Instrument C — Upon conversion, the issuer must satisfy the accreted value of the obligation (the

amount accrued to the benefit of the holder exclusive of the conversion spread) in cash and may

choose to satisfy the conversion spread (the excess conversion value over the accreted value) in

either cash or stock.

• Instrument X — As identified by market convention, provides that upon conversion, the issuer may

settle the conversion value of the debt in shares, cash or any combination of shares and cash.

The types and terms of convertible debt can vary significantly. The most common variations are discussed

in section 2.2.4.

2.1.2.2 Zero-coupon bond

A zero-coupon bond is a debt instrument that is issued at a discount to its par amount at inception and pays

no interest during the life of the instrument. When held to maturity, the bond is redeemed at its par amount,

with the return to those investors being the difference between the amount paid for the bond at issuance and

the amount received at maturity. As there are no periodic coupon payments, the investor is not subject to the

reinvestment risk (risk of reinvesting cash receipts at a lower market interest rate) that investors in coupon-

paying instruments assume. Refer to section 2.4.3.1.1 for a discussion of the effective interest method.

2.1.2.3 Term-extending debt

Debt instruments may have a stated maturity that may be extended either at the election of the issuer or

the investor or upon the occurrence of specific events or conditions. The instrument may specify a stated

interest rate for the extended period that was set at inception or require a reset of the interest rate to

either a then-market rate or to a formulaic rate. Refer to section 2.2.6.3 for more information on these

types of debt instruments.

2.1.2.4 Share-settled debt

Share-settled debt is settled using equity shares of the issuer in lieu of cash. That is, the debt is settled

for a variable number of shares with a fair value equal to the principal amount of the debt at the time of

settlement. For example, when an issuer’s common shares are trading at $20 per share, it would share-

settle debt with a principal amount of $1,000 by issuing 50 shares. In some cases, the parties may

negotiate terms that result in a discount to the fair value of the share used to determine the number of

shares to be delivered. Refer to sections 2.2.4.6 and 5.23 for more information on this type of instrument.

2.1.2.5 Indexed debt

A debt instrument’s contractual terms may require that interest and/or principal payments be adjusted based

on the price of a commodity, such as gold or an index other than an interest index (e.g., the Standard & Poor’s

(S&P) 500). These adjustments may cause the contractual payments (i.e., principal and/or interest) to

increase or decrease. Refer to section 2.2.6.4 for additional information on these types of debt instruments.

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Financial reporting developments Issuer’s accounting for debt and equity financings | 18

2.1.2.6 Exchangeable debt

Exchangeable debt permits the investor to exchange the debt for the shares of a company unrelated to

the issuer. Some indentures, often called “mandatorily exchangeable,” require that, at maturity, debt

holders accept a determinable number of common shares in an unrelated entity. In many cases, the

number of shares is determined by the share price at the exchange date in relation to a price range

specified at inception. If the price is at or below the range, the number of shares is fixed. If the price is

within the range, the number of shares may vary and the investor receives shares with a fair value equal

to the face amount of the debt. If the price is above the range, the investor receives a fixed number of

shares, and therefore participates in a portion of the upside of the underlying equity securities.

Those instruments are often used to monetize an underlying investment held by the issuer. Mandatorily

exchangeable debt typically has a shorter life than other long-term debt. Refer to section 5.1 for further

discussion of exchangeable debt.

2.1.2.7 Inflation-indexed debt

Inflation-indexed debt provides protection to the holder against the risk of inflation through periodic adjustments

of the principal amount to reflect changes in a measure of inflation, such as the Consumer Price Index. The

coupon payments are determined by applying the fixed coupon rate to the inflation-adjusted principal amount.

For example, if the annual coupon rate were 10% and the underlying principal of the debt were $10,000, the

annual interest payment would be $1,000. If the inflation index increased by 10%, the principal amount would

increase to $11,000. The coupon rate would remain at 10%, resulting in an interest payment of $1,100

($11,000 x 10%). Refer to section 2.2.6.4 for additional information on these types of debt instruments.

2.1.2.8 Perpetual debt

Perpetual debt, which is often deeply subordinated, has no stated maturity and pays regular interest payments

indefinitely. In many ways, perpetual debt is similar to preferred stock in that the coupon payments are similar

to dividend payments and the principal is typically payable only upon liquidation of the issuer. Perpetual debt

is classified as a liability because it is legally an obligation of the issuer and the holder generally has creditor’s

rights. Although perpetual debt does not have a maturity date, it may be redeemable (callable) by the issuer

after a stated period. Refer to section 2.4.3.1.2 for more information for these types of instruments.

2.1.2.9 Increasing-rate debt

Increasing-rate debt is a type of debt instrument whose maturity date can be extended at the option of

the borrower at each maturity date until a final maturity date. The interest rate increases at a specified

rate each time the debt is renewed. Refer to section 2.2.6.6 for guidance on accounting for these types

of debt instruments.

2.1.2.10 Tax increment financing entity (TIFE) (added August 2023)

A municipality may levy a special assessment to finance the development of infrastructure assets or

improvements (e.g., roads, waterlines, utilities). Alternatively, a real estate developer may form a TIFE to

issue bonds to finance the construction of infrastructure (e.g., road, water) on real estate it owns or leases.

When a TIFE issues bonds, the debt is repaid through future user fees or taxes assessed on the property.

ASC 970-470, Real Estate — General — Debt, addresses whether companies should recognize a liability for

TIFE debt. Refer to section 2.2.1 of our FRD publication, Real estate project costs, for additional discussion.

2 Debt

Financial reporting developments Issuer’s accounting for debt and equity financings | 19

2.2 Issuer’s initial accounting for debt instruments (including flowchart)

This section describes the steps generally necessary to determine the accounting for debt (including

convertible debt) at issuance. In particular, this section provides considerations related to embedded

conversion options, redemption features and other common embedded features.

The following flowchart summarizes the analysis at a conceptual level and should be used in conjunction

with the interpretive guidance that begins after the flowchart.

Box B: Does the debt instrument contain

embedded features?

Yes

Box A: Is the debt instrument required

to be accounted for at fair value under

US GAAP or, if eligible, has the issuer

elected to recognize the debt at fair value?

Box D(A): Is there a

conversion or exchange

feature?

Box D(B): Are there

redemption (put and/

or call) features?

Box D(C): Are there any

other embedded

features?

Box D1: Is the feature

clearly and closely

related to the debt host?

Yes

Box D3: Is the feature

eligible for an exception

from derivative

accounting?

Yes

Box E: Bifurcate from the proceeds

allocated to the debt host the fair

value of a single derivative that

comprises all of the individual features

requiring bifurcation. Remaining debt

proceeds are allocated to the debt host.

Box C: Record debt at cash proceeds

received or based on allocated proceeds.

Box D2: Does the

feature meet the

definition of a

derivative?

Yes

Box D: Evaluate each embedded feature

for bifurcation from a debt host instrument.

Yes

Box F: Was the feature analyzed and

not bifurcated a conversion option?

Yes

Record debt at fair value. No evaluation

of embedded features for bifurcation

necessary.

No bifurcation of the feature as an

embedded derivative required.

Box G: May the conversion

feature be settled in cash

(including partial cash

settlement) upon conversion?

Yes

Box H: Allocate the debt proceeds such that

the liability component is initially measured

at an amount equal to its fair value

considering all terms except the conversion

option. Any embedded features requiring

bifurcation will be bifurcated from the

liability component.

Box J: Is the conversion feature

in the money at the commitment

date (i.e., is it a beneficial

conversion feature)?

Box K: Allocate the debt proceeds with an

equity component receiving the intrinsic

value of the beneficial conversion feature.

Box M: Is there a significant

premium associated with the

convertible debt instrument?

Box I: Remaining debt proceeds

are allocated to the conversion

feature in equity.

Box L: Remaining debt proceeds

are allocated to the debt host.

Any embedded features requiring

bifurcation will be bifurcated from

the debt host.

Box P: For SEC registrants,

evaluate whether any equity

component related to the

conversion feature requires

presentation in temporary equity.

Box O: No separate accounting

for the conversion feature is

necessary.

Box N: Allocate the debt proceeds in an

amount equal to the premium and recognize

it in equity.

Yes

2 Debt

Financial reporting developments Issuer’s accounting for debt and equity financings | 20

2.2.1 Box A — Debt instruments accounted for at fair value

ASC 815-15-25-1(b) states that a hybrid instrument that is measured at fair value each period with

changes in fair value reported in earnings as they occur should not be evaluated for embedded derivatives.

Debt is usually not subsequently measured at fair value unless an election is made pursuant to the

separate fair value options provided in both ASC 815 and ASC 825.

The fair value option may not be

elected for certain types of debt. For example, ASC 825-10-15-5(f) prohibits an entity from electing the

fair value option for financial instruments that are, in whole or in part, classified by the issuer as a

component of shareholders’ equity (including temporary equity). Based on this restriction, the fair value

option may not be elected for convertible debt that is in the scope of the cash conversion guidance

(evaluated in Box G of the flowchart) or the BCF guidance, unless the BCF is contingent and, therefore,

not recognized when the convertible debt is issued (evaluated in Box J of the flowchart).

Under the fair value option in ASC 815-15-25-4 through 25-6, if the issuer has determined a debt

instrument has an embedded derivative that requires bifurcation pursuant to ASC 815-15-25-1, the

issuer may elect the fair value option for the hybrid instrument.

Although not entirely clear in the guidance, we generally believe the fair value option under ASC 815-15

may not be elected for a convertible debt instrument with a component classified in equity, even if the

instrument contains a non-equity-related bifurcatable derivative under ASC 815. That is, a convertible

debt instrument that was precluded from being measured at fair value pursuant to the option in ASC 825

should not be eligible for the fair value option pursuant to ASC 815.

2.2.2 Box B — Identifying embedded features

ASC 815-10-20 defines an embedded derivative as an implicit or explicit term that affects 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. Those embedded features may or may not meet the definition of a derivative pursuant to

ASC 815. Instruments that themselves are not derivatives may contain embedded features, and are

referred to as hybrid instruments, which comprise a host contract (e.g., a debt host) and one or more

embedded features.

ASC 815-15 requires an instrument that is not a derivative itself to be evaluated for embedded features

that should be bifurcated and separately accounted for as freestanding derivatives. Bifurcated embedded

derivatives are split from the hybrid instrument and recorded in the same manner as a freestanding

derivative pursuant to ASC 815 (i.e., recorded at fair value with subsequent changes in fair value

recognized in earnings each period).

Debt instruments should be carefully reviewed to identify any terms that could result in a change in either

the amount or timing (or both) of any cash or other value flows or settlements. Common embedded

features in debt instruments include conversion options, redemption features (e.g., call option or put

option), contingent interest, term extension options and make-whole provisions (incremental value

delivered at a settlement date before the stated maturity date presumably to compensate the investor

for some lost future cash flows or value).

Refer to section 2.2.3.4 for evaluating whether an embedded feature meets the definition of a derivative.

For financial liabilities measured using the fair value option under ASC 825-10 or ASC 815-15, ASC 825-10-45-5 requires entities to

recognize the changes in fair value of liabilities caused by a change in instrument-specific credit risk (own credit risk) in other

comprehensive income.

2 Debt

Financial reporting developments Issuer’s accounting for debt and equity financings | 21

2.2.3 Box D and Boxes D1, D2 and D3 — Evaluating embedded features for bifurcation

Embedded features should be evaluated as potential embedded derivatives that should be bifurcated.

Box D(A) and Box D(B) represent two broad categories of features commonly found in debt instruments:

conversion options and redemption (put/call) features, respectively. Box D(C) includes any other features

that could meet the definition of a derivative and require bifurcation.

Box D1, Box D2 and Box D3 apply to any contractual feature requiring analysis as a potential embedded

derivative. The questions in those boxes align closely with the criteria in ASC 815-15-25-1, which

requires an embedded feature to be bifurcated if all three of the following conditions are met:

(1) 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.

(2) The hybrid instrument is not remeasured at fair value under otherwise applicable US GAAP with

changes in fair value reported in earnings as they occur.

(3) A separate instrument with the same terms as the embedded derivative would be considered a

derivative instrument subject to derivative accounting (the initial net investment for the hybrid

instrument should not be considered to be the initial net investment for the embedded derivative).

Under criterion (1), if an embedded feature being analyzed is clearly and closely related to the host,

bifurcation is not required. To evaluate this criterion, the host contract should be properly identified.

Criterion (2) is not addressed because the hybrid instrument is not being measured at fair value pursuant

to the analysis in Box A.

Criterion (3) considers not only whether the embedded feature meets the definition of a derivative

(evaluated as if it were a freestanding instrument with the same terms), but also whether it is eligible for an

exception from derivative accounting. If the embedded feature would not be a derivative if freestanding,

either because it does not meet the definition of a derivative or because it does meet the definition but

receives an exception from derivative accounting under ASC 815, bifurcation is not required.

Refer to section 3 of our FRD publication, Derivatives and hedging, for additional information on embedded

derivatives.

2.2.3.1 Unit of analysis

Each embedded feature identified in a contract generally is evaluated for bifurcation. There are different

approaches used to determine whether an embedded feature requires bifurcation. Under one approach,

each embedded feature is evaluated individually. Under another, similar embedded features may be

(or in some cases should be) combined. The approach followed for the unit of analysis (i.e., embedded

features evaluated individually or in a group) may affect whether some or all of those embedded features

should be bifurcated.

For example, consider a typical contingently convertible debt instrument (or “CoCo,” which is described in

section 2.2.4.4) that may be converted in four different situations (e.g., based on the trading price, parity, a

notice of redemption or a specified corporate transaction), with each situation representing the resolution of

a contingency in the instrument. The contractual conversion features in a CoCo could be analyzed in two

ways. Under one approach, the instrument would have a single conversion option with four separate triggers

that permit conversion (e.g., based on the trading price of the common stock, parity, a notice of redemption

or a specified corporate transaction). Under another approach, the instrument could be viewed to have four

conversion options, each of which is exercisable only upon the occurrence of a certain event (i.e., the trading

price of the common stock, parity, a notice of redemption or a specified corporate transaction).

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Judgment will be required to determine when it is appropriate (or necessary) to combine terms into a single

embedded feature to be evaluated for bifurcation. Factors to be considered include the commonality of

the underlyings, a detailed analysis of the calculation of related settlement amounts, the situations in

which settlements may be required and default provisions related to the terms.

If the instrument were viewed to have one option with multiple exercise triggers, the entire conversion

option would be bifurcated if any individual trigger or related settlement met the requirements for

bifurcation. Under the second approach (four options, each with its own exercise trigger), only each

individual trigger or related settlement requiring separate accounting would be bifurcated. The valuation

of that bifurcated derivative would be based on the conversion option (or options, if several required

bifurcation) value that included an input for the probability of the trigger (or triggers) occurring. The

remaining conversion options would not be bifurcated.

We generally believe both approaches are acceptable for contingently convertible debt, but the approach

should be consistently applied. The second approach may not be applied in all circumstances (e.g., for a

freestanding equity contract, ASC 815-15-25-7 indicates that a single freestanding derivative should not

be split into multiple derivatives). Therefore, a freestanding warrant that has four exercise contingencies

should be viewed as a single equity contract.

Once the appropriate unit of analysis is determined, each unit should be evaluated in accordance with

the criteria in ASC 815-15-25-1 described below. If more than one feature requires bifurcation, a

single derivative comprising all bifurcatable features should be separated. Refer to section 2.2.7 for

further discussion.

2.2.3.2 Meaning of ‘clearly and closely related’

The clearly and closely related evaluation generally refers to a comparison of the economic characteristics

and risks of the embedded feature to those of the host instrument. The concept is not specifically defined

in the guidance, but it is illustrated throughout the examples in ASC 815-15-25-23 through 25-51. Generally,

the underlying that causes the value of the embedded feature to fluctuate, must be related to the inherent

economic nature of the host instrument to be considered clearly and closely related to the host instrument.

If the economic characteristics and risks of the embedded feature are clearly and closely related to the

economic characteristics and risks of the host contract, ASC 815 does not require bifurcation of the

feature, and there is no separate accounting as a derivative.

This concept is illustrated throughout the discussion and examples in ASC 815-15-25-23 through 25-51.

2.2.3.3 Identifying the host contract in a debt instrument

The nature of the host contract should be determined to assess whether an embedded feature

is considered clearly and closely related to the host contract. US GAAP defines an equity host as a

residual interest in an entity, and a debt host as any other financial instrument host contract. From the

examples in ASC 815-15-25, it can be inferred that interest, credit and inflation can be considered debt-

host-like characteristics. A legal form debt instrument would have a debt host.

Some instruments could be legal form equity instruments that are classified as a liability pursuant to the

guidance in ASC 480, such as preferred stock that is mandatorily redeemable. The host instrument (the

preferred stock) should be evaluated pursuant to ASC 815-15-25 to determine whether the host

instrument is more akin to debt or equity. As the instrument would have a stated maturity date or some

form of date-certain redemption in order to be classified as a liability pursuant to ASC 480, the host

instrument most likely would be deemed a debt-like host. Refer to section 3.2.6 for further discussion

of how the host contract of shares should be determined.

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The terms of the host debt instrument are based on the stated or implied substantive terms of the hybrid

instrument. Those terms may include a fixed rate, variable rate, zero coupon, discount or premium or

some combination thereof. The characteristics of the host debt instrument should not be expressed in a

manner that would result in identifying an embedded derivative that is not already clearly present in a

hybrid instrument. For example, a fixed-rate debt instrument should not be considered a variable-rate

debt host with an embedded variable-to-fixed interest rate swap.

We generally believe the debt host of a typical convertible debt instrument is generally a nonconvertible,

fixed-rate debt instrument with a stated maturity date that pays interest at the issuer’s current borrowing

rate for the contractual life of the instrument. Under this approach, when evaluating interest-related

features (such as put/call provisions) against the host instrument in convertible debt, the interest rate on

the host should be the fixed rate that would have been set on a nonconvertible instrument and should be

higher than the convertible instrument’s contractual fixed rate.

2.2.3.4 Definition of a derivative instrument

To be a derivative pursuant to ASC 815, an instrument should have all of the following characteristics:

• A derivative’s cash flows or fair value must fluctuate and vary based on the changes in one or

more underlyings.

• The contract contains one or more notional amounts or payment provisions or both.

• The contract requires no initial net investment or requires an initial net investment that is smaller

than would be required for other types of contracts expected to have a similar response to changes

in market factors.

• The contract (1) provides for net settlement, (2) can be settled net through a market mechanism

outside the contract or (3) provides for delivery of an asset that, because the delivered asset is

readily convertible to cash, puts the recipient in a position not substantially different from net

settlement (a gross settlement that is economically equivalent to a net settlement).

Refer to section 1.2.3 of this publication and section 2.4 of our FRD publication, Derivatives and hedging,

for additional guidance on the definition of a derivative.

2.2.4 Box D(A) and Boxes D1, D2 and D3 — Evaluating embedded conversion options

The conversion feature in convertible debt should be evaluated for potential bifurcation under the

criteria in ASC 815-15-25-1, which includes the considerations described in section 2.2.3. If the option

meets the definition of a derivative, the analysis should also consider whether the conversion feature,

if freestanding, would receive an exception from derivative accounting.

While issued less frequently, debt may also be exchanged into equity of another entity (referred to as

exchangeable debt). The evaluation of an exchange feature for potential bifurcation should follow the

guidance discussed in section 2.2.3 and this section. However, because the debt is not convertible into

equity of the issuer, the exchange feature would generally be bifurcated. This section primarily focuses

on the evaluation of conversion features. Refer to section 5.1 for further discussion of exchangeable debt.

2.2.4.1 Determining whether a conversion option is clearly and closely related to the debt

host instrument

To be considered clearly and closely related to the debt host in convertible debt, the embedded feature’s

underlying should relate to economic characteristics and risks that affect debt, such as interest rates,

credit considerations or inflation.

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Most commonly, the economic characteristics and risks of a conversion option embedded in a debt

instrument are considered related to those of an equity instrument, because its value is influenced

principally by the underlying equity security’s fair value (and the volatility in that fair value). Therefore,

the economic characteristics and risks of an embedded conversion option in a debt instrument should

not be considered clearly and closely related to the economic characteristics and risks of a debt host

contract, as stated in ASC 815-15-25-51.

2.2.4.2 Determining whether a conversion option meets the definition of a derivative

The criteria for the definition of a derivative should generally be applied to conversion features as follows:

• Underlying and notional amount — The underlying is the price (i.e., fair value) of the equity instrument

to be issued when the embedded conversion option is exercised, and the notional amount is the number

of shares into which the debt instrument is convertible.

• No initial net investment — The implicit premium for the embedded conversion option at inception is

considered the initial investment (not the initial investment in the convertible debt instrument),

which should generally be less than the fair value of the underlying equity security.

• Net settlement — An embedded conversion option may require physical settlement (i.e., no possibility

that the conversion option will settle in cash, such as “classic convertible debt” described in section

2.1.2.1) such that, upon conversion, the issuer is required to deliver the underlying equity shares in

settlement of the convertible debt. An embedded conversion option that requires physical settlement

would meet the net settlement requirement only if the shares to be delivered upon conversion are

“readily convertible to cash” as described in ASC 815.

For example, a share of a publicly traded company is generally considered readily convertible to cash

unless the market for the shares is not active and the number of shares to be exchanged (given the

smallest increment available for conversion) is large relative to the daily trading volume of the

underlying shares. However, if the underlying share is of a private company, the conversion option

would generally not meet the net settlement criteria in a physical settlement unless there is sufficient

active trading to result in a conclusion that a common share is readily convertible to cash.

In some cases, a convertible debt instrument may contractually require net settlement of the embedded

conversion option. This net settlement of the conversion feature could be in shares or cash. For

example, Instrument C provides that the conversion spread (i.e., the intrinsic value of the conversion

option) is to be settled in net cash or net shares upon conversion. Instruments A, B and X also permit

net settlement. In these cases, the embedded conversion option would meet the net settlement

characteristic of a derivative even if the underlying shares were not readily convertible to cash.

2.2.4.3 Exceptions from derivative accounting

Notwithstanding that an embedded feature, if freestanding, may meet all the characteristics of a derivative,

an embedded feature (including conversion options) should not be bifurcated if the feature is eligible for

a scope exception from ASC 815. The most common exception for a conversion feature is provided by

ASC 815-10-15-74(a), which states that contracts issued or held by that reporting entity that are both

(1) indexed to its own stock and (2) classified in stockholders’ equity in its statement of financial position

are not considered derivative instruments in the scope of ASC 815. That analysis draws on the indexation

and classification guidance in ASC 815-40 related to contracts in an entity’s own stock.

If the embedded conversion option does not qualify for the scope exception in ASC 815-10-15-74(a),

the issuer should determine whether the feature is eligible for other scope exceptions in ASC 815. While it is

unlikely the instrument would qualify for any other exceptions, in the event convertible debt instruments are

issued in exchange for goods or services, an exception may exist pursuant to ASC 815-10-15-74(b), which

excludes contracts issued in a company’s own securities as share-based payment arrangements until such

contracts are no longer subject to the guidance in ASC 718. Refer to our FRD publication, Share-based

payment, for further guidance related to accounting for share-based payment arrangements.

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Financial reporting developments Issuer’s accounting for debt and equity financings | 25

2.2.4.3.1 Meaning of ‘indexed to issuer’s own stock’

To determine whether a conversion feature is indexed to the issuer’s own stock, it should be analyzed

pursuant to ASC 815-40-15-5 through 15-8, including the related implementation guidance. The

examples in ASC 815-40-55-26 through 55-48 should, in particular, be considered. This guidance is

referred to throughout this publication as “the indexation guidance.”

The indexation guidance requires a two-step evaluation of an instrument or feature. In the first step, any

contingent exercise provisions are evaluated, and in the second step, an analysis of features that could

change the instrument’s settlement amount is conducted.

In the first step, an exercise contingency (as defined in the indexation guidance) does not preclude an

instrument (or embedded feature) from being considered indexed to an entity’s own stock provided that

it is not based on either of the following:

• An observable market, other than the market for the issuer’s stock (if applicable)

• An observable index, other than an index calculated or measured solely by reference to the issuer’s

own operations (e.g., sales revenue of the issuer, earnings before interest, taxes, depreciation and

amortization of the issuer, net income of the issuer or total equity of the issuer)

In the second step, an instrument (or embedded feature) is considered indexed to an entity’s own stock if

its settlement amount equals the difference between (1) the fair value of a fixed number of the entity’s

equity shares and (2) a fixed monetary amount or a fixed amount of a debt instrument issued by the

entity. While the second step appears to be a strict “fixed-for-fixed” concept, an exception is provided so

that if the feature’s strike price or the number of shares used to calculate the settlement amount is not

fixed, the embedded feature could still be considered indexed to an entity’s own stock if the only

variables that could affect the settlement amount would be inputs to a fair value valuation model for a

fixed-for-fixed forward or option on equity shares.

Any feature that adjusts the embedded conversion option should be carefully analyzed. Those features

could include antidilution provisions (e.g., adjustments for stock splits or dividends) as well as provisions

that adjust the conversion price or rate to protect the investor from a loss of value due to events that

were not expected to occur or events in the control of the issuer that could be detrimental to the holder

(e.g., as merger, tender offer, nationalization, insolvency or delisting). Refer to section B.3 for a

comprehensive discussion of the indexation guidance.

If based on the indexation guidance the conversion option is not considered indexed to the issuer’s own

stock, it would not qualify for the scope exception in ASC 815-10-15-74(a) and should be bifurcated.

2.2.4.3.2 Meaning of ‘classified in stockholders’ equity’

To determine whether an embedded conversion feature would be classified in stockholders’ equity if

considered freestanding, ASC 815-40-25-1 through 25-43 should be considered, including the related

implementation guidance (primarily codified in ASC 815-40-55-2 through 55-18). This guidance is

referred to throughout this publication as “the equity classification guidance.”

The equity classification guidance generally indicates that an embedded conversion option on a

company’s own stock, if freestanding, would be considered to be classified in equity under either of the

following types of settlement:

• Required physical settlement or net share settlement

• Issuer has a choice of net cash settlement or settlement in its own shares (physical settlement or net

share settlement), regardless of the intent of the issuer

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However, an embedded conversion option would not be considered classified in equity if either of the

following provisions is present:

• Required net cash settlement (including a requirement to net cash settle if an event occurs that is

outside the control of the issuer)

• Holder has choice of net cash settlement or settlement in shares (physical settlement or net share

settlement)

ASC 815-40-25-7 through 25-38 include additional conditions that should be met for equity classification,

including whether the issuer will have the ability, in all cases, to settle in shares. Those additional conditions

need not be met for conventional convertible debt instruments (refer to section 2.2.4.8 for guidance on

conventional convertible debt instruments). If any condition (as summarized below) is not met for a debt

instrument that is not conventional convertible debt, the embedded conversion option would not be

considered classified in stockholders’ equity and should be bifurcated:

• Settlement is permitted in unregistered shares

• Entity has sufficient authorized and unissued shares

• Contract contains an explicit share limit

• No required cash payments if entity fails to timely file

• No cash-settled top-off or make-whole provisions

• No counterparty rights rank higher than shareholder rights

• No collateral requirements

Those criteria should be applied on a theoretically possible standard. Issuers should also evaluate the

implementation guidance in ASC 815-40-55-2 through 55-6 that discusses circumstances where equity

classification is appropriate despite the possibility of a cash settlement if holders of the same class of

underlying shares also would receive cash in exchange for their shares.

Refer to section B.4 for a comprehensive discussion of the equity classification guidance.

2.2.4.4 Contingently convertible debt

In a traditional convertible debt instrument, the holder may exercise its option to convert the notes into

a number of underlying securities at any time. In contrast, CoCo debt generally entitles the holder to

convert only after certain contingencies have been satisfied. Contingently convertible debt often also

allows conversion at the end of its life.

When exercise contingencies exist and the conversion feature meets the definition of a derivative, the

issuer should evaluate each of those contingencies to determine whether they would preclude the

conversion option from being considered indexed to its own stock. This evaluation should be made in the

first step under the indexation guidance, which requires that the contingent exercise provisions not be

based on an observable market (other than the market for the issuer’s stock) or an observable index

(other than those calculated or measured solely by reference to the issuer’s own operations). Refer to

section 2.2.4.3 and Appendix B for further discussion of these requirements.

The most common exercise contingencies in a CoCo are:

• Common stock trading price — A holder may convert the note if the last reported price of the stock

for a specified period is more than some percentage of the conversion price. For example, a

convertible debt instrument with a conversion price of $12 and a contingent conversion trigger of

130% may permit conversion only if the stock trades above $15.60 ($12 x 130%) for 20 out of the

30 days before the end of the quarter.

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Financial reporting developments Issuer’s accounting for debt and equity financings | 27

• Satisfaction of trading price condition or “parity trigger” — A holder may convert during a specified

period after any period in which the trading price per $1,000 principal amount of the debt for each

day of that period was less than a percentage (e.g., 95%) of the parity value. For example, assume a

convertible instrument with a conversion price of $12 and a conversion ratio of 83.33 shares is

convertible only when the debt is trading at less than 95% of its parity (as converted) value. In this

example, if the trading price of the underlying stock is $15, the debt would be convertible only when it

was trading at less than $1,187.50 (or 95% of $1,250, which is the parity value (83.33 shares x $15)).

• Notice of redemption — A holder may convert the note if the notes have been called for redemption

by the issuer.

• Specified corporate transactions — A holder may convert the note upon the occurrence of specified

corporate transactions. These corporate events may include “fundamental change” triggers similar

to those discussed in section 2.2.5.

Many common exercise contingencies pass the first step of the indexation guidance because they are

contingent upon the trading price of the issuer’s equity shares or are not contingent on any observable

market or index unrelated to the entity’s own stock or operations.

Parity trigger exercise contingencies are specifically addressed in ASC 815-40-55-45 through 55-46,

which states in part:

The market price trigger and parity provision exercise contingencies are based on observable

markets; however, those contingencies relate solely to the market prices of the entity’s own stock

and its own convertible debt ... Therefore, Step 1 does not preclude the warrants from being

considered indexed to the entity’s own stock.

Conversion exercise contingencies based on an observable market other than the market for the issuer’s

stock or an observable index other than those referenced to the issuer’s own operations preclude the

embedded conversion option from being considered indexed to the entity’s own stock. For example, if

the embedded conversion option permits the holder to convert only if LIBOR increases or decreases

by 200 basis points, the conversion feature would fail Step 1 of the evaluation under the indexation

guidance, because LIBOR is an observable index that is not calculated or measured based on the market

for the issuer’s own stock or measured solely by reference to the issuer’s own operations.

Refer to section 2.2.3.1 for how individual contingencies should be considered in determining the unit of

analysis when evaluating embedded conversion features for bifurcation and section B.3 for more

information on the evaluation of exercise contingencies under the indexation guidance.

2.2.4.5 ‘Time value make-whole’ features

Debt instruments may include some form of a make-whole provision, which provides that in the event of

conversion by the investor under certain circumstances (e.g., change of control), the issuer is required to

deliver to the holder additional consideration beyond the settlement of the conversion obligation. The

additional consideration may be provided in cash or shares, usually at the issuer’s option. There are two

frequent forms of the make-whole feature: an “interest make-whole” and a “time value make-whole.”

Refer to section 2.2.6.2 for a discussion on interest make-whole features.

A time value make-whole feature is designed to compensate the investor for lost benefits of the investment

(including the time value of the remaining term of the conversion option) upon conversion because of the

occurrence of certain fundamental change events (refer to section 2.2.5) that result in early settlement

of the instrument.

The number of additional shares to be provided to the investor is generally determined based on (1) the

date on which the fundamental change occurs or becomes effective and (2) the price per share of the

underlying equity security at that time, as set forth in the indenture.

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In some cases, a make-whole provision may be triggered on any conversion, rather than certain

contingent conversions. In those situations, the feature should be carefully evaluated to determine if it

should be evaluated as part of the basic conversion option. Refer to the discussion of determining the

unit of analysis in section 2.2.3.1 for further guidance.

Because time value make-whole provisions are not clearly and closely related to the debt host and would

meet the definition of a derivative if considered freestanding, they should be evaluated under the

indexation guidance to determine whether they would be afforded the scope exception pursuant to

ASC 815-10-15-74(a). This evaluation is generally performed in conjunction with the analysis of the

embedded conversion feature.

ASC 815-40-55-46 indicates that if the fair value of the shares into which the debt is convertible plus the

make-whole shares would be expected to approximate the fair value of the convertible debt instrument at

the settlement date (assuming no change in the pricing inputs — other than stock price and time — since

the instrument’s inception), the time value make-whole feature would not violate the fixed-for-fixed

concept in the indexation guidance because the number of make-whole shares is determined based on

a table with axes of stock price and time, which would both be inputs in a fair value measurement of a

fixed-for-fixed option on equity shares.

The following is an example of a typical time value make-whole table (except for the “Amount” column,

which has been added for reference) that could be included in an indenture. Based upon the stock price

and the effective date, the number of additional shares per note can be determined.

Stock price

Effective date

1 December 20X0

1 December 20X1

1 December 20X2

1 December 20X3

Amount

$ 15.00

5.00

$ 75.00

5.00

$ 75.00

5.00

$ 75.00

5.00

$ 75.00

$ 20.00

3.80

76.00

3.58

71.60

3.15

63.00

2.00

40.00

$ 25.00

2.50

62.50

2.15

53.75

1.60

40.00

1.05

26.25

$ 30.00

1.75

52.50

1.40

42.00

0.85

25.50

0.80

24.00

$ 35.00

1.25

43.75

0.95

33.25

0.35

12.25

0.25

8.75

$ 40.00

1.00

40.00

0.65

26.00

0.24

9.60

—

$ 45.00

0.75

33.75

0.50

22.50

0.15

6.75

—

$ 50.00

0.50

25.00

0.35

17.50

0.10

5.00

—

In evaluating whether the time value make-whole satisfies the criteria discussed in Step 2 of the

indexation guidance, the terms of the indenture should provide that the stock price used to determine

the make-whole payment should be the fair value of a share used as an input to an appropriate valuation

model (e.g., Black-Scholes, lattice or other appropriate model that is based on the instrument’s terms

and valuation theory) for a fixed-for-fixed option or forward.

To satisfy the indexation guidance, the make-whole amounts should represent compensation for the

expected loss in the time value component at settlement (assuming no change in pricing inputs, other

than stock price and time, since the instrument’s inception). Accordingly, the make-whole amount should

fluctuate with the “Stock Price” and the “Effective Date” axes in a manner that is reasonably expected to

compensate the investor for the value lost upon an early conversion.

For example, the time value of a conversion option typically decreases as the term to maturity shortens

and decreases as the share price (fair value of the share) moves further away (higher or lower) from the

contractual conversion price. In cases where the make-whole amount results in a fixed or predominantly fixed

value for a number of different share prices on the same date, the make-whole provision may not be

considered indexed to the entity’s own stock. Rather, it may be more akin to an interest make-whole feature.

A feature expressed in such a table would likely require bifurcation (as discussed further in section 2.2.6.2).

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If the time value make-whole feature and the base conversion option are considered indexed to the

entity’s own equity, the exception in ASC 815-10-15-74(a) related to the feature being classified in

equity if freestanding should also be considered, as discussed in section 2.2.4.3.2.

While ASC 815 does not explicitly address the unit of an embedded feature that should be evaluated, make-

whole provisions are generally evaluated as part of the embedded conversion feature based on the make-

whole illustration in ASC 815-40-55-46, which implies that the entire conversion option — including the make-

whole provision — should be evaluated together. However, the original EITF consensus that was codified was

not intended to interpret the unit of analysis for embedded derivatives. Therefore, it is not clear what should

be bifurcated if the make-whole feature is not considered indexed to the entity’s own stock.

We generally believe there are different approaches that could be considered based in part on the

discussion of the unit of analysis for contingent conversion options in section 2.2.3.1.

Depending on the facts and circumstances, the make-whole feature may be viewed together with the conversion

option (or only conversion options that share the same exercise contingencies as the make-whole feature). In

this case, the conversion option(s), including the make-whole feature, would be bifurcated. Alternatively, if the

make-whole feature was viewed as a separate feature from the conversion option(s), only the make-whole

feature would be bifurcated from the debt host instrument and accounted for separately (assuming that the

conversion option itself meets the scope exception in ASC 815-10-15-74(a) and does not require bifurcation).

2.2.4.6 Share-settled debt

Convertible debt typically provides the investor with the ability to convert the debt into a fixed number of the

issuer’s equity securities. As a result, the value the holder receives upon conversion is based on the price of

the shares. However, some debt instruments may settle by providing the holder with a variable number of

shares with an aggregate fair value equal to the debt’s outstanding principal (referred to as share-settled

debt). In some cases, a discount to the fair value of the share may be used to determine the number of

shares to be delivered. This results in settlement at a premium to the debt’s outstanding principal.

Because the value that the holder of share-settled debt receives at settlement does not fluctuate with the

fair value of the shares, this variable-share settlement provision is not considered a conversion option.

As a result, the debt instrument would not be considered convertible debt unless it also contained a

conversion option (as discussed in section 2.1.2.1). Instead, debt with this variable-share settlement

provision should first be evaluated pursuant to ASC 480-10-25-14 (refer to section A.6.2.1). If the debt

is not subject to that guidance, the variable-share settlement provision should be evaluated as a

redemption feature as discussed in section 2.2.5. A share-settlement provision that is not a conversion

option should not be considered under the beneficial conversion guidance (discussed in section 2.2.10).

Refer to section 5.23 for more information on variable-share settlement provisions.

2.2.4.7 Debt that is convertible into shares of a subsidiary or the parent

ASC 815-40-15-5C states that freestanding financial instruments (and embedded features) for which the

payoff to the counterparty is based, in whole or in part, on the stock of a consolidated subsidiary are not

precluded from being considered indexed to the entity’s own stock in the consolidated financial statements

of the parent if the subsidiary is a substantive entity. Accordingly, if the subsidiary is considered to be a

substantive entity, an embedded option to convert debt (issued by the parent or the subsidiary) into a

substantive subsidiary’s shares may be considered indexed to the issuer’s own stock in the consolidated

financial statements if the two steps in the indexation guidance are met, as discussed in section 2.2.4.3.1.

ASC 815-40-15-5C does not explicitly address convertible debt issued by a subsidiary that is convertible

into the shares of its parent. We generally believe that for purposes of the parent’s consolidated financial

statements that instrument could meet the indexation guidance, in part based on concepts formerly in

EITF 98-2, Accounting by a Subsidiary or Joint Venture for an Investment in the Stock of Its Parent

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Company or Joint Venture Partner, which wasn’t finalized by the EITF and wasn’t codified. That tentative

consensus stated that in certain circumstances a subsidiary’s investment in the shares of its parent would

be treated as treasury stock in the financial statements of the subsidiary or joint venture. If such a share

could be considered treasury stock by the subsidiary, then by analogy it could be considered a share of

the subsidiary.

The following chart summarizes whether the embedded conversion option in the following instruments

may be considered indexed to the reporting entity’s stock pursuant to ASC 815-40-15-5C.

Embedded conversion feature indexed to reporting entity’s stock?

Debt issued by consolidated subsidiary

convertible into subsidiary’s stock

Yes, in consolidated financial statements and the subsidiary’s

standalone financial statements.

Debt issued by parent convertible into a

substantive consolidated subsidiary’s stock

Yes, in consolidated financial statements.

Debt issued by subsidiary convertible into

parent’s stock

Yes, in consolidated financial statements.

No, in subsidiary’s standalone financial statements because the

holder’s conversion right is for stock of an entity (parent) that is not

the reporting entity (subsidiary).

Accounting for debt issued by a subsidiary that is convertible into either the parent’s or consolidated

subsidiary’s stock at the election of the holder should be carefully determined based on the individual

facts and circumstances.

2.2.4.8 Conventional convertible debt

As discussed in ASC 815-40-25-39 through 25-42, conventional convertible debt is a specific type of

convertible debt instrument that permits the holder to convert into a fixed number of shares in its entirety

(or an equivalent amount of cash at the discretion of the issuer) and for which the ability to exercise the

conversion option is based on the passage of time or a contingent event.

The analysis for determining whether an embedded conversion feature in conventional convertible debt

receives an exception from derivative accounting pursuant to ASC 815-10-15-74(a) is simplified relative

to unconventional convertible debt. While the requirements in the indexation guidance should continue to

be met, in evaluating whether the embedded conversion feature would be classified in stockholders’

equity if freestanding, the additional criteria described in ASC 815-40-25-7 through 25-35, including the

related implementation guidance in ASC 815-40-55-2 through 55-6, are not applicable. Instead, the only

consideration under the equity classification guidance is whether the contract requires or permits the

issuer to settle in shares under the general equity classification guidance in ASC 815-40-25-1 through

25-4. Refer to section 2.2.4.3.2 for further guidance on those requirements.

In practice, convertible debt instruments infrequently permit holders to convert into a fixed number of

shares in its entirety (or an equivalent amount of cash at the discretion of the issuers) because they

generally include at least one provision that makes the number of shares to be delivered upon conversion

variable, such as:

• Any conversion feature that permits the settlement of the conversion obligation in a variable number

of shares (e.g., instruments allowing conversions to be settled in cash for the principal amount and

shares for any conversion spread, or in any mix of cash or shares, because the number of shares or

equivalent amount of cash to be delivered upon conversion is not fixed (e.g., Instruments C and X))

• The existence of a make-whole provision, which may result in a variable number of shares upon

conversion

• The inclusion of anything other than standard antidilution provisions

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Standard antidilution provisions as defined in Codification are designed to maintain the value of the

conversion option in the event of an equity restructuring. “Equity restructuring” is defined in Codification

as a nonreciprocal transaction between an entity and its shareholders that causes the per-share fair

value of the shares underlying an option or similar award to change, such as a stock dividend, stock split,

spin-off, rights offering or recapitalization through a large, nonrecurring cash dividend.

Standard antidilution adjustments require an adjustment to the conversion option when the following

events occur:

• Issuance of the underlying security as a dividend or distribution on the underlying security or a split

or combination of the underlying security

• Issuance to holders of the underlying security any rights or warrants entitling them to the underlying

security at a discount

• Distributions of capital stock, other assets or property to holders of the underlying security

• Large and nonrecurring cash dividend or distribution

Typical antidilution provisions included in recent convertible debt instruments that are not considered

standard antidilution provisions include adjustments for:

• Cash dividends — To be considered an equity restructuring, a cash dividend must be both large and

nonrecurring. Therefore, adjustments due to regular cash dividends, or even an initial cash dividend

that is not large, are not considered standard, as they are usually neither large nor nonrecurring.

• Payment in respect of a tender offer — Such offers are generally made by the issuer or a subsidiary,

but in some cases triggered by a third-party tender offer. These also include exchange offers for the

underlying security in which the tender price is higher than the last reported sale of the underlying

security. This adjustment is not considered standard as it is a reciprocal transaction with

shareholders (exchange of cash for purchase of shares).

2.2.4.9 Conversion options with a strike price denominated in a currency other than the issuer’s

functional currency

Pursuant to ASC 815-40-15-7I, a conversion option embedded in debt that is denominated in a currency

other than the issuer’s functional currency is not considered indexed to the issuers’ own stock because

the issuer is exposed to the changes in the currency’s exchange rate, and thus there is not a fixed

amount of value (in the issuer’s functional currency) being exchanged.

The determination of whether an equity-linked financial instrument is indexed to an entity’s own stock is

not affected by the currency (or currencies) in which the underlying shares trade.

2.2.5 Box D(B) and Boxes D1, D2 and D3 — Evaluating embedded redemption

(put and/or call) features

Like embedded conversion options, redemption features are also evaluated for bifurcation pursuant to

ASC 815-15-25-1. Redemption is the repayment of the principal amount at or before maturity, but is most

frequently used to describe repayment before maturity through exercise of a call or put option embedded

in the debt instrument.

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An embedded call option gives the issuer the right to fully or partially retire the debt before the

scheduled maturity date, usually at par or at a premium (e.g., 101% of par). A call feature enables the

issuer to refinance the debt at a lower borrowing rate if rates have declined since issuance.

An embedded put option is an option granted to the creditor by the issuer giving the debt holder the right

to fully or partially sell the debt back to the issuer before the scheduled maturity date, usually at par or at

a premium (e.g., 101% of par). The put option permits the creditor to force the issuer to redeem the debt

when interest rates rise after the debt’s issuance, enabling the creditor to reinvest the proceeds at higher

market rates.

Frequently, debt agreements contain a put option that enables the investor to put the debt to the issuer

upon the occurrence of a fundamental change (certain change in control transactions as defined in the

agreement). This redemption feature is commonly referred to as a “change of control put.” Although

specific to each arrangement, the following are common examples of fundamental change events:

• A person or group becoming the direct or indirect ultimate beneficial owner of more than 50% of the

voting power of the issuer’s common equity

• Sale of all or substantially all of the issuer’s net assets

• Consummation of any share exchange, consolidation or merger of the issuer into another entity

• Specified changes in the board of directors

• Shareholders approving any plan or proposal for the liquidation or dissolution of the issuing entity

• The issuer’s common stock ceasing to be quoted or listed

Depending on the specific terms of the debt, embedded put or call options may be exercisable at any time

after issuance, after the passage of time (e.g., on or after the fifth anniversary) or upon the occurrence

of specified contingent events, and may coincide with each other.

2.2.5.1 Determining whether put and call features are considered clearly and closely related to

the debt host instrument

As discussed in section 2.2.3, if the economic characteristics and risks of an embedded feature are

considered clearly and closely related to the economic characteristics and risks of the host contract or

the embedded feature does not meet the definition of a derivative, the embedded feature should not be

bifurcated pursuant to ASC 815.

ASC 815-15-25-41 provides guidance on call and put options that do not accelerate the repayment of

principal on a debt instrument, but instead require a cash settlement that is equal to the price of the option

at the date of exercise. Those options would not be clearly and closely related to the debt instrument and,

therefore, would require bifurcation unless one of the other criteria in ASC 815-15-25-1 is not met.

ASC 815-15-25-42 provides a four-step decision sequence that is applied to determine whether a call or

put that can accelerate the settlement of a debt instrument is considered clearly and closely related to

the debt host instrument. When making this assessment, entities are not required to assess whether the

event that triggers the ability to exercise a contingently exercisable put or call is indexed only to interest

rates or credit risk of the entity.

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The following chart illustrates the four-step decision sequence in ASC 815-15-25-42 (Steps 2, 3 and 4 are

further discussed below):

The concepts in ASC 815-15-25-42 and 25-43 are illustrated with several examples in ASC 815-15-55-13.

2.2.5.1.1 Application of ASC 815-15-25-26 and the double-double test

Steps 2, 3 and 4 may require calls and puts to be considered pursuant to ASC 815-15-25-26, as applicable.

ASC 815-15-25-26, as further interpreted in paragraphs ASC 815-15-25-27 through 25-29, is applicable

only for embedded features in which the only underlying is an interest rate (including the debtor’s market

rate of interest) or an interest rate index.

Step 1: Is the amount paid upon settlement

adjusted based on changes in an index?

Step 3: Does the debt involve a substantial

premium or discount (refer to section 2.2.5.2)?

Step 2: Is the amount paid upon

settlement indexed to an underlying

other than interest rates or credit risk?

Step 4: Does a contingently exercisable

call or put accelerate the repayment of

the contractual principal amount?

Is the embedded feature based solely

on an interest rate or interest rate index

as the underlying?

Not clearly and closely related to

the debt host.

Analyze under ASC 815-15-25-26

(refer to section 2.2.5.1.1).

Yes

Yes (contingency exists)

Clearly and closely related to

the debt host.

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Therefore, ASC 815-15-25-26 is not applicable to a put or call exercisable upon a contingency (e.g., put

option exercisable upon a change in control), because that feature has an underlying other than an interest

rate or interest rate index (i.e., the occurrence or nonoccurrence of the contingent event).

Puts and calls that are exercisable at any time or only after a certain time period (e.g., upon the fifth

anniversary of the debt’s issuance) are in the scope of ASC 815-15-25-26, because the passage of time

is not a contingency or an underlying. If such a put or call’s settlement is adjusted based on an underlying

other than interest rates or credit, that feature would not be in the scope of ASC 815-15-25-26. However,

ASC 815-15-25-42 and 25-43 should be considered to determine whether that feature is considered

clearly and closely related.

ASC 815-15-25-26 through 25-29 indicate that if the embedded feature’s only underlying is interest-rate

related, and it alters net interest payments that otherwise would be paid or received on an interest-

bearing host contract, the embedded feature meets the clearly and closely related criteria unless one of

the following conditions is present:

(1) The hybrid instrument could be contractually settled in such a way that the investor would not

recover substantially all of its initial recorded investment.

(2) The embedded derivative meets both of the following conditions:

(a) There is a possible future interest rate scenario (even though it may be remote) under which the

embedded derivative would at least double the investor’s initial rate of return on the host contract.

(b) For any of the possible interest rate scenarios under which the investor’s initial rate of return on

the host contract would be doubled (as discussed in (a) above), the embedded derivative would

at the same time result in a rate of return that is at least twice what otherwise would be the then-

current market return (under the relevant future interest rate scenario) for a contract that has

the same terms as the host contract and that involves a debtor with a credit quality similar to the

issuer’s credit quality at inception.

Pursuant to ASC 815-15-25-29, the test under criterion (1) above applies only where the investor

(creditor) could be forced by the contractual terms of the hybrid instrument (i.e., by the issuer) to accept

settlement at an amount that causes the investor not to recover substantially all of its initial recorded

investment. However, if the investor has the option to settle before maturity in a manner in which it

would not recover substantially all of its investment (e.g., because of market interest rate fluctuations),

the clearly and closely related presumption would not be invalidated.

The test under criterion (2) above is sometimes referred to as the “double-double test” because it

focuses on doubling both the initial rate of the return and a then-current rate of return. ASC 815-15-25-37

through 25-39 provides that the double-double test does not apply to a noncontingent embedded call

option in a debt host contract if the right to accelerate the settlement of the debt can be exercised only

by the debtor.

If the double-double test is applicable, a debt instrument issued at par and redeemable at par will

generally pass. However, for debt that can be redeemed at a premium such as 101% of par, the double-

double test should be carefully considered. The issuer should assume the option will be exercised as soon

as contractually possible. If the 101% of par redemption feature is assumed to be exercisable immediately,

the feature will likely require bifurcation because the one-day rate of return for the investor is 1% if the

put is exercised on the very next day. Assuming no compounding, a one-day rate of return of 1% on an

instrument issued at par is the equivalent of a 365% per annum return, which should clearly double the

investor’s initial rate of return, and any then-current rate of return, in any interest rate environment. Many

redemption features are exercisable only on specific dates established to pass the double-double test.

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Refer to section 3 of our FRD publication, Derivatives and hedging, for further discussion of the concept of

clearly and closely related.

2.2.5.2 Meaning of ‘involve a substantial premium or discount’

In connection with the evaluation under Step 3 in ASC 815-15-25-42 (as discussed in section 2.2.5.1),

the issuer should determine whether the debt involves a significant premium or discount. For example,

a premium or discount could exist in a debt instrument that (1) was issued with a premium or discount

(e.g., zero-coupon debt), (2) was issued in a basket transaction that required an allocation of proceeds

(refer to section 1.2.7) to the debt instrument and other freestanding instruments or (3) was assumed in

a business combination. We do not believe that issuance costs paid to third parties should be considered

a discount for the analysis. Importantly, however, a premium or discount may also exist if the debt

instrument contains either other bifurcated derivatives or equity-classified components that are

accounted for separately.

There is no authoritative guidance on what constitutes a substantial premium or discount. However,

ASC 470-50-40-10 describes debt that is substantially different based on at least a 10% difference in

cash flows on a present value basis. By analogy to the term “substantially different” in that guidance,

some have argued that if a premium or discount (as discussed above) is approximately 10% or more of

the principal amount of the note, it is substantial. This determination should be based on the specific

facts and circumstances and requires professional judgment.

We generally believe a discount or premium resulting from the bifurcation of an embedded derivative that

could be separately settled prior to or on redemption (e.g., those features are settled for consideration

that is incremental to settlement of the contractual redemption feature) should be considered in analyzing

a redemption feature. For example, a $1,000 debt instrument may be carried at $950 due to a bifurcated

contingent interest feature of $50 that could be triggered and settled prior to the exercise of the

redemption feature. This discount would be considered because the holder could receive both the

$50 contingent interest feature prior to redemption and then the $1,000 on redemption.

However, a discount or premium from a bifurcated embedded derivative (or an equity component that

is separately accounted for in cash-convertible debt or beneficially convertible debt) that could not

separately settle on or before the redemption should not be considered in the redemption feature

analysis. For example, assume a convertible bond was issued for $1,000 with an embedded conversion

option that requires bifurcation at its fair value of $200. If that debt instrument were also puttable at

par, one might first think there was a substantial discount (debt instrument of $800 puttable at $1,000,

or a 20% discount). However, on redemption, the investor would not receive both $1,000 and the value

of the conversion option. Instead, the investor would receive only the $1,000 initially invested in the

single instrument purchased. Thus, the discount from the conversion option bifurcation should not be

considered in evaluating the return provided from the redemption feature.

Another issue is how to determine whether the debt involves a substantial premium or discount. We

generally believe it is important that the guidance uses the term “involves” and not “issued at.” If the

debt is callable at a premium or a discount, we generally believe that premium or discount should be

considered in relation to the initial offering proceeds, when determining whether the debt involves a

substantial premium or discount under Step 3 in ASC 815-15-25-42.

For example, if debt were issued at par with a redemption price of 110, we generally believe the debt

redemption involves a premium even though the debt was issued at par. As another example, if debt were

issued at 93, and were redeemable at 104, the premium involved on redemption is 11 (the difference

between issuance proceeds and redemption price) rather than 4 (the difference between par and the

redemption price) or 7 (the difference between the initial proceeds and par).

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2.2.5.3 Determining whether put and call features meet the definition of a derivative subject to

derivative accounting

If the redemption feature is not considered clearly and closely related to the debt host, it should be evaluated

to determine whether the feature would meet the definition of a derivative if it were freestanding. An

embedded feature would be considered a derivative pursuant to ASC 815 only if all four characteristics

of a derivative (discussed in section 2.2.3.4) were met. Typically, a redemption feature would meet all

four criteria as outlined below:

• Underlying — The underlying is the fair value of the underlying debt instrument, which is a function of

interest rates and credit risk.

• Notional amount — The principal amount of the debt instrument is the notional amount.

• No initial net investment — The fair value of the embedded redemption feature at inception is

considered its initial investment (not the initial investment in the convertible debt instrument).

That amount is generally less than the fair value of the underlying notes.

• Net settlement — Redemption features are generally physically settled and the underlying notes may

or may not be publicly traded. ASC 815-10-15-107 through 15-109 concludes that the potential

settlement of the debtor’s obligation to the creditor that would occur upon exercise of the put option

or call option meets the net settlement criterion because (1) the debtor does not receive an asset

when it settles the debt obligation in conjunction with exercise of the put option or call option and

(2) the creditor does not receive an asset associated with the underlying, so that “neither party is

required to deliver an asset that is associated with the underlying … “

In general, redemption features will not qualify for any of the exceptions from derivative accounting in

ASC 815. We generally believe this includes scenarios where the call or put premium is received in

shares, even if the shares are not readily convertible to cash (since there is a net settlement of the

redemption feature on its own). Therefore, if a redemption feature is not considered clearly or closely

related to the debt host, the redemption feature will likely require bifurcation from the host debt

instrument and will be accounted for in the same manner as a freestanding derivative pursuant to

ASC 815, with subsequent changes in fair value recorded in earnings each period.

2.2.6 Box D(C) and Boxes D1, D2 and D3 — Evaluating other potential embedded

features

A debt instrument may have a variety of features that can affect the timing and amount of future cash

flows in a way similar to a derivative. Those features should be evaluated pursuant to the criteria in

ASC 815 (discussed in section 2.2.3) to determine if they require bifurcation. A careful analysis of the

underlying agreements is necessary to identify all potential features to be evaluated.

While not all instruments have potential embedded derivatives, some of the more common ones observed

in practice are contingent interest features, interest make-whole features (which appear more often in

convertible debt) and term-extending options.

2.2.6.1 Contingent interest features

Some debt instruments contain features that require additional interest to be paid to the holder if certain

events occur (e.g., the issuer fails to file SEC reports or fails to meet certain financial covenants or the

price of its common stock exceeds a certain target).

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Contingent interest features generally meet the definition of a derivative. If the economic characteristics

of a contingent interest feature are not clearly and closely related to those of the debt host instrument,

the contingent interest feature requires bifurcation from the host instrument. For example, a contingent

interest feature that increases the interest rate on the instrument if the market price of the issuer’s

common stock falls (or rises) to a specified level should be bifurcated and separately accounted for

pursuant to ASC 815 as the underlying (i.e., the issuer’s common stock price) is not clearly and closely

related to the debt host in a convertible debt instrument.

Another common example of a contingent interest feature is one requiring additional interest on a failure

to comply with a debt covenant or in the event of a default, as defined in the debt agreement. Generally,

an interest rate that adjusts on the creditworthiness of the issuer is clearly and closely related to a debt

host instrument as discussed in ASC 815-15-25-46, which states:

The creditworthiness of the debtor and the interest rate on a debt instrument shall be considered to

be clearly and closely related. Thus, for debt instruments that have the interest rate reset in the

event of any of the following conditions, the related embedded derivative shall not be separated from

the host contract:

a. Default (such as violation of a credit-risk-related covenant)

b. A change in the debtor’s published credit rating

c. A change in the debtor’s creditworthiness indicated by a change in its spread over US Treasury bonds

However, some default interest provisions are still required to be bifurcated. The guidance stresses that

the default should be a violation of a credit-risk-related covenant and not simply labeled a “default”

provision. Many covenants are not directly credit-risk-related. Therefore, the nature of the underlying

trigger for the contingent interest should be carefully evaluated.

In some convertible debt instruments, the trigger for the contingent interest is expressed in terms of the

market price of the entire hybrid instrument (such as a $120 market price on a $100 par convertible bond).

In these instances, although the market price is affected by the interest rate and credit risk of the issuer,

it is also affected by the equity share price. In other cases, it may be even more clear that the feature is

not clearly and closely related to the debt host, because the contingent interest may be triggered based

solely on the issuer’s share price (e.g., whenever the share price exceeds 125% of the conversion price).

A contingently convertible debt instrument that provides holders with additional interest equal to the fair

value of any dividends received by the holders of the stock into which the instrument may be converted

should be analyzed to determine whether this contingent interest feature constitutes an embedded

derivative requiring bifurcation under ASC 815. As the underlying (i.e., dividend payments) is not clearly

and closely related to the debt host instrument, the other criteria for bifurcation, including the definition

of a derivative, should be evaluated. This contingently convertible instrument should also be evaluated as

a potential participating security for EPS purposes pursuant to ASC 260.

While less frequent, some contingent interest features may qualify for an exception to derivative

accounting. For example, if a debt instrument required additional interest only if the issuer’s sales volume

failed to reach a specified threshold, that feature may meet the scope exception in ASC 815-10-15-59. If a

contingent interest feature is not required to be bifurcated pursuant to ASC 815, interest expense related

to the contingent feature generally should be recognized pursuant to the provisions in ASC 470-10-25-3

through 25-4 and 35-4 (refer to section 2.2.6.4 for indexed debt) or ASC 450 depending on the facts and

circumstances. Judgment is required when determining whether the trigger is an index or a contingency.

Refer to section 3 of our FRD publication, Derivatives and hedging, for further discussion on embedded

derivatives. Also refer to the discussion of contingent interest payments in connection with registration rights

agreements in section 5.11.

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The following example illustrates the accounting for a contingent interest feature:

Illustration 2-1: Convertible bonds with a contingent interest feature

On 1 January 20X4, Company A issues at par a series of convertible bonds with a face amount of $1,000

that mature 31 December 20Y4. The bonds have a yield to maturity of 2% per annum, computed

semiannually.

Each $1,000 par value bond is convertible into 10 shares of the issuer’s common stock for a

conversion price of $100 at any time (assume the conversion option is not bifurcatable, not cash

convertible and not beneficial).

Beginning 31 March 20X4, if the average market price of Company A’s common stock is equal to or

greater than 125% of the conversion price of the bonds (i.e., share price is $125) for any 20 out of the

last 30 trading days before such date or any 1 January or 1 July thereafter, the coupon rate will be

increased to 2.5%.

The contingent interest feature in this example meets the definition of a derivative and is indexed to

the value of the common stock, which is not related to the economic characteristics of the debt host.

Additionally, this feature is not eligible for the exception in ASC 815-10-15-74(a) used for a conversion

option because the contingent interest feature, if freestanding, would not be classified in stockholders’

equity as it is settled in cash. Accordingly, the contingent interest feature is considered an embedded

derivative that should be bifurcated from the host instrument.

2.2.6.2 Interest make-whole features (updated August 2023)

Debt instruments may include an interest make-whole provision, which provides that, in certain

circumstances (e.g., early conversion or redemption), the holder will receive an amount that is equal to

the present value of the debt’s remaining contractual interest cash flows, generally discounted at a

specified small spread over the then-current US Treasury rate. This make-whole amount compensates the

investor for forgoing future interest payments on the debt after conversion or redemption.

The triggers for those make-whole provisions can vary, but they frequently occur when a conversion or

redemption is triggered by either by the passage of time or a change-in-control event. The consideration paid

may be in cash or in a variable number of shares equal to the interest make-whole amount, usually at the

issuer’s option.

For example, assume that a five-year 10% convertible bond contains a conversion option that permits the

holder to convert the note into common stock of the issuer at any time after issuance. The bond is callable

at any time by the issuer after Year 2 at par plus an amount equal to the then-present value of all the future

contractual interest cash flows discounted at the then-current US Treasury rate plus 50 basis points. The

indenture also provides that upon conversion the holder receives, in addition to the common shares

received for each $1,000 principal amount of the notes, a similarly calculated amount for future interest.

The issuer has the option to settle this interest make-whole amount in either cash or shares.

Like a time value make-whole feature (discussed in section 2.2.4.5), the amounts that would be paid

under an interest make-whole feature could be presented in a table. However, the amount to be paid

under an interest make-whole feature for a given date would typically be the same, regardless of the

stock price.

The bifurcation analysis of an interest make-whole feature can be complex and will depend on the terms

of the transaction. Following are some considerations:

• When evaluating an interest make-whole feature in conjunction with a redemption event, the amount

may be viewed as a premium in connection with the redemption feature and, therefore, should be

analyzed as discussed in section 2.2.5.

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• When evaluating an interest make-whole feature that is triggered by a conversion event, it may

be viewed together with the conversion option as a single unit of analysis. If the feature is viewed as

part of the conversion option, the entire conversion option would be bifurcated (assuming all other

conditions in paragraph ASC 815-15-25-1 are met). This is because the conversion, including the

interest make-whole feature, is not considered indexed to the issuer’s stock, since a portion of the

settlement amount (the interest make-whole amount) is not indexed to the issuer’s stock.

There may be other acceptable views with respect to the unit of analysis. However, that determination

requires a significant amount of judgment based on the facts and circumstances. Refer to section 2.2.3.1

for further discussion of unit of analysis considerations for embedded features.

2.2.6.3 Term-extension features

Section 2.1.2.3 describes debt with term-extending features. An embedded term extension feature is

an embedded feature that unilaterally enables one party to extend significantly the remaining term to

maturity or automatically extends the maturity when triggered by a specific event or condition.

Term-extending provisions should be analyzed to determine whether they constitute an embedded

derivative. ASC 815-15-25-44 provides that if the instrument’s interest rate is not reset to the approximate

current market rate for the extended term and the debt instrument initially involved no significant discounts,

the feature is not clearly and closely related to the debt host. The other criteria for bifurcation, including

the definition of a derivative, should also be evaluated.

Some believe that term-extending options should be viewed similarly to term-shortening options such as

calls and puts. For example, some believe there is no difference between 10-year debt that is callable in

Year 5 and five-year debt that is extendable for another five years at the same rate. However, the

derivatives guidance is clear that the form of the instrument and the term are important in the analysis.

ASC 815-15-25-44 addresses only debt hosts, not other hosts such as leases, in which term-extending

options are frequently embedded.

2.2.6.4 Debt indexed to inflation and other variables (indexed debt)

Indexed debt is described in section 2.1.2.5. Those debt instruments are typically issued with both fixed

and contingent payments. The contingent payments are typically indexed to quoted market measures or

broad economic statistics, such as prices of commodities (e.g., oil, gold) or indices (e.g., the S&P 500

index). The indexing feature may be a separate freestanding financial instrument.

Indexing features that are not freestanding financial instruments should be analyzed to determine

whether they require bifurcation as embedded derivatives pursuant to ASC 815 (as discussed in section

2.2.3). The guidance in ASC 815-15-25-48 and 25-49 generally provide that changes in the fair value of

a commodity or an equity security that affect the amount of interest and/or principal payments are not

clearly and closely related to a debt instrument. Because these features typically meet the definition of a

derivative and generally do not qualify for any exceptions, they are often bifurcated.

Pursuant to ASC 815-15-25-50, inflation-indexed interest payments that are based on the rate of

inflation in the economic environment for the currency in which the debt instrument is denominated

should be considered clearly and closely related if they are not leveraged (e.g., four times the change in

an inflation index times the notional amount). Indexing features based on inflation indices that are not

consistent with the currency in which the debt is denominated may represent embedded derivatives

requiring bifurcation (e.g., USD-denominated debt that is indexed to the inflation rate in Japan).

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If the indexing feature is not freestanding and is not required to be bifurcated as an embedded derivative

pursuant to ASC 815 (e.g., because the debt was grandfathered from application of ASC 815’s

provisions or requires the delivery of a commodity that is not readily convertible to cash), the entire

instrument should be accounted for pursuant to ASC 470-10-25-4 and 35-4.

If the indexing feature is a separate freestanding financial instrument that is not subject to derivative

accounting pursuant to ASC 815, it should also be accounted for pursuant to ASC 470-10-25-4 and 35-4.

That guidance generally provides that when the indexing feature is a separate freestanding financial

instrument, the proceeds be allocated between the debt and the separate freestanding indexing feature.

The resulting premium or discount on the debt should be amortized over the life of the debt using the

effective interest method.

If the index value increases and the issuer would be required to pay the investor a contingent payment at

maturity, the issuer should recognize a liability for the amount that the contingent payment exceeds the

amount, if any, originally attributed to the indexing feature.

If the indexing feature is embedded in the debt (i.e., not a separate freestanding financial instrument) but

bifurcation is not required, the additional liability resulting from the fluctuating index value should be

accounted for as an adjustment of the carrying amount of the debt instrument.

The liability for the indexing feature should be based on the applicable index value at the balance sheet date

and should not anticipate any future changes in the index value. The guidance does not address how changes

in the indexed debt’s settlement value should be recorded. We generally believe an increase in the carrying

amount of the indexed debt (or the indexing feature that is a separate freestanding financial instrument from

the debt) should be recorded in earnings but should not be adjusted below its initial carrying amount.

If the indexing feature is embedded in the debt and bifurcation is required pursuant to ASC 815, the indexing

feature should be subsequently measured at fair value with the change in fair value recorded in earnings.

Refer to section 5.1 for a discussion of debt exchangeable into the common stock of another entity.

2.2.6.5 Participating mortgages

A participating mortgage entitles the lender to participate in (1) the appreciation in the market value of a

mortgaged real estate project and/or (2) the results of operations of the mortgaged real estate project. While

the instrument has a provision that entitles the investor to participate in the appreciation of the real estate,

bifurcation of this feature is not required because a separate contract with the same terms would be excluded

from the scope of ASC 815 based on the exception in ASC 815-10-15-59, given that settlement is based on

the value of a nonfinancial asset of one of the parties that is not readily convertible to cash.

ASC 470-30, Debt — Participating Mortgage Loans, provides that if a lender is entitled to participate in

the appreciation of the market value of a mortgaged real estate project, the fair value of the participation

feature at loan inception is recognized as a participation liability, with a corresponding debit to debt

discount. The debt discount is then amortized using the interest method. In this case, interest expense

consists of all of the following:

• Amounts designated in the mortgage agreement as interest

• Amortization of debt discount related to the lender’s participation in the fair value appreciation of

the mortgaged real estate project

The SEC staff indicated that if the debt’s terms did not provide for settlement below the original principal amount, the change

should generally be recorded in the income statement because the substance of the accounting is that of a written option. See

remarks by Russell B. Mallett at the Twenty-Third Annual National Conference on Current SEC Developments on 15 February 1996.

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At the end of each subsequent reporting period, the balance of the participation liability should be

adjusted to equal the current fair value of the participation feature. The corresponding debit or credit

should be to the related debt discount account and should be amortized prospectively, using the interest

method (i.e., the entire amount of the change in the fair value of the participation feature should not be

recognized in the current period income statement).

On the other hand, if a lender is entitled to participate in the results of operations of the mortgaged real

estate project, no liability is recognized at inception. Instead, amounts due to a lender pursuant to the

lender’s participation in the real estate project’s results of operations shall be charged to interest

expense in the period when incurred, with a corresponding credit to the participation liability. As above,

interest expense would also include amounts designated in the mortgage agreement as interest.

In either case, each component of interest expense is eligible for capitalization pursuant to ASC 835-20,

Interest — Capitalization of Interest. Once these expenses are capitalized, ASC 470-30-35-3 states that

the amounts should not be adjusted for the effects of reversals of appreciation.

2.2.6.6 Increasing-rate debt

Increasing-rate debt instruments are described in section 2.1.2.9. At initial issuance, the embedded

term-extending option of the increasing-rate debt instrument should be analyzed to determine whether

it constitutes an embedded derivative that warrants separate accounting as a derivative pursuant to

ASC 815. Refer to section 2.2.6.3 for further discussion.

ASC 470-10-35-2 provides that the issuer’s periodic interest cost should be calculated using the interest

method based on the estimated outstanding term of the debt. In estimating the term of the debt, the

issuer considers its plans, ability and intent to service the debt. Debt issuance costs and discounts or

premiums associated with the increasing-rate debt should be amortized over the same period used in the

interest cost determination.

As discussed in ASC 470-10-45-8, if the debt is paid at par prior to its estimated maturity, any excess

interest accrued would be recognized as an adjustment to interest expense and not a part of the gain or

loss on extinguishment.

2.2.6.7 Debt denominated in a currency other than the issuing entity’s functional currency

Debt payable in a foreign currency is initially measured and recorded in the functional currency using

the exchange rate at the balance sheet date (i.e., the spot rate). There is no embedded derivative

related to the foreign currency denomination pursuant to the exception to derivative accounting in

ASC 815-15-15-5. However, if the debt is convertible the conversion option will require bifurcation as

discussed in section 2.2.4.9.

2.2.6.8 Sales of future revenues

A sale of future revenue typically involves an entity receiving an up-front payment from an investor in

exchange for granting the investor the right to receive a specified percentage or amount of the future

revenue (or other measure of income such as gross margin, operating income or pretax income) of a

particular product or service of the entity (e.g., a drug compound the entity intends to develop) for a

defined period. While the transaction entitles the investor to cash flows that vary based on the entity’s

revenues (or other measure of income), bifurcation of this feature generally is not required because a

separate contract with the same terms would be excluded from the scope of ASC 815 based on the

exception in ASC 815-10-15-59(d). That exception excludes from derivative accounting non-exchange

traded contracts where settlement is based on a specified volume of sales or service revenues of one of

the parties to the contract.

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Whether the up-front payment received from the investor should be classified as debt or deferred income

depends on the specific facts and circumstances. ASC 470-10-25-2 provides a number of factors to be

considered. Pursuant to that guidance, the presence of any one of the following factors independently

creates a rebuttable presumption that debt classification is appropriate:

• The transaction does not purport to be a sale (that is, the form of the transaction is debt).

• The entity has significant continuing involvement in the generation of the cash flows due to the

investor (for example, active involvement in the generation of the operating revenues of a product

line, subsidiary or business segment).

• The transaction is cancelable by either the entity or the investor through payment of a lump sum or

other transfer of assets by the entity.

• The investor’s rate of return is implicitly or explicitly limited by the terms of the transaction.

• Variations in the entity’s revenue or income underlying the transaction have only a trifling effect on

the investor’s rate of return.

• The investor has any recourse to the entity relating to the payments due to the investor.

ASC 470-10-35-3 requires amounts recorded as debt to be amortized under the interest method as

described in ASC 835-30. Accordingly, an entity would need to determine an effective interest rate

based on future revenue streams expected to be paid to the investor. This rate represents the discount

rate that equates estimated cash flows with the initial proceeds received from the investor and is used to

compute the amount of interest expense to be recognized each period. When there is a change in

estimated cash flows from future revenue, depending on the facts and circumstances, we generally

believe that the following approaches may be appropriate to address those changes:

• Retrospective method — A new effective interest rate is calculated based on the original carrying

amount, cash flows to date and the revised estimate of remaining cash flows. This new discount rate

is then used to adjust the carrying amount of the debt to the present value of the revised estimated

cash flows, discounted at the new effective interest rate. The offset is recognized in earnings. This

method would result in an immediate adjustment to the carrying amount of the debt whenever the

expected cash flows are updated.

• Catch-up method — After a change in estimated cash flows, the entity would adjust the carrying

amount to the present value of the revised estimated cash flows, discounted at the original effective

interest rate. The offset to the adjustment is recognized in earnings. While this method would result

in an immediate adjustment to the carrying amount of the debt whenever the expected cash flows

are updated, it maintains a constant effective yield throughout the life of the instrument.

• Prospective method — A new effective interest rate is determined based on the revised estimate of

remaining cash flows. The new rate is the discount rate that equates the present value of the revised

estimate of remaining cash flows with the carrying amount of the debt, and it will be used to

recognize interest expense for the remaining periods. Under this method, the effective interest rate

is not constant, and any change in expected cash flows is recognized prospectively as an adjustment

to the effective yield. Unlike the other methods, changes in expected cash flows aren’t recognized

immediately in earnings.

We generally believe that a sale of future revenues classified as debt under ASC 470-10-25-1 through 25-2

should not be subsequently adjusted below the initially recognized amount until one of the conditions in

ASC 405-20-40-1 is met and, therefore, derecognition is appropriate. Refer to section 2.5 for the

guidance on debt extinguishment.

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2.2.7 Box E — Bifurcation of a single embedded derivative

ASC 815-15-25-7 through 25-10 does not permit an entity to account separately for more than one

derivative feature embedded in a single hybrid instrument. As a result, after identifying, evaluating and

concluding on which features of a debt instrument (e.g., conversion option, redemption features, other

embedded features) require bifurcation, a single derivative comprising all the bifurcatable features

should be separated from the debt host instrument. This unit of account for bifurcation may be different

than the unit of analysis for bifurcation that is discussed in section 2.2.3.1.

ASC 815-15-30-2 requires the embedded derivative (whether a single feature derivative or a compound

derivative) to be recorded at fair value. The difference between the proceeds allocated to the hybrid debt

instrument (refer to section 1.2.3.3) and the fair value of the bifurcated derivative is assigned to the host

debt instrument.

Refer to section 3 of our FRD publication, Derivatives and hedging, for further guidance on embedded

and compound derivatives, including those described in this section.

2.2.7.1 Option-based embedded derivatives

ASC 815-15-30-6 states that the terms of an option-based embedded derivative should not be adjusted

to result in the embedded derivative being at the money at the inception of the hybrid instrument. Rather,

the option-based embedded derivative should be bifurcated based on the stated terms documented in the

hybrid instrument whether the option is in the money, at the money, or out of the money at inception.

2.2.7.2 Forward-based embedded derivatives

ASC 815-15-30-4 states that in separating a non-option (forward-based) embedded derivative from the

host contract, the terms of that non-option embedded derivative should be determined in a manner that

results in its fair value generally being equal to zero at the inception of the hybrid instrument.

For example, a loan and an embedded derivative can be bundled in a structured note that could have

almost an infinite variety of stated terms all possessing the same economics. Therefore, it would be

inappropriate to necessarily attribute significance to every one of the note’s stated terms in determining

the terms of the non-option embedded derivative. If a non-option embedded derivative has stated terms

that are off-market at inception, that amount is quantified and allocated to the host contract because it

effectively represents a borrowing. This concept is illustrated at ASC 815-15-55-160.

2.2.7.3 Financial statement classification

While ASC 815 does not specifically address the classification of embedded derivatives (i.e., on the balance

sheet and classification in the statement of operations), the SEC staff

shared the following example in

comments made at the 2000 AICPA National Conference on Current SEC Developments:

An entity issued a debt obligation with an interest rate that was indexed to the S&P 500. Since this

embedded equity derivative was not considered clearly and closely related to the debt host, the

equity derivative was measured at fair value separate from the debt obligation. The host debt

contract was accounted for in accordance with generally accepted accounting principles applicable

to debt instruments. While measured separately, the embedded derivative and the host contract

together will result in principal and interest payments to the debt holder. The company asked if the

embedded derivative could be netted with the host contract for financial statement presentation

purposes. In this case, the staff believes presenting the embedded derivative and the host contract

on a combined basis is an appropriate presentation of the company’s overall future cash outflows for

See remarks by E. Michael Pierce at the Twenty-Eighth Annual National Conference on Current SEC Developments on 4 December 2000.

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that debt instrument as the requirements in US GAAP for legal right of offset would be met. The staff

believes Statement 133’s bifurcation requirements for embedded derivatives do not extend beyond

measurement to presentation in the financial statements.

As a result of the SEC staff comments, practice has generally combined the presentation of a bifurcated

embedded derivative with the host contract, but the individual facts and circumstances should be

considered. The disclosures in ASC 815 are required for bifurcated embedded derivatives.

2.2.8 Box F — Non-bifurcated features and conversion options

An individual feature that does not require bifurcation remains embedded in the debt instrument.

However, if that embedded feature were a conversion option, separate accounting as an equity

component may be required if (1) the debt instrument may be settled in cash or partially in cash on

conversion as described in the “Cash Conversion” subsections of ASC 470-20, (2) the conversion feature

is a BCF, as discussed throughout various sections of the “General” subsections of ASC 470-20 or (3) the

debt was issued at a substantial premium.

2.2.9 Boxes G, H and I — Cash conversion options

Convertible debt instruments that may be settled in cash (or other assets)

on conversion follow the

“Cash Conversion” sections of ASC 470-20. Examples include Instruments B, C and X that are discussed

in section 2.1.2.1. The cash conversion guidance requires the issuer to separately account for the

liability (debt) and equity (conversion option) components of the instrument in a manner that reflects

the issuer’s nonconvertible debt borrowing rate.

The cash conversion guidance is presented as a four-step process in ASC 815-15-55-76A. The first two

steps require identifying any embedded features, other than the conversion option, in the hybrid

instrument and then determining which, if any, of those embedded features may require bifurcation as a

separate derivative. The FASB determined that the first two steps should occur before proceeds are

allocated to the liability and equity components, because the conclusion to bifurcate certain embedded

features can depend on whether the hybrid instrument is issued at a discount.

Importantly, nothing

should be bifurcated yet at this point. So far, the issuer has concluded only on what requires bifurcation.

The third step of the cash conversion guidance requires the liability component to be measured at the

estimated fair value, as of the date of issuance, of a similar debt without the conversion option

(i.e., nonconvertible debt). This similar nonconvertible debt also includes any other embedded features

and covenants (e.g., prepayment features such as puts and calls) present in the actual debt instrument.

Thus, the liability component comprises, and will be allocated value based on, all of the features of the

instrument except the conversion option.

In the fourth step, after the proceeds have been allocated to the liability component, any embedded

derivative requiring bifurcation will be split from the liability component as a single derivative (or single

compound derivative if multiple features require bifurcation) that is measured at fair value.

The difference between the initial proceeds of the convertible debt and the value allocated to the liability

component is recognized in additional paid-in capital (APIC) as the carrying amount of the equity

component (i.e., the conversion option).

Refer to Appendix C for a detailed discussion of the cash conversion guidance.

The scope of the cash conversion guidance includes instruments that may be settled in cash (or other assets) upon conversion.

For simplicity, section 2 simply refers to settlement for cash.

For example, when evaluating embedded prepayment features under the guidance in ASC 815-15-25-42, 25-43 and 55-13, the

discount that is created under the cash conversion guidance does not create a discount to be considered in the application of

Step 3 of that four-step bifurcation decision sequence. Refer to sections 2.2.5.1 and 2.2.5.1.1 for further discussion.

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2.2.10 Boxes J, K and L — Beneficial conversion features and contingent beneficial

conversion features

A conversion option that is not bifurcated as a derivative pursuant to ASC 815 (Box I) should be

evaluated to determine whether it is considered a beneficial conversion option at inception or may

become beneficial in the future due to potential adjustments (often referred to as a contingent beneficial

conversion option). The guidance on BCFs is provided in ASC 470-20.

The Master Glossary to ASC 470-20 defines a BCF as “a nondetachable conversion feature that is in the

money at the commitment date.” An option is in the money if its exercise price (conversion price for

convertible stock) is less than the current fair value of the share.

For example, debt issued at $100 that is convertible into 10 shares has a stated conversion price of

$10 per share. That conversion option would be in the money if the current share price at the commitment

date (usually the issuance date) were more than $10, making immediate conversion beneficial to the

investor. If the share price were $12 per share at the commitment date, the investor could convert the debt

into 10 shares worth $120 (10 shares times $12), which is more than the initial investment of $100. It is

this immediate $20 benefit that the BCF guidance attempts to measure.

The BCF guidance generally requires embedded BCFs present in convertible securities to be valued

separately (at intrinsic value rather than fair value) and allocated to APIC. The BCF guidance states that

the effective conversion price, which may be different than the contractual conversion price, should be

used to determine the existence of a BCF. The effective conversion price is based on the proceeds

received or allocated to the convertible debt instrument (including embedded derivatives), and the

amount is measured as of the commitment date.

For example, despite having a contractual conversion price of $10 per share, the convertible debt in the

example above would have an effective conversion price of $9 per share if the $100 par amount debt had

been issued at $90 ($90 proceeds received divided by the 10 shares into which it could be converted).

That initial $10 discount could result from simply issuing the convertible debt at a discount, or more likely

from allocating part of the proceeds of issuance to other instruments in a basket transaction.

The BCF guidance establishes that costs of issuing convertible instruments paid to third parties do not

affect the effective conversion price and calculation of the intrinsic value of an embedded conversion

option. However, any amounts paid to the investor represent a reduction in the proceeds received by the

issuer and should affect the calculation of the intrinsic value of an embedded option.

If an embedded derivative requires bifurcation from the debt (e.g., a contingent interest feature or a put

or call option), we do not generally believe it affects the proceeds considered in determining the effective

conversion price unless that feature could be separately settled prior to or contemporaneous with the

conversion of the instrument.

Because BCFs are measured on the commitment date, that date should be carefully evaluated. Purchase

agreements that may permit either party to rescind its commitment to consummate the transaction

(e.g., due to material adverse change in the issuer’s operations or financial condition, customary due

diligence, shareholder approval) generally do not establish a commitment date.

Convertible debt may contain conversion terms (i.e., the conversion ratio or conversion price) that

change upon the occurrence of a future event. Those changes may give rise to contingent BCFs that are

generally measured at the commitment date at intrinsic value and recognized upon the occurrence of the

contingent event.

After allocating the intrinsic value of the BCF to APIC, the remaining proceeds are allocated to the debt

host. It is from those proceeds that any embedded derivative is bifurcated.

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Refer to Appendix D for a comprehensive discussion of the accounting for BCFs.

2.2.11 Boxes M and N — Debt issued at a substantial premium where the conversion

option is not accounted for separately

If the conversion feature (1) does not require bifurcation as an embedded derivative (Box D) and (2) is not

subject to separate accounting under the cash conversion guidance (Box G) or the BCF guidance (Box J),

the convertible debt should be classified and measured pursuant to the guidance for convertible debt in

ASC 470-20.

Convertible debt may be issued at a premium because the proceeds received upon issuance exceed the

principal amount that will be paid at maturity. For example, in a business combination, the fair value of

the acquiree’s convertible debt may also exceed the par amount. ASC 470-20-25-13 states that when

convertible debt is issued at a substantial premium, there is a presumption that the premium represents

paid-in capital. Paid-in capital is increased by reclassifying part of the debt proceeds to APIC.

The authoritative guidance does not define the term “substantial premium.” In accounting for debt

modifications, ASC 470-50-40-10 states that debt is substantially different when there is at least a 10%

difference in the present value of cash flows. Analogizing to that guidance, a premium (based on the net

proceeds allocated to the debt instrument) that is approximately 10% or more of the principal amount of

the note, might be considered substantial. However, in some cases a premium of less than 10% might still

be considered substantial. For example, a premium of less than 10% might be substantial if an entity

would recognize negative interest expense (i.e., the amortization of the premium exceeds the contractual

coupon expense). Determining the accounting for debt issued at a substantial premium should be based

on the specific facts and circumstances.

Further analysis will also be required when a convertible debt instrument has other features that could

affect the determination of whether debt is issued at a substantial premium. We generally believe that if

there are any embedded derivatives that are bifurcated and could be separately settled before or at

conversion (e.g., interest make-whole features), an issuer should adjust the proceeds it uses to

determine whether a substantial premium exists. That is, the issuer should reduce the proceeds it initially

allocated to the convertible debt by the fair value of the bifurcated embedded derivative, and use the

lower amount to determine whether a substantial premium exists.

For example, assume a five-year convertible bond that is issued at 110% of par contains an interest

make-whole in the event of conversion. The interest make-whole, which has a fair value of 7% of par, is

concluded to be an embedded derivative that should be bifurcated. After bifurcating the interest make-

whole feature, the bond would be valued at 103% of its par value, and the issuer would likely conclude

that the convertible debt is not issued at a substantial premium.

When considered substantial, the entire premium is typically allocated to paid-in capital, based on

ASC 470-20-25-13, which states that “such premium represents paid-in capital.” There is no specific

guidance on how to overcome the presumption in ASC 470-20-25-13 that the premium associated with

debt issued at a substantial premium should be allocated to paid-in capital. That determination should be

based on the specific facts and circumstances (e.g., stated interest rate was higher than the market rate

despite a conversion option or another embedded feature significantly increased the fair value of the debt).

Issuers of convertible preferred shares that are classified as liabilities under ASC 480-10 should also apply

the guidance in ASC 470-20. That is, they will evaluate whether the conversion feature needs to be

accounted for separately under the substantial premium model if the feature is not required to be

bifurcated under ASC 815.

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2.2.12 Box O — No accounting is required for the conversion option

If the conversion feature does not require bifurcation as an embedded derivative (Box E), is not subject to

separate accounting pursuant to either the cash conversion guidance (Box G) or the BCF guidance (Box

J) and the convertible debt was not issued at a substantial premium (Box M), the general conversion

guidance in ASC 470-20 states that all of the proceeds received from the issuance of convertible debt

generally should be recorded as a liability on the balance sheet. That is, no portion of the proceeds from

issuing convertible debt instruments should be attributed to the conversion feature at inception.

The general conversion guidance describes this type of convertible debt in ASC 470-20-25-10 and 25-11

as debt that is convertible into common stock of the issuer or an affiliated entity at a specified price at

the option of the holder and that is sold at a price or has a value at issuance not significantly in excess of

the face amount.

2.2.13 Box P — Temporary equity classification of the equity component separated

from convertible debt

If a convertible debt instrument has a portion of its proceeds allocated to an equity component (e.g., either

pursuant to the cash conversion guidance or the BCF guidance), paragraphs 3(e), 12(d), 16(d) and 23 of

ASC 480-10-S99-3A should be considered to determine whether a portion of the equity component

should be classified in temporary equity.

Refer to sections E.3.1 and E.7 for further discussion of these concepts.

2.3 Costs and fees incurred upon debt issuances

ASC 835 requires entities to capitalize debt issuance costs paid to third parties (e.g., legal fees, printing

costs, underwriters’ fees) that are directly related to issuing debt and that otherwise wouldn’t be incurred.

Internal costs that meet the incremental and direct criteria (e.g., travel costs directly related to financing)

may also be deferred, but costs such as salaries, rent and other period costs cannot be capitalized as

issuance costs.

Amounts paid to the lender are a reduction in the proceeds received by the issuer and are considered a

component of the discount on the issuance and not an issuance cost.

In some cases, fees paid to the lender may be compensation for services beyond their role as a creditor.

For example, a loan syndication involving multiple lenders will generally be arranged by an investment

bank that typically also assumes a role as a lender. Because of this dual role, fees paid to the investment

bank may represent compensation for its role in arranging the syndication, its role as a lender, or both.

Based on the individual facts and circumstances, the issuer should determine whether a portion of the

fees paid to the lender should be properly identified and accounted for as a debt issuance cost. This

distinction is important because fees paid to the lender and debt issuance costs are often treated

differently. For example, fees paid to the lender and debt issuance costs are treated differently in

measuring beneficial conversion features in ASC 470-20 and in accounting for debt modifications and

extinguishments in ASC 470-50.

For convertible debt within the scope of the cash conversion subtopics in ASC 470-20, debt issuance

costs are allocated between the liability and equity components in proportion to the allocation of the

proceeds. Also, when analyzing convertible debt for a BCF, debt issuance costs paid to parties other than

the investor are not considered in calculating any intrinsic value in the embedded conversion option, as

stated in ASC 470-20-30-13.

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Direct and incremental costs may also be incurred when debt is issued and (1) a derivative is required to

be bifurcated (e.g., bifurcated conversion option) or (2) another separate freestanding financial

instrument (e.g., warrant) is also issued. There is no specific guidance on how such costs should be

allocated between a debt instrument and a bifurcated derivative or separately issued freestanding

financial instrument. We generally believe a systematic and rational approach based on the facts and

circumstances should be applied.

Under one approach, all of the costs might be attributed to the debt instrument as those costs were

primarily incurred to obtain debt financing. Under another approach costs might be allocated to the

instruments issued (or bifurcated) in proportion to the allocation of proceeds or the relative amount of

total costs that would have been incurred if each instrument were issued separately. Regardless of which

method is used, it should be applied consistently.

Debt issuance costs should generally be amortized and recognized as additional interest expense over

the life of the debt instrument using the effective interest method pursuant to ASC 835-30-35-2 through

35-3, including debt instruments that are convertible or callable. Refer to section 2.4.3.1 for a general

discussion of the amortization of debt issuance costs, including estimating the life of a debt instrument

(when appropriate). Section 2.4.3.1 also discusses the amortization of issuance costs for instruments in

the scope of the cash conversion guidance.

When some portion of the costs are allocated to a bifurcated derivative or freestanding financial instrument

that is being subsequently measured at fair value, those allocated costs would be expensed immediately.

Debt issuance costs incurred in connection with debt that is measured at fair value pursuant to the election

of the fair value option should be expensed.

ASC 340-10-S99-2 provides guidance on the accounting for debt issuance costs related to a bridge

financing. It requires fees paid to the same underwriter for providing interim financing (i.e., bridge

financing) and underwriting services in connection with a business combination to be allocated between

direct costs of the acquisition and debt issuance costs on a relative fair value basis. That guidance

provides that the debt issuance costs should be amortized over the expected life of the bridge financing

without considering the expected life of the permanent financing. When the bridge financing is repaid,

any unamortized issuance costs should be expensed.

2.3.1 Presentation of debt issuance costs

ASC 835-30-45-1A requires entities to present debt issuance costs related to a recognized liability on

the balance sheet as a direct deduction from that liability rather than as an asset, consistent with the

presentation of a debt discount.

Cash payments for debt issuance costs should be classified in the statement of cash flows as a financing

activity pursuant to ASC 230-10-45-15.

2.3.1.1 Debt issuance costs related to revolving credit arrangements

Entities may incur debt issuance costs before a liability is recognized or when costs are incurred in

securing a line of credit or a revolving credit arrangement (hereafter referred to as revolving credit

arrangements) that has not been drawn. Furthermore, revolving credit arrangements often have

balances that fluctuate as entities borrow and repay amounts.

Entities typically view costs in securing a revolving credit arrangement to be associated with the overall

credit facility, not related to any specific draw. Therefore, presenting the costs as a reduction to a

specific draw does not reflect the economic substance of the costs incurred.

ASC 835-30-S45-1 states that the SEC staff will not object to an entity presenting the cost of securing a

revolving credit arrangement as a deferred asset, regardless of whether a balance is outstanding.

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An entity that repeatedly draws on a revolving credit arrangement and then repays it could present the

debt issuance costs as a deferred asset initially and reclassify all or a portion of them as a direct

deduction from the liability whenever a balance is outstanding. The SEC staff’s guidance provides a less

cumbersome alternative.

Either way, the costs should be amortized over the term of the arrangement

using an appropriate interest method, in part, based on the provisions in ASC 470-50-40-21.

The SEC staff’s guidance does not affect the presentation of costs incurred before an associated liability

is recognized in other situations. For example, an entity may incur costs to secure a term debt credit

facility where the entity does not have outstanding borrowings at inception. In these situations, we

generally believe entities should present the costs as a deferred asset initially and reclassify all or a

portion of them as a direct deduction from the liability when all or a portion of the term loan is issued.

We generally believe it is not appropriate to present debt issuance costs as a contra-liability when there is

no associated debt liability (e.g., before amounts are drawn from a revolving credit arrangement).

2.3.2 Fees paid to lenders

Fees paid to lenders on the issuance of debt are considered part of debt discount and presented in the

balance sheet as a direct deduction from the carrying amount of the related debt. Debt discounts or

premiums are amortized into interest expense using the effective interest method pursuant to ASC 835-

30-35-2 through 35-3. Refer to section 2.4.3.1 for a general discussion of the amortization of debt

issuance costs, premiums or discounts.

An entity may also pay a lender fees to secure a term debt credit facility where the entity does not have

outstanding borrowings at inception. Similar to debt issuance costs, we generally believe that in these

situations entities should initially present the fees paid to lenders as a deferred asset and reclassify all or

a portion of them as a direct deduction from the liability when all or a portion of the term loan is issued.

In addition, while the guidance in ASC 835-30-S45-1 only addresses the presentation of debt issuance

costs (i.e., costs paid to third parties) associated with revolving credit arrangements, we generally

believe an entity may also apply the SEC staff’s guidance to fees directly paid to lenders to secure these

arrangements and present those amounts as a deferred asset on the balance sheet, regardless of

whether a balance is outstanding.

Illustration 2-2: Lender fees related to term debt and a revolving credit arrangement

On 1 January 20X1, Company A (borrower) enters into a credit facility with Bank B (lender) that allows

Company A to borrow up to $10 million in term debt at a stated interest rate of 10% over a period of

five years. The credit facility also has a $5 million revolving credit arrangement with the same terms

as the term debt. Company A pays the lender a fee of $150,000 up-front to secure the credit facility.

Company A allocates the fee proportionally between the term debt and the line-of-credit arrangement,

with $100,000 allocated to the term loan and $50,000 allocated to the revolving credit arrangement.

Since Company A has not drawn any amount under the facility, it initially records the entire $150,000

as a deferred charge (i.e., asset) and amortizes the amount over the life of the credit facility.

On 1 February 20X1, Company A borrows the entire $10 million under the term loan arrangement and

reclasses the remaining unamortized deferred asset related to the term loan of $98,333 as a reduction

from the carrying amount of the liability recognized. Company A will amortize the $98,333 using the

effective interest method over the remaining life of the term loan.

While the SEC staff’s guidance addresses public entities, we generally believe that nonpublic entities can also apply this guidance.

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For the revolving credit arrangement, Company A has elected a policy to keep the allocated amount as

an asset, regardless of whether an amount is drawn. As of 1 February 20X1, the remaining unamortized

deferred asset related to the revolving credit arrangement is $49,167, which will be amortized over

the remaining life of the line-of-credit arrangement.

2.4 Subsequent accounting and measurement

2.4.1 General

This section includes guidance for subsequent accounting and measurement of debt instruments for

which the fair value option is elected as well as subsequent accounting for premium, discounts, debt

issuance costs and embedded features.

2.4.2 Debt instruments for which the fair value option is elected

As discussed in section 2.2.1, entities may elect to measure debt at fair value (the fair value option) in

certain situations. Fair value should be determined pursuant to ASC 820. ASC 825-10 requires that

changes in the fair value of financial liabilities (e.g., debt) measured using the fair value option that are

caused by changes in instrument-specific credit risk be presented separately in other comprehensive

income (OCI). This requirement does not apply to derivative liabilities since they are required to be

measured at fair value in accordance with ASC 815.

For simple (e.g., non-hybrid) financial liabilities, an entity may consider the change in fair value caused by a

change in instrument-specific credit risk to be the difference between the total change in the fair value of the

instrument and the amount resulting from a change in a base market rate (e.g., a risk-free interest rate such

as the US Treasury rate, a benchmark interest rate such as LIBOR). However, an entity may use another

method that it believes results in an amount that faithfully represents the portion of the total change in fair

value attributable to a change in instrument-specific credit risk. Entities should apply the method consistently

to each financial liability from period to period. This guidance applies, regardless of whether an entity has

designated a financial liability under the fair value option in accordance with ASC 825

or ASC 815-15.

For hybrid financial liabilities, where the change in fair value of the financial instrument may be affected by

factors other than interest and credit, questions arose about whether it is appropriate to apply the base-

rate method described above. For example, consider a financial liability whose cash flows are indexed to an

external index (e.g., S&P 500, gold). For that instrument, the difference between the total change in fair

value of the instrument and the component of the change in fair value of the financial instrument

attributable to changes in the risk-free or benchmark rate will be affected by changes in the external index

and would not solely represent the change in fair value attributable to instrument-specific credit risk.

At the 2016 AICPA National Conference on Current SEC and PCAOB Developments, a member of the SEC

staff

provided perspectives on this and other aspects on the measurement of instrument-specific credit

risk for certain types of financial liabilities in which the fair value option has been elected. The SEC staff

member discussed the application of the presentation guidance to a hybrid financial liability that consists of

a debt obligation indexed to the price of gold that requires cash settlement and noted:

“The fair value of the hybrid financial liability will be impacted, in part, by the price of gold. In this

circumstance, I do not believe application of the base rate method will faithfully represent the portion

of the total change in fair value resulting from instrument-specific credit risk. The takeaway in this

scenario is that application of the base rate method may not be appropriate in all circumstances. As

the terms of a financial liability become more complex, more judgment is needed to determine if an

alternative method is required.”

ASC 825-10-45-5.

Brian Staniszewski, 2016 — Refer to the SEC website at https://www.sec.gov/news/speech/staniszewski-2016-aicpa.html.

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The SEC staff member also provided perspectives on the application of the presentation guidance to

nonrecourse financial liabilities for which payments are tied solely to the value of cash flows of assets

pledged as collateral:

“… consider a financial liability for which the payment is solely tied to the value or cash flows of an

asset pledged as collateral. That is, there is no recourse to the debtor. The risk of nonpayment, and

the corresponding changes in the financial liability’s fair value, will be directly impacted by the risk

that the underlying asset will perform poorly (or not at all). In this fact pattern, I believe that no

portion of the total change in the financial liability’s fair value would be attributable to instrument-

specific credit risk. Instead, the financial liability’s fair value will be solely tied to the risks inherent in the

specific asset pledged as collateral. Therefore, I would expect all changes in the financial liability’s fair

value to be reported in earnings.”

Upon derecognition of a financial liability, the accumulated gains and losses due to changes in

instrument-specific credit risk are reclassified from OCI to net income.

2.4.2.1 Debt with an inseparable third-party credit enhancement that is measured at fair value for

accounting or disclosure purposes

Liabilities are often issued with credit enhancements obtained from a third party. In many circumstances,

the issuer purchases a guarantee from a third party that requires the third party to make payments on the

issuer’s behalf in the event the issuer fails to meet its payment obligations. If the guarantor is required to

make payments, the issuer becomes obligated to the guarantor for such payments.

When permitted under other US GAAP, issuers of debt with an inseparable third-party credit enhancement

may elect to subsequently measure the debt at fair value. For those issuers, the “Liabilities Issued with

an Inseparable Third-Party Credit Enhancement” guidance under the subtopics in ASC 825 requires

that those liabilities be measured at fair value on a recurring basis excluding the effect of the credit

enhancement. This guidance also applies for the disclosures (pursuant to ASC 825-10-25) for those

issuers who did not elect the fair value option.

Refer to section 5.15 for further discussion of these instruments.

2.4.3 Debt instruments for which the fair value option is not elected

If debt is not subsequently measured at fair value (e.g., the fair value option was not elected), the amount

recorded is classified as a liability and generally accreted or amortized to par. The subsequent accounting

for indexed debt is different, as discussed in section 2.2.6.4.

Subsequent changes in market interest rates or the issuer’s credit rating are generally not considered, but

the carrying amount of debt may be adjusted for hedge accounting pursuant to ASC 815 or foreign

currency transaction gains or losses pursuant to ASC 830.

Other features of an instrument or units of account that should be considered include:

• Premiums, discounts and deferred debt issuance costs (section 2.4.3.1)

• Paid-in-kind (PIK) interest (section 2.4.3.2)

• Embedded features not bifurcated from the host debt instrument (section 2.4.3.3)

• Embedded features bifurcated from the host debt instrument as a derivative and classified as an

asset or liability (e.g., conversion options, certain term-extending options and certain contingent

interest features) (section 2.4.3.4)

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• Embedded conversion features separated from the host debt instrument and classified as a

component of equity (section 2.4.3.5)

• Contingent BCFs (refer to Appendix D)

• Debt payable in a currency other than the issuing entity’s functional currency (refer to section 1.1.2

of our FRD publication, Foreign currency matters, for further guidance)

2.4.3.1 Premiums, discounts and debt issuance costs

Debt may be issued either at par, a discount or a premium. Debt premiums or discounts may arise for

several reasons, including the following:

• A difference between the market rate of interest upon issuance and the contractual rate of interest

specified in the instrument (e.g., issuing debt with a stated coupon of 6% when the market yield for a

debt instrument with similar terms and similar risks is 8%, resulting in initial proceeds of less than par

to compensate investors for the lower coupon return)

• Allocating proceeds to multiple instruments upon issuance (e.g., when debt is issued with detachable

warrants and the proceeds are allocated between the two elements)

• Bifurcating embedded derivatives in accordance with ASC 815 (e.g., certain put/call features or

contingent interest)

• Separating a conversion feature under the cash conversion guidance

• Separating a BCF under the BCF guidance

If debt is issued between coupon payment dates, as a matter of convenience the investor may pay an

amount equal to the interest accrued to the issuance date to facilitate the issuer simply making a full

coupon payment at the next interest payment date. This amount does not represent a premium.

A discount or premium is not an asset or liability separable from the associated debt instrument. Rather,

the premium or discount is reported in the balance sheet as an adjustment to the carrying amount of the

debt liability and not presented as a deferred charge or deferred credit, pursuant to ASC 835-30-45-1A.

Debt discounts or premiums and debt issuance costs are amortized into interest expense using the

effective interest method pursuant to ASC 835-30-35-2 through 35-3.

Prepayment and other features (e.g., put option held by the creditor) may result in the amortization period

being shorter than the instrument’s stated contractual life. For convertible debt instruments that are subject

to the cash conversion guidance or contain BCFs, there is specific guidance on the amortization of premiums,

discounts and deferred debt issuance costs. Costs incurred to secure lines of credit or revolving credit

arrangements are generally deferred and amortized over the life of the line-of-credit or revolving credit

arrangement using an appropriate interest method based, in part, on the provisions in ASC 470-50-40-21.

2.4.3.1.1 Effective interest method

Application of the effective interest method results in the recognition of interest expense equal to a

constant rate of interest that is applied to the carrying amount of the debt at the beginning of each

period (i.e., the outstanding face amount less any unamortized discount plus any unamortized premium

less deferred issuance costs).

Other methods of amortization may be used if the results obtained are not materially different from the

results under the effective interest method, as stated in ASC 835-30-35-4.

ASC 835-30-35-5 states that the amounts chargeable to interest expense under the guidance in

ASC 835-30, which includes the amortization of any premiums or discounts, is eligible to be capitalized

pursuant to ASC 835-20.

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Illustration 2-3 Applying the effective interest method to debt issued at a discount

On 1 January 20X2, ABC Co. issues $100 million of debt for cash proceeds of $97 million. Each

$1,000 par value note bears a fixed interest rate of 5% payable annually on 31 December. The entire

principal amount is due at maturity on 31 December 20Y2 (10 years).

ABC Co. concludes that there are no embedded features that require bifurcation. In addition, for

purposes of this illustration, assume that there are no debt issuance costs.

Recognition and initial measurement

On 1 January 20X2, ABC Co. records the following entry for its issuance of debt:

Cash $ 97 million

Debt discount 3 million

Debt $ 100 million

Subsequent measurement

ABC Co., a calendar year-end reporting entity, applies the effective interest method to amortize the

debt discount through interest expense each period. ABC Co. determines that the effective interest

rate for the debt is 5.396% and applies this constant rate to the carrying amount of the debt (i.e., the

outstanding face amount less any unamortized discount) as of the beginning of each period to

recognize the interest expense for the period.

The following table presents the contractual cash flow, discount amortization and interest expense for each

year, and the carrying amount of the debt at each year end (i.e. face amount less unamortized discount).

Date*

Contractual

cash flow

Discount

amortization

Interest

expense

Carrying

amount at

31 December

1 Jan 20X2

$97,000,000

$ 97,000,000

31 Dec 20X2

(5,000,000)

$ (234,140)

$ 5,234,140

97,234,140

31 Dec 20X3

(5,000,000)

(246,774)

5,246,774

97,480,914

31 Dec 20X4

(5,000,000)

(260,090)

5,260,090

97,741,005

31 Dec 20X5

(5,000,000)

(274,125)

5,274,125

98,015,129

31 Dec 20X6

(5,000,000)

(288,917)

5,288,917

98,304,046

31 Dec 20X7

(5,000,000)

(304,507)

5,304,507

98,608,553

31 Dec 20X8

(5,000,000)

(320,938)

5,320,938

98,929,491

31 Dec 20X9

(5,000,000)

(338,256)

5,338,256

99,267,746

31 Dec 20Y1

(5,000,000)

(356,508)

5,356,508

99,624,225

31 Dec 20Y2

(105,000,000)

(375,745)

5,375,745

—

On 31 December 20X2, ABC Co. records the interest expense and discount amortization as follows:

Interest expense $ 5,234,140

Cash $ 5,000,000

Debt discount 234,140

* For simplicity, assume that ABC Co. records the annual interest accrual and discount amortization on 31 December.

Each subsequent year, ABC Co. records interest expense and discount amortization using the amounts

in the table until the debt’s maturity date. At 31 December 20Y2 (the maturity date), the $100 million

principal balance is repaid. The cumulative amount of interest expense is $53 million, composed of

$50 million of contractual interest and $3 million of discount amortization.

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2.4.3.1.2 Determining the expected life of a debt instrument

For convertible debt instruments within the scope of either the cash conversion guidance or BCF

guidance, specific guidance is provided in ASC 470-20 for the amortization of discounts, premiums and

deferred issuance costs (refer to sections 2.4.3.1.3 and 2.4.3.1.4 for further discussion). For perpetual

debt, which is described in section 2.1.2.8, interest expense is typically recognized based on an

assumption of the life of the instrument.

For other debt instruments, pursuant to ASC 835-30-35-2, initial issuance premiums, discounts and

costs are generally amortized over the contractual life of a debt contract. However, entities need to

evaluate the amortization period when a debt contract includes substantive embedded features, such as

investor put options. We generally believe that amortization to the first put date is a preferable

accounting policy for debt with a non-contingent put option.

Whatever accounting policy is chosen for debt that contains a non-contingent put option, we generally

believe that an entity should follow that policy if that debt becomes due on demand due to covenant

violations. For example, if an entity’s accounting policy is to amortize issuance premiums, discounts and

costs over the contractual life of a debt instrument that contains a non-contingent put option, and that

debt becomes due on demand due to covenant violations, we generally believe that previously capitalized

issuance premiums, discounts and issuance costs should not be immediately written off. However, if an

entity’s accounting policy for such a debt instrument is to amortize to the first put date, we generally

believe that the premiums, discounts and issuance costs should be immediately written off if that debt

becomes due on demand due to covenant violations.

While facts and circumstances should be carefully evaluated, the amortization period should generally not

be to the first call date. The basis for conclusions in FASB Staff Position (FSP) APB (Accounting Principles

Board) 14-1, Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion

(Including Partial Cash Conversion), which was not codified, acknowledged diversity in practice in this area.

2.4.3.1.3 Amortization for cash convertible instruments

For convertible instruments within the scope of the cash conversion guidance, ASC 470-20-35-12 through

35-16 requires the discount in the liability component created by the allocation of proceeds (refer to

section 1.2.7) and any bifurcation of embedded derivatives to be amortized over the period of the expected

cash flows inherent in the recorded liability (i.e., the expected life from the valuation of the liability

component). This period may not be the full contractual term of the instrument if it contains put or call

rights. Once the amortization period is determined, it is not reassessed unless the instrument is modified.

Refer to section C.3.4 for a discussion of the subsequent measurement for those instruments.

2.4.3.1.4 Amortization of instruments with beneficial conversion features

For convertible instruments within the scope of the BCF guidance, ASC 470-20-35-7 states that the

amortization period should be from the date of issuance to the stated redemption date of the convertible

instrument. While that redemption date would be the maturity date based on a literal application, we

believe it could also be reasonably interpreted to be the first date at which the holder could put the

instrument. We generally believe the first conversion date should generally not be considered unless an

instrument has no stated redemption date (perpetual debt).

For further guidance, refer to the discussion in section D.4.1.

2.4.3.2 Paid-in-kind interest

Some debt instruments may require or permit the issuer to make coupon payments in the form of additional

underlying debt instruments. This type of interest is often referred to as PIK interest.

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While the accounting for PIK interest is not clearly defined in the accounting guidance, the following

methods may be appropriate, based on the facts and circumstances:

• Required (nondiscretionary) PIK interest — An instrument that requires interest to be paid in kind

functions much the same as a zero-coupon bond, as no cash interest payments are required until

maturity or upon redemption of the debt. In that regard, interest should be accrued at its stated rate

assuming that the interest compounds.

For example, 10% interest PIK on three-year debt with a principal amount of $100 would accrue

(assuming annual compounding for simplicity) interest expense of $10 (10% X $100) in the first year

(paid with additional debt), $11 (10% X $110) in the second year (paid with additional debt) and

$12.10 (10% X $121.00) in the third year (paid as additional debt), with the entire $133.10 settled

at maturity. The same result would have been achieved by issuing a zero-coupon instrument for

$100 that matures in three years for $133.10. However, if the instrument accrued simple interest of

10% each year on the initial principal (i.e., no compounding), only $130 would be due at maturity. We

generally believe this also represents PIK interest, and the issuer should derive an effective interest

rate that, when applied to $100 at issuance, would result in $130 at maturity.

• Discretionary PIK interest — If an instrument permits the issuer to elect to pay the interest in kind or

in cash, we generally believe that interest should be accrued at the contractual rate for cash interest.

If the interest is paid in kind, we generally believe the issuer may either (1) adjust the interest expense

to the fair value of the incremental instruments issued or (2) not adjust the interest accrued at the

contractual rate and assume that the value of the payment in kind is equal to the amount accrued,

based on the individual facts and circumstances. The approach followed should be consistently

applied. If the contractual rate for PIK interest is higher than the interest rate for cash payments, the

issuer should accrue interest based on the expected method of payment and adjust the accrual at the

payment date if settled differently.

If convertible debt requires or permits PIK interest, ASC 470-20-30-16 through 30-18 describes how to

evaluate the interest accrual for a potential beneficial conversion option. Refer to section D.3.3.1 for

further discussion of BCFs.

2.4.3.3 Embedded features not bifurcated from the host debt instrument

The accounting for embedded features that are not bifurcated from debt hosts is generally based on the

nature of the feature. Following are common examples:

• Contingent interest — A non-bifurcated contingent interest feature in a debt instrument is accounted

for pursuant to the provisions of ASC 450, or the provisions of ASC 470-10-25-3 through 25-4 and

35-4, depending on the facts and circumstances.

• Call option — A non-bifurcated call feature in debt that is callable (prepayable) by the issuer generally

is not accounted for until the debt is called, at which time extinguishment accounting is applied.

• Put option — A non-bifurcated put feature in debt that is puttable (redeemable) at par by the investor

generally is not accounted for until the debt is redeemed, at which time extinguishment accounting is

applied. However, the put feature should generally be considered in determining the amortization

period for premiums, discounts or deferred debt issuance costs, as discussed in section 2.4.3.1.

• Conversion option — A non-bifurcated or non-separated conversion feature in a debt instrument is

not accounted for until conversion occurs. At that time, conversion accounting is applied, as

discussed in section 2.5.2.

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2.4.3.3.1 Embedded derivative reassessment

Embedded features that were not bifurcated from the host debt instrument upon issuance either because

the embedded feature (1) did not meet the definition of a derivative under ASC 815 or (2) met that

definition but also qualified for an exception from derivative accounting (refer to section 2.2.4.3 for further

discussion) should be reassessed at each reporting date. This would include conversion options, even if

they were separately accounted for under the cash conversion or BCF guidance.

In reassessing embedded features for bifurcation, the initial conclusion of whether that feature was clearly

and closely related to the host debt instrument pursuant to ASC 815-15-25-1(a) is not reevaluated

(by reference to ASC 815-15-25-27). Accordingly, if initially deemed clearly and closely related (and

therefore not bifurcated), that feature would not be bifurcated in the future. While this is not clear in the

guidance, we generally believe that a modification of a debt instrument that was not accounted for as an

extinguishment pursuant to ASC 470-50-40 may require the embedded features to be reevaluated given

that the modification results in a different legal arrangement. This determination should be made based

on the individual facts and circumstances.

In reassessing the definition of a derivative, the characteristics of having an underlying or an initial net

investment generally will not change with time. However, the application of the net settlement criteria

may change. ASC 815 requires the reconsideration of market mechanism and readily convertible cash

criteria pursuant to ASC 815-10-15-118 and 15-139, respectively. A contract that was (or was not)

net settleable by its contractual terms will likely remain as such through its life. However, a market

mechanism to facilitate net settlement may emerge over time or an asset to be delivered in a physical

settlement may become readily convertible to cash. ASC 815 requires the reconsideration of those

elements (refer to ASC 815-10-15-118 and 15-139, respectively).

For example, a typical equity-linked embedded feature (e.g., conversion option), may not have met the

definition of a derivative if gross settlement were required and the issuer was not a public company

(i.e., the underlying shares were not readily convertible to cash). That condition could change if the

company underwent an IPO and its shares now were readily convertible to cash. In that case, the

embedded feature would meet the definition of a derivative for the first time and should be further

evaluated for bifurcation (i.e., evaluated for an exception from bifurcation). That initial analysis would

occur on the date the feature met the definition of a derivative (i.e., on the IPO date).

As another example, a public issuer with limited transaction volume for its shares compared with the

conversion shares may develop additional volume such that the conversion shares are now considered

readily convertible to cash (refer to ASC 815-10-55-101 through 55-108).

With respect to the reassessment of any scope exceptions, the most common exception from bifurcation

for equity-linked embedded features is under ASC 815-10-15-74(a), which requires evaluation of whether

the feature is indexed to the issuer’s own stock and would be classified in stockholders’ equity. This

reassessment should be performed at each reporting date for those features that meet the definition of

a derivative, as follows:

• Reassessment of the indexation guidance — The conclusion under the indexation guidance generally

would not be expected to change unless the contractual terms have changed.

For an embedded equity-linked feature (e.g., conversion feature) that meets the definition of a

derivative for the first time (e.g., underlying stock becomes actively traded making it readily

convertible to cash), the embedded feature should be assessed at that time for the exception

pursuant to ASC 815-10-15-74(a). That assessment would be made under the then-current

circumstances to determine whether the feature is considered indexed to the issuer’s shares.

• Reassessment of the equity classification guidance — In reassessing the criteria for equity

classification related to settlement alternatives, a particular focus should be on the availability of

shares to settle the instrument.

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2.4.3.3.2 Subsequent bifurcation

While ASC 815 requires the reassessment of certain embedded features (e.g., those linked to an entity’s own

equity) for potential bifurcation at each reporting date, it does not provide explicit guidance on how to bifurcate

an embedded feature after the issuance date. We generally believe the most literal application of ASC 815

would be to bifurcate the embedded derivative as of the date it was required to be bifurcated at its then-

current fair value from the carrying amount of the host debt instrument. Other approaches also may exist.

Under this approach, the bifurcated derivative should be recognized as an asset or liability with subsequent

changes in fair value recognized in earnings. This accounting is the same as if bifurcation was performed

upon the initial issuance of the instrument.

When determining the fair value of the feature to be bifurcated, an option-based feature would use

the contractual terms (refer to section 2.2.7.1) and a forward-based feature would use the terms that

would have implied a fair value generally being equal to zero at the date the holder entered into the

instrument (refer to section 2.2.7.2).

Any incremental discount or premium on the host instrument that results from the bifurcation would be

amortized using the effective interest method over the remaining life of the instrument (refer to section

2.4.3.1.1). Because an unusual effective interest rate may result, other methods for accounting for a

post-issuance bifurcation may result in a more reasonable effective interest rate.

For a previously non-bifurcated embedded equity-linked feature that was accounted for as a separate

component of equity under the BCF guidance, we believe one reasonable approach would be to reclassify

an amount equal to the then-current fair value of the derivative from equity to a liability. Because the debt

host instrument was initially reflected at a residual value after allocating the intrinsic value to equity, the

host instrument would be adjusted to the pro forma carrying amount of the debt (as discussed above in

the alternative method). Various methods may be appropriate for determining whether any differences

between (1) the amount initially allocated to equity and the amount reclassified to a liability and (2) the

then-current carrying amount of the debt host and the pro forma carrying amount should affect earnings.

For a previously non-bifurcated embedded equity-linked feature that was accounted for as a separate

component of equity under the cash conversion guidance, ASC 470-20-35-19 requires that the

difference in the amount previously recognized in equity and the fair value of the feature at the date of

reclassification be accounted for in equity. The guidance further provides that the reclassification would

not affect the accounting for the liability component.

2.4.3.4 Embedded features bifurcated from the host debt instrument as a derivative and

classified as an asset or liability

Embedded features bifurcated from the host debt instrument upon issuance and classified as an asset or

a liability are measured at fair value at each reporting date with changes in the fair value recognized in

earnings. Refer to section 3 of our FRD publication, Derivatives and hedging, for further discussion on

embedded derivatives.

Bifurcated derivatives should be reassessed every reporting period to determine if they continue to

require bifurcation. That is, they are reassessed to see if they still meet the definition of a derivative and

still fail to qualify for any scope exception from derivative accounting. For example, an embedded feature

may subsequently qualify for the exception from derivative accounting pursuant to ASC 815-10-15-74(a)

for reasons including:

• The provision that caused the embedded feature not to be considered indexed to the issuer’s own

stock may no longer apply. For example, assume the strike price of a conversion feature (exercisable

at any time) would be reduced by 5% if the issuer does not achieve $100 million in revenue at the end

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of the six months immediately after the convertible notes are issued. Once the initial six-month

period lapses, the conversion feature could be considered indexed to the issuer’s own stock under

the indexation guidance.

• The issuer subsequently increases its number of authorized and unissued shares sufficient to cover

the settlement of the embedded feature. This increase could result by obtaining additional share

authorization from shareholders or purchasing additional treasury shares in the market.

An issuer may amend the terms of an agreement to qualify for the exception from derivative accounting

(e.g., the issuer may add a cap to the number of shares required for settlement if it had previously issued

a convertible debt instrument without a cap). In those cases, the issuer should consider the accounting

for the modification of the instrument.

ASC 815-15-35-4 requires a previously bifurcated conversion option that no longer requires bifurcation

to be reclassified from a liability to equity at its then-current fair value on the date of reclassification. The

conversion option is not recombined with the host debt instrument. Gains or losses recognized when the

bifurcated conversion option was accounted for at fair value during the period that the conversion option

was classified as a liability are not reversed. We generally believe the same accounting would apply to

any previously bifurcated equity-linked embedded feature, such as a bifurcated forward contract

classified as an asset or liability, that no longer requires bifurcation.

2.4.3.5 Embedded conversion features separated from the host debt instrument and classified as

a component of equity

There are three forms of non-bifurcated conversion features that may require separate accounting

within equity: (1) a conversion feature in a cash convertible debt instrument, (2) a BCF recognized when

the debt is issued and (3) debt issued as a substantial premium. Refer to section 2.2.11 for a discussion

on convertible debt issued at a substantial premium.

There are other situations when non-bifurcated conversion features may require separate accounting

within equity: (1) when a previously bifurcated conversion feature in convertible debt is subsequently

reclassified to equity and (2) when a conversion feature in convertible debt is modified. Refer to section

2.4.3.4 for further discussion on a previously bifurcated conversion feature in convertible debt that is

subsequently reclassified to equity; and section 2.6.2.4 for further discussion on a conversion feature in

convertible debt that is modified.

2.4.3.5.1 Cash conversion features

The equity component of debt under the cash conversion feature guidance is not remeasured, but should

be reevaluated to determine whether equity classification under the guidance in ASC 815-40 continues to

be appropriate. Refer to section 2.4.3.3.1 for further discussion on the reevaluation of embedded derivatives.

2.4.3.5.2 Beneficial conversion features

Conversion features should be reassessed under the BCF guidance at each balance sheet date. An instrument

may become convertible only upon the occurrence of a future event outside the control of the holder or

may be convertible from inception but contain conversion terms that change (and either become beneficial or

more beneficial through the resolution of a contingency). Such contingent BCFs (or contingent adjustments to

BCFs) are measured at the commitment date, but are not recognized until the contingency is resolved.

Refer to section D.4 for further discussion on the subsequent measurement of BCFs.

An equity component of debt under the BCF guidance should be reevaluated to determine whether equity

classification under the guidance in ASC 815-40 continues to be appropriate. Refer to section 2.4.3.3.1

for further discussion of the reevaluation of embedded derivatives.

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2.4.3.5.3 Application of ASC 480-10-S99-3A

The SEC staff’s guidance on temporary equity in ASC 480-10-S99-3A requires that certain redeemable

equity instruments be classified as temporary (or mezzanine) equity in order to distinguish them from

permanent equity. That guidance also establishes that, for convertible debt instruments with equity-

classified components, the equity-classified component of the convertible debt instrument should be

considered redeemable if at the balance sheet date the issuer can be required to settle the convertible

debt instrument for cash (i.e., the instrument is currently redeemable or convertible for cash).

If the equity-classified component is considered redeemable, the portion of the equity-classified

component that is presented in temporary equity (if any) is measured as (1) the amount of cash that

would be required to be paid to the holder upon redemption or conversion in excess of (2) the current

carrying amount of the liability-classified component of the convertible debt instrument.

Refer to Question 6 in section C.5 for a discussion of the application of ASC 480-10-S99-3A to the

equity-classified components of debt under the cash conversion guidance or BCF guidance.

2.5 Debt extinguishment and conversions

Except for perpetual debt, debt will either be extinguished (i.e., mature or settle early if put or called)

or converted (or exchanged) in a final settlement. This section includes guidance for extinguishments

(section 2.5.1) and conversions (section 2.5.2).

2.5.1 Extinguishment of liabilities

The guidance in ASC 405 on the extinguishment of liabilities applies to all liabilities, including financial

and nonfinancial liabilities, unless other guidance applies to a liability (e.g., the derecognition guidance

for gaming chips in Subtopic 924-405).

For liabilities in the scope of ASC 405, ASC 405-20-40-1 provides that a liability may be derecognized

only when it has been extinguished. A liability has been extinguished if the debtor either:

• Pays the creditor and is relieved of its obligation for the liability

• Is legally released from being the primary obligor under the liability, either judicially or by the creditor

ASC 405-20 provides a narrow scope exception for the derecognition of liabilities related to certain

prepaid stored-value products redeemable for goods, services or cash at third-party merchants. Refer to

section 5.21 for additional discussion.

ASC 405-20-55-9 provides guidance on accounting for extinguishments through legal defeasances, while

ASC 405-20-55-3 through 55-4 discusses in-substance defeasances. In a legal defeasance, generally the

creditor legally releases the debtor from being the primary obligor under the liability. In an in-substance

defeasance, the debtor places assets in a trust to repay the debt, but because the debtor is not legally

released, the liability should not be extinguished.

Whether the debtor has in fact been released and the condition in ASC 405-20-40-1(b) has been met in a

legal defeasance or any other transaction is a matter of law. In some cases a legal opinion may be needed

to make that determination.

When a convertible debt instrument is redeemable or convertible for cash, consideration also must be given to the appropriate

balance sheet classification for the liability component as current or noncurrent. Refer to section 2.7.6.

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A debt is not extinguished if the entity has the intent to extinguish the liability or accepted an irrevocable

offer to repurchase debt. Therefore, debt issuance costs should not be written off and a call premium should

not be recognized pursuant to ASC 450 because ASC 470-50-40-2 provides that these amounts are part

of the measurement of the extinguishment gain or loss, which is to be recognized only upon extinguishment.

An entity that buys back its own debt should account for that purchase as a debt extinguishment (even if

the debt is not formally retired). The same is true even if the entity intends to hold the debt for a short

period until it is reissued.

Debt may also be considered extinguished when it has been modified and the terms of the new debt and old

debt are substantially different, as that term is defined in the debt modification guidance in ASC 470-50.

2.5.1.1 Measurement of debt extinguishments

Generally, ASC 470-50-40-2 indicates that for all extinguishments of debt, the difference between the

reacquisition price (which includes any premium) and the net carrying amount of the debt being extinguished

(which includes any deferred debt issuance costs) should be recognized as a gain or loss when the debt is

extinguished.

Gain or loss recognition may not be appropriate if the extinguishment of debt is with

related parties. ASC 470-50-40-2 indicates that such an extinguishment transaction may be in essence a

capital transaction (refer to section 2.5.1.7 for further discussion).

Adjustments to the debt’s carrying amount resulting from fair value hedge accounting pursuant to

ASC 815-25-35-1(b) and 35-8 are considered in calculating the debt extinguishment gain or loss. In

contrast, for extinguished debt subject to a cash flow hedge, any amounts reclassified from accumulated

comprehensive income to earnings should be excluded from the debt extinguishment gain or loss, as

described in ASC 815-30-35-44.

The fair value of nonmonetary assets (e.g., land or investments in common stock) transferred to settle

debt obligations should be used to measure debt extinguishment gains or losses. As a result, when

nonmonetary assets are used in the extinguishment of debt, the total gain or loss usually will be composed

of two elements: (1) the gain or loss resulting from the difference between the carrying value and fair

value of the assets transferred and (2) the gain or loss from the debt extinguishment. Refer to section 5.1

for an example of the settlement of debt exchangeable into common stock of another issuer.

2.5.1.2 Extinguishment of debt with a beneficial conversion feature

If a convertible debt instrument with a beneficial conversion option that was separately accounted for in

equity is extinguished prior to its conversion, a portion of the reacquisition price should be allocated to

the repurchase of the BCF. The amount of the reacquisition price allocated to the beneficial conversion

option should be measured using the intrinsic value of that conversion option at the extinguishment date.

The residual amount, if any, is allocated to the convertible debt instrument. The gain or loss on the

extinguishment of the convertible debt instrument would be determined based on its carrying amount

and allocated reacquisition price. Refer to section D.5.2 for further discussion.

ASC 470-50-40-2A clarifies the accounting for a debt extinguishment when the fair value option is elected. Upon extinguishment

an entity shall include in net income the cumulative amount of the gain or loss previously recorded in other comprehensive

income for the extinguished debt that resulted from changes in instrument-specific credit risk.

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2.5.1.3 Extinguishment of cash convertible debt

The derecognition section in the cash conversion guidance is based on the principle that an entity is

extinguishing the liability component and reacquiring the equity component that was recognized at issuance.

This approach would apply whether the debt was settled in cash, shares, other assets (or any combination) at

maturity, on a conversion or an early extinguishment. The settlement consideration is first allocated to the

extinguishment of the liability component equal to the fair value of that component immediately prior to

extinguishment. Any difference between that allocated amount and the net carrying amount of the

liability component and unamortized debt issuance costs should be recognized as a gain or loss on debt

extinguishment. Any remaining consideration is allocated to the reacquisition of the equity component

and recognized as a reduction of stockholders’ equity. Refer to section C.3.5 for further discussion.

ASC 470-20-40-26 describes the accounting when the conversion terms are modified to induce conversion

in a cash convertible instrument. Section 2.5.2.5 describes the accounting for induced conversions, which

generally requires that an amount of the proceeds be allocated to the inducement as a separate charge.

Refer to sections C.3.5 and C.3.6 for further discussion on the extinguishment of cash convertible instruments.

2.5.1.4 Extinguishment of debt with a previously bifurcated conversion option

If a convertible debt instrument with a previously bifurcated conversion option that has been reclassified

to shareholders’ equity pursuant to ASC 815-15-35-4 is extinguished before its maturity, the portion of

the reacquisition price equal to the fair value of the conversion option at the date of the extinguishment

should be allocated to equity in accordance with ASC 815-15-40-4. The remaining reacquisition price is

allocated to the extinguishment of the debt to determine the amount of a gain or loss.

2.5.1.5 Transition from a primary to a secondary obligor

If an entity is released from being a primary obligor and becomes a secondary obligor, ASC 405-20-40-2

states that the entity should recognize the guarantee as would a guarantor that had never been primarily

liable to that creditor. The guarantee obligation should be initially measured at fair value, and that

amount reduces the gain or increases the loss recognized on extinguishment.

2.5.1.6 Classification of debt extinguishment gains or losses

ASC 470-50-40-2 provides that gains and losses from the extinguishment of debt shall be presented as a

separate item within the income statement.

ASC 470-50-40-2 also states that extinguishment transactions between related entities may be in

essence capital transactions. Therefore, when related parties are involved, recognition of the difference

between the retired debt’s reacquisition price and carrying amount as either a gain or loss may not be

appropriate. Refer to section 2.5.1.7 for further discussion.

Public companies that trade in securities they issue outside their normal operations should consider the

disclosure requirements of ASC 220-20-45-1 or the management’s discussion and analysis (MD&A)

disclosures pursuant to Regulation S-K (Rule 229.303(b)(2)(i)), unless the effects of such transactions are

insignificant to the company’s results of operations. In addition, we generally believe private companies

should consider making similar disclosures.

ASC 470-50-40-2A clarifies the accounting for a debt extinguishment when the fair value option is elected. Upon extinguishment

an entity shall include in net income the cumulative amount of the gain or loss previously recorded in other comprehensive

income for the extinguished debt that resulted from changes in instrument-specific credit risk.

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2.5.1.7 Debt extinguishments with related parties

ASC 470-50-40-2 provides that a debt extinguishment transaction with related parties may be in essence

a capital transaction. While there is no specific guidance that addresses when an early debt

extinguishment should be treated as a capital transaction, a member of the SEC staff discussed its view

on these types of transactions in a speech at the 2010 AICPA conference

and provided the following:

“To be clear, the staff has not formed any bright line views on these types of transactions and

analyzes these questions individually on a specific facts and circumstances basis.

To illustrate one example and how we thought about the issue, consider the following fact pattern. A

Company has non-convertible debt outstanding to a related party

([a]n executive of the Company

who is also a significant shareholder). Assume that at a later date the related party accepts an offer

from the Company to exchange the debt for the Company’s common stock. At the date of exchange,

assume that the value of the common stock that was accepted by the related party was significantly

lower than the carrying value of the Company’s debt.

At issue is whether the Company’s exchange of common stock for the debt held by the related party

should be accounted for as an early extinguishment gain or as a capital contribution. As part of its

considerations on this issue, the staff approached the analysis by asking the following questions

(please note that this is not an exhaustive list):

• What was the role of the related party in the transaction?

• Why would the related party accept the Company’s offer, which resulted in the related party

accepting common stock that was significantly lower in value than the carrying value of the debt?

• Was the substance of the arrangement a forgiveness of debt that was owed to a related party?

Based on its analysis, which included the information provided in response to these questions, the staff

believed the substance of the transaction was in essence a capital contribution from a related party.

The staff believes that a full analysis is required in assessing the substance of these types of transactions.

Accordingly, the staff would expect that registrants consider all of the facts and circumstances and

related party relationships in a particular transaction when making its accounting assessment.”

We generally believe that a debt extinguishment transaction that involves third-party investors along with a

related party, where all parties receive identical terms (e.g., the same reacquisition price), is not, in substance,

a capital transaction with a related party. Therefore, an extinguishment gain or loss should be recognized.

2.5.2 Conversion of convertible debt instruments

The accounting for conversions of convertible debt instruments depends on the nature of the conversion

feature and whether the conversion is executed under the original conversion terms. This section

outlines the accounting for conversions of convertible debt instruments (1) subject to the general

conversion guidance pursuant to the original terms, (2) that contain a BCF or (3) that have been induced

as a result of the modification of the original conversion terms. Conversions of cash convertible debt

instruments pursuant to their original conversion terms are accounted for similar to extinguishments of

those instruments, as discussed in section 2.5.1.3. The induced conversion of cash convertible debt

instruments is discussed in section 2.5.2.5.

Refer to section 2.5.2.2 for the accounting for the conversion of a debt instrument with a conversion

option that is bifurcated pursuant to ASC 815.

Sagar S. Teotia, 2010 — Refer to the SEC website at https://www.sec.gov/news/speech/2010/spch120610sst.htm.

Based on the definition of related party as articulated in FASB ASC Topic 850.

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2.5.2.1 Conversion pursuant to the original terms of convertible debt under the general

conversion guidance

ASC 470-20-40-4 states that, upon conversion in accordance with its original terms, the carrying amount

of the convertible debt without a BCF, including any unamortized premium or discount, is credited to the

capital accounts and no gain or loss should be recognized. We generally believe unamortized issuance

costs should be accounted for in a similar manner. If the terms of the instrument require that any accrued

but unpaid interest be forfeited, the accrued interest, net of any related income tax effects, is also credited

to the entity’s capital pursuant to ASC 470-20-40-11.

Debt instruments frequently permit the debt to be converted if the issuer exercises a call during a period

in which the debt is not otherwise convertible by its terms. ASC 470-20-40-5 through 40-10 provide

that if the debt instrument contained a substantive conversion feature at issuance, the settlement of the

debt is to be accounted for as a conversion, which is described in the preceding paragraph. If the debt

instrument did not contain a substantive conversion feature at issuance, the settlement should be

accounted for as a debt extinguishment with the fair value of the shares issued considered part of the

reacquisition price of the debt.

ASC 470-20-40-7 through 40-9 provide the following considerations in determining whether the

conversion option is substantive:

• The size of the difference between the conversion price and the fair value of the underlying

equity instrument

• The fair value of the conversion feature compared with the fair value of the debt instrument

• The effective annual interest rate per the terms of the debt instrument compared with the estimated

effective annual rate of a nonconvertible debt instrument with an equivalent expected term and credit risk

• The fair value of the debt instrument compared with an instrument that is identical except for which

the conversion option is not contingent

• Qualitative evaluation of the conversion provisions such as the nature of the conditions under which

the instrument may become convertible

2.5.2.2 Conversion of debt with a bifurcated conversion option

For accounting purposes, two instruments are outstanding when a conversion option is bifurcated in

accordance with ASC 815. We generally believe that the conversion of debt with a bifurcated conversion

option should be accounted for under the debt extinguishment accounting model. That is, both the debt and

the bifurcated conversion option that is accounted for as a derivative should be derecognized at their

carrying amounts (after a final mark to the bifurcated conversion option’s fair value), and the

consideration transferred (e.g., shares issued) should be measured at its then-current fair value, with any

difference recorded as a gain or loss on the extinguishment of the two separate liabilities.

2.5.2.2.1 Conversion of debt with a conversion feature initially bifurcated and subsequently

reclassified into equity

As discussed in section 2.4.3.4, for convertible debt with a previously bifurcated conversion option that

no longer requires bifurcation, the carrying amount of the conversion option (that is, its fair value on the

date of reclassification) is reclassified to shareholders’ equity pursuant to ASC 815-15-35-4.

ASC 815-15-40-1 requires that any unamortized discount remaining at the date of conversion of such a

convertible debt instrument should be recognized as interest expense upon conversion.

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2.5.2.3 Conversion pursuant to the original terms of convertible debt that contain beneficial

conversion features

Upon conversion of an instrument with a beneficial conversion option, all unamortized discounts at the

conversion date should be recognized immediately as interest expense. The accounting for the conversion

then follows the guidance in section 2.5.2.1. Also refer to section D.5.1.

2.5.2.4 Induced conversions of general convertible debt

Induced conversions may involve revised terms that reduce the original conversion price (thereby

resulting in the issuance of additional shares of stock), the issuance of warrants or other securities not

provided for in the original conversion terms or payment of cash or other consideration (sometimes

called a convertible debt sweetener) to those debt holders who convert during a specified time period.

The additional consideration is usually offered to induce a prompt conversion of the debt to equity.

ASC 470-20-40-13 through 40-17 addresses the accounting for induced conversions of convertible debt

(other than cash convertible debt instruments that are addressed in ASC 470-20-40-26) that both

(1) occur pursuant to changed conversion privileges that are exercisable only for a limited period of time

and (2) include the issuance of all of the equity securities issuable pursuant to conversion privileges

included in the terms of the debt at issuance for each debt instrument that is converted. The form of the

transaction is important in applying this guidance. All equity shares issuable under the initial terms —

meaning all or more — must be issued.

ASC 470-20-40-14 further explains that an induced conversion includes an exchange of a convertible

debt instrument for equity securities or a combination of equity securities and other consideration,

regardless of whether the exchange involves the legal exercise of the contractual conversion privileges

included in terms of the debt.

The induced conversion guidance applies regardless of the party that initiates the offer or whether the

offer relates to all debt holders, as discussed at ASC 470-20-40-13(b). For example, even if a debt holder

makes the offer to the issuer and only that holder’s debt receives the right to convert at the sweetened

conversion price, the accounting requirements of the induced conversion guidance in ASC 470-20 apply.

Induced conversions are not subject to the debt modification guidance in ASC 470-50. Under the induced

conversion guidance in ASC 470-20, the fair value of the additional securities or other consideration

issued to induce conversion should be recognized as an expense. The consideration issuable under the

original terms would be accounted for as outlined in section 2.5.2.1. Refer to ASC 470-20-55-1 through

55-9 for illustrative examples of the application of the induced conversion guidance.

2.5.2.5 Induced conversions of convertible debt under the cash conversion guidance

For instruments subject to the cash conversion guidance, the accounting guidance for induced conversions is

outlined in ASC 470-20-40-26. This guidance is more fully discussed in section C.3.7, including determining

whether a conversion should be in the scope of the induced conversion guidance.

2.6 Troubled debt restructurings and debt modifications

After issuance, the terms of debt may be modified or debt may be exchanged with the same lender prior

to final settlement. Debt modifications or exchanges may be considered a troubled debt restructuring if

the debtor is experiencing financial difficulty and the creditor grants a concession in connection with the

restructuring. Modifications and exchanges that are not considered troubled debt restructurings are

accounted for as either (1) an extinguishment (if the terms are substantially different) or (2) a modification.

This section addresses the troubled debt restructuring guidance in ASC 470-60, Debt — Troubled Debt

Restructurings by Debtors (section 2.6.1), and debt modifications guidance in ASC 470-50, Debt —

Modifications and Extinguishments (section 2.6.2).

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Debtors should first determine whether the transaction is a troubled debt restructuring pursuant to

ASC 470-60 before applying ASC 470-50. The following flowchart illustrates the steps to be used in

assessing debt modifications or exchanges under both the troubled debt restructuring guidance and debt

modification guidance.

 Reference rate reform considerations

ASC 848, Reference Rate Reform, provides temporary optional expedients and exceptions to the US

GAAP guidance on contract modifications and hedge accounting to ease the financial reporting

burdens of the expected market transition from LIBOR and other interbank offered rates to

alternative reference rates, such as the Secured Overnight Financing Rate (SOFR).

Relevant relief: In accordance with this guidance, contracts that are modified as a result of reference

rate reform are eligible for relief from the modification accounting requirements in US GAAP (including

ASC 470-50), if certain criteria are met. Accordingly, an entity that modifies a contract as a result of

reference rate reform is not required to determine whether a modification results in the establishment

of a new contract or the continuation of an existing contract. That is, the modified contract is accounted

for and presented as a continuation of the existing contract.

Effective date: This guidance became effective upon issuance and generally can be applied through

31 December 2024.

For more information on reference rate reform, refer to ASC 848 and our Technical Line, A closer

look at the FASB accounting relief related to reference rate reform.

Yes

Are debt terms being

modified or is debt

being exchanged with

the lender?

Is the borrower

experiencing financial

difficulty?

(section 2.6.1.2.1)

Evaluate whether the

debt modification or

exchange is an

extinguishment or a

modification.

Did the lender make a

concession?

(section 2.6.1.2.2)

Apply the

troubled debt

restructuring

model.

(section 2.6.1.3)

If the debt modification or

exchange involves a convertible

debt instrument, refer to

section 2.6.2.4.

If the debt modification or

exchange involves a term loan,

refer to section 2.6.2.3.

If the debt modification or

exchange involves a line-of-

credit arrangement, refer to

section 2.6.2.8.

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2.6.1 Troubled debt restructurings

A debt restructuring is considered troubled if the creditor, for economic or legal reasons related to the issuer’s

financial difficulties, grants a concession to the issuer it would not otherwise consider. In a troubled debt

restructuring, the creditor’s objective is to maximize recovery of its investment by granting relief to the debtor.

For a debt restructuring to be considered troubled, the debtor must be experiencing financial difficulty

and the creditor must have granted a concession. Those criteria are discussed in ASC 470-60-55-4

through 55-14. Generally, a restructuring involving a debtor that is currently servicing the old debt and

can obtain funds from sources other than the existing creditor at market interest rates at or near those

for non-troubled debt is not considered a troubled debt restructuring if the creditors restructured the old

debt solely to reflect a decrease in market rates or positive changes in the debtor’s creditworthiness

when the debt was issued.

The accounting for a troubled debt restructuring by a debtor depends on the type of restructuring.

Legal

fees and other direct costs incurred in granting an equity interest to a creditor reduce the fair value of

the equity interest issued. All other direct costs incurred in connection with a troubled debt restructuring

should generally be charged to expense as incurred.

2.6.1.1 Scope of the troubled debt restructuring guidance in ASC 470-60

Liabilities that may be involved in a troubled debt restructuring include accounts payable, notes,

debentures and bonds and related accrued interest. ASC 470-60-15-4 states that the unit of account in

applying ASC 470-60 should be the individual payables, even if those payables are restructured together.

However, a creditor-by-creditor analysis may be helpful with evaluating whether a concession was

granted, as discussed below.

Troubled debt restructurings may take different forms but generally include one or a combination of

the following:

• Transfer from the debtor to the creditor of receivables from third parties, real estate or other assets

to satisfy fully or partially a debt (including a transfer resulting from foreclosure or repossession)

• Issuance or other granting of an equity interest to the creditor by the debtor in full or partial

satisfaction of debt unless the equity interest is granted pursuant to existing terms for converting

the debt into an equity interest

• Modification of debt terms, such as one or a combination of:

a. Reduction of the stated interest rate for the remaining original life of the debt

b. Extension of the maturity date or dates at a stated interest rate lower than the current market

rate for new debt with similar risk

c. Reduction of the face amount or maturity amount of the debt as stated in the instrument or

other agreement

d. Reduction of accrued interest

• Any combination of the above items (e.g., a transfer of some assets and some equity interest in

partial satisfaction, combined with a modification of the terms of the debt)

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For purposes of applying ASC 470-60, the following are not considered troubled debt restructurings:

• Lease modifications, employment-related agreements or unrecorded commitments

• Debtors’ failures to pay trade accounts according to their terms or creditors’ delays in taking legal

action to collect overdue amounts of interest and principal, unless they involve an agreement

between a debtor and creditor to restructure

• Restructurings consummated under reorganization, arrangement or other provisions of the Federal

Bankruptcy Act or other related Federal statutes in which the debtor restates its liability generally;

however, ASC 470-60 would apply to an isolated troubled debt restructuring by a debtor involved

in bankruptcy proceedings if such restructuring did not result in a general restatement of the

debtor’s liabilities

In addition, ASC 470-60-15-12 states that a troubled debt restructuring is not involved if any of the

following conditions exist even if the debtor is experiencing financial difficulty:

• The fair value of cash, other assets or an equity interest accepted by a creditor from a debtor in full

satisfaction of its receivable at least equals the creditor’s recorded investment in the receivable

• The fair value of cash, other assets or an equity interest transferred by a debtor to a creditor in full

settlement of its payable at least equals the debtor’s carrying amount of the payable

• The creditor reduces the effective interest rate on the debt primarily to reflect a decrease in market

interest rates in general or a decrease in the risk so as to maintain a relationship with a debtor that

can readily obtain funds from other sources at the current market interest rate

• The debtor issues in exchange for its debt new marketable debt having an effective interest rate

based on its market price that is at or near the current market interest rates of debt with similar

maturity dates and stated interest rates issued by non-troubled debtors

2.6.1.2 Distinguishing a troubled debt restructuring from a modification or exchange

The guidance in ASC 470-60-55-4 through 55-14 (referred to herein as “the guidance for distinguishing

a troubled debt restructuring”) provides a two-step decision tree for determining whether a modification

or an exchange of debt instruments is within the troubled debt restructuring guidance:

Step 1: Is the debtor experiencing financial difficulty (ASC 470-60-55-8 and 55-9)?

Step 2: Has the creditor granted a concession (ASC 470-60-55-10 through 55-14)?

If the answer to either of the questions above is no, the debt restructuring is not within the scope of the

troubled debt restructuring guidance in ASC 470-60, and the debt modification guidance in ASC 470-50

should be applied. Refer to section 2.6.2 for a discussion of debt modification accounting.

ASC 470-60-55-6 provides a list of factors that should not be considered in determining whether a

modification or exchange constitutes a troubled debt restructuring:

• The amount invested in the old debt by the current creditors

• The fair value of the old debt immediately before the modification or exchange compared to the fair

value of the new debt at issuance

• Transactions among debt holders

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• The length of time the current creditors have held the investment in the old debt (unless all the

current creditors recently acquired the debt from the previous debt holders to effect what is in

substance a planned refinancing).

2.6.1.2.1 Debtor experiencing financial difficulties

If a debtor’s creditworthiness has deteriorated since the debt was originally issued, ASC 470-60 requires

the debtor to evaluate whether it is experiencing financial difficulties. The guidance provides that while a

decline in credit rating from investment to noninvestment grade is considered a deterioration in the

debtor’s creditworthiness for purposes of ASC 470-60, a change within the range of investment-grade

credit ratings is not.

ASC 470-60-55-8 provides a list of indicators of financial difficulties:

• The debtor is currently in default on any of its debt.

• The debtor has declared or is in the process of declaring bankruptcy.

• There is significant doubt as to whether the debtor will continue to be a going concern.

• Currently, the debtor has securities that have been delisted, are in the process of being delisted or

are under threat of being delisted from an exchange.

• Based on estimates and projections that only encompass the current business capabilities, the debtor

forecasts that its entity-specific cash flows will be insufficient to service the debt (both interest and

principal) in accordance with the contractual terms of the existing agreement through maturity.

• Absent the current modification, the debtor cannot obtain funds from sources other than the existing

creditors at an effective interest rate equal to the current market interest rate for similar debt for a

non-troubled debtor.

These indicators are examples of financial difficulties and no single indicator is determinative of whether

the debtor is experiencing financial difficulties. All aspects of the debtor’s current financial situation

should be considered in making this determination.

Notwithstanding other evidence of financial problems, the debtor is not deemed to be experiencing

financial difficulties (and thus the restructuring is outside the scope of ASC 470-60) if both of the

following conditions are met:

• The debtor is currently servicing the old debt and can obtain funds to repay the old prepayable debt

from sources other than the existing creditors at an effective interest rate equal to the current

market interest rate for a non-troubled debtor

• The creditors agree to restructure the old debt solely to reflect a decrease in current market interest rates

for the debtor or positive changes in the creditworthiness of the debtor since the debt was originally issued

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2.6.1.2.2 Creditor granting concession

For the creditor to be considered to have granted a concession, the effective borrowing rate on the

restructured debt must be less than the effective borrowing rate of the old debt immediately prior to the

restructuring. The effective borrowing rate of the restructured debt should be calculated by projecting

all the cash flows under the new terms including new or revised sweeteners (e.g., options, warrants,

guarantees, letters of credit)

and solving for the discount rate that equates the present value of

the cash flows under the new terms to the debtor’s current carrying amount

of the old debt.

Illustration 2-4: Debt restructuring involving granting concession

Assumptions:

Company C has subordinated convertible debt outstanding with a face amount of $100 million

(increments of $1,000) and a fixed interest rate of 7% (Old Debt). Old Debt has a conversion price of

$35 and the fair value of Company C’s common stock was $30 at issuance. Both Old Debt and the

common stock are publicly traded. The current fair value of Old Debt is $450 per $1,000 increment

(aggregate fair value of $45 million).

Company C is in an industry that is experiencing financial difficulties, and Company C has defaulted on

its senior debt. It is doubtful whether Company C can meet all cash requirements as they come due

over the next 12 months. However, Company C has made all principal and interest payments on Old

Debt when due. Further assume Company C issued $50 million (face amount) of new subordinated

convertible debt at 8% per annum that has a conversion price of $8 (New Debt) to the current lenders

in exchange for Old Debt. Company C’s common stock is trading at $5 per share at the time of the

exchange. The fair value of New Debt is $50 million at issuance.

Analysis:

The debt exchange would be accounted for as a troubled debt restructuring under ASC 470-60 because

(1) the debtor is experiencing financial difficulties as it is in default on its senior debt and it is doubtful it

can service Old Debt and (2) the creditor has granted a concession because the effective borrowing rate

of the restructured debt is less than the effective borrowing rate of Old Debt immediately prior to the

restructuring primarily after considering the reduction in the principal amount of the debt and the change

in fair value of the conversion option. The fact that the fair value of New Debt is greater than the fair value

of Old Debt is not considered in determining whether the transaction is a troubled debt restructuring.

Further assume Company C exchanges Old Debt for New Debt with the same holders and issues an

additional $10 million face amount of New Debt to new investors for $10 million in proceeds.

It could be viewed that the exchange does not represent a troubled debt restructuring because the issuance

of the $10 million New Debt to investors other than existing creditors could be considered evidence of

Company C’s ability to issue debt at market interest rate consistent with that of non-troubled borrowers.

However, we generally do not believe the additional debt issued should be considered when evaluating

Company C’s ability to issue debt at a non-troubled borrower’s market rate if it were unlikely that

Company C could have issued the additional debt without restructuring Old Debt.

When determining the effect of any new or revised sweeteners, the fair value of the new sweetener or change in fair value of the

revised sweetener would be included in day one cash flows. Timing of the exercisability of the sweeteners should be reflected in

the estimation of their initial fair value.

The carrying amount for purposes of this calculation would not include any hedging effects but would include any unamortized

premium, discount, issuance costs and accrued interest payable.

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ASC 470-60-55-14 provides that if an entity recently restructured the debt and is restructuring that debt

again, the debtor’s previous carrying amount of the debt immediately preceding the earlier restructuring

would be used in obtaining the effective borrowing rate of the restructured debt. The effective borrowing

rate of the restructured debt should be compared with the effective borrowing rate of the debt immediately

preceding the earlier restructuring to determine whether the effective borrowing rate has decreased.

2.6.1.3 Debtor’s accounting for a troubled debt restructuring

The accounting for a troubled debt restructuring by a debtor depends on the type of restructuring as follows:

• A debtor that transfers its assets to a creditor in full settlement of a payable recognizes a gain

measured as (1) the carrying amount of the payable settled in excess of (2) the fair value of the

assets transferred to the creditor. Additionally, any difference between the fair value and carrying

amount of the assets transferred is recognized as a gain or loss on the disposition of those assets.

• The issuance of an equity interest to a creditor in full settlement of a payable should be accounted

for similar to the transfer of assets as described previously, with the equity interest being measured

at its fair value, less legal fees and other direct costs.

• A debt restructuring involving a modification of terms of a payable is accounted for prospectively

from the time of restructuring, and the carrying amount of the payable is not changed unless its

carrying amount exceeds the total undiscounted future cash payments specified by the new terms.

Interest expense is computed using the interest method, with the interest rate determined as the

amount that equates the present value of the future cash payments specified by the new terms

(excluding amounts contingently payable) with the carrying amount of the payable.

• A troubled debt restructuring involving a combination of term modifications, transfer of assets

and/or equity instruments is accounted for similarly to a restructuring through a modification of

terms except that, first, assets transferred or equity interests issued are measured at fair value and

the carrying amount of the payable reduced by the total fair value of those assets or equity interests.

Legal fees and other direct costs incurred in granting an equity interest to a creditor reduce the fair value

of the equity interest issued. In all other instances, such costs incurred by a debtor should be deducted in

measuring the gain on restructuring or included in expense for the period if no gain is recognized.

2.6.1.3.1 Full satisfaction of a payable through transfer of assets or equity interest

When a debtor transfers its receivables from third parties, real estate or other assets or issues an equity

interest to the creditor in full satisfaction of its payable, the transaction is accounted for on the basis of

the fair value of the assets transferred or equity interest issued. The fair value of the equity interest

transferred is reduced by legal fees and other direct issuance costs.

ASC 470-60 requires that the excess of the carrying amount of the payable over the fair value of the

assets or equity interest transferred be recognized as a gain.

In addition, the debtor recognizes a gain

or loss on disposition of assets to the extent the fair value of those assets differs from their carrying

amount (and that gain or loss should not be offset against the debt extinguishment gain).

Consistent with ASC 820 the fair value of the assets transferred is the amount that the debtor would

receive for them in a current sale between a willing buyer and a willing seller (i.e., other than in a forced

or liquidation sale).

Although the fair value of the assets transferred or the fair value of an equity interest granted should be

used in accounting for the settlement of a payable, the fair value of the payable settled may be used if it

is more clearly evident than the fair value of the assets transferred or of the equity interest granted in a

Gain recognition may not be appropriate if the restructuring is with related parties. ASC 470-50-40-2 indicates that such a

restructuring may be in essence a capital transaction.

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full settlement of a payable. However, in a partial settlement of a payable (refer to section 2.6.1.3.3), the

fair value of the assets transferred or of the equity interest granted should be used in all cases to avoid

the need to allocate the fair value of the payable between the part settled and the part still outstanding.

Illustration 2-5: Debt restructuring involving transfer of real estate

In connection with a troubled debt restructuring on 31 December 20X8, ABC Company transfers real

estate under construction with a carrying value of $15,000,000 to XYZ Bank in full settlement of a

debt of $16,000,000. Because current quoted market prices are not available for either the asset or

similar assets, fair value is determined by discounting cash flows related to the real estate at a rate

commensurate with the risk involved. Both parties estimate it will require $5,000,000 (to be incurred

ratably over the next 12 months) to complete construction and that the property would be sold

immediately upon completion for $20,000,000. Assuming a discount factor of 12%, the fair value

based on discounted future cash flows would be estimated as follows:

Estimated selling price of property at completion

$ 20,000,000

Apply a discount factor for 12% for 12 months

0.89299

17,858,000

Less present value of estimated costs to be incurred ratably over the 12 months

(4,689,629)

Estimated fair value

$ 13,168,371

The following journal entries summarize the accounting for the restructuring at 31 December 20X8 by

the debtor:

Payable to XYZ Bank

$ 16,000,000

Loss on disposition of assets ($15,000,000 — $13,168,371)

1,831,629

Real estate under construction

$ 15,000,000

Gain on debt restructuring ($16,000,000 — $13,168,371)

2,831,629

To record transfer of real estate with an estimated fair value of $13,168,371 in satisfaction of

payable to XYZ Bank.

Illustration 2-6: Debt restructuring involving transfer of note receivable

ABC Company transfers a $10,000,000 mortgage note receivable from a third party to XYZ Bank in full

settlement of $9,000,000 debt of ABC. The mortgage has a remaining term of 10 years and is payable

in monthly installments of $121,000, including interest at 8%. Assuming a current market interest rate

of 12% for similar financing, the fair value of the mortgage would be determined as follows:

Monthly payment

$ 121,000

Apply a discount factor for 120 monthly payments at 1% (12% per year compounded monthly)

69.701

Estimated fair value

$ 8,433,821

The following journal entries summarize the accounting for the restructuring by the debtor:

Payable to XYZ Bank

$ 9,000,000

Loss on disposition of assets ($10,000,000 — $8,433,821)

1,566,179

Mortgage loan receivable

$ 10,000,000

Gain on debt restructuring ($9,000,000 — $8,433,821)

566,179

To record transfer of mortgage in satisfaction of payable to XYZ Bank.

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Illustration 2-7: Debt restructuring involving transfer of equity interest

ABC Company issues 2,000,000 shares of its common stock to XYZ Bank in full settlement of debt

totaling $8,000,000. The common stock is selling at $1 per share in the open market. In accounting

for the debt restructuring, ABC would recognize a gain of $6,000,000 ($8,000,000 less $2,000,000,

the estimated fair value of the shares issued).

2.6.1.3.2 Modification of terms in a troubled debt restructuring

When a troubled debt restructuring involves a modification of terms, ASC 470-60 requires the debtor to

account for the modification on a prospective basis. The carrying amount of the payable is not adjusted

(except in the circumstances discussed below), and the effects of the changes are reflected in future

periods. Interest expense for future periods (exclusive of contingent interest) is computed by the interest

method. That is, a constant effective interest rate is applied to the carrying amount of the payable at the

beginning of each period between restructuring and maturity. The effective interest rate is the discount

rate that equates the present value of the future cash payments specified by the new terms (excluding

amounts contingently payable) with the carrying amount of the payable.

The accounting described in the preceding paragraph is based on the premise that a troubled debt

restructuring involving a modification of terms does not involve the transfer of resources or obligations

and is a continuation of an existing debt. A creditor’s primary objective is to recover its investment by

reducing the effective interest rate between the restructuring date and maturity. The effect on cash

flows is essentially the same whether the modifications involve changes in amounts designated as face

amount or interest and that accounting for restructured debt should be based on the substance of the

modification — the effect on cash flows — not on labels chosen to describe those cash flows.

However, an adjustment to the carrying amount of the restructured debt is required when the carrying

amount exceeds the aggregate undiscounted future principal and interest payments specified in the new

terms. When this occurs, the debtor recognizes a gain equal to the carrying amount of the payable in

excess of future cash payments. However, no gain on a restructured payable may be recognized if the

maximum total undiscounted future cash payments could exceed the carrying amount of the payable

(refer to section 2.6.1.3.4 for discussions on payables involving variable cash flows).

If the carrying amount of the payable is in excess of the maximum total undiscounted future cash flows, a

gain is recognized by the debtor for the excess. Subsequently, all cash receipts and payments under the

terms of the restructured debt, whether designated as interest or as face amount, reduce the carrying

amount of the payable and no interest expense is recognized (contingent payments can affect this

accounting as discussed in section 2.6.1.3.4 ).

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Illustration 2-8: Debt restructuring involving modification of terms (no gain recognized)

On 31 December 20X1, a $10,000,000 note is restructured by (1) forgiving $1,000,000 of principal

and $1,200,000 of accrued interest, (2) extending the maturity date from 31 December 20X1 to

31 December 20X6 and (3) reducing the interest rate from 12% to 6%. The aggregate undiscounted

future cash flows under the new terms total $11,700,000 (principal of $9,000,000 and interest of

$2,700,000), which exceeds the aggregate pre-restructuring carrying amount of $11,200,000.

Consequently, no adjustment would be made to the debtor’s carrying amount of the payable.

To compute interest expense in future periods, the debtor would calculate a new effective interest rate

that equates the future cash flows under the restructured terms to the aggregate pre-restructuring

carrying amount of $11,200,000.

The following schedule summarizes the payments under the new terms and the amount of interest

based on a calculated effective interest rate of 0.9682%, the rate necessary to discount the future

stream of cash payments to a present value equal to the carrying amount of the debt.

Date

Payment

Nature of payment

under new terms

Interest at effective

interest rate

Balance

12-31-X1

$ 11,200,000

12-31-X2

$ 540,000

Interest

$ 108,437

10,768,437

12-31-X3

540,000

Interest

104,259

10,332,696

12-31-X4

540,000

Interest

100,040

9,892,736

12-31-X5

540,000

Interest

95,781

9,448,517

12-31-X6

540,000

Interest

91,483

9,000,000

12-31-X6

9,000,000

Principal

—

$ 11,700,000

$ 500,000

Note that the amounts to be recognized as interest expense are not the amounts designated as

“interest” under the terms of the debt. The following journal entries summarize the accounting by the

debtor for future cash payments under the restructured terms:

20X2:

Debt

$ 431,563

Interest expense

108,437

Cash

$ 540,000

To record payment of $540,000 on 31 December 20X2 as a partial reduction in the carrying amount

of the debt and a charge to interest expense based on the calculated interest rate (0.9682%) under the

new debt terms. Similar entries would be made for each year 20X3–20X6.

Upon maturity, the following entry would be made:

Debt

$ 9,000,000

Cash

$ 9,000,000

To record payment of stated principal amount due under the terms of the restructured debt on

31 December 20X6.

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Illustration 2-9: Debt restructuring involving modification of terms (gain recognized)

Assume the above facts as in the preceding illustration, except that the interest rate is reduced to 2%.

Aggregate undiscounted future cash payments total $9,900,000, which is $1,300,000 less than the

pre-restructuring amounts. In this case, the debtor would reduce the carrying amount of the payable

by $1,300,000 and recognize a gain equal to this amount. Future cash payments reduce the payable,

and no interest expense would be recognized as the effective interest rate is 0%.

The following journal entries summarize the accounting by the debtor for this transaction:

20X1:

Debt

$ 1,300,000

Gain on restructuring of debt

$ 1,300,000

To adjust carrying amount of the debt to reflect modification of terms.

20X2 through 20X6:

Debt

$ 180,000

Cash

$ 180,000

To record annual payment of amounts under the terms of the payable for each year 20X2 through

20X6 as reductions in the carrying amount of the debt (0% interest rate).

20X6:

Debt

$ 9,000,000

Cash

$ 9,000,000

To record payment of principal amount due under the terms of the restructured debt on 31 December

20X6.

2.6.1.3.3 Combination of types including partial satisfaction

Debt restructurings may include a combination of transferring an asset or equity interest and modifying

the terms of the debt. The accounting for these restructurings is the same as that for a modification of

terms. The fair value of assets transferred or equity interest granted should be accounted for as a partial

cash payment. The accounting for debt restructurings including a combination of terms is as follows:

• The carrying amount of the payable is reduced by the fair value of the assets or equity interest

transferred (the guidance precludes the use of fair value of debt in these situations).

• The debtor recognizes a gain or loss resulting from any disposition of assets (based on the difference

between the fair value of the assets disposed and their respective carrying amount).

• No gain on restructuring is recognized unless the remaining balance of the debt exceeds total

undiscounted future cash payments specified in the new terms (refer to section 2.6.1.3.4 on a

discussion of variable interest and contingent interest).

• Future interest expense (if any) is computed using the interest method.

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Illustration 2-10: Debt restructuring involving a combination of types including partial satisfaction

On 31 December 20X8, XYZ Bank agrees to restructure a $10,000,000 loan receivable from ABC

Company by accepting:

• Real estate with a fair value of $6,000,000 (ABC’s carrying amount was $6,500,000).

• A 10% note for $3,000,000 from ABC due 31 December 20Y6.

The debtor would reduce the $10,000,000 debt by $6,000,000, the fair value of the real estate

transferred. Whether a gain on restructuring should be recognized would be determined as follows:

Total undiscounted future cash payments:

Principal

$ 3,000,000

Interest ($3,000,000 x 10% for 8 years)

2,400,000

5,400,000

Less remaining debt:

(4,000,000)

Excess of future cash payments over remaining debt

$ 1,400,000

Because the total of future cash payments is more than the remaining carrying amount, no gain

should be recognized on the restructuring. ABC would recognize loss on disposition of assets of

$500,000 ($6,500,000 — $6,000,000). Interest for future periods would be computed using a new

effective interest rate of 4.8697%, which is the rate necessary to discount the future stream of cash

payments to the remaining debt.

The following schedule summarizes the payments under the new terms and the amount of interest to

be recognized in future periods:

Date

Payment

Nature of payment

under new terms

Interest at effective

interest rate

Balance

12-31-X8

$ 4,000,000

12-31-X9

$ 300,000

Interest

$ 194,789

3,894,789

12-31-Y0

300,000

Interest

189,665

3,784,454

12-31-Y1

300,000

Interest

184,292

3,668,746

12-31-Y2

300,000

Interest

178,658

3,547,404

12-31-Y3

300,000

Interest

172,748

3,420,152

12-31-Y4

300,000

Interest

166,552

3,286,704

12-31-Y5

300,000

Interest

160,053

3,146,757

12-31-Y6

300,000

Interest

153,243

3,000,000

12-31-Y6

3,000,000

Principal

—

$ 5,400,000

$ 1,400,000

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2.6.1.3.4 Contingent payments and payments based on variable interest rates

Contingent payments

Troubled debt restructurings often include provisions that require payment of additional amounts if

certain conditions are met in the future. Generally, those conditions will require additional payments

based on a specified improvement in the debtor’s financial condition or operating results within a

specified period. Generally, no gain is recognized on a restructured payable that involves indeterminate

cash payments as long as it is possible that the maximum total future cash payments on an undiscounted

basis may exceed the carrying amount of the payable.

Pursuant to ASC 470-60-35-7, contingent payments should be included in the total future cash

payments specified by the new terms to the extent necessary to prevent recognizing a gain at the time of

restructuring that may be offset by future interest expense. A gain should be recognized only when the

total future payments are certain to be less than the then-carrying amount of the restructured payable.

As described in ASC 470-60-35-10, after the time of restructuring, the debtor recognizes interest

expense and a payable for contingent payments when it is probable that a liability has been incurred and

the amount can be reasonably estimated (i.e., a loss contingency), pursuant to the provisions of ASC 450.

However, accrual or payment of those amounts should be first deducted from the carrying amount of the

restructured payable to the extent that the contingent payments were included in total future cash

payments specified by the new terms and prevented recognition of a gain at the time of restructuring.

Payments based on variable interest rates

In some cases, future payments on the restructured payable are expected to fluctuate because the

restructured debt involves a variable interest rate. Although these cash flows could be viewed as

indeterminate, ASC 470-60-35-11 requires the estimate of the maximum total future cash payments for

variable interest payments to be based on the contractual variable interest rate in effect at the time of

the restructuring (the “TDR rate”). We generally believe a gain can be recognized only when the maximum

total future payments, estimated using the TDR rate, is less than the carrying value of the restructured

payable. In circumstances where a gain is recognized, the carrying value of the debt will equal the

maximum total future payments, estimated using the TDR rate. If there are any other contingent or

indeterminate cash flows, gain recognition would not be appropriate if it is possible that the maximum

total future cash payments on an undiscounted basis, plus the estimate of variable cash flows based on

the TDR rate, may exceed the carrying amount of the payable.

If the interest rate remains unchanged after the restructuring, all future principal and interest payments

will reduce the carrying amount resulting in no amounts being charged to interest expense. Fluctuations

in the contractual interest rate after the restructuring from changes in the variable rate index should be

accounted for as changes in estimates in the periods in which the changes occur (prospectively). To the

extent the contractual interest rate increases above the TDR rate in a subsequent period, we generally

believe interest expense should be recognized in the subsequent period equal to the amount the interest

payment exceeds the payment estimated using the TDR rate. A decrease in the contractual interest rate

below the TDR rate should not result in recognizing a gain for that particular interest payment, as that

gain may be offset by future higher cash payments. Rather, future cash payments should reduce the

carrying amount until the time that any gain recognized cannot be offset by future cash payments.

Because the interest rate can increase in the future, we generally believe no gain should be recognized

until the entire debt balance is extinguished.

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Illustration 2-11: Debt restructuring involving a variable rate payable

On 31 December 20X8, an $8,000,000 note and related accrued interest of $1,000,000 are

restructured by:

• Forgiving $1,500,000 of the face amount of the note and forgiving the accrued interest of

$1,000,000

• Extending the maturity date five years from 31 December 20X8 to 31 December 20Y3

• Reducing the interest rate from 12% to a rate equal to the prime interest rate

Based on the interest rate in effect at time of the restructuring (the prime interest rate at

31 December 20X8 is 7%), future cash payments under the new terms total $8,775,000 (principal of

$6,500,000 and interest of $2,275,000 — calculated as five years times 7% times $6,500,000), which

is $225,000 less than the pre-restructured carrying amount of the debt.

The following schedule summarizes the payments under the new terms (note the actual payments and

estimated maximum payments reflect the actual prime rate of 7% for 20X9, 8% for 20Y0, 6.5% for

20Y1 and 20Y2, and 6% for 20Y3):

Date

Estimated

maximum total

future cash

payments based

on prime rate as

of restructuring

date

Actual payments

Carrying amount

of payable

Income

statement effect

Income/(expense)

12-31-X8 before restructuring

$ 9,000,000

12-31-X8 after restructuring

8,775,000

$ 225,000

12-31-X9

$ 455,000

8,320,000

—

12-31-Y0

455,000

520,000

7,865,000

(65,000)

12-31-Y1

455,000

422,500

7,442,500

—

12-31-Y2

455,000

422,500

7,020,000

—

12-31-Y3 interest

455,000

390,000

6,630,000

—

12-31-Y3 principal

6,500,000

—

130,000

Total

$ 8,775,000

$ 8,710,000

$ 290,000

(1)

After recognition of gain on restructuring. The gain is the difference between the carrying amount of

$9,000,000 (principal and accrued interest before restructuring) less the estimated maximum total future

undiscounted cash flows of $8,775,000 at the restructuring date.

(2)

Because the interest rate has increased above the TDR rate, interest expense is recognized in the amount of

$65,000 ($520,000 — $455,000).

We generally believe that in situations where interest payments are expected to fluctuate, a gain

should be recognized at the time of restructuring when the maximum total future cash payments,

estimated using the interest rate in effect at the time of restructuring, is less than the carrying amount

of the restructured payable. Because the prime rate increased in 20Y0 above the interest rate at the

date of restructuring, additional interest expense is recognized in 20Y0. In years subsequent to 20Y0,

the interest rate decreased below the interest rate at the date of restructuring. No gain is recognized

in those periods and the cash payments reduce the carrying amount. A gain is not recognized until the

entire debt is extinguished.

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2.6.1.3.5 Notes payable ‘on demand’ or with prepayment provisions

If the number of interest payments is not determinable because the principal and interest are or become

payable on demand, estimates of the total future cash payments under the restructured terms should be

based on the maximum number of periods that payments may possibly be made by the debtor.

In situations in which a debtor is permitted to prepay a reduced face amount without penalty, total future

cash payments could be less than the carrying amount of the debt. ASC 470-60 gives no recognition to

prepayment provisions in determining gain or loss at the date of restructuring. Likewise an investor’s put

option would be ignored. If the debtor does prepay, a change in estimate should be recognized at the

time of prepayment.

Illustration 2-12: Debt restructuring involving payable “on demand”

On 31 December 20X8, a $1,000,000 note is restructured by

• Forgiving $200,000 of principal and total accrued interest of $100,000

• Extending the maturity date from 31 December 20X8 to 31 December 20Y3

• Reducing the interest rate from 10% to 8%.

In addition, the new terms provide that the principal becomes payable on the investor’s demand if

management’s profit projections are not met during any year after 31 December 20Y0. The earliest

payment date for the borrower is three years after restructuring, 31 December 20Y1.

The aggregate future cash payments are determined based on the maximum number of periods and

payments, ignoring the potential for an early redemption by the investors. Under the new terms,

assuming the maximum possible term (5 years), the aggregate possible future cash payments total

$1,120,000, which is $20,000 greater than the pre-restructuring carrying amount. Consequently,

no adjustment would be made to the debtor’s carrying amount of the payable on restructuring.

If actual aggregate future cash flows differ from the estimated amounts, as determined above, the

effect should be accounted for as a change in estimate in the period the change occurs.

2.6.1.3.6 Costs incurred in connection with troubled debt restructurings

Direct costs incurred in granting equity interests in a troubled debt restructuring should be recognized

as a reduction to the carrying amount of the equity interests. All other direct costs incurred should be

deducted in measuring gain on restructuring of payables or expensed for the period if no gain recognized

on restructuring.

2.6.2 Modifications or exchanges of debt instruments

2.6.2.1 General

Modifications or exchanges of debt that are not considered troubled debt restructuring pursuant to

ASC 470-60 should be evaluated under ASC 470-50, which states that modifications or exchanges are

considered extinguishments with gains or losses recognized in current earnings if the terms of the new

debt and original instrument are substantially different. The instruments are considered “substantially

different” pursuant to ASC 470-50 (generally in ASC 470-50-40-6 through 40-23) when the present

value of the cash flows under the terms of the new debt instrument is at least 10% different from the

present value of the remaining cash flows under the terms of the original instrument.

If the original and new debt instruments are substantially different, the original debt is derecognized and

the new debt should be initially recorded at fair value, with the difference recognized as an extinguishment

gain or loss. Gain or loss recognition may not be appropriate if the restructuring is with related parties.

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ASC 470-50-40-2 indicates that such a restructuring may be in essence a capital transaction. When

modifications or exchanges are not considered extinguishments, they are accounted for prospectively as

yield adjustments, based on the revised terms.

The accounting for (1) fees paid by the debtor to the creditor or received by the debtor from the creditor

and (2) costs incurred with third parties directly related to the exchange or modification depends on

whether the exchange or modification is to be accounted for as an extinguishment or modification.

Modifications to or exchanges of line-of-credit or revolving arrangements should be evaluated pursuant

to ASC 470-50-40-21 through 40-23. The accounting for unamortized deferred costs, costs paid to

third parties and fees paid to or received from the creditor depends on whether the borrowing capacity —

the product of the remaining term and the maximum available credit — has increased or decreased.

2.6.2.2 Scope of the debt modification guidance in ASC 470-50

ASC 470-50 provides the accounting for a modification or exchange of a debt instrument between the

same debtor and creditor. An exchange of debt instruments with different terms but with the same

creditor has the same economic effect of modifying the terms of an existing debt instrument and thus is

in the scope of ASC 470-50.

When the debtor and creditor agree to modify existing debt or exchange old debt for new debt, they

have, in effect, renegotiated the old debt by changing its cash flows. While the modification or exchange

of debt does not meet the conditions specified in ASC 405-20 for extinguishment accounting, substantial

changes in the cash flows are viewed to represent extinguishments of the old debt and the creation of

new debt, resulting in recognition of gain or loss by the debtor.

ASC 470-50 does not apply to:

• Conversion of debt into equity securities of the debtor pursuant to the conversion right contained in

the terms of the debt instrument

• A troubled debt restructuring

• Transactions entered into between a debtor (or its agent) and a third party that is not the creditor

• Transactions among creditors

When there is more than one creditor in a debt arrangement (e.g., a loan syndication), the debt

modification guidance should be applied on a creditor-by-creditor basis. In certain cases, it may not be

clear who the “creditor” is for purposes of applying the modification guidance. For example, when multiple

limited partnership funds, managed by a general partner, participate as lenders in a loan syndication for

which a debt modification or exchange occurs, the question arises as to whether the individual funds

should be viewed as separate creditors or as one creditor. When identifying the creditors, the specific

facts and circumstances should be considered. In this case the debtor may consider (1) how the funds are

structured and managed; (2) whether the funds are consolidated by the general partner; and (3) what the

roles of the general partner and the funds are in the negotiation of the debt modification or exchange.

2.6.2.2.1 Contemporaneous exchange of cash between the same debtor and creditor from issuance of

new debt and satisfaction of an existing debt by the debtor

A contemporaneous exchange of cash between the same debtor and creditor in connection with the

issuance of a new debt instrument and satisfaction of an existing debt instrument by the debtor is covered

by the scope of the debt modification guidance, according to ASC 470-50-40-9. That is, the transaction

would be accounted for as a debt extinguishment only if the existing and new debt instruments have

substantially different terms.

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2.6.2.2.2 Debtor with an irrevocable offer to redeem a debt instrument at a future date

An issuer’s irrevocable offer to redeem a debt instrument does not require the application of the debt

modification guidance in ASC 470-50 because the irrevocable offer is not a binding contract between the

debtor and creditor and thus neither a modification nor an exchange has occurred.

2.6.2.3 Determining whether debt instruments are substantially different

Modified terms are considered substantially different pursuant to ASC 470-50 (thus requiring

extinguishment accounting) if, after an exchange or modification of debt instruments with the same creditor,

the present value of cash flows under the terms of the new debt instrument differs by at least 10% from

the present value of the remaining cash flows under the terms of the original debt instrument (commonly

referred to as the “10% cash flow test”).

We believe that this assessment should be performed at the reporting entity level. For example, if a

subsidiary’s debt is exchanged for new debt issued to the same lender by the parent entity, the 10% cash

flow test would be performed on a consolidated basis, for the purposes of the consolidated financial

statements. If the subsidiary has a standalone financial reporting requirement, the subsidiary’s debt

would be considered extinguished in the exchange transaction.

For the purposes of this calculation, the cash flows of the original and new instruments should be

discounted at the effective interest rate used for accounting purposes of the original debt instrument.

We believe the original debt’s effective interest rate should generally be the rate under the interest

method described in ASC 835-30-35-2 and 35-3, which is the rate that was computed using the original

debt’s face amount, stated interest rate and unamortized premium or discount, as appropriate. We

generally do not believe that the effect of (1) debt issuance costs or (2) subsequent hedging (including

basis adjustments to the old debt under a fair value hedge) should be included in computing the debt’s

original effective rate.

The effect of changes in principal amounts, interest rates or maturity should be considered in determining

whether the terms of the original debt and new debt are substantially different. The 10% cash flow test

should be performed using the gross cash inflows and outflows, including all principal increases and

decreases.

Refer to Illustrations 2-16 and 2-17 in section 2.6.2.3.3 for examples of applying the 10%

cash flow test that involve changes in principal amounts.

Cash flows can also be affected by fees exchanged between the debtor and creditor attributable to

changes in recourse features, collateralization, debt covenants and option features. For example, fees

paid to a creditor in exchange for a waiver of a debt covenant should be viewed as a modification of the

debt instrument, and that cash flow should be considered in the calculation of the present value of cash

flows. Any amounts paid by the debtor to the creditor less any amounts received by the debtor from the

creditor as part of the transaction are to be included as part of the cash flows of the new debt instrument.

The debt modification guidance in ASC 470-50 also requires the following items to be considered in the

calculation of the present value of cash flows:

• If the original debt instrument and/or the new debt instrument has a floating interest rate, the

variable rate in effect at the date of the exchange or modification should be used to determine future

cash flows.

• If the debt instruments contain contingent payment terms or unusual interest rate terms, judgment

should be used to determine the appropriate cash flows.

Refer to the discussion on accounting for fees for prepayable debt below in section 2.6.2.5.

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• If the debt was exchanged or modified within a year before the current exchange or modification and

the debt was not deemed to be substantially different at that time (i.e., the exchange or modification

was not accounted for as an extinguishment), the debt terms that existed before the earlier

exchange or modification should be used to determine whether the debt is substantially different

after the current exchange or modification.

There may be instances in which a debtor has multiple debt instruments outstanding with a single

creditor. The debtor and creditor may modify one instrument, a combination of instruments or all of

those instruments. While this is not addressed in ASC 470-50, we believe judgment should be applied to

determine whether the debt instruments should be evaluated individually or collectively. In some cases it

may be appropriate or necessary to combine multiple instruments into a single unit of analysis to

accurately capture the economics of the transaction. That is, if some or all of the instruments are

modified contemporaneously to achieve a desired economic effect, they may need to be evaluated

collectively. All facts and circumstances should be considered when making this determination.

To the extent some or all of the debt instruments should be combined into a single unit of analysis, the

debtor should use a blend of the effective interest rates of the original debt instruments before they were

modified. The result of the 10% cash flow test should be applied to all debt instruments outstanding that

were combined into the single unit of analysis (e.g., if the terms are considered to be substantially

different, all of the debt instruments combined for analysis are considered extinguished).

Refer to section 2.6.2.3.3 for examples of applying the 10% cash flow test to modifications and exchanges

of nonconvertible debt instruments.

If the modification or exchange involves a convertible debt instrument, the change in the fair value of an

embedded conversion option resulting from the modification or exchange should not be included in the

10% cash flow test calculation, and the specific guidance in ASC 470-50 on convertible instruments

should be considered (refer to section 2.6.2.4).

2.6.2.3.1 Performing the cash flow test involving exchange of noncash consideration

Modifications or exchanges of debt instruments may involve issuance of noncash consideration

(e.g., warrants, options, shares) to the creditor. ASC 470-50-40-12 states that the cash flows of the new

instrument should include all cash flows specified by the terms of the new instrument plus any amounts

paid or exchanged between the debtor and the creditor in connection with the exchange or modification.

While the guidance is not specific as to what is considered “any amount paid,” we generally believe that

the fair value of the noncash consideration issued as part of the modification or exchange transaction

should be included as a day one cash flow in the 10% cash flow test. This treatment is consistent with the

guidance in ASC 470-60-55-12 for troubled debt restructurings when determining whether a concession

is made by the creditor. That guidance requires the fair value of any new or changes in the fair value of

revised sweeteners (e.g., warrants, options, guarantees) be included in day one cash flows in

determining whether the creditor has made concession.

2.6.2.3.2 Performing the cash flow test when debt instruments are prepayable prior to maturity

If either the new debt instrument or the original debt instrument is callable or puttable (prepayable),

separate cash flow analyses should be performed assuming exercise and non-exercise of the call or put.

The cash flow assumptions that generate the smaller change should be used as the basis for determining

whether the 10% threshold is met. If the instrument is callable and/or puttable at several points during

its life (e.g., puttable or callable at any time), the present value of the remaining cash flows should be

computed using each call or put date and amount. Because the cash flow assumptions that generate the

smaller change are used to determine whether the 10% threshold is met, if any of the call or put exercises

results in less than a 10% difference, extinguishment accounting should not be followed.

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As discussed above, even though existing debt may be prepayable, we generally believe the 10% cash

flow test must include any principal repayment when the debt remaining after prepayment is modified.

2.6.2.3.3 Illustrations — 10% cash flow test

Illustration 2-13: Reduced interest rate on non-callable debt

On 1 January 20X1, Debtor borrows $100,000 from Creditor at par with a stated interest rate of 14%.

No fees were paid by Debtor to Creditor, so the debt was initially recorded at par. Subsequently, market

interest rates decline. On 1 January 20X4, Debtor and Creditor modify the debt, which under its new terms

has a stated interest rate of 12%. The original terms and the terms of the modified debt are as follows:

Terms

Original

Modified

Principal:

$100,000

Term (from modification date):

7 years

Rate:

14%

12%

Callable:

Non-callable

Summary of cash outflows:

Year

Remaining

interest

Original

principal

Total

Modified

interest

Principal

Total

$ 14,000

—

$ 14,000

$ 12,000

—

$ 12,000

14,000

—

14,000

12,000

—

12,000

14,000

—

14,000

12,000

—

12,000

14,000

—

14,000

12,000

—

12,000

14,000

—

14,000

12,000

—

12,000

14,000

—

14,000

12,000

—

12,000

14,000

$ 100,000

114,000

12,000

$ 100,000

112,000

Total

$ 98,000

$ 100,000

$198,000

$ 84,000

$ 100,000

$184,000

Present value test:

Using the effective interest rate of the original debt, which in this case is also the stated interest rate

(14%) as there are no unamortized premium or discount, the present values of (1) the cash flows

under the terms of the modified debt instrument and (2) the remaining cash flows under the original

debt’s terms, are as follows:

Present value of modified debt’s cash flows

$ 91,424

Present value of original debt’s remaining cash flows

$ 100,000

The original and modified debt instruments are not considered substantially different as the difference

between the present value of the remaining cash flows under the original and the modified terms is

less than 10% (i.e., the difference is 8.58%).

Because the original and new debt instruments are not considered substantially different,

extinguishment accounting does not apply. A new effective interest rate should be determined at the

date of modification that equates the revised cash flows to the carrying amount of the original debt.

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Illustration 2-14: Reduced interest rate in return for giving up call privilege

On 1 January 20X1, Debtor borrows $100,000 from Creditor at par with a stated interest rate of

14.5%. No fees were paid by Debtor to Creditor, so the debt was initially recorded at par. The debt is

callable at the end of Year 5 for 109. Since issuance, market interest rates have declined. On

1 January 20X4, Debtor agrees to give up its call privilege two years before the exercise date. In

exchange for giving up the call privilege, Debtor will pay a reduced interest rate of 9.5%, which is still

above the then-current market rate of 8.5%.

Terms

Original

Modified

Principal:

$100,000

Term (from modification date):

7 years

Rate:

14.5%

9.5%

Callable:

End of Year 5

Non-callable

Call Premium:

N/A

Summary of cash outflows:

Year

Remaining

interest

Original

principal

Total

Modified

interest

Principal

Total

$ 14,500

—

$ 14,500

$ 9,500

—

$ 9,500

14,500

—

14,500

9,500

—

9,500

14,500

—

14,500

9,500

—

9,500

14,500

—

14,500

9,500

—

9,500

14,500

—

14,500

9,500

—

9,500

14,500

—

14,500

9,500

—

9,500

14,500

$ 100,000

114,500

9,500

$ 100,000

109,500

Total

$ 101,500

$ 100,000

$ 201,500

$ 66,500

$ 100,000

$ 166,500

Present value test:

If either the new debt instrument or the original debt instrument is callable, the debt modification

guidance in ASC 470-50 requires separate cash flow analyses to be performed assuming exercise and

non-exercise of the call. The cash flow assumptions that generate the smaller change would be the

basis for determining whether the 10% threshold is met.

Discounting the cash flows at the original debt’s effective rate of 14.5% (which is also the stated

interest rate in this case as there are no unamortized premium or discount), the present values of the

original and revised cash flows are as follows:

Present value of modified debt’s cash flows

$ 78,882

Present value of original debt’s remaining cash flows, call exercised

$ 106,865

Present value of original debt’s remaining cash flows, call not exercised

$ 100,000

The present value of the original cash flows is calculated both assuming the call is not exercised

(present value is $100,000) and assuming the call is exercised on 31 December 20X5 (present value

is $106,865). The present value of the modified cash flows is only calculated through maturity as the

call no longer exists (present value is $78,882). The debt modification guidance in ASC 470-50

requires the smaller difference between the modified $78,882 present value and the original

$100,000 present value to be used in the substantially different test. Because the difference between

the $78,882 and $100,000 represents a change of 21.12% (which is greater than the 10% threshold),

the terms of the modified debt are considered substantially different from the original loan terms.

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Once becoming callable, debt may remain callable (at decreasing call premiums) until maturity. The debt

modification guidance in ASC 470-50 requires that the present value of the original debt’s remaining

cash flows be computed using each call date and amount. Because the cash flow assumptions that

generate the smaller change are determining whether the 10% threshold is met, if any of the calculations

of the call exercises result in less than a 10% difference from the present value of the modified debt’s

cash flows, extinguishment accounting would not apply. Debt may be callable at any time, which would

require a calculation as if the debt were repaid immediately after the modification, suggesting no

discounting of the principal amount and no future interest payments.

Illustration 2-15: Debtor pays fee for release from restrictive covenants

On 1 January 20X1, Debtor borrows $100,000 from Creditor at par with a stated interest rate of 10.5%.

No fees were paid by Debtor to Creditor, so the debt was initially recorded at par. On 1 January 20X4,

Debtor pays a 3% fee to Creditor for a release from certain restrictive covenants.

Terms

Original

Modified

Principal:

$100,000

Term (from modification date):

7 years

Rate:

10.5%

Covenants:

Yes

Summary of cash outflows:

Year

Remaining

interest

Original

principal

Total

Modified

interest

Fee

Principal

Total

$ 10,500

—

$ 10,500

$ 3,000

—

$ 13,500

10,500

—

10,500

—

10,500

—

10,500

—

10,500

—

10,500

—

10,500

—

10,500

—

10,500

—

10,500

—

10,500

$ 100,000

110,500

10,500

—

$ 100,000

110,500

Total

$ 73,500

$ 100,000

$173,500

$ 73,500

$ 3,000

$ 100,000

$ 176,500

Present value test:

Using the effective interest rate of the original debt, which is also the stated interest rate (10.5%) in

this case as there are no unamortized premium or discount, the present values of (1) the cash flows

under the terms of the new debt instrument (the $3,000 fee is treated as day one undiscounted cash

flow) and (2) the remaining cash flows under the original debt’s terms are as follows:

Present value of modified debt’s cash flows

$ 103,000

Present value of original debt’s remaining cash flows

$ 100,000

The original and modified debt instruments are not considered substantially different as the difference

between the present value of the remaining cash flows under the original terms and the modified

terms is less than 10% (i.e., the difference is 3.0%).

At the modification date the following entry would be required to record the $3,000 fee paid to Creditor

as a discount on the debt (rather than being expensed):

Debt

$ 3,000

Cash/payable

$ 3,000

Because the original and new debt instruments are not substantially different, extinguishment

accounting does not apply. A new effective interest rate should be determined based on the carrying

amount ($97,000) and the revised cash flows.

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Illustration 2-16: Additional borrowings with reduction in interest rate

On 1 January 20X1, Debtor borrows $100,000 from Creditor at par with a stated interest rate of 14%.

No fees were paid by Debtor to Creditor, so the debt was initially recorded at par. Subsequently, market

interest rates declined. On 1 January 20X4, Debtor and Creditor modify the debt, reducing the

interest rate to 12%. In addition, Debtor borrows an additional $50,000. The terms of the original and

modified debt are as follows:

Terms

Original

Modified

Principal:

$100,000

$150,000

Term (from modification date):

7 years

Rate:

14%

12%

Callable:

Non-callable

Summary of cash (inflows)/outflows:

Year

Interest

Remaining

principal

Original

total

Modified

interest

Modified

principal

Total

$ 14,000

—

$ 14,000

$ 18,000

$ (50,000)

$ (32,000)

14,000

—

14,000

18,000

—

18,000

14,000

—

14,000

18,000

—

18,000

14,000

—

14,000

18,000

—

18,000

14,000

—

14,000

18,000

—

18,000

14,000

—

14,000

18,000

—

18,000

14,000

$ 100,000

114,000

18,000

150,000

168,000

Total

$ 98,000

$ 100,000

$ 198,000

$ 126,000

$ 100,000

$ 226,000

Present value test:

Using the effective interest rate of the original debt, which is also the stated interest rate (14%) in this

case as there are no unamortized premium or discount, the present values of (1) the cash flows under

the terms of the new debt instrument and (2) the remaining cash flows under the original debt’s terms

are as follows:

Present value of modified debt’s cash flows

$ 87,135*

Present value of original debt’s remaining cash flows

$ 100,000

Calculated as PV of principal ($150,000 in 7 years at 14%) plus PV of interest annuity ($18,000 per year for 7 years at 14%)

less additional borrowings of $50,000 (treated as a day one cash inflow on the modified debt).

The terms of the instruments would be considered substantially different because the difference in

the present value of the remaining cash flows under the old terms and the new terms is greater than

10% (i.e., the difference is 12.87%). The modification is to be accounted for in the same manner as a

debt extinguishment.

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Illustration 2-17: Debtor prepays a portion of principal on non-callable debt and Debtor and

Creditor agree to a reduced interest rate and a two-year extension of the

maturity date

On 1 January 20X1, Debtor borrows $100,000 from Creditor at par with a stated interest rate of 10%.

No fees were paid by Debtor to Creditor, so the debt was initially recorded at par. The debt is not

prepayable by its terms. Subsequently, market interest rates decline. On 1 January 20X4, Debtor

negotiates to prepay $25,000 of the principal balance. In addition, the Debtor and Creditor modify the

debt, reducing the interest rate to 8% and extending the maturity date two years. The original terms

and the terms of the modified debt are as follows:

Terms

Original

Modified

Principal:

$100,000

$75,000 (reduced by negotiated prepayment)

Term (from modification date):

7 years

9 years

Rate:

10%

Callable:

Non-callable

Summary of cash outflows:

Year

Interest

Remaining

principal

Original

total

Modified

interest

Modified

principal

Total

$ 10,000

—

$ 10,000

$ 6,000

$ 25,000

$ 31,000

10,000

—

10,000

6,000

—

6,000

10,000

—

10,000

6,000

—

6,000

10,000

—

10,000

6,000

—

6,000

10,000

—

10,000

6,000

—

6,000

10,000

—

10,000

6,000

—

6,000

10,000

$ 100,000

110,000

6,000

—

6,000

—

6,000

—

6,000

—

6,000

75,000

81,000

Total

$ 70,000

$ 100,000

$ 170,000

$ 54,000

$ 100,000

$ 154,000

Present value test:

Using the effective interest rate of the original debt, which is also the stated interest rate (10%) in this

case as there are no unamortized premium or discount, the present values of (1) the cash flows under

the terms of the new debt instrument and (2) the remaining cash flows under the original debt’s terms

are as follows:

Present value of modified debt’s cash flows

$ 91,361*

Present value of original debt’s remaining cash flows

$ 100,000

* Calculated as PV of principal ($75,000 in nine years at 10%) plus PV of interest annuity ($6,000 per year for nine years at

10%) plus the prepayment of $25,000 (treated as an undiscounted day one cash flow on the modified debt).

The terms of the new and modified instruments would not be considered substantially different

because the difference in the present values is less than 10% (i.e., the difference is 8.63%).

The debtor should reduce the debt balance by $25,000 for the cash paid to the creditor on the

modification date and determine a new effective interest rate based on the carrying amount

($75,000) and the revised cash flows.

Although the original debt was not prepayable in this example, we believe the approach would be the

same if the original debt was prepayable.

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2.6.2.4 Modifications or exchanges of convertible debt instruments

Issuers may modify the terms of convertible debt (e.g., changing the maturity date or the number of

shares of common stock issuable upon conversion of the debt). The debt modification guidance in

ASC 470-50 has specific criteria that apply to modifications of convertible debt when the conversion

feature is not bifurcated either before or after the transaction. Further, there are additional considerations

for modifications or exchanges involving convertible debt instruments subject to the cash conversion or

beneficial conversion guidance (refer to section 2.6.2.4.2).

ASC 470-50-40-10 provides that the change in the fair value of an embedded conversion option resulting

from an exchange or modification is not included in the debt modification guidance’s 10% cash flow test.

However, if the 10% cash flow test does not result in a conclusion that a substantial modification or an

exchange has occurred, a further step is required and an extinguishment is deemed to have occurred if the

change in the fair value of the embedded conversion option (calculated as the difference between the fair

value of the embedded conversion option immediately before and after the modification or exchange) is

at least 10% of the carrying amount of the original debt instrument immediately prior to the modification

or exchange.

For example, assume the carrying amount of convertible debt is $1,000 and it is convertible into

20 shares at a conversion price of $50. On the date that the share price is $30 and the fair value of the

embedded derivative option is $5, the conversion option is modified to allow for conversion into 40 shares

at a conversion price of $25. That new in-the-money conversion option has a fair value of $230. Despite

having no changes in cash flows, this modification would be accounted for as an extinguishment because

the fair value of the conversion option changed by $225 ($230–$5), or 22.5% ($225/$1,000), which is at

least 10% of the carrying amount of the original debt immediately before the modification.

ASC 470-50-40-10 also provides that a modification or an exchange that adds or eliminates a substantive

conversion option as of the conversion date would always be considered substantial and require

extinguishment accounting. ASC 470-20-40-7 defines a substantive conversion feature to be at least

reasonably possible

of being exercised in the future. For example, if the conversion price of a convertible

instrument is extremely high as compared to the fair value of the underlying equity instrument at the date

of modification (i.e., a deep out-of-money conversion option), the conversion feature might not be

considered substantive. In addition, ASC 470-20-40-8 states that conversion features that are exercisable

only upon the issuer’s exercise of its call option should not be considered substantive. In determining

whether a conversion feature is reasonably possible of being exercised, the assessment should not

consider the holder’s intent.

ASC 470-20-40-9 provides the following considerations in determining whether the conversion option

is substantive:

• The fair value of the conversion feature relative to the fair value of the debt instrument

• The effective annual interest rate per the terms of the debt instrument relative to the estimated

effective annual rate of a nonconvertible debt instrument with an equivalent expected term and

credit risk

• The fair value of the debt instrument relative to an instrument that is identical except for which the

conversion option is not contingent

• Qualitative evaluation of the conversion provisions, such as the nature of the conditions under which

the instrument may become convertible

The term “reasonably possible” has the same meaning as in ASC 450, Contingencies.

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Pursuant to ASC 470-50-40-15, if the modification or exchange of a convertible debt instrument is not

accounted for as an extinguishment, the accounting for the change in the fair value of the embedded

conversion option depends on whether the change (calculated as the difference between the fair value of

the embedded conversion option immediately before and after the modification or exchange) is an

increase or decrease, as follows:

Change

Accounting

Increase in fair value of the embedded option

Reduce carrying amount of debt instrument (increasing a

debt discount or reducing a debt premium) with a

corresponding increase in APIC

Decrease in fair value of the embedded option

No accounting required

The convertible debt provisions of the debt modification guidance in ASC 470-50 are illustrated below:

Illustration 2-18: Modify fixed-rate convertible debt by reducing the conversion price and

extending the term

On 1 January 20X1, Debtor borrows $100,000 from Creditor bearing 6% interest that matures in 10

years and is convertible into Debtor’s common stock. No fees were paid by Debtor to Creditor, so the

debt was initially recorded at par. On 1 January 20X4, Debtor and Creditor agree to modify the debt by

reducing the conversion price and extending the debt term, as follows:

Terms

Original

Modified

Principal:

$100,000

Term (from modification date):

7 years

12 years

Rate:

6.0%

Conversion ratio:

20 shares per $1,000

40 shares per $1,000

Conversion price:

$50

$25

Share price of common stock:

$40 (at issuance)

$30 (at modification date)

Fair value of embedded conversion option

(at modification date):

$5,000

$28,000

Summary of cash outflows:

Year

Remaining

interest

Original

principal

Total

Modified

interest

Principal

Total

$ 6,000

—

$ 6,000

—

$ 6,000

6,000

—

6,000

—

6,000

—

6,000

—

6,000

—

6,000

—

6,000

—

6,000

—

6,000

—

6,000

—

6,000

$ 100,000

106,000

6,000

—

6,000

—

6,000

—

6,000

—

6,000

—

6,000

—

6,000

—

6,000

—

6,000

—

6,000

—

6,000

$ 100,000

106,000

Total

$ 42,000

$ 100,000

$ 142,000

$ 72,000

$ 100,000

$ 172,000

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Step 1: Present value test

Using the effective interest rate of the original debt, which is also the stated interest rate (6.0%) in this

case as there are no unamortized premium or discount, the present values of the cash flows (1) under

the terms of the new debt instrument and (2) the remaining cash flows under the original debt’s terms,

are as follows:

Present value of modified debt’s cash flows

$ 100,000

Present value of original debt’s remaining cash flows

$ 100,000

As the change in the present value of the cash flows is less than 10% (no change in the above

example), the modification does not result in extinguishment accounting. Step 2 is required to

evaluate the change in the fair value of the conversion option.

Step 2: Fair value of conversion option test

(1) Calculate the change in fair value of the conversion option

Fair value of the embedded conversion option, immediately before the modification

$ 5,000

Fair value of the embedded conversion option, immediately after the modification

$ 28,000

Change in fair value of the conversion option

$ 23,000

(2) Compare the change in the fair value to the carrying amount of the debt

Change in fair value of the conversion option

$ 23,000

Carrying amount of the debt instrument, immediately prior to the modification

$ 100,000

As the change in fair value of the embedded conversion option is at least 10% of the carrying amount

of the debt instrument immediately prior to the modification, a substantial modification or exchange of

the debt instrument has occurred and the issuer should apply extinguishment accounting.

2.6.2.4.1 Modifications or exchanges involving convertible debt instruments with a conversion option

that is bifurcated

ASC 470-50-40-11 states the tests related to the change in fair value of a conversion option and the

addition or deletion of a substantive conversion option do not apply to modifications or exchanges of

convertible debt instruments in circumstances in which the embedded conversion option is separately

accounted for as a derivative before the modification, after the modification or both.

While ASC 470-50 does not specifically address the accounting for modifications or exchanges of these

convertible debt instruments, based on the individual facts and circumstances, we generally believe the

following approaches may be considered in accounting for these transactions:

• Conversion option is bifurcated both before and after the modification or exchange — The debt

instrument without the conversion option is evaluated under the guidance in ASC 470-50 for

nonconvertible debt using the 10% cash flow test. Since the bifurcated conversion option is

accounted for at fair value both before and after the modification, any changes in the fair value of

the conversion option would be reflected in earnings.

• Conversion option is not bifurcated before the modification or exchange but is bifurcated after the

transaction — The 10% test for the change in the conversion option’s fair value relative to the

carrying amount of the debt (refer to section 2.6.2.4) and the 10% cash flow test (refer to section

2.6.2.3) are applied. If the modification or exchange is not accounted for as an extinguishment

(because the change in the conversion option’s fair value is less than 10% of the carrying amount of

the debt and the terms of the new instrument are not considered “substantially different” under the

10% cash flow test), the issuer would (a) reflect any increase in the fair value of the conversion

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option from the modification or exchange as an adjustment to the carrying amount of the debt as an

additional discount with an offset to equity as described in ASC 470-50-40-15 and (b) bifurcate the

conversion option at fair value and determine the new effective interest rate for the debt based on

the new carrying amount and new terms.

Alternatively, based on the specific facts and circumstances, the issuer could conclude (as an

accounting policy election) that because the accounting for the conversion option has changed after

the modification or exchange, the modified debt was fundamentally different from the existing debt

and therefore apply extinguishment accounting.

• Conversion option is bifurcated before the modification or exchange but is not bifurcated after the

transaction — If the change in the conversion option’s fair value is at least 10% of what would have been

the carrying amount of the original debt absent the bifurcation at inception (i.e., a pro forma carrying

amount) or the new debt is considered “substantially different” under the 10% cash flow test, the

transaction would be accounted for as an extinguishment with (a) the bifurcated conversion option

being first marked to its pre-modification or exchange fair value, (b) the new debt recorded at fair value

and (c) the old debt and bifurcated conversion option removed with any difference between the fair

value of the new debt and the sum of the pre-modification or exchange carrying amount of the old debt

and the bifurcated conversion option’s fair value recognized as a gain or loss upon extinguishment.

If the modification or exchange is not accounted for as an extinguishment, the issuer would (a) mark

the conversion option to its new fair value based on the modified terms and reclassify the derivative

liability to equity and (b) determine the new effective interest rate for the modified debt based on its

carrying amount and new terms. Alternatively, based on the specific facts and circumstances, the

issuer could conclude (as an accounting policy election) that because the accounting for the conversion

option has changed after the modification or exchange, the modified debt was fundamentally different

from the existing debt and therefore, apply extinguishment accounting.

2.6.2.4.2 Modifications or exchanges involving convertible debt instruments that contain a separately

classified equity component

ASC 470-50 also does not specifically address modifications or exchanges of convertible instruments

when the conversion option is separately accounted for in equity under the cash conversion guidance or

the BCF guidance (although ASC 470-50-40-16 states that the issuer should not recognize a BCF or

reassess an existing BCF upon a modification or exchange of a convertible debt instrument that is not

accounted for as an extinguishment).

Beneficial conversion feature

We generally believe that the assessment of a convertible debt instrument that has a recognized

component in equity for a BCF should consider the tests in ASC 470-50 and reflect that the single

convertible debt instrument is presented in two balance sheet line items: debt with a discount and an

equity component. While one approach is described below, there may be other reasonable approaches

(that should be applied consistently).

• For the purpose of the 10% cash flow test, the debt’s original effective interest rate would be based

on its carrying amount after separating the BCF.

• For the purpose of the change in the option’s fair value test, the change in the fair value of the option

should be compared to a pro forma current carrying amount of the debt as if the BCF had not been

separated at inception. As the test in ASC 470-50-40-10(a) focuses on a convertible debt that is

accounted for in its entirety as a liability, it seems reasonable to compare the change in the fair value

of the conversion option to what would be the carrying amount of the entire debt rather than to the

carrying amount of a liability (the liability component) after separating the BCF.

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Illustration 2-19: Debt modification involving convertible instruments with equity component

Assume the following:

• Convertible debt was issued for $1,000 with an interest rate of 3%.

• The conversion option at issuance had an intrinsic value of $200 (a BCF).

• The debt was recorded at $800, resulting in an effective rate of 8%.

• Two years after issuance, the conversion option is modified by decreasing the strike price. There

are no modifications to the cash flows.

• The conversion option’s fair value was $125 before the modification and $215 after the

modification ($90 change).

• The carrying amount of the liability component at the modification date was $850, and the

carrying amount absent separate accounting for the BCF would have been $1,000 (as there

would have been no initial discount).

In this fact pattern, the 10% cash flow test would not be applied as there were no changes to cash

flows. Had the test been necessary, we generally believe that 8% would have been an acceptable

discount rate to use.

For the change in option fair value test, we believe the $90 change would be compared to the pro

forma $1,000 carrying amount (as opposed to the current $850 carrying amount for accounting

purposes), resulting in less than a 10% change, and thus the modification would not be accounted for

as an extinguishment. Under the guidance in ASC 470-50-40-15, the increase in the conversion option

fair value would be recorded as additional debt discount with an offset to equity, resulting in a new

carrying amount of $760 ($850–$90), and a new effective interest rate should be calculated. There

would be no reassessment of the BCF due to the modification.

While there is no specific guidance to account for convertible debt that had a BCF recognized in equity but

the conversion option is required to be bifurcated as a derivative after the modification or exchange, an

issuer could consider the guidance in ASC 470-50-40-15 to account for any increase in conversion

option’s fair value as an additional debt discount with an offset to equity and the guidance in ASC 470-

20-35-19 to reclassify the conversion option from equity to liability at its fair value.

Cash convertible debt

Modifications and exchanges of instruments in the scope of the cash conversion guidance are discussed

in ASC 470-20-40-23 through 40-25. That guidance states the model in ASC 470-50 should be used to

assess whether a modification or exchange should be accounted for as an extinguishment or a modification.

If the modification or exchange is accounted for as an extinguishment, the derecognition model in

ASC 470-20-40-19 through 40-20 should be applied. If the transaction is not accounted for as an

extinguishment, ASC 470-20-40-23 states that the expected life of the liability component should be

reassessed and a new effective interest rate should be determined based on the new terms.

The guidance, however, does not explain how to apply the change in cash flows and the change in the

conversion option fair value tests when the conversion option is separately accounted for in equity. We

generally believe the same concepts discussed above for evaluating a modification or exchange of debt

with BCFs could be applied.

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ASC 470-20-40-23 through 40-25 also addresses the accounting for a modification or extinguishment

of cash convertible debt that does not result in an extinguishment accounting. The accounting is based

on whether the instrument is in the scope of the cash conversion guidance before and/or after the

modification, as follows:

• If the instrument within the scope of the cash conversion guidance is modified such that the

convertible debt is no longer subject to that guidance, the debt and equity components of the

instrument should continue to be accounted for separately.

• If the instrument that is not within the scope of the cash conversion guidance is modified such that it

becomes subject to the cash conversion guidance, the issuer should apply the cash conversion

guidance to the modified instrument prospectively and measure the liability component at its fair

value as of the modification date.

However, the guidance in ASC 470-20-40-23 through 40-25 does not address the accounting for the

change in the conversion option’s fair value when the modification or exchange does not result in

extinguishment accounting. In those situations, an issuer could consider the guidance in ASC 470-50-40-15

to account for any increase in the value of the conversion option as follows:

• If the modification or exchange results in a cash convertible instrument remaining subject to the cash

conversion guidance, any increases (but not decreases) in the fair value of the conversion option

should be recorded as a reduction to the liability component’s carrying amount with an offset to

equity, as required pursuant to ASC 470-50-40-15. This carrying amount should be used to

determine the new effective interest rate.

• If the modification or exchange results in a cash convertible instrument becoming no longer subject

to the cash conversion guidance, any increases (but not decreases) in the fair value of the conversion

option should be recorded as a reduction to the liability component’s carrying amount with an offset

to equity as required pursuant to ASC 470-50-40-15. This carrying amount should be used to

determine the new effective interest rate.

If a debt instrument becomes no longer subject to the cash conversion guidance because the

conversion option requires bifurcation as a derivative after the modification or exchange, in addition

to making an adjustment to the carrying amount of the liability component for any increases in the

conversion option’s fair value, the conversion option should be reclassified from equity to liability at

an amount equal to the fair value of the conversion option pursuant to ASC 470-20-35-19.

• If the modification or exchange results in a convertible debt that was not in the scope of the cash

conversion guidance becoming subject to that guidance, the requirement to reflect the liability

component at its fair value as of the modification date in ASC 470-20-40-25 should be applied. The

expected life of the liability component should be reassessed and a new effective interest rate should

be determined based on the new terms. Any increase (but not decrease) in the fair value of the

conversion option is not considered in determining the new effective interest rate.

2.6.2.5 Accounting for debt modification or exchange and fees paid and costs incurred

If a modified instrument is considered substantially different from the original debt instrument, the

modification or exchange is accounted for as an extinguishment. The new instrument should be recorded

at its fair value and that fair value is used to determine the extinguishment gain or loss.

If the modification or exchange is not accounted for as an extinguishment (i.e., the modified instrument is not

considered substantially different from the original debt instrument), a new effective interest that equates

the revised cash flows to the carrying amount of the original debt is computed and applied prospectively.

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The following chart summarizes the accounting treatment for fees paid or received by the debtor as part of

the exchange or modification as well as costs incurred with third parties in connection with the transaction:

Exchange or modification

accounted for as debt

extinguishment

Exchange or modification not

accounted for as debt extinguishment

Fees paid by debtor to creditor

(or received by debtor from

creditor)

Included in calculation of gain

or loss

Reflected as additional debt discount and

amortized as an adjustment of interest

expense over remaining term of exchanged

or modified debt using interest method

Costs incurred with third parties

directly related to exchange or

modification (such as legal fees)

Capitalized as deferred debt

issuance costs and associated

with new debt and amortized

over term of new debt using

interest method

Expensed as incurred

Previously deferred fees and

costs for existing debt

Included in calculation of gain

or loss

Amortized as an adjustment of interest

expense over remaining term of exchanged

or modified debt using interest method

2.6.2.5.1 Accounting for fees and costs when principal is partially repaid or prepaid

When debt is not prepayable by its contractual terms, any transaction that occurs that involves a partial

repayment of principal at a time and/or for an amount other than that originally scheduled should be

evaluated under the 10% cash flow test to determine whether the repayment represents a modification or

extinguishment of the entire instrument. Generally, any costs and fees associated with the original and

remaining debt will be accounted for as described in section 2.6.2.5 above.

However, some debt instruments’ contractual terms permit prepayment. If such debt is partially prepaid in

accordance with its contractual terms (i.e., strictly under a condition and for an amount contractually

specified) and the terms of the remaining debt are not modified, the amount prepaid should be treated as

a partial extinguishment. Therefore, a proportion of any deferred debt issuance costs, fees or other

elements of premium or discount would be written off with that extinguishment. This conclusion is reached

without regard to any consideration of the 10% cash flow test, because nothing in the debt instrument was

modified as it was simply prepaid (in whole or in part) according to its original terms.

When debt is prepayable by its contractual terms, and a transaction occurs that involves both a partial

prepayment and amendment to the terms of the remaining debt, the 10% cash flow test should be

applied. That test should incorporate the prepayment as a “day one” cash outflow with the future,

originally scheduled, principal payment (or payments if amortizing debt) reduced appropriately. In some

cases, the application of the 10% cash flow test may result in a modification, not an extinguishment, of

the original debt instrument.

However, the accounting treatment for unamortized deferred fees and costs in a debt exchange or

modification that is not accounted for as an extinguishment may lead to a counter-intuitive result. For

example, even though a large proportion of the debt may be prepaid pursuant to its contractual terms

and only a small remaining portion modified, literal application of the guidance in ASC 470-50 could

suggest that no unamortized deferred fees or costs should be written off. Rather, those amounts would

continue to be amortized against a much lower debt balance, which could result in an effective interest

rate that appears unusually high.

Based on discussions with the SEC staff, we believe that it would be acceptable for an entity to write

down a proportionate amount of a debt instrument’s unamortized deferred fees and costs, as well as any

debt premium or discount (e.g., original issuance discount), if the original debt was prepaid in accordance

with its contractual terms. This would be a matter of accounting policy that should be applied consistently.

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2.6.2.6 Effect of third-party intermediary’s involvement

A third-party intermediary may be involved in a debtor’s modification or exchange of its debt instrument.

Although the third-party intermediary may be acting as a principal for legal purposes, a separate

determination should be made as to whether the third-party intermediary is acting as the debtor’s agent

or as a principal for accounting purposes.

In transactions involving a third-party intermediary acting as an agent on behalf of a debtor, the actions

of the intermediary should be viewed as those of the debtor to determine whether an exchange or

modification of debt instruments has occurred between a debtor and a creditor. That is, when a third-

party intermediary acts as an agent, the analysis should “look through” the intermediary. In a transaction

whereby the intermediary acquires existing debt instruments from the current holders and then sells the

modified debt entirely to new investors, a determination that the intermediary is acting as the debtor’s

agent will automatically require the debtor to account for the transaction as an extinguishment as the

debtor would be deemed to have settled debt with existing creditors using proceeds from new investors.

Conversely, in transactions involving a third-party intermediary acting as principal, the intermediary

should be viewed as a third-party creditor to determine whether there has been a modification or

exchange of debt instruments between a debtor and a creditor. That is, when a third party acts as

principal, the analysis should not “look through” the intermediary. The issuer will evaluate its interactions

directly with the intermediary.

While all of the relevant facts and circumstances should be considered in determining whether a third-

party intermediary is acting as an agent or a principal, ASC 470-50-55-7 provides four indicators that

should be considered in that evaluation:

• If the intermediary’s role is restricted to placing or reacquiring debt for the debtor without placing

its own funds at risk, that would indicate the intermediary is an agent. For example, that may be the

case if the intermediary’s own funds are committed and those funds are not truly at risk because the

intermediary is made whole by the debtor (and therefore is indemnified against loss by the debtor).

If the intermediary places and reacquires debt for the debtor by committing its funds and is subject

to the risk of loss of those funds, that would indicate the intermediary is acting as principal.

• In an arrangement where an intermediary places notes issued by the debtor, if the placement is done

under a best-efforts agreement, that would indicate the intermediary is acting as an agent. Under a

best-efforts agreement, an agent agrees to buy only those securities that it is able to sell to others; if

the agent is unable to remarket the debt, the issuer is obligated to pay off the debt. The intermediary

may be acting as principal if the placement is done on a firmly committed basis, which requires the

intermediary to hold any debt that it is unable to sell to others.

• If the debtor directs the intermediary and the intermediary cannot independently initiate an

exchange or modification of the debt instrument, that would indicate the intermediary is an agent.

The intermediary may be a principal if it acquires debt from or exchanges debt with another debt

holder in the market and is subject to loss as a result of the transaction.

• If the only compensation derived by an intermediary from its arrangement with the debtor is limited

to a pre-established fee, that would indicate the intermediary is an agent. If the intermediary derives

gains based on the value of the security issued by the debtor, that would indicate the intermediary is

a principal.

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In evaluating a third-party intermediary that is an investment bank or similar entity, based on the

guidance above and SEC staff comments made at the 2003 AICPA National Conference on Current SEC

Developments,

we generally believe an issuer may consider the following questions in determining

whether the intermediary’s funds are at risk:

• Has the investment bank obtained “soft bids” for the sale of the debt prior to or concurrent with the

closing of the debt issuance? “Soft bids” reduce the investment bank’s exposure to market risk and

may indicate the investment bank’s role is that of an agent.

• What period of time will the investment bank hold the new debt before reselling it? We generally do

not believe that there is a bright line for the number of days the investment bank must hold the new

debt in order to indicate it is acting as a principal. However, the period should generally be long

enough for the holder to be at risk for the type of instrument held.

• Has the investment bank been compensated for any costs associated with hedging its exposure to

market risk on the new debt? Are all fees paid to the investment bank at market as underwriter?

Payments to the investment bank through fees or other means to reduce its market risk may indicate

the investment bank’s role is that of an agent.

• How volatile is the market price of the debt? The combination of the debt’s underlying price volatility

and the length of time the investment bank will hold the debt before reselling it may provide an

indicator as to whether the investment bank has substantive market risk.

2.6.2.7 Loan participations and loan syndications

In a loan syndication, a group of lenders may jointly fund loans because a debtor may request loans in

amounts greater than any one lender is willing to lend. Each lender loans a specific amount to the debtor

and has the right to repayment from the debtor. Accordingly, separate debt instruments exist between

the debtor and the individual creditors participating in the syndication. This may be the case even if a

single creditor has been appointed to negotiate on behalf of the collective group of creditors. Therefore,

the guidance in ASC 470-50 should be applied to modified or exchanged syndicated loans on a creditor-

by-creditor basis.

In a loan participation, the debtor borrows from a lead lender who typically sells participating interests

that may take the legal form of either assignments or participations. In this case, the debt instrument is a

contract between the debtor and the lead creditor, and the lead creditor is the only entity with legal rights

against the debtor. Therefore, the debtor should account for a modification or exchange between it and

the lead lender pursuant to the debt modification guidance in ASC 470-50. The debtor does not account

for transactions that may occur between or among lenders to the participation agreement because the

debtor is not a party to the transaction (its only legal obligation is to the lead lender).

2.6.2.8 Modification of line-of-credit arrangements

ASC 470-50-40-21 through 40-23 provides guidance on accounting for any unamortized deferred debt

issuance costs, fees paid to the creditor and any third-party costs incurred in connection with the

modification or exchange of line-of-credit or revolving arrangements. That guidance requires the debtor

to compare the product of the remaining term and the maximum available credit of the old arrangement

(the borrowing capacity) with the borrowing capacity of the new arrangement.

Robert J. Comerford, 2003 — Refer to the SEC website at https://www.sec.gov/news/speech/spch121103rjc.htm.

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The accounting for the costs and fees depends on whether the borrowing capacity of the new arrangement

is greater than or equal to the borrowing capacity of the old arrangement. The following chart summarizes

the provisions applicable to the modification of a line-of-credit.

Accounting for fees and costs

Borrowing capacity of new

greater than or equal to

borrowing capacity of old

All fees and costs are deferred and amortized over the term of new

arrangement, including:

• Unamortized deferred debt issuance costs

• Any fees paid to creditors

• Any third-party costs incurred

Borrowing capacity of new less

than borrowing capacity of old

Any fees paid to creditor and any third-party costs incurred should be deferred

and amortized over the term of new arrangement.

Unamortized deferred debt issuance costs are written off in proportion to the

decrease in borrowing capacity of old arrangement. Remaining unamortized

deferred costs are amortized over the term of new arrangement.

2.6.2.9 Modifications of credit facilities

Credit facilities often include both term loans and line-of-credit or revolving arrangements. ASC 470-50

has separate guidance for a modification of term loans (refer to sections 2.6.2.3 and 2.6.2.5) and a

modification of line-of-credit or revolving arrangements (refer to section 2.6.2.8). However, it does not

address how the debtor should apply the two accounting models (i.e., whether each component should

be separately evaluated or viewed in the aggregate), when a modification is made to a credit facility that

contains both term loans and line-of-credit or revolving arrangements.

In those transactions, there may be new investors joining the credit facility, old creditors departing the

facility or existing creditors continuing to be involved. Accounting for the modification may be different

for each creditor. Extinguishment accounting is applied for creditors involved in the facility before the

amendment but not after. Creditors not involved initially but holding a portion of the amended facility,

are considered new issuances.

Accounting for continuing creditors that were involved before and after the amendment (e.g., held a

different amount of the term loan or line-of-credit or reallocated its position between the two components)

depends on the individual facts and circumstances and requires professional judgment. An issuer may

consider the following approaches:

• For a creditor holding only term loans both before and after the modification, apply the 10% cash

flow test (refer to section 2.6.2.3)

• For a creditor holding only a line-of-credit both before and after the modification, apply the line-of-

credit model (refer to section 2.6.2.8)

• For a creditor that had holdings reallocated such that amounts previously drawn under the line-of-

credit that are now outstanding as additional term loan borrowings, consider applying the line-of-

credit model in the examples in ASC 470-50-55-12(c) and 55-12(d) (where a line-of-credit is

replaced with a term loan)

• For a creditor that had holdings reallocated such that amounts previously outstanding as term loan

borrowings are now outstanding as draws under the line-of-credit, consider applying the 10% cash

flow test to the amounts outstanding under the line-of-credit as if it were a term loan borrowing

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2.6.2.10 Modifications or exchanges involving public debt issuances

ASC 470-50-55-3 states that, for purposes of applying the debt modification guidance, the debt instrument

is the individual security and the creditor is the security holder for a public debt issuance (defined as when a

debtor issues a number of identical debt instruments to an underwriter that sells the debt instruments (in

the form of securities) to various investors). If a modification or exchange offer were made to all investors

and only some accepted, the debt modification guidance should be applied only to those investors.

When an issuer refinances its public debt by repurchasing existing debt in the market and simultaneously

issuing new public debt with different terms, there may be investors that both held the old debt and

invested in the new debt, resulting in the contemporaneous exchange of cash between the same creditor

and debtor as discussed in ASC 470-50-40-9. Determining this fact may be difficult given the number of

potential investors involved. In addition, public debt repurchases through new public debt issuances are

frequently not negotiated transactions between the debtor and the existing creditors.

In certain cases, we believe it is reasonable that the old debt be viewed collectively as the entire public

issuance with a deemed single creditor (i.e., the public, without regard to the individual investors) that is

refinanced with another distinct single issuance (another public issuance) with a different creditor and that

the transaction should be accounted for as an extinguishment without the application of the 10% cash flow

test on either the entire issuance or at the individual creditor level.

Said differently, the nature of a public-to-public refinancing with no indications of a negotiated economic

outcome based on a mutually agreed-upon realignment of economic interests, would be one of extinguishment.

Such a public-to-public refinancing is likely to include the following characteristics: (1) no single investor or

small group of investors holds a significant concentration of both the old and the new public debt issuances,

(2) none of the old investors were included in negotiations with the underwriter in setting the terms of the

new public debt issuance and (3) the old investors had the opportunity to participate in the new issuance

in the same manner as new investors (i.e., the old creditors did not receive preferential treatment in terms

of access to the offering or participation at a predetermined principal amount).

The same concept may be applicable to a widely held private placement depending on the facts and

circumstances, including whether the issuer can practically determine the identities of the old and new investors.

The accounting for modifications or exchanges of existing public debt issuances should be based on the

individual facts and circumstances and requires professional judgment.

2.6.2.11 Transactions between or among creditors

Transactions between or among creditors do not result in a modification or exchange of the original debt

instrument between the debtor and creditor. Accordingly, those transactions do not affect the accounting

by the debtor.

2.7 Classification and presentation

The ASC 210-10-20 Glossary defines current liabilities as “obligations whose liquidation is reasonably

expected to require the use of existing resources properly classifiable as current assets, or the creation

of other current liabilities.” ASC 210-10-45 provides the principal guidance in determining the balance

sheet classification of liabilities. Under that guidance, current liabilities include liabilities whose liquidation

is expected to occur within 12 months (or operating cycle, if longer), such as:

• Current maturities of long-term debt

• Short-term debt with maturity of one year or less (or operating cycle, if longer)

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• Due on demand loan agreements

• Long-term debt that becomes callable by the creditor

within 12 months (or operating cycle) or

upon contingent events such as covenant violations or change of control events and those events

have occurred at the reporting date

• Convertible or contingently convertible debt that requires the debtor to settle the accreted value in

cash upon conversion and the contingency has been met at the reporting date

Certain short-term obligations that are expected to be refinanced on a long-term basis may not require

the use of current assets and therefore may not be required to be included in current liabilities.

Liabilities that will be paid through the use of noncurrent assets or the incurrence of long-term

obligations should not be classified as current pursuant to ASC 210-10-45-12.

2.7.1 Classification of debt with contractual maturity greater than one year

2.7.1.1 Due on demand loan arrangements

ASC 470-10-45-9 and 45-10 provide that debt that is due on demand or will be due on demand within

one year from the balance sheet date should be classified as a current liability, even though the liability

may not be expected to be paid within that period or the liability has scheduled repayment dates that

extend beyond one year but nevertheless is callable by the creditor within one year. For example, debt

that is due on demand or that is callable by the creditor but is otherwise scheduled for payment in 10

annual installments should be classified as a current liability.

2.7.1.2 Debt that becomes callable upon covenant violations

ASC 470-10-45 addresses the classification of long-term debt when there has been a covenant violation

or other default at the balance sheet date and as a result of such violation or default the debt is callable

by the creditor. It also addresses situations when such a violation or default is anticipated to occur within

the next year.

The debt classification guidance in ASC 470-10-45 and more specifically in ASC 470-10-55-4 addresses

both debt that is callable at the balance sheet date and debt that becomes callable after the balance

sheet date but before the financial statements are issued (or available to be issued for private

companies). We generally believe debt in default at the date the financial statements are issued (or

available to be issued) should be viewed similarly to debt that is in default at the balance sheet date.

In evaluating the debt classification guidance in ASC 470-10-45, a debtor should consider the effect, if

any, of the default on other debt instruments. Debt covenants may include cross-default provisions that

automatically trigger an event of default if any of the issuer’s other obligations are in default. In those

cases, the other debt instruments would also be considered in default and should be evaluated under the

guidance to determine the appropriate classification.

Debt callable by the creditor may also be referred to as puttable debt (i.e., the holder may require the issuer to repay the debt

prior to its contractual maturity date).

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2.7.1.2.1 Covenant violation at the balance sheet date (or prior to the issuance of financial statements)

ASC 470-10-45-11 through 45-12 provide guidance on the classification of debt that is callable at the

balance sheet date when there has been a violation of a debt covenant at the balance sheet date and as a

result of such violation the debt is callable, either as a direct result of the violation or as a result of failure

to cure the violation within a contractual grace period. The guidance requires callable debt to be classified

as a current liability unless either of the following conditions is met:

(1) The creditor has waived or subsequently lost the right to demand repayment for more than one year

(or operating cycle, if longer) from the balance sheet date.

(2) For long-term debt that contains a contractual grace period within which the borrower may cure the

violation, it is probable that the violation will be cured within that period, thus preventing the debt

from becoming callable.

Obligations that are callable by the creditor as of the balance sheet date or may become callable by the creditor

as a result of a violation at the balance sheet date would not require current classification if the debtor

has cured the violation after the balance sheet date within a contractual grace period and the obligation

is not callable by the creditor at the time the financial statements are issued (or available to be issued).

For situations in which it is probable a violation will be cured within a contractual grace period that extends

beyond the issuance date of the financial statements, the related debt may continue to be classified as

noncurrent. Disclosure of the violation and courses of action to be taken to remedy the situation, together

with a statement that management believes the action will cure the violation, may be appropriate.

Determining whether it is probable that the borrower will cure the debt covenant violation within the

contractual grace period requires the use of professional judgment considering all of the relevant facts

and circumstances, as illustrated in the following examples:

Illustration 2-20: Debt covenant cure

Example 1 — Cure probable

At the balance sheet date the borrower inadvertently violated a minimum compensating balance

requirement, but has a contractual 90-day grace period in which to restore the balance. Sufficient cash is

readily available in a separate money market account. Management intends to transfer funds from the

money market account to cover the compensating balance requirement before the grace period expires.

Forecasts and other evidence indicate that the cash will not be used for any other purpose.

Example 2 — Cure remote

The borrower has experienced three successive years of losses and is in violation of a minimum

working capital provision at year end. Management’s forecast for the coming year indicates it is

unlikely the borrower will be able to cure the default within the contractual 90-day grace period. The

lender has adopted a “wait-and-see” attitude, expressing its present intention not to call the loan.

In order for the debt to be classified as long-term in this example, a waiver of the lender’s right to call the

debt for more than a year from the balance sheet date should be obtained. Refer to section 2.7.1.2.1.1

for further discussion if the covenant compliance requirement is ongoing.

The seriousness of a covenant violation is not relevant for the purpose of balance sheet classification,

but the nature of the violation might affect whether the debtor is able to obtain a satisfactory waiver or

the probability of the debtor curing the default during any contractual grace period (refer to section

2.7.1.2.1.1 for further discussion on obtaining a satisfactory waiver).

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2.7.1.2.1.1 Covenant violation at balance sheet date (or prior to the issuance of financial statements) but a

waiver has been obtained for a period greater than one year

A loan covenant may be modified or eliminated prior to the balance sheet date, and absent that modification,

the debtor would have been in violation of the covenant and as a result the debt would be callable. In other

situations, covenant violations may have occurred at the balance sheet date but the creditor waives the

current violation for a period greater than one year. In both of those scenarios, the creditor typically retains

future debt covenant requirements at subsequent compliance measurement dates within the next year.

ASC 470-10-45-1 and the implementation guidance in ASC 470-10-55-4 (specifically, illustrations in

scenarios (d) and (e)) provide guidance in determining whether such long-term debt obligations should

be classified as current when future covenant requirements are retained. In those circumstances, the

guidance provides that the debt should be classified as noncurrent unless it is probable that the borrower

will not be able to cure the default (comply with the future covenant requirements) at measurement

dates that are within the next 12 months.

A waiver’s terms should be carefully evaluated because it may not be a valid waiver for classifying the

callable debt as noncurrent, depending on the nature of the violation and the financial circumstances of

the borrower. Generally, a lender’s expression of no “present intention” to accelerate a callable debt’s

maturity, whether given orally or in writing, does not constitute a satisfactory waiver for callable debt

under the debt classification guidance in ASC 470-10-45.

If the creditor waived its right to call the debt for more than one year for the current covenant violation,

yet the creditor retains future debt covenant requirements at subsequent compliance measurement

dates within the next year, the guidance in ASC 470-10-45-1 should be considered. The probability that

a lender will waive or subsequently lose its right to call the debt or that a debt will be refinanced or

renegotiated should not be considered.

In some cases, an event of default might be an isolated occurrence, such as the purchase of property in

excess of a specified yearly maximum. A waiver of the lender’s rights as a result of this type of violation is,

in effect, an amendment to the loan agreement and will “cure” this specific event of default permanently.

Other covenants may be based on the financial position or results of operations of the borrower. The

terms of a waiver of a violated covenant should be carefully evaluated, considering the nature of the

violation and the financial circumstances of the borrower, as the following examples illustrate.

Illustration 2-21: Obtaining a satisfactory waiver

Example 1

Entity A is required to maintain working capital of $1,500,000 throughout the year. The loss of a key

customer resulted in a sales decline and a reduction of working capital below the $1,500,000

minimum during the months of June, July and August. By 31 December 20X1, the company has

working capital of $1,500,000. In addition, Entity A expects that it is reasonably possible it will be able

to maintain working capital in excess of the required minimum throughout the next year. That is, it is

not probable the covenant will be violated in the next 12 months.

In this case, obtaining a letter from the lender waiving compliance with the working capital minimum

for the periods during the year ended 31 December 20X1, would support continued classification of

the debt as noncurrent because it is not probable the borrower will fail to maintain the minimum

working capital requirements during the next year.

Entity A should consider whether to disclose in a financial statement footnote a description of the

possible future violation and state that a waiver might have to be obtained from the lender if there is a

violation in order for the debt not to become callable at a specified future date.

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Example 2

Entity B is required to maintain working capital of $1,500,000 throughout the year. Entity B has

incurred an operating loss for the year and, at 31 December 20X1, does not meet the working capital

requirement. Prospects for a return to profitability and achievement of the working capital

requirement for the coming year are uncertain.

The debt should be classified as current if the lender waives its rights to call the loan as a result of the

company’s noncompliance with the working capital minimum for the year ended 31 December 20X1.

Although the lender waived its rights due to the violation for the year ended 31 December 20X1, a

new violation occurs every day after year end as a result of the company not satisfying the required

working capital minimum. That is, the covenant was immediately violated again on 1 January 20X2.

In order for the debt to be classified as long-term in this example, the lender should either (1) amend

the loan agreement to reduce the working capital requirement at 31 December 20X1, and any

subsequent interim measurement date within one year to levels that currently are achieved and are

not probable of being violated by the borrower during the next year or (2) waive its rights to call the

loan as a result of the company’s noncompliance and expected future noncompliance with the working

capital requirement for a period of more than one year from the balance sheet date.

2.7.1.2.1.2 Covenant violation has not occurred at the balance sheet date (or prior to the issuance of

financial statements) but violation probable within next year

ASC 470-10-45-1 and the implementation guidance in ASC 470-10-55-4 (specifically, illustrations in

scenarios (a), (b) and (c)) indicate that, unless facts and circumstances indicate otherwise, debt should be

classified as noncurrent if there is no debt covenant violation at the balance sheet date but a violation is

probable within the next year. This guidance generally indicates that these situations are more akin to non-

recognized subsequent event (formerly Type II) situations and, accordingly, do not warrant adjustment to

the noncurrent classification of the debt at the balance sheet date. However, we generally believe debt in

default prior to the issuance of financial statements (i.e., a violation is known to have occurred or is certain

to occur in the near future) should be viewed similarly to debt in default at the balance sheet date.

Individual facts and circumstances should be considered when evaluating violations occurring or

expected to occur after the balance sheet date. For example, management may announce it will not

make the next scheduled principal or interest payment, resulting in a debt covenant violation within the

next year. ASC 470-10-55-5 requires borrowers to disclose the adverse consequences of its probable

failure to satisfy future covenants.

The following examples illustrate how to apply the provisions of the debt classification guidance in

ASC 470-10-45-1 and the related implementation guidance in ASC 470-10-55-4.

Illustration 2-22: Classification of debt pursuant to ASC 470-10-45-1

Assume the debtor’s fiscal year end is 31 December, and it issues its financial statements 27 February.

Example 1 — Debtor in compliance at balance sheet date, future violation reasonably possible

Debtor is in compliance with its debt covenants at the balance sheet date, but it is reasonably possible

that it will violate a financial covenant at 31 March.

The debt should be classified as noncurrent.

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Example 2 — Debtor in compliance at balance sheet date, future violation probable

Debtor is in compliance with its debt covenants at the balance sheet date, but it is probable that it will

violate a financial covenant at 31 March.

The debt generally should be classified as noncurrent, but facts and circumstances may indicate that

the debt should be classified as current. For example, if the debtor concluded that it will not meet the

31 March financial covenant and publicly disclosed that fact, we believe the debt may be more

appropriately classified as current.

Example 3 — Debtor in compliance at balance sheet date because of modification, future violation

probable

Debtor is in compliance with its debt covenants at the balance sheet date only because, prior to the

balance sheet date, the debtor negotiated a modification of the loan agreement that modified the

covenant. Absent the modification, it would have been in violation of the covenant at the balance

sheet date. A more restrictive covenant must be met on 31 March, and it is probable the borrower will

fail to meet that requirement.

The debt should be classified as current.

2.7.1.3 Debt in default financial statement disclosure

Rule 4-08(c) of SEC Regulation S-X (codified in ASC 235-10-S99-1) specifies certain disclosures about

debt in default. We generally believe nonpublic companies should follow those disclosure requirements

as well.

• Lender waives or loses right to call loan — Rule 4-08(c) requires that “If a default or breach exists but

acceleration of the obligation has been waived for a stated period of time beyond the date of the most

recent balance sheet being filed, state the amount of the obligation and the period of the waiver.”

• No waiver obtained or cure within a contractual grace period not probable — Rule 4-08(c) of SEC

Regulation S-X requires that “the facts and amounts concerning any default in principal, interest,

sinking fund, or redemption provisions with respect to any issue of securities or credit agreements,

or any breach of covenant of a related indenture or agreement, which default or breach existed at

the date of the most recent balance sheet being filed and which has not been subsequently cured,

shall be stated in the notes to the financial statements.”

2.7.1.4 Settlement of long-term debt shortly after the balance sheet date

The intention, prior to the balance sheet date, to voluntarily settle a long-term obligation (i.e., settlement

not contractually required in the next 12 months) in the next operating cycle could affect the

classification of the obligation as long-term at the balance sheet date. This determination depends on

facts and circumstances.

While the Codification provides direct guidance for evaluating the intent and ability to refinance a short-

term obligation as noncurrent (ASC 470-10-45) as of the balance sheet date there is no direct guidance

on when a long-term obligation is intended to be repaid within the next operating cycle.

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The Codification defines current liabilities as “ … obligations whose liquidation is reasonably expected to

require the use of existing resources properly classifiable as current assets, or the creation of other

current liabilities.” In contrast, long-term obligations are defined as “ … those scheduled to mature

beyond one year (or the operating cycle, if applicable) from the date of an entity’s balance sheet.”

Further, ASC 210-10-45-4 notes that the classification of assets that would otherwise be considered

current assets may be affected by how those funds will be used. ASC 210-10-45-4 excludes from current

assets cash and claims to cash that “are segregated for the liquidation of long-term debt. Even though

not actually set aside in special accounts, funds that are clearly to be used in the near future for the

liquidation of long-term debts, payments to sinking funds, or for similar purposes shall also, under this

concept, be excluded from current assets.”

The definitions of current liabilities and long-term obligations as well as the requirements of ASC 210

require the use of judgment in determining what “reasonably expected,” “scheduled” and “clearly to be

used” mean. In addition, the definitions and requirements are themselves circular in that the classification

for the obligation is based on the assets that will reasonably be expected to be used in satisfying the

obligation, while the classification of the assets is also affected by the obligations they are used to satisfy.

As a result of the differing interpretations of how the definitions should be applied, we generally believe

there are two acceptable views and either view may be applied as an accounting policy election, as follows:

View A: This view focuses on the definition of a current liability and whether the entity is required to use

current assets, properly classified as of the balance sheet date, to satisfy the obligation. Under this view,

as long as the obligation is not contractually required to be satisfied within the next operating cycle, the

obligation would be classified as noncurrent. Under this view, however, any funds that are clearly to be

used in the near future for the liquidation of a long-term obligation would also be classified as

noncurrent. The following example illustrates the application of this view:

Company A has an outstanding debt ($1 million) that is required to be repaid on 31 December 20X5.

In December 20X1, Company A decides that it will retire the debt in 20X2, although it is not required

to do so. As of 31 December 20X1, Company A has accumulated sufficient funds to retire the debt

and Company A has designated those funds ($1 million out of a total of $5 million of available funds)

to be used to retire the debt in 20X2. In assessing the balance sheet classification of the debt,

Company A has concluded that at 31 December 20X1, its obligation under the debt agreement does

not require the use of assets properly classified as current assets because Company A does not have

a contractual requirement to retire the debt in 20X2. In fact, the debt is scheduled to mature beyond

one year (20X5). However, because Company A has designated $1 million of funds to retire the long-

term debt and has concluded they are clearly to be used for that purpose, the funds are required by

ASC 210 to be classified as a long-term asset. As a result, in this example both the funds and the

debt would be classified as long-term.

View B: An obligation is classified as current when (a) the obligation is reasonably expected to be retired

and (b) such retirement will require the use of current assets (as opposed to a long-term refinancing or

current assets that will be generated in a future period). Under this view, as long as the otherwise long-

term obligation is classified as current based on the balance sheet date intention to retire the obligation,

the current assets that will be used to fund the retirement remain properly classified as current assets.

The following example illustrates the application of this view:

Company B has outstanding debt ($1 million) that is required to be repaid on 31 December 20X5. In

December 20X1, Company B decides that it will retire the debt in 20X2, although it is not required to

do so. As of 31 December 20X1, Company B has accumulated sufficient funds to retire the debt and

Company B has designated those funds ($1 million out of a total of $5 million of available funds) to be

used to retire the debt in 20X2. In assessing the balance sheet classification of the debt, Company B

has concluded that at 31 December 20X1, the retirement of the debt in 20X2 is reasonably expected

to require the use of existing resources properly classifiable as current assets. While Company B

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does not have a contractual requirement to do so, Company B reasonably expects to use $1 million

of funds classified as current assets to retire the debt in 20X2. As a result, Company B classifies both

the debt and the $1 million of funds to be used in its retirement as current liabilities and assets,

respectively, in the 20X1 balance sheet.

An early settlement of a long-term obligation after the balance sheet date but prior to the issuance of the

financial statements (or the date they are available to be issued) could also affect the classification of either

the obligation or the settlement consideration in the year-end financial statements. For example, assume an

issuer has long-term obligations outstanding that mature more than 12 months following the balance sheet

date. Subsequent to the end of the year but prior to the issuance of the financial statements, the issuer

voluntarily pays the long-term obligation using funds that were available as of the balance sheet date.

The debt classification in this example will depend on the facts and circumstances. The early settlement

of a long-term obligation after the balance sheet date but prior to the issuance of the financial statements

(or the date they are available to be issued) is not, in itself, determinative. Instead, it is evidence that

should be considered in assessing the balance sheet date classification of the liability and related assets.

We believe that the settlement of what would otherwise be considered a long-term obligation shortly

after the balance sheet date may suggest that the issuer had the intention, at the balance sheet date, of

settling the obligation (refer to the discussion above). The closer to the balance sheet date the settlement

is, the more likely it is that such an action would be viewed as intended as of the balance sheet date and

that the funds used to settle the obligation were already held at the balance sheet date (rather than

generated subsequently). If it is determined that the intention existed as of the balance sheet date, the

issuer would apply one of the two views discussed above.

The settlement of a long-term obligation after the balance sheet date may affect the issuer’s evaluation of

the classification of that obligation and any funds used to settle it as of the balance sheet date. However,

the settlement does not affect the measurement or timing of any gain or loss recognized upon settlement.

2.7.2 Subjective acceleration clauses

A subjective acceleration clause (SAC) is a provision in a debt or financing agreement that allows the lender

to accelerate the scheduled maturities of the debt or to cancel the financing agreement under conditions

that are not objectively determinable, such as “if a material adverse change occurs” or for “failure to

maintain satisfactory operations.” In contrast, an objective acceleration clause can be independently

verified and is not subject to the interpretation of the lender. Examples would include covenant violations

that require compliance with specific ratios that can be calculated from objective information.

A debtor’s (rather than the lender) requirement to determine whether there has been a “material adverse

change” is not a subjective acceleration clause if it does not result in the lender being able to accelerate

payment based on the lender’s separate assessment of whether a “material adverse change” has occurred.

In such a situation, a careful assessment of the terms of the agreement may be necessary, and it generally

is appropriate to obtain input regarding the lender’s rights from the company’s legal counsel.

2.7.2.1 Long-term debt with subjective acceleration clauses

When otherwise long-term debt includes a SAC, judgment about the likelihood of acceleration of debt

maturity caused by the creditor’s exercise of the SAC is required to determine whether noncurrent

classification is appropriate. ASC 470-10-45-2 indicates that in some situations, the circumstances

(e.g., recurring losses or liquidity problems) would suggest that long-term debt subject to a SAC should

be classified as a current liability. Other situations would indicate only disclosure of the existence of such

clauses. ASC 470-10-45-2 also provides that neither reclassification nor disclosure would be required if

the likelihood of the acceleration of the due date were remote.

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Refer to section 2.7.3.2.3 for the consideration of SACs in refinancing arrangements and section 2.7.5

for consideration of SACs in lock-box arrangements.

2.7.3 Classification of short-term obligations expected to be refinanced on a long-

term basis

Short-term obligations expected to be refinanced on a long-term basis are not expected to require the

use of working capital during the ensuing fiscal year.

ASC 470-10-45-14 provides that short-term obligations should be excluded from current liabilities if the

debtor has the intent to refinance the short-term obligation on a long-term basis and it can demonstrate

the ability to refinance by (1) actually doing so after the balance sheet date by issuance of a long-term

obligation or equity securities or (2) by entering into a long-term financing agreement with a party

expected to be financially capable of honoring such agreement.

To demonstrate an entity has the intention to refinance short-term debt on a long-term basis, the entity

must assert working capital will not be used during the ensuing fiscal year or operating cycle, if longer,

to satisfy the obligation. ASC 470-10-45-15 indicates that payment of short-term debt, or any portion

thereof, after the balance sheet date but prior to obtaining a long-term source of funds, would undermine

any such assertion.

However, noncurrent classification may not be precluded if repayment of obligations subsequent to the

balance sheet date but prior to the issuance of financial statements (or the date available for issuance as

appropriate under ASC 855) is from funds other than working capital existing at the balance sheet date.

For example, funds from the subsequent sale of noncurrent assets, the issuance of long-term debt, the

sale of equity securities, or cash flows from subsequently profitable operation may provide evidence that

the source of subsequent repayments was not a working capital existing at the balance sheet date. In the

absence of evidence to the contrary, repayments of amounts outstanding at the end of the fiscal year

that are made subsequent to the balance sheet date but prior to the issuance of the financial statements

are classified as a current liability.

2.7.3.1 Demonstrating ability via actual refinancing

For the purposes of refinancing a short-term obligation on a long-term basis, an entity may issue a long-

term obligation or equity securities after the date of the balance sheet but before the financial statements

are issued (or the date they are available to be issued as appropriate under ASC 855). For example, a

31 January 20X6 refinancing may be considered in preparing the 31 December 20X5 balance sheet that

is issued when available on 15 February 20X6.

If equity securities are issued in the refinancing of a short-term obligation prior to the issuance of the

financial statements (or the date they are available to be issued as appropriate under ASC 855), the

short-term obligation may be excluded from current liabilities. The equity securities should not be

included in shareholders’ equity at the balance sheet date, however.

Long-term debt actually issued for purposes of refinancing short-term obligations that contains a SAC

should be evaluated under ASC 470-10-45-2 to determine whether noncurrent classification is appropriate

(refer to section 2.7.2.1 for a discussion of the classification of a long-term obligation with SACs).

If a short-term obligation is repaid after the balance sheet date and long-term obligations or equity

securities are subsequently issued whose proceeds are used to replenish current assets before the

balance sheet is issued (or is available to be issued, as appropriate), ASC 470-10-45-15 states that the

short-term obligation should be classified as current because the repayment of the short-term obligation

required the use of current assets that existed at the balance sheet date.

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2.7.3.2 Demonstrating ability via a financing agreement

As an alternative to actually refinancing short-term debt, an entity may enter into a financing agreement

before the financial statements are issued (or available to be issued as appropriate under ASC 855) that

clearly permits it to refinance the short-term debt on a long-term basis on terms that are readily

determinable and meet the following conditions pursuant to ASC 470-10-45-14(b):

• The agreement does not expire within one year (or operating cycle) and any debt issued under the

agreement is not callable within one year of the balance sheet date.

• The agreement must not be cancelable by the lender except for violation of a provision with which

compliance may be readily and objectively determined or measured.

• There must be no violation of any provision of the agreement at the date of the balance sheet or

prior to its issuance (or the date it is available to be issued as appropriate under ASC 855) for which

a waiver has not been obtained.

• The other party to the agreement must be expected to be financially capable of honoring the agreement.

2.7.3.2.1 Demonstrating ability via a standby credit agreement

Entities that have short-term or maturing commercial paper frequently intend to replace that commercial

paper with new commercial paper. In many instances, they obtain a standby credit agreement that would

provide financing in the event the replacement commercial paper cannot be sold. For the short-term or

maturing commercial paper to be excluded from current liabilities, (1) the entity must assert that working

capital will not be used during the fiscal year (or operating cycle, if longer) to satisfy the obligation and

(2) the standby credit agreement should meet the conditions provided by ASC 470-10-45-14(b).

2.7.3.2.2 Demonstrating ability through potential alternative source of financing

An entity may intend to seek an alternative (and perhaps more advantageous) source of financing rather

than exercise its rights under an existing financing agreement. In those situations, provided that the

existing financing agreement meets the conditions in ASC 470-10-45-14(b), the short-term debt may be

classified as noncurrent only if the entity intends to exercise its rights under the existing agreement

when the alternative source does not become available. However, the intent to exercise may not be

present if the existing financing agreement contains conditions (such as interest rates or collateral

requirements) that are unreasonable to the entity.

2.7.3.2.3 Refinancing agreement that contains subjective acceleration clause

Because the debt being evaluated is already short-term and the issuer is attempting to justify a

classification as noncurrent, the guidance has a higher standard for a financing agreement that supports

the assertion that an enterprise can refinance a short-term obligation on a long-term basis than what is

required for an existing long-term debt for which early repayment might be requested.

ASC 470-10-45-14(b)(1) requires that a financing agreement intended to be used to refinance short-

term debt cannot be cancelable or callable by the creditor for at least a year, except for violation of an

objectively determinable or measurable provision. This paragraph further states that “financing

agreements cancelable for violation of a provision that can be evaluated differently by parties to the

agreement (such as a material adverse change or failure to maintain satisfactory operations) do not

comply with this condition.”

Therefore, the existence of subjective acceleration clauses in a financing agreement intended to be used to

refinance short-term debt precludes classification of the short-term debt as noncurrent under this guidance.

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Illustration 2-23: Classification of variable rate demand obligation supported by a liquidity facility

Variable rate demand obligations (VRDOs) are debt instruments with interest rates that reset

periodically (e.g., every seven days) to a market or indexed rate. VRDOs are typically issued by tax-

exempt entities, such as health care entities, municipalities and educational institutions. Some VRDOs

allow the holder to put the bonds (redeem the bonds) at any reset date directly to the issuer, in which

case the VRDO would be classified as a current liability given its potential short-term nature.

In other cases, issuers may arrange for a liquidity facility to fund the purchase of the VRDO. Such a

purchase facility can take several forms:

• The purchase facility may provide that a liquidity facility provider would draw on its own funds to

purchase the VRDO, which remain outstanding from the perspective of the issuer. However, the

liquidity facility provider may request the VRDO be modified subsequently into a term loan with

the issuer if, after a certain period (for purposes of this example that period is assumed to be less

than one year), the VRDO cannot be remarketed.

• In other cases, the liquidity provider may agree to purchase the VRDO from the investor under a standby

letter of credit (LOC) and immediately modify the VRDO into a term loan with the issuer. In those

cases, the VRDO is no longer outstanding and is replaced immediately by a term loan under the LOC.

Because the liquidity facility provides the issuer with the ability to refinance the otherwise short-

term obligation (the VRDO), issuers should evaluate the terms of the liquidity facility pursuant to

ASC 470-10-45-14 to determine the classification of VRDOs, including:

• The contractual expiration date of the liquidity facility (which is often shorter than the life of the

VRDO) should be considered. For example, if a liquidity facility has a five-year term, once the fifth

year begins, it would no longer support noncurrent classification of the VRDO (i.e., any term loan

would become current when due within 12 months of the balance sheet date).

• The liquidity facility may contain a “subjective material adverse change” clause that allows the

liquidity provider to terminate the arrangement at its discretion. A liquidity facility with SACs would

not support the classification of the VRDO as a noncurrent liability because one of the conditions in

ASC 470-10-45-14 requires the long-term financing agreement that is intended to be used to

refinance the otherwise short-term debt not be cancelable or callable by the lender for at least a year,

except for violation of an objectively determinable or measurable provision (e.g., a debt covenant).

2.7.3.3 Amount to be excluded from current liabilities

Even though an entity may demonstrate its ability to consummate the refinancing of a short-term

obligation, the amount to be excluded from current liabilities may be limited under certain circumstances.

If an actual refinancing occurs, the portion of the short-term obligation to be excluded from current

liabilities may not exceed the proceeds from the new obligation or equity securities issued that are

applied to retire the short-term obligation.

When a financing agreement is relied upon to demonstrate ability to consummate refinancing, the

amount of the short-term debt to be excluded from current liabilities should be reduced, as appropriate,

to the lesser of the following:

• The amount available for refinancing under the agreement

• The amount obtainable under the agreement after considering restrictions included in other

agreements or restrictions as to transferability of funds

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• A reasonable estimate of the minimum amount expected to be available for refinancing if the

amounts that could be obtained fluctuate (e.g., in relation to the entity’s needs, in proportion to the

value of collateral, in accordance with other terms of the agreement)

If any of these amounts cannot be reasonably estimated, the entire amount of the short-term debt

should be included in current liabilities.

Illustration 2-24: Examples of limitations on amounts excluded from current liabilities

Example 1 — Amount excluded due to results of actual refinancing

An entity with $5,000,000 of short-term debt issues 250,000 shares of common stock subsequent to

the date of the balance sheet, but before the financial statements are issued, and intends to use the

proceeds to liquidate the short-term debt when it matures. Assuming the net proceeds from the sale

of the 250,000 shares totaled $4,000,000, only that amount of the short-term debt could be excluded

from current liabilities. The $4,000,000 of debt is presented as part of long-term liabilities, but not

included in equity because the shares were not yet issued on the balance sheet date.

Example 2 — Amount excluded due to terms of financing agreement

An entity enters into an agreement with a bank to borrow up to 75% of the amount of its trade

receivables. The provisions of the agreement comply with the conditions for financing agreements

under ASC 470-10-45-14(b). During the next fiscal year, the receivables are expected to range

between a low of $2,000,000 in the first quarter and a high of $6,000,000 in the third quarter. The

minimum amount expected to be available to refinance the short-term obligations that mature during

the first quarter of the next year is $1,500,000 (75% of the expected low for receivables during the

first quarter). Consequently, no more than $1,500,000 of short-term obligations may be excluded

from current liabilities at the balance sheet date.

2.7.4 Revolving credit agreements

Entities often enter into revolving credit arrangements to meet their financing needs. Revolving credit

arrangements can take various forms and have various terms. Some revolving arrangements are long-

term in nature (e.g., 10 years) that allow the debtor to draw down and repay during the duration of the

arrangement. Others are short-term (e.g., 90 days), but provide the debtor the ability to automatically

renew the short-term debt for an uninterrupted period extending beyond one year. Generally, these

arrangements permit a series of renewals or extensions that individually are for periods of less than one

year. The renewal periods or extensions in such arrangements may aggregate several years, and some

arrangements may provide that the outstanding obligation can be converted into term loans.

Determining the classification of obligations incurred under revolving credit agreements will depend on

the form of the revolver.

2.7.4.1 Classification of long-term revolver

Borrowings that are contractually long-term under a long-term revolving credit agreement should

generally be classified as noncurrent. The debtor should give the same considerations to call provisions

that may exist in those revolving agreements as with long-term debt. Refer to section 2.7.1.2 for further

details about classification of callable debt.

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2.7.4.2 Classification of short-term revolver

A revolver that is short-term in nature allowing for automatic renewal or extension is essentially

refinancing of the short-term debt via another short-term obligation. Under the debt classification

guidance in ASC 470-10-45, the exclusion of such short-term debt from current liabilities can occur only

when the debtor establishes its intent and ability to refinance the short-term obligation on a long-term

basis. Specifically, the revolving credit agreement must meet all the conditions for financing agreements

in ASC 470-10-45-14(b). Otherwise, the short-term debt should be classified as current.

Short-term revolving credit agreements may provide for either unrestricted or collateralized borrowing.

In an unrestricted borrowing, a debtor may borrow up to a stated amount or a maximum amount

permitted under the arrangement. The borrowings may be continuously renewed at the option of the

debtor (often for several years) at which time amounts outstanding may be converted to a term loan

having a fixed repayment schedule. If an entity intends to renew its present short-term debt obligation

under such an arrangement for an uninterrupted period extending beyond one year from the balance

sheet date, that short-term debt amount may be classified as noncurrent, provided there are no

subjective considerations that would allow the creditor to deny any such renewal.

Collateralized revolving credit agreements may limit the amount that can be borrowed based on financial

statement tests, such as a percentage of receivables and inventories. In those cases, the amount to be

excluded from current liabilities is limited to the lowest amount that is expected to remain outstanding in

the coming year based on anticipated levels of those financial statement amounts. The following example

illustrates this situation:

Illustration 2-25: Collateralized revolving credit agreements

An entity has a revolving credit agreement permitting it to borrow up to $20 million. So long as the

entity complies with the provisions of the agreement (all of which are objectively determinable or

measurable), the amounts borrowed are continuously renewable for 90-day periods at the company’s

option for three years. The agreement includes a provision that limits borrowing to 75% of total

receivables and inventories at any date.

The entity intends to renew borrowings under the agreement for the full three years. Consequently,

the short-term debt should be excluded from current liabilities to the extent that amounts expected to

be borrowed do not exceed the limitation. For example, assume $15 million of short-term debt is

outstanding at 31 December 20X0, and the lowest level of combined receivables and inventories

expected at any time during 20X1 is $16 million. In that case, the amount of short-term debt to be

excluded from current liabilities would be limited to $12 million ($16 million x 75%), and the remaining

$3 million would continue to be classified as a current liability.

If the amount of borrowings otherwise may fluctuate based on the entity’s needs, only the minimum

amount expected to be outstanding during the next year is excluded from current liabilities.

2.7.5 Lock-box and ‘springing lock-box’ arrangements in revolving credit agreements

2.7.5.1 Lock-box arrangements

Borrowings outstanding under certain revolving credit agreements may require that the debtor maintain

a lock-box arrangement. Under a lock-box arrangement, the debtor’s customers remit directly to the

bank and the amounts received are applied to reduce the debt outstanding under the revolving credit

agreement. At the end of each day, the debtor may request additional borrowings under the revolving

credit agreement and thus the balance outstanding could remain unchanged.

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The flow of transactions under a revolving credit agreement results in a payment and a new borrowing,

although the balance outstanding may remain unchanged. Because of the lock-box arrangement, the debt

outstanding under the revolving credit agreement would be considered a short-term obligation and the

guidance in ASC 470-10-45-14 should be applied in determining the debt classification. If the underlying

revolving credit agreement satisfied the criteria of that guidance for financing arrangements, the debt

outstanding could be classified as noncurrent. However, if the revolving credit agreement contained a

subjective acceleration clause, the revolving credit agreement would not qualify under that guidance.

Accordingly, a revolving credit agreement containing a subjective acceleration clause and a requirement

to maintain a lock-box arrangement with the creditor should be classified as a current liability.

2.7.5.2 Springing lock-box arrangements

Under a springing lock-box arrangement, remittances from customers go directly to a lock-box

maintained by the creditor but in the debtor’s name, subject to a security interest in the favor of the

creditor. The remittances from the customers are then forwarded to the debtor’s general bank account.

The debt is not reduced by those payments. The agreement may have a SAC which, if exercised, allows

the creditor to immediately cause the cash in the lock-box at that moment, as well as all subsequent cash

remittances by customers into the lock-box, to be redirected from the lock-box to the creditor’s account

and applied against the debt outstanding. Once the SAC is exercised, the cash is no longer transferred to

the debtor’s general account; it is transferred to reduce the outstanding debt.

The debt under a revolving credit agreement containing a SAC and a “springing lock box” arrangement is

classified as noncurrent until the SAC is exercised (or probable of becoming exercised) because remittances

do not automatically reduce the debt outstanding without another event occurring. The effect of the SAC

is evaluated under the guidance in ASC 470-10-45-2 based on the likelihood of exercise.

2.7.6 Classification of convertible debt instruments

Frequently, convertible debt instruments permit conversion upon defined contingencies (e.g., a fundamental

change event) and require that, on conversion, the principal amount be settled in cash and the conversion

spread be settled in shares or cash at the issuer’s option (“Instrument C” discussed in section 2.1.2.1).

At different points in time, the instrument may also be puttable by the holder, either by the passage of

time or upon a contingent event, or will mature.

Under the principle in ASC 210-10-45, current classification is required for the convertible debt (or the liability

component of the instrument

) if the settlement in cash is expected to occur within 12 months (or operating

cycle, if longer), subject to the issuer’s intent and ability to refinance the debt on a long-term basis pursuant to

ASC 470-10-45. For example, debt would be classified as current if it is scheduled to mature within 12

months (or operating cycle, if longer) or if it could be put by the holder on any dates within that period.

With contingent conversion or put features, because contingencies must be met before the debt becomes

convertible (thus requiring part of the conversion obligation to be satisfied in cash) or puttable by the

holder, in those circumstances, noncurrent classification may still be appropriate as long as the

contingencies have not been met and the holders cannot put or convert the debt. In the event contingencies

have been met at the balance sheet date and the debt becomes convertible or puttable at the holder’s option,

current classification would be required.

For convertible instruments where the issuer has an option to settle the conversion value of the debt in

cash, shares or any combination of shares and cash, the issuer’s intended settlement method should be

considered in determining the instrument’s classification.

Convertible debt instruments involving cash or partial cash settlement upon conversion is subject to the cash conversion

guidance in ASC 470-20, which requires the issuer to separately account for the liability and equity (conversion option)

components of the convertible debt instrument.

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2.7.7 Classification of increasing-rate debt

Increasing-rate debt instruments are described in section 2.1.2.9. ASC 470-10-45-7 provides that the

classification of increasing-rate debt as current or noncurrent should reflect the issuer’s anticipated

source of repayment (e.g., current assets, a new short-term borrowing versus a long-term refinancing

agreement). An obligation whose liquidation is reasonably expected to require the use of existing

resources that are classified as current assets or the creation of other current liabilities, would be

classified as a current liability. In contrast, liabilities that will be paid through the use of noncurrent

assets or the incurrence of long-term obligations should not be classified as current.

ASC 470-10-35-2 states that the periodic interest cost of increasing-rate debt is determined using

the interest method based on the estimated outstanding term of the debt. However, pursuant to ASC 470-

10-45-7, the classification of the increasing-rate debt need not be consistent with the time frame used to

determine the periodic interest cost; rather, it should reflect the issuer’s anticipated source of repayment.

Financial reporting developments Issuer’s accounting for debt and equity financings | 112

3 Common shares, preferred shares and

other equity-related topics

3.1 Overview

While the form of an equity interest may vary based on the type of entity (corporation, partnership, etc.),

equity generally represents the residual interest in the assets of an entity after all liabilities have been

satisfied. Equity may be divided among investors on a pro-rata basis based on their percentage ownership

or based on preferential rights held by certain investors.

3.1.1 General description of common and preferred shares

Common shares represent the basic ownership interest in an entity and is the residual corporate interest

that bears the ultimate risk of loss and receives the benefit of success. Common shareholders generally

control the management of the entity by voting for a board of directors. Entities may offer different

classes of shares, each with different rights or privileges. A liquidation preference is typically viewed as a

key distinguishing characteristic between a common share and a preferred share. The terms of shares

are commonly established in the corporate governance documents (e.g., articles of incorporation) at

issuance and not subject to change without the approval of the shareholders.

Common shares are usually perpetual in nature with voting rights, dividend rights and a residual interest

in liquidation. For some forms of organization, the basic ownership or residual interest may not be called

a share, but have similar characteristics (e.g., a unit in a limited liability entity).

Preferred shares are usually characterized by (1) the life of the instrument (i.e., perpetual or redeemable)

and (2) convertibility (i.e., convertible or nonconvertible).

The terms of preferred shares can vary significantly. Certain preferred shares function much like debt

instruments (i.e., they have a stated dividend rate, like interest, and have a stated redemption date, like

a maturity date). Other preferred shares are more akin to traditional common stock (i.e., they are perpetual in

nature, have no stated dividend and share in the distributed earnings of the entity with the common share).

Although they may have some debt-like characteristics, preferred stock represents, in legal form, an

ownership relationship with the issuer (as opposed to a creditor relationship). A preferred shareholder

has priority over common shareholders in a bankruptcy proceeding, but would receive consideration only

after all creditors had been paid. There may be various series of preferred shares (usually designated by

letters, such as Series A, Series B, Series C, etc.).

3.1.2 Share terminology

Stock generally is characterized with the following terms:

• Issue price — The price at which the investor buys a share when it is first issued

• Par value — A minimum amount that a shareholder may be legally required to pay for a share on

issuance (Stock may be issued as “no-par” depending on the laws of the state of incorporation.)

• Liquidation preference — A fixed or calculable amount that represents the legal amount of capital to

which a share (typically a preferred share) has a right upon liquidation of the entity

• Voting rights — The ability to vote on certain corporate matters

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• Dividends — The primary mechanism by which profits are distributed to shareholders. May be stated

as a predefined rate (frequently with preferred shares), and may be cumulative in the circumstance

that they are not paid based on a stated schedule (e.g., quarterly). Typically must be declared by the

board of directors

• Authorized shares — The maximum number of shares that an entity can issue, typically outlined in the

entity’s articles of incorporation.

Depending on the nature of the stock, there may also be terms that address the contractual life of the share

and whether it is convertible into another instrument or redeemable by either the issuer or the investor.

3.1.3 Common types of stock instruments

3.1.3.1 Par value stock

The par value of a share of stock is sometimes defined as the legal capital of a corporation. The par value

of common stock is usually an insignificant amount that is sometimes required by law. In addition, the

original purchaser or the current holder of the shares issued below par may be called on to contribute

additional capital in the amount of the difference to prevent creditors from sustaining a loss upon

liquidation of the corporation. The par value of a stock has no relationship to its fair value. Preferred

stock is typically issued for proceeds equal to its par value (which likely also equals its initial liquidation

value), and any dividends are generally calculated as a percentage of par. Refer to section 3.2.5 for

further discussion of the recognition of stock issued with and without par value.

3.1.3.2 No par value stock

Many states permit the issuance of capital stock without a par value. No par value shares, like par value

shares, are sold for whatever price they will bring, but unlike par value shares, the proceeds are not

allocated to a par value. The amount received represents a credit in a single stock account. Some

jurisdictions permit the issuance of no par stock and either require or permit that stock to have a stated

value (i.e., a minimum value below which it cannot be issued).

3.1.3.3 Treasury stock

Treasury stock is stock that is repurchased by the issuing entity, reducing the amount of outstanding

shares in the open market. When shares are repurchased, they may either be canceled or held for

reissue. If not canceled, such shares are referred to as treasury shares. Treasury shares do not give the

entity the right to vote, exercise preemptive rights as a shareholder, receive cash dividends or receive

assets upon the liquidation of the entity. Treasury shares are essentially the same as unissued capital and

reduce ordinary share capital. State laws may require the shares be retired rather than held in treasury.

Refer to section 3.5.1.1 for a discussion of the accounting for treasury stock transactions.

3.1.3.4 Perpetual preferred stock

Perpetual preferred stock has no stated maturity date, but often may be convertible and/or redeemable

(callable by the issuer or puttable by the investor) at any time, after a stated period or upon a contingent event.

3.1.3.5 Convertible stock

Convertible stock provides the investor the ability to convert the stock into other equity securities of the

issuer (or of a subsidiary of the issuer or the issuer’s parent), usually at some predetermined ratio (which

may be adjusted in certain circumstances). The stock includes a conversion option (or forward in the case

of mandatorily convertible stock), which is an embedded call option (or forward to sell) written on the

underlying shares by the issuer to the investor. Convertible stock is considered to be a hybrid instrument

that contains a host contract with an embedded feature. Conversion features are more likely to be found

in preferred shares than common shares.

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Convertible instruments contain the following elements related to the embedded conversion option:

• Conversion price — The price at which convertible shares can be converted into the underlying equity

security (e.g., par or liquidation preference/conversion rate)

• Conversion rate (or conversion ratio) — The number of underlying equity securities to be received by

investors at the time of conversion for each fixed dollar value of preferred stock (e.g., par or

liquidation preference/conversion price)

• Parity value — The as-converted value of each share, which is equal to the current underlying equity

security trading price multiplied by the number of shares into which the preferred is convertible

• Conversion spread — The amount by which the parity value of the convertible share exceeds the

accreted value (sometimes also referred to as conversion premium)

There are many variations in the nature and terms of convertible stock instruments. The most common

variations are discussed in section 3.2.8.

3.1.3.6 Redeemable stock

Redemption is the repurchase of the stock instrument by the issuer. The ability to force redemption may

be held by either the issuer (an embedded purchased call option) or the holder (an embedded written put

option). An instrument is conditionally redeemable if it represents a conditional obligation that could

require, or permit, the issuer to redeem the instrument at some point in the future or under specified

conditions that are not certain to occur. Redemption rights are more frequently found in preferred

shares than common shares.

3.1.3.7 Mandatorily redeemable stock

Some redeemable shares are mandatorily redeemable and must be repurchased by the issuer on a specified

date or on the occurrence of a specified event that is certain to occur, such as the death of an owner. Shares

are considered mandatorily redeemable pursuant to ASC 480-10-25-4 through 25-7 if they are subject to

an unconditional obligation to be redeemed by transferring assets (i.e., cash or other assets). That is,

redemption is mandatory on both parties (the issuer must redeem and the holder must surrender), as

opposed to mandatory on the issuer only if the holder decides to redeem. However, if the instruments are

redeemable only upon the liquidation or termination of the reporting entity, those instruments are not

considered mandatorily redeemable. Refer to section 3.2.1 for further discussion of those instruments.

3.1.3.8 Increasing-rate preferred stock

Some types of preferred stock initially pay little or no dividends and later pay dividends at an increasing

rate (often characterized as “increasing rate preferred stock”). Refer to section 3.4.5.9 for further

discussion of those instruments.

3.1.3.9 Restricted shares

Restricted shares are shares for which sale is contractually or legally (e.g., governmental regulations)

restricted. A common type of restricted share is a form of compensation granted by an entity to employees

or directors. ASC 718 defines restricted shares as fully vested and outstanding shares whose sale is

contractually or governmentally prohibited for a specified period of time. However, most shares granted

to employees and nonemployees under ASC 718 are better termed as nonvested shares because the

limitation on sale stems solely from the forfeitability of the shares before the grantee has satisfied the

necessary service or performance condition(s) to earn the rights to the shares. In some instances, a

shareholder may be asked to put legally outstanding shares in an escrow account or otherwise subject

those shares to a vesting requirement. These arrangements are presumed to be compensatory under

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ASC 718; however, entities should consider the substance of the transaction. Refer to section 2.6 of our

FRD publication, Share-based payment, for a discussion of the accounting for shares when a vesting

requirement has been added.

3.1.3.10 Nominal stock issuances

Nominal issuances of stock, sometimes called “cheap stock,” refers to stock issued for nominal

consideration (i.e., a price significantly below its fair value or the price at which stock is subsequently

sold in a public issuance of shares) to employees or others closely related to the issuer. Those types

of transactions may occur prior to an IPO and raise a number of accounting issues, including share-based

payment, EPS and BCF considerations. Refer to section 6.4.5 of our FRD publication, Share-based

payment, and section 6.6 of our FRD publication, Earnings per share, for further discussion. Refer to

section D.3.1.3 for fair value considerations in calculating the intrinsic value of a BCF.

3.1.4 Additional paid in capital and retained earnings

APIC is generally the excess amount paid on capital stock over its par value. APIC may be created,

increased or decreased due to a variety of transactions including:

• Treasury stock transactions (refer to section 3.5.1.1)

• Stock splits and stock dividends (refer to sections 3.4.4 and 3.4.5.4)

• Conversion of convertible securities (refer to sections 2.5.2 and 3.5.2)

• Liquidating dividends (refer to section 3.4.5.3)

• Issuance or settlement of equity contracts (refer to section 4)

• Termination of an S corporation election

• Share-based payments accounted for under ASC 718

• Payments or settlements of obligations by shareholders on a company’s behalf (ASC 220)

Retained earnings are profits generated by an entity that have not been distributed to shareholders.

Companies may be legally or contractually required (or may elect) to appropriate retained earnings.

In such cases, appropriated retained earnings are specifically identified within equity.

3.2 Issuer’s initial accounting for stock instruments (including flowchart)

This section describes the steps generally necessary to determine the accounting for stock (including

convertible stock) at issuance. In particular, this section provides detailed considerations related to the

balance sheet classification, embedded conversion options, redemption features and other common

embedded features.

ASC 505-10-S99-3 indicates when an S corporation’s election is terminated undistributed earnings should be reflected in the financial

statements as APIC. This assumes a constructive distribution to owners followed by a contribution to the capital of the corporation.

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The following flowchart summarizes the analysis at a conceptual level and should be used in conjunction

with the related guidance throughout the rest of section 3.2.

Refer to section 5.10.2.1 for a flowchart that provides the road map for determining the classification of

equity contracts over NCI.

Box A: Is the stock mandatorily redeemable

on a fixed or determinable date or upon an

event that is certain to occur?

Box B: Does the stock represent an

unconditional obligation that (1) the

issuer must or may settle in a variable

number of its equity shares and (2) the

monetary value is predominantly

(a) fixed, (b) varying with something other

than the fair value of the issuer’s equity

shares or (c) varying inversely in relation

to the issuer’s equity shares?

Box C: Does the stock qualify for any

of the scope exceptions (generally for

mandatorily redeemable instruments

of nonpublic companies) that would

preclude it from being classified as

a liability?

Box D: The stock is classified and

accounted for as an ASC 480 liability.

Box F: Record stock at proceeds

received (net of issuance costs) or

based on allocated proceeds.

Box E: Does the stock contain embedded

features?

Box G: Evaluate the nature of the host

instrument. Is it more akin to equity

than debt?

Box I: Evaluate each embedded feature for

bifurcation from an equity host instrument.

Box H: If the host instrument is

considered a debt host, the embedded

features are evaluated for bifurcation

using the debt model and the

guidance in section 2.

Box P: For SEC registrants, evaluate

whether the stock requires

presentation in temporary equity.

Box I(A): Is there

a conversion or

exchange feature?

Box I(B): Are

there redemption

(put and/or call)

features?

Box I(C): Are

there any other

embedded

features?

Box I1: Is the feature clearly and closely related to

the equity host?

Box L: No bifurcation of the

features as an embedded

derivative required.

Box M: Is the conversion

feature in the money at the

commitment date (i.e., is it

a beneficial conversion

feature)?

Box N: Further allocate the stock

proceeds with an equity component

receiving the intrinsic value of the

beneficial conversion feature.

Box O: Remaining proceeds are

allocated to the equity host. Any

embedded derivatives will be

bifurcated from this equity host.

Box K: Was the feature analyzed and

not bifurcated a conversion option?

Box J: Bifurcate from the proceeds

allocated to the equity host the fair

value of a single derivative that

comprises all of the individual

features requiring bifurcation.

Remaining proceeds are allocated

to the equity host.

Box I2: Does the

feature meet the

definition of a

derivative?

Box I3: Is the feature

eligible for an

exception from

derivative accounting?

Yes

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3.2.1 Box A — Mandatorily redeemable stock

ASC 480-10-25-4 through 25-7 and related implementation guidance requires an instrument issued in

the form of a share that is mandatorily redeemable to be classified as a liability. Shares are considered

mandatorily redeemable if the issuer has an unconditional obligation to redeem them by transferring assets.

That is, the issuer must redeem the shares, and the holder must surrender them. The shares wouldn’t be

mandatorily redeemable if the issuer had to redeem them only when the holder decided to do so.

However, if the shares are redeemable only upon the liquidation or termination of the reporting entity,

those shares are not considered mandatorily redeemable. Additionally, ASC 480-10-15-7A through 15-7F

provides a scope exception from liability classification for certain mandatorily redeemable shares issued

by nonpublic entities (as defined in the guidance) and certain mandatorily redeemable NCIs. Shares that are

subject to an unconditional obligation to be settled by issuing other shares are discussed in section 3.2.2.

Examples of mandatorily redeemable shares include stock (more frequently preferred stock) that is redeemable

on a specified date or upon an event that is certain to occur (e.g., an instrument that must be redeemed upon

the death of the holder). A mandatorily redeemable instrument that contains a provision to defer redemption to

a future date, but not indefinitely, may change the timing of redemption but does not eliminate the obligation

to redeem the instrument and, therefore, does not alter the requirement for liability classification.

The existence of a mechanism to fund the redemption of mandatorily redeemable shares does not affect

their classification. For example, shares subject to mandatory repurchase upon the death of the holder

for which the issuer has acquired insurance on the holder’s life in an amount sufficient to fund the

redemption are liabilities pursuant to ASC 480, notwithstanding the fact that the issuer is reasonably

assured of having the funds necessary to satisfy the redemption obligation.

An instrument’s terms should be carefully evaluated in determining whether it is mandatorily redeemable.

If an otherwise mandatorily redeemable security is convertible into shares, the security is only contingently

redeemable until the conversion feature expires, at which time the security becomes mandatorily redeemable.

For example, if an instrument has a stated redemption date, but the instrument may be converted into

another equity instrument, that instrument is not mandatorily redeemable until the conversion option expires.

As long as the conversion option is considered substantive, the instrument is considered contingently or

optionally redeemable as there is the possibility of conversion obviating redemption. However, if conversion

requires settlement of the liquidation preference in cash and the remaining conversion spread in shares, then

it is known that a settlement of the liquidation preference in cash will occur (either on redemption or on

conversion) and that instrument would be classified as a liability and evaluated as a debt instrument.

Refer to section A.4 for further discussion of mandatorily redeemable instruments, including a discussion

of certain deferred transition provisions for nonpublic companies.

3.2.2 Box B — Stock settled in a variable number of equity shares

ASC 480-10-25-14 requires liability accounting for certain financial instruments, including shares that

embody an unconditional obligation to transfer a variable number of shares, provided that the monetary

value

of the obligation is based solely or predominantly on one of the following three characteristics:

a. A fixed monetary amount known at inception (e.g., a preferred share that will be settled by issuing a

variable number of common shares equal in value at that time to the liquidation preference of the

preferred stock)

b. Variations in something other than the fair value of the issuer’s equity shares (e.g., a preferred share that

will be settled in a variable number of common shares with its monetary value tied to a commodity price)

ASC 480 defines monetary value as the fair value of the cash, shares or other instruments that a financial instrument obligates

the issuer to convey to the holder at the settlement under specified market conditions.

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c. Variations in the fair value of the issuer’s equity shares, but the monetary value to the counterparty

moves in the opposite direction as the value of the issuer’s shares

Notwithstanding the fact that those instruments can be settled in shares, equity classification is not

appropriate because instruments with those characteristics do not expose the counterparty to risks and

rewards similar to those of an owner and, therefore, do not create a shareholder relationship.

Shares with the characteristics described in (b) and (c) above are not as common as shares with the

characteristics of (a). For example, some preferred shares require an exchange for a variable number of

common shares equal to a fixed monetary amount, resulting in a fixed redemption value regardless of the

share price. Pursuant to criterion (a), those shares would require liability classification if such an exchange

feature is unconditional. Refer to section 3.2.8.3 for further discussion of those types of instruments.

Refer to section A.6 for further discussion of stock that may be settled in a variable number of shares.

3.2.3 Boxes C and D — Liability classification for stock

A share that is either (1) mandatorily redeemable (refer to Box A) or (2) unconditionally settled in a

variable number of shares based on certain characteristics (refer to Box B) is classified as a liability

unless it qualifies for one of the scope exceptions pursuant to ASC 480-10-15-7A through 15-7F for

certain mandatorily redeemable shares of nonpublic entities or certain mandatorily redeemable NCIs.

When shares are classified as liabilities, the initial and subsequent measurement would be evaluated

under the applicable guidance in Appendix A and the debt guidance in section 2.

3.2.3.1 Shares that represent legal form debt

Although uncommon, some shares represent legal form debt. An example is a preferred equity certificate

(PEC) and related instruments (e.g., convertible PEC (CPEC)) issued by entities (often financing subsidiaries)

domiciled in Luxembourg as part of various tax strategies. Refer to section 5.14 for a detailed discussion

on those instruments.

3.2.4 Box E — Identifying embedded features

ASC 815-10-20 defines an embedded derivative as an implicit or explicit term that affects 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. Those embedded features may or may not meet the definition of a derivative pursuant to

ASC 815. Instruments that themselves are not derivatives may contain embedded features, and are

referred to as hybrid instruments, which comprise a host contract (e.g., an equity host) and one or more

embedded features.

ASC 815-15 requires an instrument that is not a derivative itself to be evaluated for embedded features

that should be bifurcated and separately accounted for as freestanding derivatives. Bifurcated embedded

derivatives are split from the hybrid instrument and recorded in the same manner as a freestanding

derivative pursuant to ASC 815 (i.e., recorded at fair value with subsequent changes in fair value

recognized in earnings each period).

Preferred stock instruments generally have embedded features more frequently than common shares

and should be carefully reviewed to identify any terms that could result in a change (increase or

decrease) in either the amount or timing (or both) of any cash or other value flows or settlement. Typical

embedded features in preferred stock include conversion options, exchange options, redemption

features (e.g., callable preferred or puttable preferred) and contingent dividends (additional dividends in

certain circumstances). Similar features may be found in common shares, but they are atypical.

Refer to section 3.2.7 for evaluating whether an embedded feature meets the definition of a derivative.

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3.2.5 Box F — Recognition at issuance

When stock with a par or stated value is issued for cash consideration, the proceeds (or amount allocated

as discussed in section 1.2.7) should be credited to the applicable capital account in the amount of the

aggregate par or stated value of the issued shares with any excess credited to APIC. Proceeds from the

issuance of stock without a par or stated value should be credited entirely to the applicable capital account.

3.2.5.1 Stock subscription

If a public company enters into an agreement to sell its stock and issues the stock before it receives the

proceeds in one or more scheduled payments (in what is commonly known as a stock subscription

agreement), Rule 5-02.29 of SEC Regulation S-X requires the subscription receivable to be reflected as a

reduction in stockholders’ equity. Similar guidance is provided in ASC 310-10-S99-2 for capital stock that

is issued to officers or other employees before cash payment is received.

For nonpublic companies, ASC 505-10-45-2 requires that notes receivable recognized in connection with

the issuance of stock be reflected as a reduction of shareholders’ equity in most cases (rather than as an

asset) until paid. However, ASC 505-10-45-2 provides that, for nonpublic companies, subscription

receivables may be recorded as an asset if they are collected in cash prior to the issuance of the financial

statements. Additionally, ASC 505-10-45-2 indicates that under very limited circumstances, when there

is substantial evidence of ability and intent to pay within a reasonably short period of time, nonpublic

companies may record subscriptions receivables as assets. Although not carried forward into Codification,

the guidance formerly in EITF 85-1

contained observations from Task Force members that they were

aware of only a few cases where notes were reported as assets, and more specifically only when they

(1) were secured by irrevocable letters of credit or other liquid collateral or were discountable at a bank

and (2) included a stated maturity in a reasonably short period of time. The SEC staff has stated that, for

registrants, exceptions to the general rule would be rare.

The treatment of consideration received under a stock subscription prior to the issuance of shares

depends on the subscription arrangement. If the entity is obligated to refund consideration received in

the event the subscription is canceled, amounts received should be accounted for as a liability until the

underlying shares are issued. If consideration received is nonrefundable, payments received should

generally be recorded as an addition to shareholders’ equity.

Unlike stock subscriptions where stock is issued once all of the agreed upon consideration is received,

when shares are issued prior to the receipt of all of the agreed upon consideration, the shares are

frequently described as partially paid. The accounting for partially paid stock should be the same as that

for stock subscriptions.

3.2.5.2 Stock issued to nonemployees (including customers)

ASC 718 addresses the accounting for share-based payments issued to employees and nonemployees in

exchange for goods or services to be used or consumed in the grantor’s own operations as well as the

measurement and classification of awards issued to customers in conjunction with a revenue

arrangement that is not in exchange for a distinct good or service. For guidance on accounting for the

issuance of equity instruments to nonemployees (including customers), refer to our FRD publication,

Share-based payment. Additionally, refer to section 5.7 of our FRD publication, Revenue from contracts

with customers (ASC 606), for guidance on accounting for the issuance of equity instruments granted in

conjunction with selling goods or services to customers.

EITF Issue No. 85-1, Classifying Notes Received for Capital Stock (EITF 85-1).

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3.2.6 Boxes G and H — Evaluate the nature of the host contract

A hybrid instrument consists of a host contract and an embedded feature. Pursuant to ASC 815-15-25-1(a),

an embedded feature does not require bifurcation if the feature is clearly and closely related to the host

contract. Therefore, the nature of the host contract must be determined in order to assess whether any

embedded features are considered clearly and closely related.

Unlike the evaluation of most common stock (an equity host) or of a debt instrument (a debt host), the

nature of the host contract in a hybrid instrument issued in the form of a preferred share may not be clear

because the preferred share may contain both equity-like and debt-like features. A preferred share should

be evaluated based on its terms and features to determine whether it is a debt host or an equity host. If an

equity instrument is required to be classified as a liability pursuant to ASC 480, we generally believe it

would be rare for an entity to conclude that the nature of the host instrument is equity.

While liability classification is indicative that the nature of the host instrument generally would be debt-like, the

fact that the instrument is classified in equity does not indicate the host is equity-like. Rather, a comprehensive

analysis of the factors in ASC 815-15-25-17C and 25-17D should be performed to reach a conclusion.

3.2.6.1 Defining the host contract

ASC 815-15-25-17A requires an issuer or investor to consider the economic characteristics and risks of

a hybrid instrument issued in the form of a share, including all of its stated and implied substantive terms

and features, to determine whether the nature of the host contract in the share is more akin to debt or to

equity. This is commonly referred to as the whole instrument approach.

Under this approach, all stated and implied features, including the embedded feature being evaluated for

bifurcation, must be considered. Each term and feature should be weighed based on the relevant facts

and circumstances to determine the nature of the host contract. This approach results in a single,

consistent determination of the nature of the host contract, which is then used to evaluate each

embedded feature for bifurcation.

The guidance clarifies that the existence or omission of any single feature, including an investor-held,

fixed-price, noncontingent redemption option, does not necessarily determine the economic

characteristics and risks of the host contract. Instead, an entity must base that determination on an

evaluation of the entire hybrid instrument, including all substantive terms and features.

However, an individual term or feature may be weighed more heavily in the evaluation on the basis of

facts and circumstances. An entity should use judgment based on an evaluation of all of relevant terms

and features, including the circumstances surrounding the issuance or acquisition of the equity share, as

well as the likelihood that an issuer or investor is expected to exercise any options within the host

contract, to determine the nature of the host contract.

3.2.6.1.1 Weighing terms and features

Excerpt from Accounting Standards Codification

Derivatives and Hedging—Embedded Derivatives

Recognition

815-15-25-17C

When applying the guidance in paragraph 815-15-25-17A, an entity shall determine the nature of the

host contract by considering all stated and implied substantive terms and features of the hybrid

financial instrument, determining whether those terms and features are debt-like versus equity-like,

and weighing those terms and features on the basis of the relevant facts and circumstances. That is,

an entity shall consider not only whether the relevant terms and features are debt-like versus equity-

like, but also the substance of those terms and features (that is, the relative strength of the debt-like

or equity-like terms and features given the facts and circumstances). In assessing the substance of the

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relevant terms and features, each of the following may form part of the overall analysis and may

inform an entity’s overall consideration of the relative importance (and, therefore, weight) of each

term and feature among other terms and features:

a. The characteristics of the relevant terms and features themselves (for example, contingent

versus noncontingent, in-the-money versus out-of-the-money)

b. The circumstances under which the hybrid financial instrument was issued or acquired (for

example, issuer-specific characteristics, such as whether the issuer is thinly capitalized or

profitable and well-capitalized)

c. The potential outcomes of the hybrid financial instrument (for example, the instrument may be

settled by the issuer issuing a fixed number of shares, the instrument may be settled by the issuer

transferring a specified amount of cash, or the instrument may remain legal-form equity), as well

as the likelihood of those potential outcomes. The assessment of the potential outcomes may be

qualitative in nature.

815-15-25-17D

The following are examples (and not an exhaustive list) of common terms and features included within a

hybrid financial instrument issued in the form of a share and the types of information and indicators that an

entity (an issuer or an investor) may consider when assessing the substance of those terms and features in

the context of determining the nature of the host contract, as discussed in paragraph 815-15-25-17C:

a. Redemption rights. The ability for an issuer or investor to redeem a hybrid financial instrument

issued in the form of a share at a fixed or determinable price generally is viewed as a debt-like

characteristic. However, not all redemption rights are of equal importance. For example, a

noncontingent redemption option may be given more weight in the analysis than a contingent

redemption option. The relative importance (and, therefore, weight) of redemption rights among

other terms and features in a hybrid financial instrument may be evaluated on the basis of

information about the following (among other relevant) facts and circumstances:

1. Whether the redemption right is held by the issuer or investors

2. Whether the redemption is mandatory

3. Whether the redemption right is noncontingent or contingent

4. Whether (and the degree to which) the redemption right is in-the-money or out-of-the-money

5. Whether there are any laws that would restrict the issuer or investors from exercising the

redemption right (for example, if redemption would make the issuer insolvent)

6. Issuer-specific considerations (for example, whether the hybrid financial instrument is

effectively the residual interest in the issuer [due to the issuer being thinly capitalized or the

common equity of the issuer having already incurred losses] or whether the instrument was

issued by a well-capitalized, profitable entity)

7. If the hybrid financial instrument also contains a conversion right, the extent to which the

redemption price (formula) is more or less favorable than the conversion price (formula),

that is, a consideration of the economics of the redemption price (formula) and the conversion

price (formula), not simply the form of the settlement upon redemption or conversion.

b. Conversion rights. The ability for an investor to convert, for example, a preferred share into a fixed

number of common shares generally is viewed as an equity-like characteristic. However, not all

conversion rights are of equal importance. For example, a conversion option that is noncontingent

or deeply in-the-money may be given more weight in the analysis than a conversion option that is

contingent on a remote event or deeply out-of-the-money. The relative importance (and,

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therefore, weight) of conversion rights among other terms and features in a hybrid financial

instrument may be evaluated on the basis of information about the following (among other

relevant) facts and circumstances:

1. Whether the conversion right is held by the issuer or investors

2. Whether the conversion is mandatory

3. Whether the conversion right is noncontingent or contingent

4. Whether (and the degree to which) the conversion right is in-the money or out-of-the-money

5. If the hybrid financial instrument also contains a redemption right held by the investors,

whether conversion is more likely to occur before redemption (for example, because of an

expected initial public offering or change-in-control event before the redemption right

becoming exercisable).

c. Voting rights. The ability for a class of stock to exercise voting rights generally is viewed as an equity-

like characteristic. However, not all voting rights are of equal importance. For example, voting rights

that allow a class of stock to vote on all significant matters may be given more weight in the analysis

than voting rights that are only protective in nature. The relative importance (and, therefore, weight)

of voting rights among other terms and features in a hybrid financial instrument may be evaluated on

the basis of information about the following (among other relevant) facts and circumstances:

1. On which matters the voting rights allow the investor’s class of stock to vote (relative to

common stock shareholders)

2. How much influence the investor’s class of stock can exercise as a result of the voting rights.

d. Dividend rights. The nature of dividends can be viewed as a debt-like or equity-like characteristic.

For example, mandatory fixed dividends generally are viewed as a debt-like characteristic, while

discretionary dividends based on earnings generally are viewed as an equity-like characteristic.

The relative importance (and, therefore, weight) of dividend terms among other terms and

features in a hybrid financial instrument may be evaluated on the basis of information about the

following (among other relevant) facts and circumstances:

1. Whether the dividends are mandatory or discretionary

2. The basis on which dividends are determined and whether the dividends are stated or

participating

3. Whether the dividends are cumulative or noncumulative.

e. Protective covenants. Protective covenants generally are viewed as a debt-like characteristic.

However, not all protective covenants are of equal importance. Covenants that provide

substantive protective rights may be given more weight than covenants that provide only limited

protective rights. The relative importance (and, therefore, weight) of protective covenants among

other terms and features in a hybrid financial instrument may be evaluated on the basis of

information about the following (among other relevant) facts and circumstances:

1. Whether there are any collateral requirements akin to collateralized debt

2. If the hybrid financial instrument contains a redemption option held by the investor, whether

the issuer’s performance upon redemption is guaranteed by the parent of the issuer

3. Whether the instrument provides the investor with certain rights akin to creditor rights (for

example, the right to force bankruptcy or a preference in liquidation).

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In determining the nature of a host contract, the guidance requires an entity to first identify all of the

stated and implied substantive terms and features (e.g., a conversion option, a redemption option, voting

rights, dividend rights, protective covenants) within the hybrid instrument and to determine whether

those terms and features are debt-like or equity-like. The entity will then weigh each term and feature on

the basis of the relevant facts and circumstances to determine the relative strength of the debt-like and

equity-like terms and features. To assess the substance of relevant terms and features, it is important to

determine not only which terms and features are debt-like or equity-like, but also the extent to which

those terms and features are debt-like or equity-like.

When assessing the relative importance of the terms and features, an entity must consider their

substance. In doing so, an entity may consider the following:

• The characteristics of the terms and features (e.g., contingent versus noncontingent, in-the-money

versus out-of-the-money)

• The circumstances under which the hybrid instrument was issued or acquired (e.g., issuer-specific

characteristics, such as whether the issuer is thinly capitalized or profitable and well-capitalized)

• The potential outcomes of the hybrid instrument and the likelihood of those potential outcomes

(e.g., the instrument may be settled by the issuer issuing a fixed number of shares or by transferring

a specified amount of cash, or the instrument may remain legal-form equity), as well as the likelihood

of those potential outcomes

The potential outcomes may be assessed qualitatively. The entity’s expectation of the potential outcomes

as well as the investor’s expectation of the nature of return (i.e., debt-like or equity-like) from the

investment should be considered in the assessment.

The table below presents several key features that are common in preferred stock and whether those

terms and features are, by their nature, debt-like or equity-like. Once a determination is made as to

whether the feature is debt-like or equity-like, such feature should be weighted based on the relevant

facts and circumstances to determine the nature of the host contract.

Feature

Equity-like

Debt-like

Redemption

Perpetual

Puttable (at holder’s

option) on

contingent event

Puttable (at holder’s

option) with passage

of time

Mandatorily

redeemable

Dividends

Cumulative participating

(and presumably noncumulative

participating)

Noncumulative fixed rate

(and presumably

indexed variable rate)

Cumulative fixed rate

(and presumably cumulative

indexed variable rate)

Voting rights

Votes with common

on as-converted

basis

Votes with common

on as-converted basis

on specific matters

Votes only on

matters related to

specific instrument

Nonvoting

Covenants

No provisions that are substantively

protective covenants

Includes provisions that are substantively

protective covenants

Conversion rights

Mandatorily convertible

Optionally convertible

Not convertible

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3.2.7 Box I and Boxes I1, I2 and I3 — Evaluating embedded features for bifurcation

Embedded features should be evaluated as potential derivatives that should be bifurcated and accounted

for separately. Box I(A) and Box I(B) represent two broad categories of features commonly found in

stock: conversion options and put/call (i.e., redemption) features. Box I(C) captures any other features

that meet the definition of an embedded derivative that could require bifurcation.

Boxes I1, I2 and I3 apply to any contractual feature requiring analysis as a potential embedded

derivative. The questions in those boxes align closely with the criteria in ASC 815-15-25-1, which

requires an embedded derivative to be bifurcated if all three of the following conditions are met:

a. 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.

b. The hybrid instrument is not remeasured at fair value under otherwise applicable US GAAP with

changes in fair value reported in earnings as they occur.

c. A separate instrument with the same terms as the embedded derivative would be considered a

derivative instrument subject to derivative accounting (the initial net investment for the hybrid

instrument should not be considered to be the initial net investment for the embedded derivative).

Under criterion (a), if an embedded feature being analyzed is clearly and closely related to the host,

bifurcation is not required. To evaluate this criterion, the host contract should be properly identified.

The evaluation of embedded features in this section is in the context of only an equity host contract.

Preferred stock that is deemed a debt host is treated as a debt instrument in evaluating embedded

features. Refer to the discussion in section 2.2.3 for evaluating embedded features for bifurcation when

the host is determined to be a debt instrument.

Criterion (b) is not addressed because the fair value option cannot be elected for an equity-classified

instrument, such as stock. Embedded features in stock classified as liabilities (refer to section 3.2.3)

should be evaluated under the debt guidance in section 2.

Criterion (c) considers not only whether the embedded feature meets the definition of a derivative

(evaluated as if it were a freestanding instrument with the same terms), but also whether it is eligible for an

exception from derivative accounting. If the embedded feature would not be a derivative if freestanding,

either because it does not meet the definition of a derivative or because it does meet the definition but

receives an exception from derivative accounting pursuant to ASC 815, bifurcation is not required.

3.2.7.1 Unit of analysis

The unit of analysis is important when evaluating potential derivatives because each embedded feature

identified in a contract generally is evaluated for bifurcation. There are different approaches in practice in

determining whether embedded features require bifurcation. Under one approach, each embedded feature is

evaluated individually, while under another approach similar embedded features may be (or in some cases

must be) combined. The approach followed for the unit of analysis (i.e., embedded features evaluated

individually or in a group) may affect whether some or all of those embedded features should be bifurcated.

For example, consider a typical contingently convertible preferred stock instrument that may be converted in

four different situations (e.g., based on the trading price, parity, a notice of redemption or a specified corporate

transaction), with each situation representing the resolution of a contingency in the instrument. The contractual

conversion features in a contingently convertible preferred share could be analyzed in two ways. Under one

approach, the instrument would have a single conversion option with four separate triggers that permit

conversion (e.g., based on the trading price of the common stock, parity, a notice of redemption or a specified

corporate transaction). Under another approach, the instrument could be viewed to have four conversion

options for bifurcation, each of which is exercisable only upon the occurrence of a certain event (e.g., the trading

price of the common stock, parity, a notice of redemption or a specified corporate transaction).

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If the instrument were viewed to have one option with multiple exercise triggers, the entire conversion

option would be bifurcated if any individual trigger or related settlement met the requirements for

bifurcation. Under the second approach (four options, each with its own exercise trigger), only each

individual trigger or related settlement requiring separate accounting would be bifurcated. The valuation

of that bifurcated derivative would be based on the value of a conversion option (or options, if several

required bifurcation) that included an input for the probability of the trigger (or triggers) occurring. The

remaining conversion options would not be bifurcated.

We generally believe either approach is acceptable in evaluating embedded derivatives. The approach

followed should be consistently applied. However, the second approach may not be applied in all

circumstances. For example, ASC 815-15-25-7 states that a single freestanding derivative may not be

split into multiple derivatives. Therefore, a freestanding warrant that has four exercise contingencies

should be viewed as a single equity contract.

Judgment will be required to determine when it is appropriate (or necessary) to combine terms into

a single embedded feature to be evaluated for bifurcation. Factors to be considered include the

commonality of the underlyings, a detailed analysis of the calculation of related settlement amounts,

the situations in which settlements may be required and default provisions related to the terms. Once

the appropriate unit of analysis is determined, each unit should be evaluated in accordance with the

criteria in ASC 815-15-25-1 described below.

3.2.7.2 Meaning of ‘clearly and closely related’

The clearly and closely related evaluation generally refers to a comparison of the economic characteristics

and risks of the embedded feature to those of the host instrument. The concept is not specifically defined

in the guidance, but is illustrated throughout the examples in ASC 815-15-25-23 through 25-51. Generally,

the underlying, which causes the value of the embedded feature to fluctuate, must be related to the inherent

economic nature of the host instrument to be considered clearly and closely related to the host instrument.

If the economic characteristics and risks of the embedded feature are clearly and closely related to the

economic characteristics and risks of the host contract, ASC 815 does not permit bifurcation of the feature.

For a share that has an equity host, the embedded feature’s underlying must bear the economics and

risks of the issuer’s equity interest (i.e., be related to a residual interest) to be considered clearly and

closely related. For example, a conversion option in a preferred stock that is deemed an equity host is

generally considered clearly and closely related to the host instrument.

3.2.7.3 Definition of a derivative instrument

To be a derivative pursuant to ASC 815, an instrument should have all of the following characteristics:

• A derivative’s cash flows or fair value must fluctuate and vary based on the changes in one or more

underlyings.

• The contract contains one or more notional amounts or payment provisions or both.

• The contract 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 (a) provides for net settlement, (b) can be settled net through a market mechanism

outside the contract or (c) provides for delivery of an asset that, because the delivered asset is

readily convertible to cash, puts the recipient in a position not substantially different from net

settlement (a gross settlement that is economically equivalent to a net settlement).

Refer to section 1.2.3 of this publication and section 2.4 of our FRD publication, Derivatives and hedging,

for additional information on the definition of a derivative.

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3.2.8 Box I(A) and Boxes I1, I2 and I3 — Evaluating embedded conversion options

The conversion feature in convertible stock should be evaluated for potential bifurcation pursuant to the

criteria in ASC 815-15-25-1, which includes the considerations described in section 3.2.7. If the option

meets the definition of a derivative, the analysis should also consider whether the conversion feature,

if freestanding, would receive an exception from derivative accounting.

The bifurcation analysis in this section addresses stock with an equity host. If convertible stock is

determined to have a debt host, the evaluation of whether the conversion option requires bifurcation

is performed as if the stock is a debt instrument. Refer to section 2.2.4 for guidance on evaluating

embedded conversion options in debt instruments.

3.2.8.1 Determining whether a conversion option is clearly and closely related to an equity host

instrument

Most commonly, the economic characteristics and risks of a conversion option embedded in a stock

instrument are considered clearly and closely related to an equity host as its value is influenced

principally by the underlying equity security’s fair value. Therefore, bifurcation would not be required.

However, if the host instrument and the embedded conversion feature are not clearly and closely related

(e.g., the host is equity-like and it converts into debt or a debt-like security), an analysis pursuant to Box

I2 is necessary to determine whether bifurcation of the embedded conversion feature is required.

3.2.8.2 Contingently convertible stock

In a traditional convertible stock instrument, the holder may exercise its option to convert the stock into a

number of underlying securities at any time. In contrast, a contingently convertible instrument entitles the

holder to convert only after certain contingencies have been satisfied. The evaluation of a conversion

feature in any stock hybrid instrument will depend on whether the host instrument is considered an equity

host or a debt host (refer to section 3.2.6 for additional information regarding identifying the nature of

the host). In an equity host, the conversion feature will usually be considered to be clearly and closely

related to the equity host, even if it is contingently exercisable, and thus bifurcation would not be required.

3.2.8.3 Share-settled stock

Convertible stock typically provides the investor the ability to convert the stock into a fixed number

(only to be adjusted under certain events) of different shares of the issuer. As a result, the value the

holder receives upon conversion is based entirely on the price of the other shares. However, some stock

instruments may settle by providing the holder with a variable number of different shares with an

aggregate fair value that equals the stock instrument’s liquidation preference. In some cases, a slight

fixed discount to the fair value of the other share price may be used to determine the number of other

shares to be delivered, resulting in settlement in shares at a fixed premium.

Because the value that the holder receives at settlement does not vary with the value of the other

shares, that settlement provision is not considered a conversion option and the stock instrument would

not be considered convertible stock unless it also contained a conversion option (as discussed in

section 3.1.3.5). Instead, this provision should first be evaluated pursuant to ASC 480-10-25-14 (refer

to section A.6 for a discussion of the application of this guidance). If not subject to that guidance, the

provision should be evaluated as a redemption feature as described in section 3.2.9. A settlement

provision that is not a conversion option should be not considered under the BCF guidance (refer to

section 3.2.13).

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3.2.9 Box I(B) and Boxes I1, I2 and I3 — Evaluating embedded redemption

(put and/or call) features

A call option gives the issuer the right to repurchase the stock instrument, usually at par plus any

cumulative dividends or stated increases in liquidation preference. A call feature is usually intended to

enable the issuer to refinance an existing stock issuance with a lower cost alternative.

A put option gives the investor the right to sell the stock back to the issuer at an agreed upon or

determinable amount. This enables the investor to obtain liquidity if the stock is not regularly traded as

well as to exit an investment that is paying a below-market dividend rate.

Frequently, preferred stock instruments contain a put option that enables the investor to put the stock to

the issuer upon the occurrence of a deemed liquidation event (as defined in the agreement). Although

specific to each arrangement, common examples of deemed liquidation events include the following:

• A person or group becoming the direct or indirect ultimate beneficial owner of the issuer’s common

equity representing more than 50% of the voting power of the common equity

• Sale of all or substantially all of the issuer’s net assets

• Consummation of any share exchange, consolidation or merger of the issuer into another entity

• Continuing directors cease to constitute at least a majority of board of directors

• Shareholders approve any plan or proposal for the liquidation or dissolution of the issuing entity

• The issuer’s common stock ceases to be quoted or listed

If the redemption feature is triggered based on some kind of change in control, it is usually referred to as

a change of control put.

Depending on the specific terms of the instrument, embedded put or call options may be exercisable at

any time after issuance, after the passage of time (e.g., on or after the fifth anniversary) or upon the

occurrence of specified contingent events. Puts and calls may be structured to coincide with each other.

Similar to the evaluation of the embedded conversion option, redemption features are also assessed in

accordance with guidance provided in ASC 815-15-25-1.

The analysis of whether bifurcation is required changes based on whether the nature of the host stock

instrument is equity-like or debt-like. If stock is determined to have an equity host as discussed at

ASC 815-15-25-20, a redemption option is often not considered clearly and closely related to the equity

host, and the redemption feature should be evaluated to determine whether it meets the definition of a

derivative. If the redemption provision meets the definition of a derivative, the analysis then considers

whether the redemption feature, if freestanding, would receive an exception from derivative accounting.

The bifurcation analysis in this section addresses only stock with an equity host. Refer to section 2.2.5

for guidance on evaluating embedded redemption (put and call) features in hosts determined to be

debt instruments.

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3.2.9.1 Determining whether put and call features are considered clearly and closely related to an

equity host instrument

ASC 815-15-25-20 states that a put option that enables the holder to require the issuer of an equity

instrument to reacquire that equity instrument for cash or other assets is not clearly and closely related

to that equity instrument, and likewise a purchased call option by the issuer is not clearly and closely

related. Puts and calls embedded in equity hosts are also not clearly and closely related as their economic

characteristics and risks are unrelated to an equity interest, which is generally a residual interest that

would reside with an investor until the issuing entity ceased to exist. The ability for the holder to redeem,

or for the entity to force the holder to redeem, would not appear to be clearly and closely related to

holding that residual interest.

Because the economic characteristics and risks of a holder’s put and issuer’s call option are generally not

clearly and closely related to an equity host, any embedded put or call should be evaluated as to whether

it (a) meets the definition of a derivative if it were freestanding (Box I2) and (b) if so, whether there is an

exception from derivative accounting (Box I3).

3.2.9.2 Determining whether put and call features meet the definition of a derivative subject to

derivative accounting

An embedded feature is a derivative pursuant to ASC 815 only if it meets the four characteristics of a

derivative. A redemption feature would likely have the first three characteristics of a derivative in

ASC 815-10-15-83, but may not have the fourth, based on the following:

• Underlying — The market price of the stock is the underlying in an equity-linked instrument.

• Notional amount — The number of shares of common or an amount of liquidation preference of

preferred is the notional amount.

• No initial net investment — The fair value of the embedded redemption feature at inception (not the

initial investment in the stock instrument) is generally substantially less than the fair value of the

underlying stock.

• Net settlement — Redemption features generally require settlement via gross physical delivery

(i.e., delivery of the stock to the issuer in exchange for delivery of cash to the investor). Gross settlement

would not meet the net settlement requirement unless the stock is readily convertible to cash, as that

phrase is interpreted in ASC 815, in which case the gross physical settlement qualifies as net settlement

because it puts the recipient in a position not substantially different from net settlement.

For example, a share of a publicly traded company is generally considered readily convertible to cash

unless the market for the shares is not active and the number of shares to be exchanged (given the

smallest increment available for conversion) is large relative to the daily trading volume of the

underlying shares. However, if the underlying share is equity of a private company, the redemption

feature would generally not meet the net settlement criteria in a physical settlement. However, active

trading by a large enough group of the equity owners could result in a conclusion that a common share is

readily convertible to cash and therefore a gross physical settlement meets the net settlement criterion.

Refer to section 2.4.4 of our FRD publication, Derivatives and hedging, for further guidance on net

settlement.

If the redemption feature does not meet all of the characteristics of a derivative pursuant to ASC 815-10-15-83,

it should not be bifurcated from its equity host. If the redemption feature does meet all of the characteristics

of a derivative pursuant to ASC 815-10-15-83, it should be analyzed to determine whether it is eligible

for an exception from derivative accounting pursuant to ASC 815-10-15-13.

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3.2.9.3 Exceptions from derivative accounting

Notwithstanding that an embedded feature, if freestanding, may meet all the characteristics of a

derivative, an embedded feature should not be bifurcated if the feature is eligible for any of the scope

exceptions provided by ASC 815. The most common exception for an equity redemption feature is

provided by ASC 815-10-15-74(a), which states that contracts issued or held by that reporting entity that

are both (1) indexed to its own stock and (2) classified in stockholders’ equity in its statement of financial

position are not considered derivative instruments in the scope of ASC 815. That analysis draws on the

indexation and classification guidance in ASC 815-40 related to contracts in an entity’s own stock.

Appendix B includes a comprehensive discussion of those concepts.

3.2.9.3.1 Meaning of ‘indexed to issuer’s own stock’

To determine whether an equity redemption feature is indexed to its own stock, it should be analyzed

pursuant to ASC 815-40-15-5 through 15-8, including the related implementation guidance. The

examples in ASC 815-40-55-26 through 55-48 should, in particular, be considered. This guidance is

referred to throughout this publication as “the indexation guidance.”

The indexation guidance requires a two-step evaluation of an instrument or feature. In the first step, any

contingent exercise provisions are evaluated, and in the second step, an analysis of features that could

change the instrument’s settlement amount is conducted.

In the first step, an exercise contingency (as defined in the indexation guidance) does not preclude an

instrument (or embedded feature) from being considered indexed to an entity’s own stock provided that

it is not based on either of the following:

a. An observable market, other than the market for the issuer’s stock (if applicable)

b. An observable index, other than an index calculated or measured solely by reference to the issuer’s

own operations (e.g., sales revenue of the issuer, earnings before interest, taxes, depreciation and

amortization of the issuer, net income of the issuer, total equity of the issuer)

In the second step, an instrument (or embedded feature) is considered indexed to an entity’s own stock if

its settlement amount equals the difference between (1) the fair value of a fixed number of the entity’s

equity shares and (2) a fixed monetary amount or a fixed amount of a debt instrument issued by the

entity. While the second step appears to be a very strict fixed-for-fixed concept, an exception is provided

such that if the instrument’s strike price or the number of shares used to calculate the settlement

amount is not fixed, the instrument (or embedded feature) could still be considered indexed to an entity’s

own stock if the only variables that could affect the settlement amount would be inputs to a fair value

valuation model for a fixed-for-fixed forward or option on equity shares. Accordingly, any feature that

adjusts the embedded redemption feature should be carefully analyzed.

Many redemption features (1) have either no contingencies or contingencies that are solely related to the

issuer and (2) settle by delivering the shares (a fixed number of shares) to the issuer in exchange for a

fixed amount of cash (the redemption price), and thus are considered indexed to the issuer’s stock.

An equity redemption feature that is not considered indexed to the issuer’s own stock would not qualify

for the scope exception in ASC 815-10-15-74(a) and should be bifurcated.

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3.2.9.3.2 Meaning of ‘classified in stockholders’ equity’

To determine whether an equity redemption feature would be classified in stockholders’ equity if

considered freestanding, ASC 815-40-25-1 through 25-43 should be considered, including the related

implementation guidance (primarily codified in ASC 815-40-55-2 through 55-18). This guidance is

referred to throughout this publication as “the equity classification guidance.”

The equity classification guidance generally indicates that an equity redemption feature on a company’s

own stock, if freestanding, would be considered to be classified in equity under either of the following

types of settlement:

• Required physical settlement or net share settlement

• Issuer has choice of net cash settlement or settlement in its own shares (physical settlement or net

share settlement), regardless of the intent of the issuer

In contrast, an equity redemption feature would not be considered to be classified in equity if either of

the following provisions is present:

• Required net cash settlement (including a requirement to net cash settle if an event occurs that is

outside the control of the issuer)

• Holder has choice of net cash settlement or settlement in shares (physical settlement or net

share settlement)

ASC 815-40-25-7 through 25-38 include additional conditions that must be met for equity classification.

If any condition (as summarized below) is not met for a stock instrument, the equity redemption feature

would not be considered to be classified in stockholders’ equity and should be bifurcated:

• Settlement is permitted in unregistered shares

• Entity has sufficient authorized and unissued shares

• Contract contains an explicit share limit

• No required cash payments if entity fails to timely file

• No cash settled top-off or make-whole provisions

• No counterparty rights rank higher than shareholder rights

• No collateral requirements

An equity redemption feature typically requires the investor to deliver the underlying share in return for

the consideration in a gross physical settlement. As the issuer does not typically deliver shares in

settlement, and gross physical settlement meets the criteria to be classified in equity (even though the

issuer must deliver cash), bifurcation is generally not required.

3.2.9.4 Stock of a consolidated subsidiary that includes redemption rights

Refer to section 5.10.2.4 for guidance on redeemable NCI.

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3.2.10 Box I(C) and Boxes I1, I2 and I3 — Evaluating other potential embedded features

A stock instrument may have a variety of features that can affect the timing and amount of future cash

flows in a way similar to a derivative. Those features should be evaluated pursuant to the criteria in

ASC 815 (discussed above in section 3.2.7) to determine if they require bifurcation. A careful analysis of

the underlying agreements is necessary to identify all potential features to be evaluated.

While not all instruments have potential embedded derivatives, some of the more commonly observed

features in practice are exchange features, rights offering features, indexed dividends and poison pill features.

3.2.10.1 Exchange features

Exchangeable preferred stock or convertible exchangeable preferred stock is typically issued in a form that

is identical to preferred stock or convertible preferred stock, except that it contains a provision that permits

the issuer to call (or the investor to put) the preferred stock from the investor and, in consideration, the

issuer issues debt to the investor with the same economics as the redeemed preferred stock.

As discussed in section 3.2.7, the exchange feature should be evaluated as to whether it is clearly and

closely related to the host instrument and, if not, whether it meets the definition of a derivative pursuant

to ASC 815. If the exchange option meets the definition of a derivative, it is unlikely that such a feature

would qualify for any scope exceptions in ASC 815. In particular, the scope exception ASC 815-10-15-74(a)

that is often available to conversion features generally should not be applied as those exchange features

are not indexed to, and would not be classified in, the issuer’s equity.

The exchange feature should also be considered in evaluating the preferred stock for temporary or

permanent equity classification. If the exchange feature can be exercised only by the issuer at the

issuer’s option, permanent equity classification would be appropriate assuming no other features required

temporary equity classification. However, if the exchange feature is exercisable by the investor or upon

an event that is outside the control of the issuer, the exchange feature would require the preferred stock

to be classified in temporary equity as the instrument would ultimately be settled in cash (with the maturity

of the subsequent debt). Refer to section 3.2.14 and Appendix E for further guidance on temporary and

permanent equity classification.

Another form of an exchangeable preferred share is a preferred share that may be, or is required to be,

exchanged for common shares of another issuer (e.g., a PRIDES (preferred redeemable increased dividend

equity security)). If the exchangeable preferred share is not required to be classified as a liability pursuant

to ASC 480, the embedded exchange feature should be evaluated for bifurcation. If the exchange feature

meets the net settlement requirements pursuant to ASC 815 (refer to section 3.2.7.3), the feature will

likely require bifurcation. This bifurcation analysis is similar to that of debt exchangeable into the common

stock of another issuer, which is discussed in section 5.1.

3.2.10.2 Rights offering features

Rights offering features generally provide investors with the right to purchase additional shares of the

issuer and may be freestanding instruments or embedded in shares. Embedded preemptive rights or

privileges issued or granted to shareholders to purchase shares should be carefully evaluated as to

whether they are clearly and closely related to an equity host, and if not, further analyzed pursuant to

ASC 815-15-25-1, as discussed in section 3.2.7. In general, rights offering features that are embedded

in a share are clearly and closely related to an equity host contract.

Rights offerings that are freestanding financial instruments should be evaluated pursuant to ASC 480

and ASC 815. Refer to section 4.2 for guidance on freestanding equity contracts.

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3.2.10.3 Indexed dividends

Some preferred shares may have a variable dividend rate that is tied to an external index, such as LIBOR

or US Treasury rates or a commodity price. External references for dividends, particularly such as a

quoted interest rate or index, should be considered for bifurcation from an equity host contract.

One view is that an issuer can always choose how to calculate the amount of dividends distributed for

instruments without a stated dividend, so selecting a method in advance (i.e., stating the use of an index)

should not preclude the dividends from being considered clearly and closely related to its equity host,

particularly for dividends that are a liability only when, if and as declared.

Under another view, the movement of an external index may be deemed unrelated to the equity host

and, therefore, a dividend linked to such an index would not be considered clearly and closely related.

The use of an index that bears some relation to the issuer, its operations or general financial concepts is

more likely to be found clearly and closely related to an issuer’s ability to generally set its dividend policy

in an economically rational manner.

We generally believe judgment should be applied based on the individual facts and circumstances when

determining whether indexed dividends are clearly and closely related to the equity host.

3.2.10.4 Shareholders’ rights plans (Poison pills)

Shareholders’ rights plans are arrangements, often in the form of a contingent rights offering, with current

shareholders that permit companies to potentially defend against hostile takeovers by making such actions

overly expensive through the immediate dilution of the acquirer’s accumulated position. Those plans encourage

direct negotiations with the target’s board of directors and are typically activated by an acquisition of a large

block of the target entity’s shares. Those strategies are also known as poison pills. Those arrangements

can take various forms and may include a combination of rights, the most common of which include:

• Flip-over or shareholders’ rights plan — The most common type of arrangement. Under this plan, the

holders of common stock of an entity receive certain rights for each share held, which allow them an

option to buy or receive more shares in the entity, generally at a deeply discounted price, if anyone

acquires more than a prescribed percentage of the entity’s stock.

• Flip-in plan — A variation of the flip over is the flip-in plan. This plan allows the rights holder to

purchase shares in the target entity at a discount in the event an acquiring entity were to merge or

otherwise combine with the target entity.

• Voting poison pill plan — Under this plan, the target entity issues a dividend of securities, conferring

special voting privileges to its stockholders. For example, the target entity might issue shares that do

not have special voting privileges at the outset. When a potential hostile bid occurs, the stockholders,

other than the acquiring party, receive super voting privileges.

While the specific facts and circumstances for each arrangement should be carefully evaluated, those

protective plans are typically initiated by issuing certain rights to existing shareholders in the form of a

dividend. Generally, those rights are not transferable separately from the underlying common stock and all

further issuances of common stock (including stock issued in connection with the exercise of outstanding

options) include those rights. Additionally, those rights are frequently cancelable or redeemable at the

option of the issuing entity (e.g., on a vote of the board of directors) for a de minimis amount.

The original dividend of those rights to existing shareholders should be recorded at fair value, which may not

be significant given the contingent nature of the rights as well as the de minimis call feature. Because those

rights are typically considered embedded in the underlying shares after issuance, they should be evaluated

pursuant to ASC 815. Many of those embedded rights will be considered clearly and closely related to the

underlying equity host and, therefore, do not require separate accounting. If the plan is activated and the

rights can transfer or trade separate from the share, then their classification should be reevaluated.

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Careful consideration of the specific rights, including the terms of the instruments for which those rights

may be exercisable into, is required to determine the appropriate accounting.

3.2.11 Box J — Bifurcation of a single embedded derivative

ASC 815-15-25-7 through 25-10 indicates that an entity should not account separately for more than

one derivative feature embedded in a single hybrid instrument. As a result, after identifying, evaluating

and concluding on which features of a share require bifurcation, a single derivative comprising all the

bifurcatable features should be separated from the host instrument. This unit of account for bifurcation

may be different than the unit of analysis for bifurcation as discussed in section 3.2.7.1.

ASC 815-15-30-2 requires the embedded derivative (whether a single feature derivative or a compound

derivative) to be recorded at fair value. The difference, if any, between the proceeds allocated to the

hybrid stock instrument (refer to section 1.2.3.3) and the fair value of the bifurcated derivative is

assigned to the host stock instrument.

Refer to section 3 of our FRD publication, Derivatives and hedging, for further guidance on embedded

and compound derivatives, including defining option-based and forward-based embedded derivatives.

Stock that contains a potentially cash-settled embedded feature (e.g., redemption feature) should be

evaluated in Box P to determine whether temporary equity classification is required, even if the

embedded feature is bifurcated. Refer to section 3.2.14 and Appendix E for further guidance.

3.2.11.1 Option-based embedded derivatives

ASC 815-15-30-6 states that the terms of an option-based embedded derivative should not be adjusted to

result in the embedded derivative being at the money at the inception of the hybrid instrument. Rather, the

option-based embedded derivative should be bifurcated based on the stated terms documented in the

hybrid instrument whether the option is in the money, at the money or out of the money at inception.

3.2.11.2 Forward-based embedded derivatives

ASC 815-15-30-4 states that in separating a non-option (forward-based) embedded derivative from the

host contract, the terms of that non-option embedded derivative should be determined in a manner that

results in its fair value generally being equal to zero at the inception of the hybrid instrument. This concept

is illustrated at ASC 815-15-55-160.

3.2.11.3 Financial statement classification

Bifurcated derivatives are presented as assets or liabilities. The individual facts and circumstances should

be considered in classifying such an asset or liability as current or noncurrent in the balance sheet.

ASC 815 does not specifically address the classification of changes in the fair value of derivatives (including

bifurcated derivatives) but requires disclosure as to where the changes are reported in the statement of

financial performance. The disclosures in ASC 815 are required for bifurcated embedded derivatives. Refer

to section 8 of our FRD publication, Derivatives and hedging, for further discussion of derivatives

disclosures and financial statement presentation considerations.

3.2.12 Boxes K and L — Non-bifurcated features including conversion options and

redemption features

An embedded conversion option that has not been bifurcated should be evaluated pursuant to the

guidance in Box N for conversion options that have a positive intrinsic value (i.e., conversion price is less

than the fair value of the share) at issuance. Those BCFs are further evaluated in section 3.2.13.

If a feature is not bifurcated, and does not require further accounting under other guidance, it remains with

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the host instrument and no proceeds should be allocated to the embedded feature. However, there may be

accounting consequences for subsequent measurement and presentation as discussed in section 3.4.3.2.

An embedded redemption feature that has not been bifurcated should be evaluated in Box P pursuant to

the SEC staff’s guidance on equity-classified instruments that may be redeemable outside the control of

the issuer. This guidance may require temporary (mezzanine equity) classification for the entire share or

a portion of the share. Refer to section 3.2.14 and Appendix E for further guidance.

3.2.13 Boxes M, N and O — Beneficial conversion features and contingent beneficial

conversion features

A conversion option that is not bifurcated as a derivative pursuant to ASC 815 (Box I) should be

evaluated to determine whether it is considered a beneficial conversion option at inception or may

become beneficial in the future due to potential adjustments (often referred to as a contingent beneficial

conversion option). The guidance on BCFs is in ASC 470-20.

The Master Glossary to ASC 470-20 defines a BCF as “a nondetachable conversion feature that is in the

money at the commitment date.” An option is in the money if its exercise price (conversion price for

convertible stock) is less than the current fair value of the share.

For example, preferred stock issued at $100 that is convertible into 10 shares has a stated conversion price of

$10 per share. That conversion option would be in the money if the current share price at the commitment

date (usually the issuance date) was more than $10, making immediate conversion beneficial to the investor.

If the share price were $12 per share at the commitment date, the investor could convert the preferred

stock into 10 shares worth $120 (10 shares times $12), which is more than the initial investment of $100.

It is this immediate $20 benefit that the BCF guidance attempts to measure.

The BCF guidance generally requires embedded BCFs present in convertible securities to be valued

separately (at intrinsic value rather than fair value) and allocated to APIC. The BCF guidance states that

the effective conversion price, which may be different than the contractual conversion price, is used to

determine the existence of a BCF. The effective conversion price is based on the proceeds received or

allocated to the convertible stock instrument (including embedded features), and the amount is

measured as of the commitment date.

For example, despite having a contractual conversion price of $10 per share, the convertible preferred

stock in the example above would have an effective conversion price of $9 per share if the $100 par

amount preferred stock had been issued at $90 ($90 proceeds received divided by the 10 shares into

which it could be converted). That initial $10 discount could result from simply issuing the convertible

preferred stock at a discount, or more likely from allocating part of the proceeds of issuance to other

instruments in a basket transaction.

The BCF guidance states that costs of issuing convertible instruments paid to third parties do not affect

the effective conversion price and calculation of the intrinsic value of an embedded conversion option.

Any amounts paid to the investor as issuance costs represent a reduction in the proceeds received by the

issuer and should affect the calculation of the intrinsic value of an embedded option.

If an embedded derivative requires bifurcation from the stock (e.g., a put or call option), we do not

generally believe it affects the proceeds considered in determining the effective conversion price unless

that feature could be separately settled prior to or contemporaneous with the conversion of the instrument.

Because BCFs are measured on the commitment date, that date should be carefully evaluated. Purchase

agreements that may permit either party to rescind its commitment to consummate the transaction

(e.g., due to material adverse change in the issuer’s operations or financial condition, customary due

diligence, shareholder approval) generally do not establish a commitment date.

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A convertible stock instrument may contain conversion terms (i.e., the conversion ratio or conversion

price) that change upon the occurrence of a possible future event. Those changes may give rise to

contingent BCFs that are generally measured at the commitment date at intrinsic value and recognized

upon the occurrence of the contingent event.

After allocating the intrinsic value of the BCF to APIC, the remaining proceeds are allocated to the equity

host. It is from those proceeds that any embedded derivative is bifurcated.

Refer to Appendix D for a comprehensive discussion of the accounting for BCFs.

3.2.14 Box P — Temporary equity classification

ASC 480-10-S99-3A provides guidance on the classification and measurement of redeemable securities.

That guidance, issued by the SEC staff, requires classification in temporary equity of securities

redeemable for cash or other assets if they are redeemable under any of the following conditions:

• At a fixed or determinable price on a fixed or determinable date

• At the option of the holder

• Upon the occurrence of an event that is not solely within the control of the issuer

A feature, whether or not bifurcated, that permits or requires the holder to exchange stock for cash or

other assets (e.g., put option in stock) will likely cause the stock to be considered redeemable. Public

entities should consider the redeemable equity guidance when classifying the stock. An item classified in

temporary equity is classified after liabilities but before equity in the statement of financial position and

cannot be included in any subtotal for equity, if one is presented.

Determining whether the redemption of an equity security is within the control of the issuer can be complex

and all of the individual facts and circumstances should be considered. For instruments potentially settled in

the issuer’ shares (such that cash or assets may not be necessary), this includes evaluating whether there is

any scenario in which the issuer may not be able to settle the redemption feature with its own stock pursuant

to the equity classification guidance in ASC 815-40-25. In the absence of assurance that settlement in shares

is within the control of the issuer, classification outside of permanent equity is required.

ASC 480-10-S99-3A states that stock classified in temporary equity should be initially measured at its

fair value on the date of issuance. Such instruments will have ongoing measurement, disclosure and EPS

considerations resulting from the conclusion that they are redeemable outside the control of the issuer.

Refer to Appendix E for further guidance on redeemable securities.

3.3 Share issuance costs

Stock issuances may be either classified in equity or as a liability. Issuance costs for stock requiring

liability classification pursuant to ASC 480 should follow the accounting for debt issuance costs. Refer to

section 2.3 for further guidance.

For stock that is classified in equity, direct and incremental costs related to its issuance such as legal

fees, printing costs and bankers’ or underwriters’ fees, among others, should be accounted for as a

reduction in the proceeds of the stock, and are considered a component of any premium or discount on

preferred stock. Internal costs that meet the incremental and direct criteria (e.g., travel costs directly

related to financing) may also be accounted for as a reduction in proceeds, but costs such as salaries,

rent and other period costs may not be capitalizable as issuance costs.

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For stock classified in equity, stock issuance costs are not amortized or accreted unless the stock is classified

in temporary equity and the carrying amount is being accreted to its full redemption amount pursuant to

ASC 480-10-S99-3A. Refer to section 3.2.14 for further guidance on temporary equity classification.

ASC 340-10-S99-1 states that, prior to the effective date of an offering of equity securities, specific

incremental costs directly attributable to a proposed or actual offering of securities may be deferred and

charged against the gross proceeds of the offering. In addition, ASC 340-10-S99-1 states that deferred

costs of an aborted offering may not be deferred and charged against proceeds of a subsequent offering.

A short postponement (up to 90 days) does not represent an aborted offering.

Cash payments for stock issuance costs should be classified in the statement of cash flows as a financing

activity together with the proceeds from the issuance of the stock by analogy to ASC 230-10-45-15.

3.4 Selected guidance on subsequent accounting and measurement

3.4.1 General

Depending on the terms of the stock instrument issued, there may be several subsequent accounting

considerations.

3.4.2 Stock that is classified as a liability due to the provisions of ASC 480

Stock that is classified as a liability follows the subsequent measurement guidance specified in ASC 480.

In general, a mandatorily redeemable instrument that has (1) a fixed redemption amount and (2) a fixed

redemption date should be accreted to the redemption amount using the effective interest method. If

the redemption amount varies (e.g., the redemption amount is based on a formula or is equal to the

instrument’s fair value) or the redemption date is unknown (e.g., must be redeemed upon the death of

the holder), the instrument should be carried at the amount of cash that would be paid under the

conditions specified in the contract if the shares were repurchased or redeemed at the reporting date.

Refer to section A.4 for further guidance on mandatorily redeemable instruments.

A share that is classified as a liability because it represents an unconditional obligation to issue a variable

number of shares whose monetary value is predominantly (1) fixed, (2) varies with something other than

the fair value of the issuer’s equity shares or (3) varies inversely related to changes in the fair value of

the issuer’s equity shares shall be classified as a liability, is subsequently remeasured pursuant to

ASC 480. Refer to section A.6 for further guidance on those instruments.

Shares that are classified as liabilities are eligible to be measured at fair value pursuant to the fair value

option provided no component of the share is classified in equity. If the fair value option is elected for an

instrument at inception, fair value should be measured pursuant to the guidance in ASC 820 and all

subsequent changes in fair value for that instrument are reported in earnings.

Refer to our FRD publication,

Fair value measurement, for further guidance on fair value measurement.

3.4.3 Stock that is classified in equity

If stock is not required to be classified as a liability pursuant to ASC 480, it is classified as either permanent or

temporary equity. Regardless of the section in equity in which the stock is classified, there may be some

features associated with the stock that require separate accounting and measurement, including the following:

• Premiums, discounts and issuance costs (section 3.4.3.1)

• Embedded features not bifurcated from an equity host instrument (section 3.4.3.2)

For financial liabilities measured using the fair value option under ASC 825-10 or ASC 815-15, ASC 825-10-45-5 requires entities to

recognize changes in the fair value of liabilities caused by changes in instrument-specific credit risk (own credit risk) in other

comprehensive income.

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• Embedded features bifurcated from an equity host instrument as a derivative and classified as an

asset or liability (section 3.4.3.3)

• Beneficial conversion features (section 3.4.3.4 and Appendix D)

3.4.3.1 Premiums, discounts and issuance costs

Preferred stock may be issued either at par, a discount or a premium. Premiums or discounts (generally

on preferred shares) may arise for several reasons, including the following:

• Allocating proceeds to multiple instruments upon issuance (e.g., when stock is issued with

detachable warrants and the proceeds are allocated between the two elements)

• Bifurcating embedded derivatives in accordance with ASC 815 (e.g., certain put/call features or

conversion options)

• Separating a BCF under the BCF guidance

• Issuing a preferred share with a stated dividend rate that is higher or lower than the market rate

Premiums or discounts on stock classified in permanent equity should generally not be accreted or

amortized. However, a discount arising from the recognition of a BCF is amortized and treated as a deemed

dividend. Discounts on stock classified in temporary equity may require accretion depending on the

application of the SEC staff’s subsequent measurement guidance for redeemable equity.

Costs associated with equity-classified stock are considered an adjustment to the proceeds of the stock,

and therefore reduce the carrying amount of the stock. For stock classified in permanent equity, stock

issuance costs are not amortized. For stock classified in temporary equity, stock issuance costs may be

required to be amortized in certain cases. However, issuance costs are considered part of the carrying

amount of the stock in an extinguishment or conversion. Stock issuance costs are discussed in section 3.3.

Refer to sections 3.4.3.5, 3.4.3.6 and 3.4.3.4 for further guidance on permanent equity classification,

temporary equity classification and discounts from BCFs, respectively.

3.4.3.2 Embedded features not bifurcated from an equity host instrument

The subsequent accounting for embedded features not bifurcated from their host instrument is based on

the nature of the feature. The following are common examples:

• Call option — A non-bifurcated call feature in stock that is redeemable by the issuer generally is not

accounted for until the stock is called, at which time the appropriate settlement accounting is

applied. Refer to section 3.5.1 for further discussion.

• Put option — A non-bifurcated put feature in stock that is redeemable at par by the investor generally

is not accounted for until the stock is redeemed, at which time the appropriate settlement accounting

is applied. However, for SEC registrants, the put feature likely requires consideration of the

redeemable equity guidance. Refer to section 3.4.3.6 for further discussion.

• Conversion option — A non-bifurcated or non-separated conversion feature in convertible stock is

not accounted for until conversion. At that time, conversion accounting is applied as discussed in

section 3.5.2.

• Increasing rate dividend — The non-bifurcated increasing rate dividend provision is accounted for in

accordance with ASC 505-10-S99-7. Refer to an additional discussion in section 3.4.5.9.

If the embedded feature was not bifurcated from the instrument at issuance, it should be reassessed at

each reporting date to determine that continued non-bifurcation is appropriate.

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3.4.3.2.1 Embedded features reassessment

Embedded features that are not clearly and closely related to the equity host, yet not bifurcated on

issuance either because the embedded feature (1) did not meet the definition of a derivative pursuant to

ASC 815 or (2) met that definition but also qualified for an exception from derivative accounting (refer to

section 3.2.7 for further discussion) should be reassessed at each reporting date. Such a feature may

meet the definition of a derivative at some point in the future or lose its exception from derivative

accounting and require bifurcation at that time.

In reassessing embedded features for bifurcation, the initial conclusion of whether that feature was

clearly and closely related to the host instrument pursuant to ASC 815-15-25-1(a) is not reevaluated (by

analogy to ASC 815-15-25-27). Accordingly, if initially deemed clearly and closely related (and therefore

not bifurcated), that feature would not be bifurcated in the future. While not clear in the guidance, we

generally believe that modifications of a stock instrument may require the embedded features be

reevaluated, given that the modification results in a changed legal arrangement. This determination

should be made based on the individual facts and circumstances.

In reassessing the definition of a derivative, the characteristics of having an underlying or an initial net

investment generally will not change with time. However, the application of the net settlement criteria

may change. A contract that was (or was not) net settleable by its contractual terms will likely remain as

such through its life. However, a market mechanism to facilitate net settlement may emerge over time or

an asset to be delivered in a physical settlement may become readily convertible to cash. ASC 815

requires the reconsideration of those elements (refer to ASC 815-10-15-118 and 15-139, respectively).

For example, a typical embedded feature (e.g., redemption feature) may not have met the definition of

a derivative if gross settlement was required and the stock was not actively traded on an exchange

(i.e., the underlying shares were not readily convertible to cash). If the issuer’s stock were to actively

trade on an exchange, the embedded derivative would meet the net settlement criterion on that date and

should be further evaluated for bifurcation (i.e., evaluated for an exception from bifurcation).

As another example, a public issuer with limited transaction volume for its shares relative to the

conversion shares may develop additional volume such that the conversion shares are now considered

readily convertible to cash. Refer to ASC 815-10-55-101 through 55-108 for further guidance.

With respect to the reassessment of any scope exceptions, the most common exception from bifurcation

for equity redemption features is pursuant to ASC 815-10-15-74(a), which requires an evaluation of

whether the feature is indexed to the issuer’s own stock and would be classified in stockholders’ equity

as follows.

• Reassessment of the indexation guidance — The conclusion under the indexation guidance generally

would not be expected to change unless the contractual terms have changed.

For an embedded equity-linked feature (e.g., redemption feature) that meets the definition of a

derivative for the first time (e.g., preferred stock becomes actively traded making it readily

convertible to cash), the embedded feature should be assessed at that time for the exception

pursuant to ASC 815-10-15-74(a), if applicable. That assessment would be made under the then-

current circumstances to determine if the feature is considered indexed to the issuer’s shares.

• Reassessment of the equity classification guidance — In reassessing the criteria for equity

classification related to settlement alternatives, a particular focus should be on the availability of

shares to settle the instrument.

In accordance with ASC 815-40-35-8, this reassessment of the exception from derivative accounting

under ASC 815-10-15-74(a) should be performed at each reporting date for those features that meet

the definition of a derivative.

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3.4.3.2.2 Subsequent bifurcation

While ASC 815 requires the reassessment of embedded features for potential bifurcation at each

reporting date, it does not provide explicit guidance on how to bifurcate an embedded feature after the

issuance date. One approach, which is based on the literal application of ASC 815, would be to bifurcate

the embedded derivative as of the date it was required to be bifurcated at its then-current fair value from

the carrying amount of the host instrument and recognize it as an asset or liability. This accounting is the

same as the initial issuance of the instrument. There may be other reasonably supportable methods of

bifurcation. Subsequent changes in fair value should be recognized in earnings.

When determining the fair value of the feature to be bifurcated, an option-based feature would use the

contractual terms (refer to section 3.2.11.1) and a forward-based feature would use the terms that would

have implied a fair value equal to zero at the initial issuance of the instrument (refer to section 3.2.11.2).

3.4.3.3 Embedded features bifurcated from an equity host instrument as a derivative and

classified as an asset or liability

Embedded features that were bifurcated from the equity host instrument upon issuance and are

classified as an asset or a liability are measured at fair value at each reporting date with changes in fair

value recognized in earnings. Refer to section 3 of our FRD publication, Derivatives and hedging, for

further discussion on embedded derivatives.

Bifurcated derivatives should be reassessed every reporting period to determine if they continue to

require bifurcation. That is, they are reassessed to see if they still meet the definition of a derivative and

still fail to qualify for any scope exception from derivative accounting. For example, an embedded feature

may subsequently qualify for the exception from derivative accounting pursuant to ASC 815-10-15-74(a).

This could result from the lapse of a noncompliant contractual term, or the authorization of additional

shares (if there had been an insufficient number of shares to settle the feature).

An issuer may amend the terms of an agreement to qualify for the exception from derivative accounting.

In those cases, the issuer should consider the accounting for the modification of the instrument.

If a bifurcated feature no longer requires bifurcation, it should be reclassified to equity at its then fair value.

Gains and losses recognized to account for the feature at fair value during the period of bifurcation should

not be reversed.

3.4.3.4 Beneficial conversion features

Conversion features should be reassessed under the BCF guidance at each balance sheet date. An

instrument may become convertible only upon the occurrence of a future event outside the control of

the holder or may be convertible from inception but contain conversion terms that change (and either

become beneficial or more beneficial through the resolution of a contingency). Such contingent BCFs

(or contingent adjustments to BCFs) are measured at the commitment date, but are not recognized,

until the contingency is resolved.

Convertible instruments within the scope of the beneficial conversion guidance should follow

the guidance on amortization of discounts arising from the recognition of a BCF pursuant to

ASC 470-20-35-7. Pursuant to that guidance, the discount resulting from the separation of the BCF

from the share should be amortized as a deemed dividend.

For stock with no stated redemption date, that guidance requires amortization of a BCF discount over

a minimum period from the date of issuance to the earliest conversion date. Stock with no stated

redemption date that is convertible at issuance would require full amortization of the discount at issuance.

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BCF discounts on convertible instruments with a stated redemption date should be amortized over the

period from the date of issuance to the stated redemption date using the effective yield method. While

that redemption date would be the maturity date, we also believe the redemption date could be

reasonably interpreted to be the first date at which the holder could put the instrument. We generally

believe the first conversion date should not be considered unless an instrument has no stated redemption

date. We generally believe, based on pre-Codification guidance, that discounts retain their character

when evaluating amortization periods. For example, a discount on a preferred stock from the allocation

of proceeds to a warrant issued at the same time would be evaluated for amortization separately from a

discount created by recognizing a BCF. For SEC registrants, other discounts on perpetual preferred stock

that has no stated redemption date but that is required to be redeemed if a future event that is outside the

control of the issuer occurs (such as a change in control) is accounted for pursuant to ASC 480-10-S99-3A.

Refer to section D.4 for further discussion of the subsequent measurement of BCFs.

3.4.3.5 Stock that is classified in permanent equity

Stock that is classified in permanent equity is not subsequently remeasured. Equity issuance costs, premiums

and discounts recognized for stock classified in permanent equity are generally not accreted or amortized

except for discounts arising from the recognition of a BCF. Refer to section 3.4.3.4 for further discussion.

ASC 480-10-S99-3A requires equity instruments to be evaluated on an ongoing basis for temporary equity

classification. For example, a company with redeemable preferred securities settleable in the company’s own

stock that were initially classified in permanent equity may issue convertible debt resulting in the number of

shares issuable under all outstanding instruments exceeding the number of authorized but unissued shares

available for the preferred securities. As the settlement of the redeemable preferred stock in shares no

longer would be within control of the company, temporary equity classification would be required.

ASC 480-10-S99-3A does not provide specific guidance on reclassifications of instruments from

permanent into temporary classification. We believe one reasonable approach would be to reclassify

the security at its fair value as of the date of the event that caused reclassification. By analogy to the

guidance in ASC 815-40-35-9 on reclassifying contracts from permanent equity to assets or liabilities,

any difference between the fair value of the security to be recorded in temporary equity and the previous

carrying value of the security recorded in permanent equity would be accounted for as an adjustment to

shareholder’s equity (i.e., APIC). There may be other acceptable methods.

Refer to Appendix E for further guidance on these instruments.

3.4.3.6 Stock that is classified in temporary equity

ASC 480-10-S99-3A provides subsequent measurement guidance for situations where (1) the stock is

currently redeemable, (2) the stock is not currently redeemable but probable of becoming redeemable and

(3) the stock is not currently redeemable and not probable of becoming redeemable. ASC 480-10-S99-3A

also provides guidance on reclassifications of instruments into permanent equity.

Refer to Appendix E for further guidance on those instruments.

3.4.3.7 Stock classified in equity (temporary or permanent) that becomes mandatorily

redeemable subsequent to issuance

While an instrument that must be redeemed upon or after the occurrence of an event that is not certain

of occurrence is not required to be accounted for as a liability pursuant to ASC 480, once the event

becomes certain of occurrence, that instrument should be reclassified to a liability. The term “certain of

occurrence” should not be confused with “probable” or even “highly probable.” Often, an event will not

be certain of occurrence until it actually occurs. The assessment of whether a contingently or optionally

redeemable instrument has become mandatorily redeemable pursuant to ASC 480 should be made

throughout the life of the instrument.

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For example, a common type of contingently redeemable shares is preferred stock the holder can put to the

issuer for redemption at any time. This type of preferred stock becomes mandatorily redeemable when the

holder notifies the issuer that it is exercising its put option. In some cases, the issuer is allowed a specified time

period (e.g., 30 days) to satisfy the put. However, once the holder has notified the issuer of the exercise of

the put option, the instrument becomes mandatorily redeemable and should be reclassified to a liability.

Preferred stock that becomes mandatorily redeemable pursuant to ASC 480 should be reclassified to a

liability at fair value. For SEC registrants, that reclassification is considered the settlement of the equity

instrument in consideration for the issuance of a liability pursuant to ASC 260-10-S99-2. The difference

between the fair value and the carrying amount (whether classified as permanent or temporary equity)

should be recognized in retained earnings as a deemed dividend. Refer to section 3.5.1.2 for further

guidance on the extinguishment of preferred shares.

3.4.4 Capital restructuring

ASC 505-20-20 defines a stock split as follows:

“an issuance by a corporation of its own common shares to its common shareholders without

consideration and under conditions indicating that such action is prompted mainly by a desire to

increase the number of outstanding shares for the purpose of effecting a reduction in their unit

market price and, thereby, of obtaining wider distribution and improved marketability of the shares.

Sometimes called a stock split-up.”

The accounting for stock splits is primarily governed by ASC 505-20. Unless required under corporate

law, no accounting is required for stock splits other than potentially recording the incremental par value

of the newly issued shares. To the extent an incremental par value is required to be recorded, the

amount should be offset against APIC.

Reverse stock splits are the cancellation of issued and outstanding shares on a pro-rata basis and are

generally intended to decrease the number of outstanding shares and thus increase their unit market

price. Similar to traditional stock splits, unless required under corporate law, no accounting is required

for reverse stock splits other than potentially recording the decrease in par value for the canceled

shares. To the extent a decrease in par value is required, the amount should be offset against APIC.

ASC 505-10-S99-4 indicates that for public companies, changes in the capital structure of a reporting entity

due to a stock dividend, stock split or reverse split occurring after the date of the latest reported balance

sheet but before the release of the financial statements (or the effective date of the registration statement,

whichever is later) should be given retroactive effect in the balance sheet. In such cases, appropriate

disclosure should be made of the retrospective treatment and the date the change became effective.

3.4.5 Accounting for dividends

Dividends are a distribution of an entity’s retained earnings (or return of capital in the case of a

liquidating dividend) to its owners. Dividends generally must be declared by the board and sometimes are

subject to restrictions under state law based on historical earnings. Preferred shares often include a

preference such that dividends are paid to preferred holders before common stockholders.

Dividends on preferred stock instruments are often cumulative, in which case the cumulative amount of

any unpaid dividends on the preferred stock must be paid prior to the payment of any common stock

dividends. For example, assume that a preferred stock is issued 1 January 20X1, and has a stated

cumulative annual dividend of $5 that is payable on 31 December. If the entity elects not to distribute the

dividend at the end of 20X1, the unpaid amount is added to the liquidation preference. Such amounts are

usually required to be paid by the earlier of either (1) maturity, redemption, liquidation or conversion of

the preferred stock or (2) the payment of any dividends on common stock. Preferred stock with

cumulative dividends typically has a stated, nonparticipating dividend rate.

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Dividend distributions typically involve the following key dates:

Date of declaration

The date the board of directors declares the dividend to shareholders

and it becomes a liability

Date of record

The date the board of directors specifies that shareholders of record on

that date are entitled to the dividend payment

Date of payment

The date the dividend is actually paid by the entity

Dividends should generally not be recognized as a liability (with an offset to retained earnings) until

declared, even if the dividends are cumulative. As most dividends are paid within one year of the

declaration date, dividends payable are typically current liabilities. ASC 505-10-50-5 requires entities to

disclose either on the face of the statement of financial position or in the notes thereto the aggregate

and per-share amounts of arrearages in cumulative preferred dividends.

With respect to EPS, ASC 260-10-45-11 states that income available to common shareholders (i.e., the

numerator) is calculated by reducing income from continuing operations and net income by (1) the

dividends declared in the period on preferred stock (whether or not paid) and (2) the dividends

accumulated for the period on cumulative preferred stock (whether or not earned). If there is a loss from

continuing operations or a net loss, the amount of the loss should be increased by those preferred

dividends. Refer to section 3.2 of our FRD publication, Earnings per share, for further guidance on the

calculation of income available to common stockholders and related adjustments.

In addition, the AICPA’s non-authoritative Technical Question and Answers section 4210.04, Accrual of

Preferred Dividends (TQA 4210.04), states that if preferred dividends are cumulative only if earned, they

should be deducted to arrive at income available to common shareholders only to the extent that they

are earned. That guidance also states that in all cases, the effect that has been given to preferred

dividends in arriving at income available to common stockholders in computing basic EPS should be

disclosed for every period for which an income statement is presented. The guidance also emphasizes

that cumulative dividends are not accrued until they become a corporate liability when declared.

The following types of dividends are addressed in this section:

• Cash dividends

• Noncash dividends

• Liquidating dividends

• Stock dividends

• Dividends on liability-classified stock instruments

• Dividends on temporary-equity classified stock

• Fixed-rate dividends

• Variable-rate dividends

• Increasing or decreasing-rate dividends

• PIK dividends

• Participating dividends

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3.4.5.1 Cash dividends

A cash dividend becomes a liability once it is declared. Since payment is generally required within a short

period of time, the dividend payable is usually classified as a current liability.

In some cases, the issuer or the shareholder has the ability to elect to receive the dividends in cash or

shares of equivalent value. The accounting is essentially the same as for cash dividends but there may be

EPS implications based on the guidance in ASC 505-20-15-3A.

3.4.5.2 Noncash dividends

Noncash dividends are payable in assets of a corporation other than cash and may include merchandise,

real estate, investments or other assets, as designated by the board of directors. ASC 845-10-30-1

through 30-10 address the accounting for noncash dividends. Noncash dividends to owners of an entity

that are not in the form of a spin-off, reorganization or liquidation, or in a plan that is in substance the

rescission of a prior business combination should be recorded at the fair value of the property to be

distributed, provided that the fair value is objectively measurable and would be clearly realizable to the

distributing entity in an outright sale at or near the time of the distribution; otherwise, carrying values

should be used in recording the dividend. Pursuant to ASC 845-10-30, differences between the fair value

and carrying value of noncash assets distributed should be measured and recorded as a gain or loss. We

believe that this should be recognized and measured on the date the noncash dividend is declared and

becomes a liability of the entity.

When a subsidiary pays dividends in noncash assets, a gain or loss should be recognized in the

consolidated financial statements of the parent only to the extent of dividends paid to NCI, if any, and

any gain or loss recognized should be allocated entirely to NCI in the parent’s consolidated income

statement. Noncash dividends received by a parent or other companies under common control should be

recorded at the historical cost of the parent of the entities under common control, pursuant to ASC 805-

50-30-5. See Appendix C of our FRD publication, Business combinations, for more guidance on the

accounting for common control transactions.

A noncash dividend that is a pro rata nonreciprocal transfer of nonmonetary assets to owners in a spin-

off or other form of reorganization or liquidation, or in a plan that is in substance the rescission of a prior

business combination, is recognized at the carrying amount (after reduction for an indicated impairment,

if necessary) of the nonmonetary assets transferred if the nonmonetary assets being distributed meet

the definition of a business. Spin-offs are accounted for in accordance with ASC 505-60.

3.4.5.3 Liquidating dividends

Liquidating dividends are dividends based on something other than retained earnings, such as paid-in

capital. Therefore, they are a return of the stockholders’ investment rather than of profits and should not

decrease retained earnings. AICPA TQA 4210.01, Write-Off of Liquidating Dividends, states the following:

“ … when liquidating dividends are declared, the charge is made to accounts such as “capital

repayment,” “capital returned,” or “liquidating dividends” which appear on the balance sheet as

offsets to paid-in capital … “

3.4.5.4 Stock dividends

ASC 505-20-20 defines a stock dividend as follows:

“an issuance by a corporation of its own common shares to its common shareholders without

consideration and under conditions indicating that such action is prompted mainly by a desire to give

the recipient shareholders some ostensibly separate evidence of a part of their respective interests

in accumulated corporate earnings without distribution of cash or other property that the board of

directors deems necessary or desirable to retain in the business.”

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A stock dividend results in each stockholder having the same proportionate interest in the corporation

and same total book value as before the dividend. The purpose of a stock dividend is to capitalize part of

the earnings (i.e., reclassify amounts from retained earnings to contributed capital) and therefore retain

the earnings on a permanent basis.

When the relative size of the stock dividend is so small that the issuance does not have any apparent effect on

the share’s market price, ASC 505-20-30 requires the fair value of the stock issued to be transferred from

retained earnings. This is commonly referred to as a small or ordinary stock dividend. Although the point at

which the relative size of the stock dividend becomes large enough to materially influence the unit market

price of the stock will vary with individual companies and market conditions, ASC 505-20-25-4 through 25-6

indicates that stock dividends amounting to less than 20–25% of the common shares outstanding at the time

of the dividend declaration are generally considered to be small or ordinary, requiring a transfer from

retained earnings to capital surplus (APIC) based on the fair value of the stock issued. However, in closely

held entities it is presumed that shareholders have significant knowledge of the corporation’s affairs and

there is no need to capitalize retained earnings other than to meet legal requirements.

When shareholders may elect to receive cash in lieu of a stock dividend or when stock of another class is

distributed, the cash consideration or fair value of the shares issued should be used to determine the

amount of capitalized retained earnings.

Pursuant to ASC 505-20-25-4 through 25-6, a stock dividend of more than 20–25% of the number of

shares previously outstanding is generally considered a large stock dividend and should be treated similar

to a stock split. The SEC staff has stated that distributions of 25% or more should be treated similar to a

stock split. Stock splits generally do not result in the capitalization of earned surplus (retained earnings).

Occasionally, subsidiary enterprises capitalize retained earnings arising since acquisition/inception by

means of a stock dividend or otherwise. ASC 810-10-45-9 states that this event does not require a

transfer to retained earnings in consolidation, inasmuch as the retained earnings in the consolidated

financial statements should reflect the accumulated earnings of the consolidated group not distributed to

the shareholders of, or capitalized by, the parent entity.

3.4.5.5 Dividends on stock instruments classified as a liability

For stock instruments classified as liabilities pursuant to ASC 480 (refer to sections 3.2.1 and 3.2.2), any

dividends are accounted for and presented as interest expense pursuant to that guidance.

3.4.5.6 Dividends on stock classified in temporary equity

Pursuant to the SEC staff’s guidance in ASC 480-10-S99-2, the carrying amount of stock classified in

temporary equity that is currently redeemable or probable of becoming redeemable should be increased

by dividends not currently declared or paid, but that may be payable upon redemption. This accounting

would apply irrespective of whether the stock may be voluntarily redeemed by the issuer or converted into

another class of securities by the holder before the redemption date that is out of the registrant’s control.

The increase in the carrying amount of the stock should be treated in the same manner as dividends on

non-redeemable stock, and would result in a charge against retained earnings or, in the absence of retained

earnings, to APIC. The increase should also be considered when determining income available to common

shareholders for EPS purposes. Refer to section 3.2.2 of our FRD publication, Earnings per share, for

further guidance on the effect of redeemable securities on income available to common stockholders.

3.4.5.7 Fixed-rate dividends

Fixed-rate dividends are calculated as a fixed percentage of the stock’s par amount and generally become

payable only when, and if, declared by the board of directors. A liability should be recognized once

dividends are declared.

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3.4.5.8 Variable-rate dividends

Variable-rate dividends are typically calculated based on an index such as an interest rate index (e.g., LIBOR)

or based on a specified formula. Other variable rate dividends are based on the issuer’s financial

performance. Particular consideration should be given to variable-rate dividends as to whether they

represent an embedded derivative requiring bifurcation pursuant to ASC 815 (refer to section 3.2.10.3 for

a discussion of indexed dividends). If bifurcation is not required, a liability should be recognized for the

variable-rate dividends when they become payable, generally upon declaration by the board of directors.

3.4.5.9 Increasing or decreasing rate preferred stock

Excerpt from Accounting Standards Codification

Equity

SEC Materials

505-10-S99-7

The following is the text of SAB Topic 5.Q, Increasing Rate Preferred Stock.

Facts: A registrant issues Class A and Class B nonredeemable preferred stock FN19 on 1/1/X1.

Class A, by its terms, will pay no dividends during the years 20X1 through 20X3. Class B, by its

terms, will pay dividends at annual rates of $2, $4 and $6 per share in the years 20X1, 20X2 and

20X3, respectively. Beginning in the year 20X4 and thereafter as long as they remain outstanding,

each instrument will pay dividends at an annual rate of $8 per share. In all periods, the scheduled

dividends are cumulative.

FN19 “Nonredeemable” preferred stock, as used in this SAB, refers to preferred stocks which

are not redeemable or are redeemable only at the option of the issuer.

At the time of issuance, eight percent per annum was considered to be a market rate for dividend

yield on Class A, given its characteristics other than scheduled cash dividend entitlements (voting

rights, liquidation preference, etc.), as well as the registrant’s financial condition and future

economic prospects. Thus, the registrant could have expected to receive proceeds of approximately

$100 per share for Class A if the dividend rate of $8 per share (the “perpetual dividend”) had been

in effect at date of issuance. In consideration of the dividend payment terms, however, Class A

was issued for proceeds of $79 3/8 per share. The difference, $20 5/8, approximated the value of

the absence of $8 per share dividends annually for three years, discounted at 8%.

The issuance price of Class B shares was determined by a similar approach, based on the terms

and characteristics of the Class B shares.

Question 1: How should preferred stocks of this general type (referred to as “increasing rate

preferred stocks”) be reported in the balance sheet?

Interpretive Response: As is normally the case with other types of securities, increasing rate

preferred stock should be recorded initially at its fair value on date of issuance. Thereafter, the

carrying amount should be increased periodically as discussed in the Interpretive Response to

Question 2.

Question 2: Is it acceptable to recognize the dividend costs of increasing rate preferred stocks

according to their stated dividend schedules?

Interpretive Response: No. The staff believes that when consideration received for preferred

stocks reflects expectations of future dividend streams, as is normally the case with cumulative

preferred stocks, any discount due to an absence of dividends (as with Class A) or gradually

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increasing dividends (as with Class B) for an initial period represents prepaid, unstated dividend

cost. FN20 Recognizing the dividend cost of these instruments according to their stated dividend

schedules would report Class A as being cost-free, and would report the cost of Class B at less than

its effective cost, from the standpoint of common stock interests (i. e., for purposes of computing

income applicable to common stock and earnings per common share) during the years 20X1

through 20X3.

FN20 As described in the “Facts” section of this issue, a registrant would receive less in

proceeds for a preferred stock, if the stock were to pay less than its perpetual dividend for

some initial period(s), than if it were to pay the perpetual dividend from date of issuance. The

staff views the discount on increasing rate preferred stock as equivalent to a prepayment of

dividends by the issuer, as though the issuer had concurrently (a) issued the stock with the

perpetual dividend being payable from date of issuance, and (b) returned to the investor a

portion of the proceeds representing the present value of certain future dividend entitlements

which the investor agreed to forgo.

Accordingly, the staff believes that discounts on increasing rate preferred stock should be

amortized over the period(s) preceding commencement of the perpetual dividend, by charging

imputed dividend cost against retained earnings and increasing the carrying amount of the

preferred stock by a corresponding amount. The discount at time of issuance should be computed

as the present value of the difference between (a) dividends that will be payable, if any, in the

period(s) preceding commencement of the perpetual dividend; and (b) the perpetual dividend

amount for a corresponding number of periods; discounted at a market rate for dividend yield on

preferred stocks that are comparable (other than with respect to dividend payment schedules)

from an investment standpoint. The amortization in each period should be the amount which,

together with any stated dividend for the period (ignoring fluctuations in stated dividend amounts

that might result from variable rates, FN21 results in a constant rate of effective cost vis-a-vis the

carrying amount of the preferred stock (the market rate that was used to compute the discount).

FN21 See Question 3 regarding variable increasing rate preferred stocks.

Simplified (ignoring quarterly calculations) application of this accounting to the Class A preferred

stock described in the “Facts” section of this bulletin would produce the following results on a per

share basis:

Carrying amount of preferred stock

Beginning of Year (BOY)

Imputed Dividend (8% of

carrying Amount at BOY)

End of year

Year 20X1

$ 79.38

6.35

85.73

Year 20X2

85.73

6.86

92.59

Year 20X3

92.59

7.41

100.00

During 20X4 and thereafter, the stated dividend of $8 measured against the carrying amount of

$100 FN22 would reflect dividend cost of 8%, the market rate at time of issuance.

FN22 It should be noted that the $100 per share amount used in this issue is for illustrative

purposes, and is not intended to imply that application of this issue will necessarily result in

the carrying amount of a nonredeemable preferred stock being accreted to its par value,

stated value, voluntary redemption value or involuntary liquidation value.

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The staff believes that existing authoritative literature, while not explicitly addressing increasing

rate preferred stocks, implicitly calls for the accounting described in this bulletin.

The pervasive, fundamental principle of accrual accounting would, in the staff’s view, preclude

registrants from recognizing the dividend cost on the basis of whatever cash payment schedule

might be arranged. Furthermore, recognition of the effective cost of unstated rights and

privileges is well-established in accounting, and is specifically called for by FASB ASC Subtopic

835-30, Interest—Imputation of Interest, and Topic 3.C of this codification for unstated interest

costs of debt capital and unstated dividend costs of redeemable preferred stock capital,

respectively. The staff believes that the requirement to recognize the effective periodic cost of

capital applies also to nonredeemable preferred stocks because, for that purpose, the distinction

between debt capital and preferred equity capital (whether redeemable FN23 or nonredeemable)

is irrelevant from the standpoint of common stock interests. …

FN23 Application of the interest method with respect to redeemable preferred stocks

pursuant to Topic 3.C results in accounting consistent with the provisions of this bulletin

irrespective of whether the redeemable preferred stocks have constant or increasing stated

dividend rates. The interest method, as described in FASB ASC Subtopic 835-30, produces

a constant effective periodic rate of cost that is comprised of amortization of discount as

well as the stated cost in each period.

ASC 505-10-S99-7 provides the SEC staff’s view on nonredeemable preferred stock with increasing rate

features that pay little or no dividends in the early years but then increase and usually level off to a fixed

dividend rate, which is referred to as the “perpetual dividend amount.” ASC 505-10-S99-7 indicates that

such instruments are typically issued at a discount to compensate the holder for the lower amount of

dividends in the early years of the instrument’s life, and that this discount represents a prepaid unstated

dividend that should be amortized to retained earnings using a discount rate equal to the market rate for

comparable preferred stock without consideration of dividends.

The discount should be amortized over the period preceding the commencement of the perpetual

dividend and the periodic amortization, when added to the stated dividend for the period, results in a

constant rate of cost for the period preceding the commencement of the perpetual dividend that equals

the perpetual dividend (which is the market dividend rate for the preferred stock at the time of issuance).

The subsequent accounting for the dividends paid for increasing rate preferred stock is consistent with

the accounting for dividends paid on preferred stock without the increasing rate feature. That is, the

dividends are recorded to retained earnings at each reporting date.

Some preferred stock instruments with increasing rate dividends may not be in the scope of the SEC

staff’s model. For example, consider preferred stock that has a dividend rate that will increase to 25%

(which is considered significantly above market) beginning in year six and is callable by the issuer at any

time. The preferred stock is issued at par (i.e., no discount to indicate an investor is being made whole for

a low initial dividend). The dramatic increase in the dividend rate could suggest that the preferred stock is

expected to be redeemed by the issuer at or prior to the dividend step-up date (i.e., it was intended as

more of a penalty rate if the preferred stock was not redeemed timely). In this case, it may be

appropriate to accrue dividends based on the stated rate.

3.4.5.10 Paid-in-kind dividends

Some preferred shares have dividends that are PIK (e.g., dividends paid in the form of additional shares

of preferred stock) or permit the issuer to pay dividends in kind or in cash. If PIK, the issuer would

typically issue stock with a liquidation preference amount equal to the dividends payable at the contractual

rate. For example, an entity issues preferred stock that pays dividends quarterly at 2% of the liquidation

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preference ($1,000,000), when and if declared by the board of directors. To the extent dividends are

declared, the issuer can pay the $20,000 quarterly dividends either in cash or by issuing shares with a

total liquidation preference of $20,000 (e.g., 20 shares of $1,000 par amount preferred stock).

When determining the amount to accrue for the PIK dividend payable upon declaration, some entities

analogize to the guidance for stock dividends in ASC 505-20, which defines a stock dividend, in part, as

“An issuance by a corporation of its own common shares to its common shareholders[.]” As discussed in

section 3.4.5.4, that guidance requires stock dividends (that are not treated as stock splits) to be

capitalized out of retained earnings at the fair value of the shares on the declaration date. We generally

believe the issuer may either (1) record the dividend payable based on the fair value of the instruments

issued (the fair value of the $20,000 par amount of preferred stock in the example) or (2) record the

contractual rate ($20,000 in the example). The approach followed should be consistently applied.

Other PIK dividends may be for a fixed (or predominantly fixed) monetary value, so the number of

preferred shares distributed will vary between the declaration date and the payment date based on

changes in the fair value of the underlying preferred shares, in which case the declared dividend

represents a liability pursuant to ASC 480-10-25-14.

Convertible preferred stock may also have PIK dividends, which should be evaluated to determine if there

are BCFs in the preferred shares issued as dividends and how they would be measured. Refer to the

discussion in section D.3.3.1.

3.4.5.11 Participating dividends

Participating stock shares in dividends with common stock according to a predetermined formula

(e.g., dollar for dollar, two for one) with, at times, an upper limit on the extent of participation (e.g., up

to, but not beyond, a specified amount per share). The participating dividend feature should be analyzed

to determine whether bifurcation is required under ASC 815. When a participating preferred share is

considered to contain an equity host, the participating dividend feature would be considered clearly and

closely related to the host. However, if the host contract is more akin to debt, the underlying (i.e., a

dividend payment) is not considered clearly and closely related to the debt host instrument. The other

criteria for bifurcation, including the definition of a derivative, should be further evaluated.

In addition, any security meeting the definition of a participating security pursuant to ASC 260-10-45-

59A through 45-70 requires the use of the two-class method for calculating its impact on EPS. Refer to

section 5 of our FRD publication, Earnings per share, for further guidance on participating securities and

the two-class method.

3.5 Share repurchase and conversions

Stock may be repurchased (i.e., redeemed if put or called or repurchased directly from the market)

or converted (or exchanged). This section includes guidance for repurchases (section 3.5.1) and conversions

(section 3.5.2) for stock that is classified in equity. Stock classified as a liability is accounted for as a debt

instrument and would follow the appropriate debt guidance. Refer to section 2.5 for guidance on redemption

and conversions of debt instruments. Stock terms also may be amended prior to redemption, retirement

or conversion, and with that amendment, accounted for as either an extinguishment or a modification.

3.5.1 Repurchase of stock

The repurchase of common stock is generally referred to as the acquisition of treasury shares or as a

retirement (or constructive retirement). Guidance on the accounting for repurchases of common stock is

provided in ASC 505-30.

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Repurchase of preferred stock upon the exercise of a call or put option is generally referred to as a

redemption. Guidance on the redemption or repurchase of preferred stock for public companies is

provided in ASC 260-10-S99-2. Although the scope of ASC 260-10-S99-2 addresses public entities,

we generally believe that guidance is preferable for nonpublic entities.

3.5.1.1 Treasury shares

It is not unusual for companies to buy back their own common shares. For example, corporations

purchase their outstanding stock:

• To provide tax efficient distributions of excess cash to shareholders

• To increase future EPS and return on equity

• To provide stock for employee stock compensation contracts or to meet potential merger needs

• To discourage takeover attempts or to reduce the number of stockholders

• To make a market in the stock

Once shares are reacquired, they may either be retired or held in the treasury for reissue. If not retired,

such shares are referred to as treasury shares or treasury stock. The laws in the state of incorporation

and any future changes in those laws should be considered as they may require a particular accounting

treatment for the reacquired shares.

If an enterprise acquires shares of its own capital stock, the cost of the acquired shares should generally

be shown as a deduction from stockholders’ equity. Dividends on such shares held in the entity’s treasury

should not be reflected as income and not shown as a reduction in equity. Gains and losses on sales of

treasury stock should be accounted for as adjustments to stockholders’ equity and not as part of income.

Stock of a corporation held in its own treasury stock should not be presented as an asset. ASC 505-30-30-8

provides two methods of accounting for treasury shares depending on whether the stock is acquired for

constructive retirement.

There is no authoritative guidance on the accounting for direct costs incurred to repurchase treasury

stock. However, AICPA Technical Questions and Answers — Costs Incurred to Acquire Treasury Stock

(TQA 4110.09) states that costs associated with the acquisition of treasury stock may be added to the

cost of the treasury stock in a manner similar to stock issuance costs.

When stock is retired or purchased for constructive retirement, any excess purchase price over par value

may be allocated between APIC and retained earnings or may be charged directly to retained earnings.

When allocating any excess purchase price over par value between capital surplus and retained earnings,

the portion of the excess allocated to capital surplus should be limited to the sum of both of the following:

(a) All capital surplus arising from previous retirements and net gains on sales of treasury stock of the

same issue

(b) The pro rata portion of capital surplus paid in, voluntary transfers of retained earnings, capitalization

of stock dividends, etc., on the same issue. For this purpose, any remaining capital surplus applicable

to issues fully retired (formal or constructive) is deemed to be applicable pro rata to shares of

common stock

Any excess par value over the purchase price should be credited to capital surplus.

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When stock is acquired for purposes other than formal or constructive retirement or when ultimate

disposition has not yet been decided, the accounting for constructive retirement may be followed.

Another acceptable approach is to present the cost of the acquired stock separately as a deduction from

the total of capital stock, capital surplus and retained earnings.

Gains on sales of treasury stock not previously accounted for as constructively retired should be credited

to capital surplus; losses may be charged to capital surplus to the extent that previous net gains from

sales or retirements of the same class of stock are included therein, otherwise to retained earnings.

Adequate recordkeeping of historical treasury transactions is required to properly apply the abovementioned

accounting. Additionally, an acceptable inventory method, such as FIFO or average cost basis, should be

used to track treasury transactions and determine the appropriate amount of gain or loss to be recorded

upon the sale of treasury stock not previously accounted for as constructively retired.

Several states have enacted corporation laws that generally affect the legal status of dividends, redemptions,

stock purchases and partial liquidations. An important feature of those laws provide that purchases of an

entity’s own stock immediately return the stock to the status of authorized and unissued, regardless of an

entity’s future intent to reissue the acquired stock. Companies incorporated in states with those laws would

not report treasury stock as a separate line item within shareholders’ equity in the financial statements.

Refer to section 2.7.1 of our FRD publication, Share-based payment, for a discussion on the accounting

for shares of a company’s own stock held in a rabbi trust.

3.5.1.1.1 Common stock purchased above fair value

ASC 505-30-50-3 states that a repurchase of shares at a price significantly in excess of the current

market price creates a presumption that the repurchase price includes amounts attributable to items

other than the shares repurchased. For example, a selling shareholder may agree to abandon certain

acquisition plans, forego other planned transactions, settle litigation, settle employment contracts or

voluntarily restrict its purchase of shares of the entity or the entity’s affiliates within a stated time period.

The SEC staff indicated that in applying ASC 505-30-30-2 through 30-4 (typically referred to as a

“greenmail transaction”), the quoted market price of the common stock generally should be used for

purposes of determining the fair value of the treasury shares purchased. The SEC staff generally has

objected to the use of valuations that differ from prices existing in public markets.

If the purchase of treasury shares includes the receipt of stated or unstated rights, privileges or

agreements in addition to the capital stock, only the amount representing the fair value of the treasury

shares at the date the major terms of the agreement to purchase the shares are reached should be

accounted for as the cost of the shares acquired. The price paid in excess of the amount accounted for as

the cost of treasury shares should be attributed to the other elements of the transaction and accounted

for according to their substance (i.e., under other applicable US GAAP). If the fair value of those other

elements of the transaction is more clearly evident, for example, because an entity’s shares are not

publicly traded, that amount should be assigned to those elements and the difference recorded as the

cost of treasury shares. If no stated or unstated consideration in addition to the capital stock can be

identified, the entire purchase price should be accounted for as the cost of treasury shares.

We generally believe circumstances that may provide a reasonable basis to recognize an amount paid in

excess of fair value as the cost of treasury shares would be based on the facts and circumstances, but

generally are limited to premiums paid in purchases to obtain:

(a) The desired number of shares in a tender offer to all or most shareholders

(b) A block of shares representing a controlling interest (i.e., a control premium)

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3.5.1.1.2 Shares escrowed in connection with an IPO

In order to facilitate an IPO, underwriters may request that some or all shareholders (some or all of

whom may be employees) of a privately held entity place a portion of their shares in an escrow account.

The escrowed shares generally are legally outstanding and may continue to have voting and dividend

rights. The shares are released from escrow based on the attainment of certain performance measures

by the entity in subsequent periods, such as specified earnings or market price levels. If the targets are

not achieved, the escrowed shares are returned to the entity and canceled. Escrow share arrangements in

an IPO are often tied to employee service. Those arrangements are presumed to be compensatory, as

discussed in section 2.6 of our FRD publication, Share-based payment.

3.5.1.1.3 Excise tax on stock repurchases (added August 2023)

The Inflation Reduction Act of 2022 established a 1% excise tax provision on stock repurchases of more

than $1 million by publicly traded US corporations. The amount of excise tax is calculated as 1% of the

fair market value of the stock repurchased during the tax year, less the fair market value of stock issued

during the tax year, including stock issued to employees of the corporation or its subsidiaries. The excise

tax provision also applies to repurchases of stock of a publicly traded foreign corporation by the foreign

corporation’s domestic affiliate and applies to repurchases of stock made after 31 December 2022.

The excise tax is not based on income and, therefore, is outside of the scope of the income tax

accounting guidance in ASC 740. There is no other guidance that addresses the accounting for the excise

tax. Because the excise tax is a cost associated with the repurchase of a reporting entity’s stock, an

entity may treat the excise tax as a cost of treasury stock repurchases if it determines that it is a direct

cost associated with repurchasing its common stock. The accounting would follow the guidance in TQA

4110.09, which states that costs associated with the acquisition of treasury stock may be added to the

cost of the treasury stock in a manner similar to stock issuance costs.

Additional considerations may be necessary to determine the appropriate accounting for excise taxes

incurred to redeem preferred stock or stock classified outside of permanent equity.

3.5.1.2 Redemption of preferred stock

A redemption of preferred stock according to its original terms may be paid using cash, other instruments

issued by the issuer or other assets (individually and collectively, the consideration) and may include a

premium or discount. ASC 260-10-S99-2 provides the SEC staff’s view that a premium (discount) on

redemption represents a return to (from) the preferred stockholder that should be treated in a manner

similar to a dividend to the preferred stockholder. Accordingly, the SEC staff requires that the difference

between the fair value of the consideration paid upon redemption and the carrying value of the preferred

stock be deducted from (if a premium) or added to (if a discount) net income to arrive at income available

to common stockholders in the calculation of EPS. Additionally, this guidance requires that unamortized

issuance costs be included in the carrying amount of the preferred stock when calculating the premium

or discount upon redemption. See section 3.2.1 of our FRD publication, Earnings per share, for further

discussion of ASC 260-10-S99-2.

On 27 December 2022, the Internal Revenue Service (IRS) and the Department of the Treasury issued Notice 2023-2, Initial

Guidance Regarding the Application of the Excise Tax on Repurchases of Corporate Stock under Section 4501 of the Internal

Revenue Code, to address application of the excise tax. Refer to the IRS website at https://www.irs.gov/pub/irs-drop/n-23-

02.pdf. Companies should continue to monitor developments in this area.

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If the instrument being redeemed has embedded features that have been bifurcated and accounted for

separately as a derivative, judgment is necessary to determine if there is any gain or loss to be recognized

in earnings on the settlement. We generally believe one reasonable approach is to include the then-current

fair value of the bifurcated derivative in the carrying value of the preferred stock in the calculation

described above, as the bifurcated derivative is inherently being redeemed as part of the transaction.

Sometimes a company will make an offer to the preferred shareholders to repurchase or redeem an

equity-classified preferred stock instrument (1) prior to the stated call date, (2) at an amount other

than that prescribed in the instrument or (3) when there are no redemption features embedded in the

instrument. In those instances, the accounting is the same as if the preferred stock were being redeemed

according to a contractual feature of the contract.

If a preferred share becomes mandatorily redeemable pursuant to ASC 480, it is reclassified at fair value

from equity to a liability. For SEC registrants, the difference between the carrying amount and fair value

is treated as a deemed dividend and charged to income available to common stockholders under the SEC

staff’s belief that a liability instrument has been issued to extinguish an equity instrument.

3.5.1.2.1 Extinguishment of preferred stock with a beneficial conversion feature

If a convertible preferred stock with a beneficial conversion option that was separately accounted for

in equity is extinguished prior to its conversion or stated maturity date, the EITF reached a tentative

conclusion that a portion of the reacquisition price is allocated to the repurchase of the beneficial

conversion option. The amount of the reacquisition price allocated to the beneficial conversion option

should be measured using the intrinsic value of that conversion option at the extinguishment date. The

residual amount, if any, is allocated to the preferred stock.

The excess of (1) the fair value of the consideration transferred to the holders of the preferred stock over

the sum of (2) the carrying amount of the preferred stock plus and (3) the amount previously recognized for

the beneficial conversion option should be subtracted from net income to arrive at net income available to

common shareholders in the calculation of EPS. Refer to section D.5.2.2 for further guidance.

3.5.1.3 Repurchase of redeemable shares issued by a subsidiary

The accounting for certain transactions for preferred shares issued by subsidiaries in consolidation is

specified in ASC 810-10-40-1 through 40-2A. See section 18.1 of our FRD publication, Consolidation,

for more guidance on the scope of ASC 810.

Consistent with the accounting for purchases of additional ownership interests of a subsidiary pursuant

to ASC 810-10-45-21A through 45-24, if a subsidiary’s redeemable preferred stock is not accounted for

as a liability, and the transaction is within the scope of ASC 810, the parent’s acquisition of a subsidiary’s

redeemable preferred stock (i.e., purchase the subsidiary’s preferred stock from a current third-party

preferred shareholder) is accounted for as a capital stock transaction pursuant to ASC 810-10-40-2.

Accordingly, the consolidated entity would not recognize in its income statement any gain or loss from the

acquisition of the subsidiary’s preferred stock.

If redeemable preferred stock is accounted for as a liability, any amounts paid or to be paid to holders of

those contracts in excess of the initial measurement amount are reflected as interest cost and not as a

capital stock transaction. ASC 405 specifies whether a liability has been extinguished and ASC 470-50

requires that the parent recognize a gain or loss upon extinguishment of the subsidiary’s liability for

redeemable preferred shares for any difference between the carrying amount and the redemption amount.

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3.5.1.4 Purchases of parent’s stock by a subsidiary

Accounting for shares of a parent purchased by a subsidiary in the consolidated financial statements is

addressed in ASC 810-10-45-5. That paragraph states that shares of the parent held by a subsidiary

should not be reflected as outstanding shares in the consolidated financial statements of the parent.

Such outstanding shares should be reflected as treasury shares in the consolidated financial statements.

Refer to section 17.1.3 of our FRD publication, Consolidation, for information regarding the treatment of

a subsidiary’s ownership interest in its parent in the consolidated financial statements and the

subsidiary’s separate financial statements.

3.5.2 Conversion of convertible stock instruments

The accounting for conversions of convertible stock instruments classified in equity depends on the

nature of the conversion feature and whether the conversion is executed pursuant to the original

conversion terms.

3.5.2.1 Conversion pursuant to the original terms without a beneficial conversion feature

The conversion of equity-classified stock generally does not result in a deemed dividend or a gain/loss upon

conversion if the conversion is pursuant to the original terms of the agreement. Upon conversion, the

issuer derecognizes the stock based on their current carrying values (including any discount or premium),

and allocates that amount to common stock (including both par value and APIC, as appropriate).

3.5.2.2 Conversion pursuant to the original terms with a beneficial conversion feature

Upon conversion of an instrument with a beneficial conversion option, all unamortized discounts,

including any original issue discounts and discounts from allocation of proceeds, at the conversion date

should be recognized immediately as a deemed dividend and deducted from income available to common

stockholders. The accounting for the conversion then follows the guidance in section 3.5.2.1. Refer to

section D.5.1 for further guidance on BCFs.

3.5.2.3 Induced conversions of convertible stock

ASC 260-10-S99 provides the SEC staff’s view on the accounting for induced conversions of convertible

preferred stock and states that issuers should consider the guidance in ASC 470-20-40-13 through 40-17

to determine whether a conversion of preferred stock is pursuant to an inducement offer.

ASC 470-20-40-13 through 40-17 addresses the accounting for induced conversions of convertible debt

(other than cash convertible debt instruments) that (1) occur pursuant to changed conversion privileges

that are exercisable only for a limited period of time, (2) include the issuance of all of the equity

securities issuable pursuant to conversion privileges included in the terms of the debt at issuance for

each debt instrument that is converted and (3) involve any of the following:

• Reduction of the original conversion price (thereby resulting in the issuance of additional shares

of stock)

• Issuance of warrants or other securities not provided for in the original conversion terms

• Payment of cash or other consideration (sometimes called a convertible stock sweetener) to those

shareholders who convert during the specified time period. The additional consideration is usually

offered to induce prompt conversion of the stock to another class of equity.

As the form is important to the application of this guidance, all equity shares issuable under the initial

terms — meaning all or more — must be issued.

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ASC 470-20-40-14 further explains that an induced conversion includes an exchange of a convertible

debt instrument for equity securities or a combination of equity securities and other consideration,

whether or not the exchange involves legal exercise of the contractual conversion privileges included in

the terms of the debt.

The induced conversion guidance in ASC 470 applies regardless of the party that initiates the offer or

whether the offer relates to all debt holders, as discussed at ASC 470-20-40-13(b). For example, even if

a stockholder makes the offer to the issuer and only that holder’s stock receives the right to convert at

the sweetened conversion price, the accounting requirements of the induced conversion guidance in

ASC 470-20 apply.

If a conversion of equity-classified preferred stock is an inducement offer pursuant to ASC 470-20, the

fair value of the additional securities or other consideration issued to induce conversion should be

subtracted from net income to arrive at income available to common stockholders in the calculation of

EPS pursuant to ASC 260-10-S99-2. Refer to section 3.2.1 of our FRD publication, Earnings per share,

for further guidance on ASC 260-10-S99-2.

Refer to ASC 470-20-55-1 through 55-9 for illustrative examples of the application of this induced

conversion guidance.

3.6 Modifications or exchanges of stock instruments

Significant modifications or exchanges of common stock instruments are infrequent. As the accounting

for such transactions is not directly addressed in the accounting literature, the accounting considerations

are heavily based on the individual facts and circumstances.

The accounting literature does, however, specifically address the extinguishment of equity-classified

preferred shares, but does not address determining whether an amendment to an equity-classified

preferred share is an extinguishment or a modification. Nor does it address the subsequent accounting

for modifications. Common amendments include changes to, additions of, or deletions of redemption

features, conversion rights, preference or seniority, voting or dividend rights. These changes may be

executed through an exchange of preferred shares or by amending terms of existing preferred shares.

3.6.1 Modifications or exchanges of common stock instruments

In most instances common stock is modified or exchanged in connection with a capital restructuring,

whereby by all common shareholders are receiving or giving up specified rights. Although all facts and

circumstances should be considered, often no accounting is required, except where value is transferred from

the common holders to the preferred holders, and that value represents a dividend to the preferred holders.

In instances where only a subset of common stock is being modified or exchanged, consideration should be

given as to whether that class of common stock is required to follow the two-class method of calculating EPS.

Refer to section 5 of our FRD publication, Earnings per share, for further guidance on the two-class method.

3.6.2 Modifications or exchanges of preferred stock instruments

Equity-classified preferred shares include those classified within equity and those within the “mezzanine”

(i.e., both “permanent equity” and “temporary equity”). For SEC registrants, the accounting for the

extinguishment of equity-classified preferred stock is addressed by SEC staff guidance at ASC 260-10-S99-2.

Under that guidance, when equity-classified preferred shares are extinguished, the difference between

(1) the fair value of the consideration transferred to the holders of the preferred shares (i.e., the cash or

the fair value of new instruments issued) and (2) the carrying amount of the preferred shares (net of

issuance costs) are subtracted from (or added to) net income to arrive at income available to common

stockholders in the calculation of EPS. Refer to section 3.2.1 of our FRD publication, Earnings per share,

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for further discussion of ASC 260-10-S99-2. In addition to the effect on EPS, extinguishment accounting

will result in adjustments within equity but will not result in recognition of any amounts in net income. The

accounting guidance in ASC 260 does not, however, define an extinguishment, particularly in the context

of whether amendments to an existing equity-classified preferred share constitute an extinguishment.

3.6.2.1 Determining whether an amendment of an equity-classified preferred share is an

extinguishment or modification

ASC 470-50 addresses whether a debt instrument has been significantly modified such that extinguishment

accounting is required. If extinguishment accounting is required for debt, the original debt is removed from

the balance sheet, the new debt is recognized at its current fair value and the difference is recorded as a gain

or loss on extinguishment. ASC 470-50 also applies to preferred shares that are classified as liabilities.

However, comparable guidance for evaluating amendments to equity-classified preferred shares does not

exist. The accounting literature does not address how to evaluate whether an amendment to an equity-

classified preferred share should be accounted for as an extinguishment (with a corresponding effect on EPS

and equity). Therefore, there may be certain reasonable accounting policies to apply in making this

evaluation. The SEC staff updated the guidance in ASC 260-10-S99-2 in September 2009 through technical

corrections in ASU 2009-08 and added a scope paragraph explicitly stating that a modification of preferred

shares accounted for as an extinguishment is within its scope. We believe that implicitly acknowledged

that there may be some modifications of preferred shares that do not require extinguishment accounting.

This was further clarified in comments made by the SEC staff at the 2014 AICPA National Conference on

Current SEC and PCAOB Developments:

“The staff believes that an amendment to preferred stock can be of such significance that it

represents an extinguishment of the existing preferred stock and the issuance of new preferred

stock. On the other hand, the staff also believes that an amendment to preferred stock, while

important to the parties, can lack the same level of significance and is more appropriately

characterized as a modification. We believe current accounting literature supports this view. First,

debt literature acknowledges that certain changes are merely modifications while other changes

should be captured by extinguishment accounting. The staff believes it is appropriate to apply

similar analysis to preferred stock. Second, in September 2009 when technical corrections were

made to the scoping guidance to ASC 260-10-S99, the staff believed exchanges of preferred

stock could be either extinguishments or modifications.”

The following are examples of accounting policies that were discussed by the SEC staff and that may be

considered based on the prevailing facts and circumstances:

• Policy based on an evaluation of the changes in projected cash flows — For equity-classified preferred

shares that have well-defined periodic contractual cash flows (especially those determined to have a

debt-like host instrument), an amendment that results in a greater than 10% change in cash flows

based on an analysis similar to ASC 470-50 is an extinguishment. An amendment that does not meet

this criterion is a modification.

• Policy based on a change in fair value — If the fair value of the equity-classified preferred share

immediately after the amendment is significantly different (e.g., by more than 10%) than the fair

value of the instrument immediately before the amendment, the amendment is considered an

extinguishment. An amendment that does not meet this criterion is a modification.

T. Kirk Crews, 2014 — Refer to the SEC website at http://www.sec.gov/News/Speech/Detail/Speech/1370543665379.

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• Policy based on qualitative considerations — An amendment that adds, deletes or significantly changes

a substantive contractual term (e.g., one that is at least reasonably possible of being exercised) or

fundamentally changes the nature of the preferred shares is considered an extinguishment. That

evaluation could include the consideration of both the expected economics, as well as the business

purpose for the amendment. An amendment that does not meet these criteria is a modification.

The SEC staff also discussed what was referred to as a “legal form approach.” Under this approach, any

legal exchange resulting in the issuance of new preferred stock would be viewed as an extinguishment.

Otherwise, any change in terms (regardless of significance) that does not result in the legal exchange of

the preferred stock would be captured as a modification. However, the SEC staff cautioned that the legal

form of the transaction is merely one data point to consider and should not be viewed as determinative

with respect to this issue.

Other observations related to amendments to preferred shares include:

• Changes to the classification of the preferred shares from temporary (mezzanine) to permanent equity

under the guidance in ASC 480-10-S99-3A may be considered an extinguishment under certain

accounting policies whereas the accounting guidance specifically notes that an amendment resulting in

reclassification of an equity instrument (permanent or temporary) to a liability is an extinguishment.

• A small incremental amendment to an equity-classified preferred share may not be an extinguishment

(e.g., an amendment to preclude the issuance of senior equity without permission of preferred stock

holders), yet cumulatively a series of small incremental amendments could result in an instrument

that is very different than the original. Therefore, the issuer may need to consider the cumulative

effect of any amendments over time. This would be similar to the guidance in ASC 470-50-40-12(f)

which requires consideration of changes made within one year.

• In assessing whether an extinguishment has occurred, differences between the current fair value of

equity-classified preferred shares and their current carrying amount we believe would not be considered.

If equity-classified preferred shares are amended and the amendment is viewed as an “extinguishment”

based on the company’s accounting policy and related analysis, the derecognition accounting model in

ASC 260-10-S99-2 discussed above applies.

3.6.2.1.1 Amendments to equity-classified preferred stock instruments due to reference rate transition

(added September 2022)

ASC 848 provides temporary optional practical expedients to the US GAAP guidance on contract

modifications and hedge accounting to ease the financial reporting burdens of the expected market

transition from LIBOR and other interbank offered rates to alternative reference rates, such as the SOFR.

US GAAP, including ASC 848, does not specifically address the modification of equity-classified preferred

stock. In practice, the accounting for such modification is generally based on the SEC staff remarks

discussed in section 3.6.2.1.

At the 2019 AICPA National Conference on Current SEC and PCAOB Developments, an SEC staff

member discussed a consultation on the accounting for amendments to equity-classified preferred stock

instruments due to the cessation of LIBOR (i.e., amendments solely to designate the SOFR as the

replacement rate) when dividend payments were previously indexed to LIBOR.

Jamie N. Davis, 2019 — Refer to the SEC website at https://www.sec.gov/news/speech/davis-speech-2019-aicpa-conference.

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To evaluate the amendments, the issuer considered the business purpose of the amendment and whether

the amendment may influence investors’ decisions. The SEC staff member noted the staff has previously

observed that there are various acceptable approaches for assessing whether preferred stock amendments

are a modification or extinguishment. The SEC staff member further observed that the issuer had elected

an accounting policy to apply a qualitative approach, which is one of the models that the staff has previously

accepted. Since the issuer concluded that the changes were not considered significant on the basis of the

business purpose for the changes and how the changes may influence the investor’s economic decisions,

the Office of the Chief Accountant (OCA) staff did not object to the issuer’s conclusion that the amendments

would be treated as a modification to the preferred stock rather than an extinguishment.

The SEC staff member also addressed whether the modification required accounting recognition. The

SEC staff has previously accepted an analogy to the modification guidance in ASC 718-20, which

requires recognition of the increase in fair value of the modified instrument as a result of the

modification. Because there was no business purpose other than to designate the replacement rate for

LIBOR, the SEC staff did not object to the issuer’s conclusion that the modification is presumed to be

negotiated at fair value, and, therefore, no accounting recognition is necessary.

The views expressed by the SEC staff member for preferred stock are consistent with the relief provided

by the FASB in ASC 848 for other contract modifications due to reference rate transition.

For more information on reference rate reform, refer to ASC 848 and our Technical Line, A closer look

at the FASB accounting relief related to reference rate reform.

3.6.2.2 Accounting for modifications of equity-classified preferred shares that are not extinguishments

When an equity-classified preferred share has been modified and extinguishment accounting is not

considered appropriate, the issuer must evaluate the proper accounting for the modification. An issuer’s

policy for recognizing the effects of a modification should apply an appropriate methodology based on a

careful consideration of the specific facts and circumstances.

There are two accounting models that may be useful when determining the accounting for modifications

of an equity-classified preferred share and the corresponding EPS and equity effects, although the

models focus on the income statement effects of a modification.

• The model for modified debt instruments that are not considered extinguished is discussed in

ASC 470-50. It generally provides for prospective treatment of the modification of the contractual

cash flows by establishing a new effective interest rate to equate the future contractual cash flows

to the carrying amount of the debt. The debt model also specifies the accounting for a modification

which increases the value of an embedded conversion feature.

• The model for a modified share-based payment award that is classified as equity and remains classified

in equity after the modification is addressed in ASC 718-20-35. Under that model, the incremental fair

value from the modification (the difference in the fair value of the instrument immediately before and

immediately after the modification) is recognized as an expense in the income statement to the extent

the modified instrument has a higher fair value. Modifications that result in a decrease in the fair value

of an equity-classified share-based payment award are not recognized.

The modified debt model in ASC 470-50 may be more appropriate when an issuer uses a discounted cash

flow analysis when concluding that an amendment is a modification and not an extinguishment. That

model results in accounting for the change in the equity-classified preferred share generally on a

prospective basis (e.g., changing the amortization period and accretion or the dividend rate on a

prospective basis). Accretion and dividends on equity-classified preferred shares are deducted from net

income to arrive at net income available to common shareholders when calculating EPS.

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For other modifications, the share-based payment model may be more appropriate, especially when there

is a transfer of value from the common shareholders to the preferred shareholders. This may be the case

in a “refinancing” with existing investors, or when preferred shareholders are demanding some form of

compensation or fee for their consent to a company action. Under this model the value transferred from the

common to preferred shareholders is reflected as a deemed dividend reconciling net income to net income

available for common shareholders. If the carrying amount of the preferred share was also adjusted by the

deemed dividend, rather than simply reflecting it as a reconciling item between net income and net income

available for common shareholders (e.g., as is done with cumulative dividends that are not declared during a

period), then the issuer would need to appropriately consider the change in the preferred share’s carrying

value on the subsequent measurement of the preferred share, for example under ASC 480-10-S99-3A. As

noted previously, when analogizing to the share-based payment model, modifications that result in a

decrease in the fair value of an equity-classified preferred share would not be recognized.

3.6.2.3 Liability-classified preferred shares that are modified

For preferred stock instruments classified as liabilities under ASC 480 (refer to sections 3.2.1 and 3.2.2),

the issuer should follow the accounting models for the modification or extinguishment of debt. Refer to

section 2.6 for further details and discussion.

3.7 Financial presentation and disclosure

ASC 505-10-50 outlines the general disclosures required for capital stock, which require that an entity

explain the pertinent rights and privileges of the various securities outstanding, including the following:

• Dividend and liquidation preferences

• Participations rights

• Call prices and dates

• Conversion or exercise prices or rates and pertinent dates

• Sinking-fund requirements

• Unusual voting rights

• Significant terms of agreements to issue additional shares

In addition, ASC 505-10-50 requires an entity to disclose the number of shares issued upon conversion,

exercise or satisfaction of required conditions during at least the most recent annual fiscal period and

any subsequent interim period presented.

Entities are required to disclose terms that may change the conversion or exercise prices of financial

instruments, including those related to down round features, as well as actual changes to conversion or

exercise prices that occur during a reporting period. These disclosures do not pertain to standard antidilution

provisions. Further, when a down round feature is triggered and an entity has recognized its effect pursuant

to ASC 260-10-25-1, the entity is required to disclose that fact and the value of the effect of the down round

feature. Refer to section B.3.4.1 for further discussions on financial instruments with down round features.

ASC 505-10-50 also provides that companies that issue preferred stock (or other senior stock) that have

a preference in involuntary liquidation considerably in excess of the par or stated value of the shares are

required to disclose the liquidation preference of the stock in the equity section of the statement of

financial position in the aggregate, either parenthetically or “in short,” rather than on a per-share basis

or through disclosure in the notes. In addition, companies are required to disclose within its financial

statements, either on the face of the statement of financial position or in the notes thereto, the

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aggregate or per-share amounts at which preferred stock may be called or is subject to redemption

through sinking-fund operations or otherwise, and the aggregate and per-share amounts of cumulative

preferred dividends in arrears.

In addition, ASC 210-10-S99-1 requires certain presentation of capital stock on the face of the balance

sheet or disclosures in the notes if more than one issue is outstanding, including information about the

title of each issue, the dollar amount of each issue, the number of shares authorized and the number of

shares issued or outstanding.

Stock may qualify as a liability (debt) in which case disclosure requirements applicable to debt

instruments would apply to the stock. In addition to those general requirements, various pieces of

authoritative literature provide disclosure requirements that may be applicable to stock transactions,

based on the facts and circumstances.

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4 Equity contracts

4.1 Overview and general description of equity contracts

An entity may issue a freestanding financial instrument (other than an outstanding equity share) whose

value fluctuates with changes in an underlying based on the fair value of the company’s own equity

shares. Those underlying equity shares can include all forms of ownership interests, such as common

and preferred shares, as well as partnership interests, and equity shares of a member of a consolidated

group. This section refers to those freestanding financial instruments as equity contracts. Some equity

contracts may also meet the definition of a derivative pursuant to ASC 815 and not receive an exception

from derivative accounting. Those equity contracts are referred to as “equity derivatives” in this section.

Equity contracts are classified as either liabilities (or assets in some cases) or in equity. Contracts that do

not involve the issuer’s equity shares are subject to other guidance (e.g., ASC 815) and are outside the

scope of this section.

Upon exercise, an equity contract may be settled in net shares or net cash or require physical settlement.

The settlement method may significantly influence the classification of the equity contract. Those

settlement methods are generally described as follows:

• Physical settlement — The party designated in the contract as the buyer delivers the full stated

amount of cash to the seller, and the seller delivers the full stated number of shares to the buyer.

• Net share settlement — The party with a loss delivers to the party with a gain shares with a current

fair value equal to the gain.

• Net cash settlement — The party with a loss delivers to the party with a gain a cash payment equal to

the gain, and no shares are exchanged.

The most basic types of equity contracts are options and forwards. More complex equity contracts can be

created from these basic contracts (e.g., by combing features or instruments).

4.1.1 Common types of equity contracts

There are many varieties of equity contracts. Basic equity options and basic forward contracts are

described first, followed by a description of more complex structures that are constructed from the

basic contracts.

4.1.1.1 Equity option

An option is a contract between two parties that gives one party (the buyer, holder or purchaser of the

option) the right, but not the obligation, to buy or sell an equity security at a reference price, while the other

party (the seller or writer of the option) has the obligation to fulfill the transaction if requested by the buyer.

The most basic types of equity options are call and put options.

• Call options give the holder the right to buy the underlying equity securities on a certain date

(or during a certain period of time) at a fixed or determinable price.

• Put options give the holder the right to sell the underlying equity securities on a certain date

(or during a certain period of time) at a fixed or determinable price.

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Options are also referred to as purchased options from the perspective of the option holder and written

options from the perspective of the option seller. A single option contract is a purchased option to one

party and a written option to the other party. For example, a purchased put option that entitles the

holder to sell shares to the option seller is a written put option from the perspective of the option seller.

Equity options generally are characterized with the following terms:

• Strike price or exercise price — The price (e.g., fixed or formula-determined) at which the option

buyer can buy (call) or sell (put) the underlying equity security

• Exercise date — The date on which an option holder exercises the right to buy or sell the underlying

equity security

• Expiration date — The date after which an option is no longer valid and can no longer be exercised

• Notional — The number of underlying equity securities to be purchased or sold, which can be fixed

or variable

• Premium — The cost that an option buyer pays to acquire the option. Generally, the premium at

inception of an option contains only the time value of the option but can also include intrinsic value

• In-the-money option — A call option where the strike price is less than the then-current fair value of

the underlying equity security or a put option in which the then-current equity security fair value is

lower than the strike price (e.g., If the strike price of a call option is $10 and the current fair value of

the share is $13, that call option is $3 in the money; or if the strike price of a put option is $15 and

the current fair value of the share is $11, that put option is $4 in the money)

• At-the-money option — An option where the contractual strike price equals the then-current fair value

of the underlying equity security

• Out-of-money option — A call option where the strike price is greater than the then-current fair value

of the underlying equity security or a put option where the strike price is less than the then-current

equity security’s fair value

• Intrinsic value — The in-the-money portion of the option’s current fair value (for call options, the

intrinsic value is the excess of the underlying equity security’s fair value over the strike price; for put

options, it is the excess of the strike price over the underlying equity security’s fair value.)

• Time value — The difference between the option’s fair value and its intrinsic value (the time value generally

represents the value of the instrument attributed to the volatility of the underlying share (i.e., the chance

an option could go in the money or further in the money) and the length of time to exercise.)

• American option — An option that can be exercised at any time up to the expiration date

• European option — An option that can be exercised only on the expiration date itself

• Bermuda option — An option that can be exercised only on predetermined dates

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Warrants are call options written by the issuer that permit the holder to purchase the issuer’s equity shares

at a specified price on a certain date or during a certain period of time. Similarly, rights offerings are also

written call options by the issuer to provide investors the right to receive additional shares of the issuer.

In some cases, the exercise price of a warrant is set at a penny (often referred to as a penny warrant).

While the payoff of a penny warrant is essentially the same as actually holding the underlying shares, it is

viewed as an equity contract because the warrant contains all of the characteristics of an equity option

as described above and usually lacks the other legal characteristics of a share (such as the ability to

vote). Refer to section 5.13 for additional discussion of penny warrants.

4.1.1.2 Equity forward

An equity forward is a contract between two parties under which one party must deliver (sell), at a future

date (maturity or settlement date), an equity security in exchange for an agreed-upon price that the

other party must pay. Unlike an option, both parties to a forward contract are required to perform in

accordance with the agreed-upon terms. A contingent forward requires the parties to perform upon the

occurrence of an event that is not certain to occur.

An equity forward differs from a spot purchase, in which the purchase or delivery of the equity security

occurs on the transaction date at the current market price. Some forward contracts may have the

forward price paid at inception and the shares delivered at a future date (prepaid forward).

The basic equity forwards on an issuer’s own equity securities are:

• Forward purchase — A contract requiring the issuer to buy its own shares from the seller at a

predetermined price at a future date.

• Forward sale — A contract requiring the issuer to sell its own shares to the buyer at a predetermined

price at a future date.

Equity forwards generally are characterized with the following terms:

• Forward buyer — The party that agrees to buy the underlying equity security (also referred to as a

long position).

• Forward seller — The party that agrees to sell the underlying equity security (also referred to as a

short position).

• Notional — The number of underlying equity securities to be delivered, which can be fixed or variable.

• Forward price — The price (e.g., fixed or formula-determined) the buyer will pay upon maturity or

settlement date to acquire the underlying equity security. Sometimes also referred to as the

contract price.

The agreed-upon forward price is usually set at market, such that the fair value of the contract is zero at

inception. The payoff of a forward at maturity depends on the relationship between the forward price and

the underlying share price at that time. The contract results in a gain to one party and a loss to the other

party as the underlying share price fluctuates.

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4.1.1.3 Variable share forward

A variable share forward is a forward contract that has a fixed forward price but the number of shares

underlying the forward (i.e., the number of shares to be delivered in a physical settlement) varies. The

number of shares is determined by dividing the contract price by some measure of share price (e.g., share

price at period end, an average share price for some period). For example, if the forward price is $100,000

and the average share price is $10, the number of shares that the issuer repurchases would be 10,000;

if the average share price is $15, the number of shares would be 6,667.

A range forward is a common variation of the basic variable share forward. The number of shares

underlying a range forward varies based on the then-current fair value of the shares relative to preset

price levels. If the share price is above an upper threshold, the seller delivers a fixed number of shares

equal to the contract price divided by that upper threshold. If the share price is below a lower threshold,

the seller delivers a fixed number of shares equal to the contract price divided by that lower threshold. If

the share price is between the two thresholds, the seller delivers a variable number of shares equal to the

contract price divided by the then-current share price.

4.1.1.4 Prepaid forward purchase

A prepaid forward purchase contract requires the issuer (the forward purchaser) to prepay the counterparty

a fixed amount up-front in exchange for the delivery of shares at a future date (the maturity date). That

number of shares to be received can be either fixed or variable, such as the variable share forwards

discussed in section 4.1.1.3.

4.1.1.5 Accelerated share repurchase

An accelerated share repurchase (ASR) is an arrangement executed by a company with an investment

bank to repurchase shares that generally results in an immediate effect to EPS but settles the economics

of the share repurchase at a future date based on the subsequent stock price.

In a traditional ASR, the issuer makes an up-front payment and receives a specific number of shares from

the bank in a contract typically documented as a forward purchase contract. Upon maturity (typically

three to six months later), the ASR is settled based on the VWAP of the issuer’s shares during the contract

period. Through this settlement, changes in the stock price subsequent to the initial share purchase serve

to increase or decrease the overall cost of the share repurchase by the issuer under the ASR.

There are many different ASR structures. The accounting depends on the specific terms of the

arrangement. Refer to section 5.9 for a detailed discussion of certain ASR transactions.

4.1.1.6 Equity collar

An equity collar is a combination of a purchased option and a written option on the issuer’s own shares.

It can be structured to consist of a purchased put option with a strike price at or below the current share

price (lower strike) and a written call option with a strike price above the current market price (higher

strike). The put option provides the issuer with the right to sell its own stock while the call option permits

the counterparty to buy the issuer’s stock at a specific price on or before a specific date. An equity collar

may also be a combination of a lower strike written put option and higher strike purchased call option.

When the premium received from sale of the written option completely offsets premium paid for the

purchased option within the collar, the arrangement is referred to as a zero cost collar.

The accounting for an equity collar depends on whether it is issued as a single instrument with two

features or as separate financial instruments. Refer to section 4.2.1.1 for a discussion on analyzing an

instrument with more than one component.

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Frequently, issuers use a collar strategy to limit their exposure to changes in the share price that arises

from other outstanding equity contracts on their stock. For instance, a traditional ASR exposes the issuer to

a potentially unlimited payment if the stock price rises during the forward period. To mitigate the potential

payment, the issuer may incorporate a collar arrangement (which consists of a high strike purchased call

option and a low strike written put option) in the ASR to limit the range of the settlement price.

Refer to section 5.9.3 for further discussion of collared ASR structures.

4.1.1.7 Call spread transaction

One form of equity collar is a call spread. A call spread is a combination of a purchased call option at a

specific strike price (referred to as the low strike call option) and a written call option at a higher strike

price (referred to as the high strike call option). For example, a call spread permits the issuer to buy

shares from the counterparty if the price is above $10 (a purchased call option) and permits the

counterparty to purchase shares from the issuer if the strike price is above $14 (a written call option).

The transaction can be documented as either a single combined option contract (a capped call option)

or as two separate option contracts.

Call spreads are often entered into in conjunction with convertible debt issuances. In those transactions,

the purchased call option (referred to in those cases as the “bond hedge”) usually has a strike price equal

to the conversion price of the convertible debt and economically offsets the payoff of the conversion

option. The written call option partially finances the purchased call option. The combined economics of

the convertible debt and the call spread is a synthetic increase of the strike price of the convertible debt.

Refer to section 5.16 for further discussion of convertible debt with a call spread structure.

4.1.1.8 Prepaid written put option

A prepaid written put option is a written put option on the issuer’s own shares in which the issuer has

prepaid the strike price of the option at inception of the transaction. Some refer to this instrument by its

original commercial product name of a “Dragon” (due to the shape of the payoff diagram) or CAESAR

(cash enhanced share repurchase).

In a typical prepaid written put transaction, often executed in a form of a European option, the issuer

(the option writer) makes an up-front payment to the counterparty (the option purchaser) in an amount

equal the strike price of the put option (normally the spot price at inception) less the option premium the

issuer is entitled to receive from the option purchaser for providing the put option.

At maturity, the written put option will be settled in one of two ways:

• If the stock price on the settlement date is below the strike price, the counterparty will deliver to the

issuer the specified number of shares underlying the option. No cash is paid by the issuer as the

strike was prepaid at inception.

• If the stock price on the settlement date is above the strike price, the issuer will receive from the

counterparty a payment equal to the option strike price (i.e., a return of the prepaid strike price).

The payment may also be in a form of variable number of the issuer’s shares equal to the amount

due, at the issuer’s choice.

Companies often use a prepaid written put option to lower the overall cost of their share repurchase

programs. Refer to section 5.17 for further discussion on prepaid written put options.

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4.1.1.9 Puttable warrant

A puttable warrant (sometimes called a put warrant) is a warrant with an embedded put option. The

warrant will have terms that either permit the holder to require the issuer to pay cash to (1) repurchase

the warrant itself or (2) purchase the shares obtained upon the holder’s exercise of the warrant (i.e., put

the shares) at a specified date for a fixed monetary amount.

A puttable warrant can be distinguished from a warrant where the underlying shares have a term that

makes them redeemable. However, the accounting for a warrant for redeemable shares is similar to the

accounting for a puttable warrant. Refer to section 5.7 for additional discussion of warrants for

redeemable shares.

4.1.1.10 Tranched preferred share financing

A tranched preferred share issuance, also referred to as a delayed issuance of preferred shares or a

contingent issuance of preferred shares, consists of an initial issuance of preferred shares and a later or

second tranche or delayed issuance. This later tranche (or in some cases tranches), while contractually

agreed to at the initial closing date, results in preferred shares being issued at a specific future date or on

the occurrence of a future event or milestone. The future issuance may be automatic, optional in the

control of the issuer, optional in the control of the investor or entirely contingent on external factors.

Tranched preferred share transactions are commonly used by emerging biotech and technology entities

to fund research and development and general operations. The later tranche(s) are often timed to

coincide with a future expected need for capital to continue the entity’s product development. Refer to

section 5.8 for further discussion.

4.1.1.11 Contracts settled in the stock of a consolidated subsidiary

A parent company may enter into freestanding equity contracts that are indexed to, and potentially

settled in, the stock of a consolidated subsidiary. Those equity contracts can take the form of options or

forwards. Refer to section 5.10 for a discussion of equity contracts on NCI.

4.1.1.12 Share lending arrangement

An entity may enter into a share lending arrangement that is executed separately from, but in contemplation

of, a convertible debt offering (or some other convertible financing transaction). Although the convertible

debt instrument is ultimately sold to investors, the share lending arrangement is an agreement between

the convertible debt issuer (share lender) and the investment bank (share borrower) and is intended to

increase the availability of the issuer’s shares in order to facilitate the ability of the investors to hedge

the conversion option in the issuer’s convertible debt. Companies often execute share lending arrangements

to facilitate a convertible instrument offering or increase the attractiveness of an offering. Refer to

section 5.5 for further discussion.

4.1.1.13 Unit structures

Unit structures are a combination of (1) a debt or trust preferred security and (2) a warrant or a forward

contract to purchase the issuer’s common stock. The debt (or sometimes preferred stock) and equity

contracts in a typical unit generally are deemed to be separate instruments as the holder may transfer or

settle the equity contract separately from the debt instrument. The debt and equity contracts are detachable

and, therefore, analyzed and accounted for separately. Refer to section 5.2 for further discussion.

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4.2 Issuer’s initial accounting for freestanding equity contracts (including flowchart)

This section describes the steps generally necessary to determine the accounting for equity contracts

at issuance.

The following flowchart summarizes the analysis at a conceptual level and should be used in conjunction

with the related guidance that begins after the flowchart.

4.2.1 Box A — Equity contracts within the scope of ASC 480

ASC 480 applies only to freestanding financial instruments that embody an obligation of the issuer.

The guidance defines a freestanding financial instrument as a financial instrument that is entered into

(1) separately and apart from any of the entity’s other financial instruments or equity transactions or

(2) in conjunction with some other transaction and is legally detachable and separately exercisable.

Refer to section A.3.2.2 for further discussion on determining whether an instrument is freestanding.

The term “obligation” refers to either a conditional or unconditional obligation on the part of the issuer to

transfer assets or issue equity shares. Equity contracts that do not embody any obligation to the issuer

are not liabilities pursuant to ASC 480.

Classify the

instrument in equity.

Box F: Classify the

equity contract as an

asset or liability.

Yes

Box E: Does the equity contract meet all the

conditions for equity classification?

Yes

Record the equity contract as liability (or an

asset in some circumstances) pursuant to

ASC 480.

Box A: At inception, does the equity contract

embody an obligation to (1) buy back the

issuer’s equity shares by transferring assets

or (2) issue a variable number of shares for

which the monetary value is predominantly

(a) fixed, (b) varying with something other

than the fair value of the issuer’s equity

shares or (c) varying inversely in relation

to the issuer’s equity shares?

Box B: Is the equity contract indexed to the

issuer’s own stock?

Box C: Does it meet the definition of a

derivative?

Box G: Determine if the equity contract

meets the definition of a derivative and

if so, it is subject to the derivative

disclosures requirements.

Account for the

equity contract as

a derivative.

Box D: Classify the

equity contract as an

asset or liability.

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For example, options purchased by the issuer do not embody obligations of the issuer because they

permit, but do not require, the issuer to buy or sell shares (whether on a gross or net basis). Therefore,

purchased options are not subject to ASC 480. On the other hand, contracts that require or could require

the issuer to purchase or issue its shares (e.g., forward purchase contracts, written put options, written

call options on redeemable shares) are obligations and thus could be subject to ASC 480.

A prepaid forward purchase contract whereby the issuer prepays the forward price at inception (refer to

section 4.1.1.4) is not an obligation if the issuer prepays the forward price at inception and has no

further obligation to either transfer an asset or issue equity shares to the counterparty. Accordingly,

such a prepaid forward is not a liability pursuant to ASC 480.

In addition to mandatorily redeemable shares, ASC 480 generally requires liability classification for the

following broad classes of freestanding equity contracts:

• Instruments (other than an outstanding equity share) that, at inception, embody, or are indexed to,

an obligation to buy back the issuer’s equity shares that requires or could require transfer of assets

(ASC 480-10-25-4 through 25-13). Examples are:

• Forward contracts that require the issuer to purchase its own shares

• Written options that permit the counterparty to require the issuer to buy back its own shares.

Equity contracts in this category are not classified in equity because they usually represent an

obligation in that the issuer knows it will, or can be forced to, settle an obligation or distribute assets,

which is more akin to a liability.

• Instruments (other than an outstanding share) that embody an obligation, that the issuer must or

may settle by issuing a variable number of its equity shares if, at inception, the monetary value of the

obligation is based solely or predominantly on any one of the following conditions (ASC 480-10-25-14):

• Has a fixed value known at inception (e.g., an obligation to deliver shares with a fair value at

settlement equal to $1,000) (ASC 480-10-25-14(a))

• Derives its value from an underlying other than the issuer’s equity shares (e.g., an obligation

to deliver shares with a fair value at settlement equal to the value of one ounce of gold)

(ASC 480-10-25-14(b))

• Has a value to the counterparty that moves in the opposite direction to changes in fair value of

the issuer’s shares (e.g., net share settled written put options) (ASC 480-10-25-14(c))

ASC 480 defines “monetary value” as the fair value of the cash, shares or other instruments that a

financial instrument obligates the issuer to convey to the holder at the settlement under specified

market conditions.

Equity contracts in this category are classified as liability (or an asset) because they do not expose

the counterparty to risks and rewards similar to those of an owner and therefore, do not create a

shareholder relationship.

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The following table lists certain common equity contracts and whether they are in the scope of ASC 480.

Equity contract

(single contract)

In scope of

ASC 480

Outside scope

of ASC 480

Forward purchase contract (contract to purchase issuer’s own shares)

Forward sale contract (contract to sell issuer’s own shares)

Equity collar with lower strike purchased put option and higher strike

written call option (issuer holds the collar)

Equity collar with lower strike written put option and higher strike

purchased call option (issuer provides the collar)

Purchased call option

Purchased put option

Written call option

Written put option

Warrant on puttable shares or puttable warrants

An equity contract determined to be a liability (or an asset in some circumstances) pursuant to ASC 480

should follow the initial and subsequent measurement and disclosure requirements of that guidance. In

addition, if the instrument also meets the definition of a derivative under ASC 815 (including consideration

of all scope exceptions), the disclosures in that guidance are also required.

Refer to section A.3 for further discussion of financial instruments in the scope of ASC 480.

4.2.1.1 Equity contracts with more than one component

ASC 480 also provides specific guidance on freestanding financial instruments that are composed of more

than one option or forward contract embodying obligations that may require settlement by transfer of

assets or delivery of a variable number of shares. Various scenarios are described in ASC 480-10-55-29

through 55-52.

Examples of those instruments include puttable warrants (or forwards) and equity collars. A puttable

warrant has a written call option that entitles the holder to buy the issuer’s shares and a written put

option that entitles the holder to put the warrants back to the issuer at a specified price. Similarly, a

forward sale contract on puttable shares obligates the holder to buy and the issuer to sell a number of

shares at a specified price and contains a written put option that entitles the holder to put the shares

obtained upon the settlement of the forward back to the issuer at a specified price. An equity collar is a

combination of a purchased option and a written option. Although containing two options, an equity

collar is legally one freestanding instrument because the two option components are not legally

detachable and separately exercisable.

Provided the underlying shares are not puttable.

The contract also does not embody, nor is it indexed to, an obligation to repurchase the issuer’s equity shares that could require

settlement by transferring assets. Also, while this equity contract embodies an obligation that may require the issuer to issue a

variable number of its equity shares, the obligation is not based on any of the three types under ASC 480-10-25-14.

This freestanding equity collar is subject to the provisions of ASC 480 due to the written put component. If required to be physically

settled or net cash settled, the contract is a liability pursuant to ASC 480-10-25-8 through 25-13 because it embodies an obligation

that may require repurchase of the issuer’s equity shares and settlement by a transfer of assets. If net share settlement is required,

the equity collar could also be a liability pursuant to ASC 480-10-55-43 (refer to section 4.2.1.1.2 for further discussion).

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4.2.1.1.1 Component requires or may require transfer of assets (ASC 480-10-25-8 through 25-13)

Generally, if a financial instrument is composed of more than one component and any component obligates

the issuer to repurchase shares (or is indexed to such an obligation) and may require a transfer of assets,

the presence of this obligation would require the entire financial instrument be classified as a liability (or an

asset in some circumstances). For example, a puttable warrant is a liability pursuant to ASC 480-10-25-8

through 25-13 because the put option component embodies an obligation that is indexed to repurchasing

the issuer’s shares and may require a transfer of assets. The same is true for a warrant for shares that are

puttable for cash. Both instruments embody an obligation that may require a transfer of assets.

4.2.1.1.2 Component requires delivery of a variable number of shares (ASC 480-10-25-14)

ASC 480-10-55-43 summarizes a two-step approach to evaluating instruments where one component

requires or may require the delivery of a variable number of shares. The approach is different than that

for the contract that requires or may require a transfer of assets.

An issuer should first identify all component obligations. Each component obligation should be evaluated

to determine whether that component potentially requires the delivery of a variable number of shares

and, if freestanding, would be a liability pursuant to the three conditions outlined in ASC 480-10-25-14,

as discussed in section 4.2.1.

If any component(s) potentially requiring delivery of a variable number of shares meets one of the

conditions in ASC 480-10-25-14, the issuer should next determine whether the monetary value of that

component obligation(s), is (collectively) predominant over the collective monetary value of all other

component obligation(s) identified. If so, the entire instrument would be classified as a liability (or an

asset in some circumstances). Otherwise, the equity contract is not in the scope of ASC 480 and other

guidance should be considered.

While not defined in ASC 480, the concept of predominance is discussed briefly in ASC 480-10-55-44

and is illustrated in several examples in ASC 480. We generally believe the determination of whether a

component(s) is predominant is based on the likelihood the equity contract will settle in accordance

with that particular component(s), compared to the likelihood of settling under the other component

obligation(s). The issuer should analyze an equity contract at inception and consider all possible outcomes

to evaluate which component obligation(s) is predominant. The information to be considered includes the

issuer’s current stock price and volatility, the strike price of the instrument and other factors.

Consider a collar arrangement that is comprised of a higher strike purchased call option and a lower strike

written put option that requires net share settlement. The written put option component, if freestanding,

would be within the scope of ASC 480 because its value moves in the opposite direction as the fair value

of the issuer’s shares, pursuant to ASC 480-10-25-14(c). Once identified, the monetary value of this

component obligation is assessed to determine whether it is predominant over the monetary value of

the other component obligation. In this case, because the collar does not contain any other obligations

(the purchased call option does not embody any obligation and therefore does not affect the classification

of the entire instrument), the net settled written put component obligation governs the classification of

the instrument (i.e., it is predominant). As such, the collar in its entirety should be classified as a liability

(or asset) and recognized at fair value with changes in fair value recognized in earnings.

Even though the value of the purchased call option may exceed the value of the written put option at

inception (i.e., a net purchased option), the instrument is within the scope of ASC 480 because the

written put option component, if freestanding, would be a liability pursuant to ASC 480-10-25-14(c) as

the monetary value of the issuer’s obligation to deliver a variable number of shares under the written put

option varies inversely in relation to changes in the fair value of the issuer’s share price. The fair value

would represent an asset if the fair value of the purchased option component exceeds the fair value of

the written option component, and would represent a liability if the opposite were true.

Refer to sections A.5.1.1 and A.6.1.4 for further discussion of compound financial instruments.

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4.2.1.2 Puttable warrants and warrants on redeemable shares

Puttable warrants (refer to section 4.1.1.9) and warrants on redeemable shares are generally required to

be classified as a liability pursuant to ASC 480 because they embody an obligation or are indexed to such

an obligation to repurchase the issuer’s shares and may require a transfer of assets by the issuer to settle

the obligation.

Refer to section 5.7 for additional discussion of warrants on redeemable shares.

4.2.1.3 Forward purchase contract

A freestanding forward contract for the issuer to purchase its equity shares that requires physical or

net cash settlement is generally classified as a liability (or asset) because that instrument embodies an

obligation that requires settlement by the issuer transferring assets (ASC 480-10-25-8 through 25-13).

If net share settlement is required, the forward purchase contract is classified as a liability pursuant to

ASC 480-10-25-14(c) because that instrument embodies an obligation by the issuer to deliver a variable

number of shares and the monetary value of that obligation to the holder moves inversely in relation to

changes in the fair value of the issuer’s equity shares. ASC 480-10-25-14(c) requires instruments with

such characteristics to be classified as liabilities because they do not establish a shareholder relationship

with the counterparty, as the payoff to the counterparty has an inverse relationship to changes in the fair

value of the underlying equity shares.

As a result, regardless of the form of settlement, all forward purchase contracts are liabilities pursuant to

ASC 480. However, the measurement attributes may be different based on the form of settlement.

Refer to sections A.5.1.1 and A.6.1.3 for additional discussion.

4.2.1.4 Variable share forward

A variable share forward contract (refer to section 4.1.1.3) is an equity contract that requires the issuer

to settle the contract by issuing a variable number of its equity shares (this can be in the form of a

forward to sell or a net share settled forward to purchase). Because it embodies an obligation of the

issuer to deliver a variable number of shares, the instrument should be evaluated pursuant to ASC 480-

10-25-14. That paragraph states that financial instruments, other than an outstanding share, that

embody obligations that can be settled by issuing a variable number of shares are 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 one of several conditions, one of which is that the settlement amount has a fixed

value (ASC 480-10-25-14(a)).

In a variable share forward contract, the number of shares deliverable upon settlement is determined

based on the market price of the shares at the settlement date. That is, the number of shares delivered

is obtained by dividing the contract price (agreed to at inception) by the fair value of the shares at

settlement. In some cases, an average market price over a period of time (e.g., the last 30 days) may be

used in the calculation.

Although the number of shares will be variable (based on the fair value of the issuer’s shares), the holder

will receive a fixed monetary value equal to the fixed contract price. In a situation where the variable

number of shares to be issued is based on an average market price (e.g., an average market price for the

shares over the last 30 days) instead of the share price on the date of settlement, ASC 480-10-55-22

indicates that while the monetary value of the obligation is not entirely fixed at inception and is based, in

small part, on variations in the fair value of the issuer’s equity instruments, the monetary value of the

obligation is predominantly based on a fixed monetary amount known at inception.

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Overall, the forward contract embodies an obligation for which the issuer must issue a variable number

of its equity shares upon settlement. Because at inception the final settlement amount that the issuer is

obligated to deliver represents a fixed monetary amount (regardless of the share price at delivery), the

variable share forward should be classified as a liability pursuant to ASC 480-10-25-14(a).

Refer to section A.6.1.1 for further discussion of this concept.

4.2.1.5 Range forward

The settlement of a range forward sale contract (refer to section 4.1.1.3) depends on where the share

price on the settlement date falls within the ranges defined in the agreement. Because the forward seller

(i.e., the issuer) may be required to deliver a variable number of its own shares, consideration of

ASC 480-10-25-14 is required.

Consider the following example:

Illustration 4-1: Range forward sale contract

A range forward sale contract provides that, at the end of one year, the counterparty will purchase

and the issuer will sell for $25 a variable number of shares of the issuer’s common stock based on the

average price for a period of 30 days ending on the settlement date as follows:

• If the common stock price at the settlement date is at or above $30, the counterparty will receive

0.83 shares of stock upon settlement of the contract.

• If the price of a share of the issuer’s common stock at the settlement date is at or below $25, the

counterparty will receive one share of stock upon settlement of the contract.

• If the price of a share of the issuer’s common stock at the settlement date is between $25 and

$30, the counterparty will receive a variable number of shares of the issuer’s stock equal to $25

in value. For example, if the stock price is $26, the counterparty will receive approximately

0.962 ($25/$26) shares of stock upon settlement of the contract. If the stock price is $29, the

counterparty will receive approximately 0.862 ($25/$29) shares on settlement.

ASC 480-10-25-14 requires liability accounting for equity contracts that embody an obligation to

transfer a variable number of shares provided that the monetary value of the obligation is based solely or

predominantly on: (1) a fixed monetary amount, (2) variations in something other than the fair value of the

issuer’s shares or (3) variations inversely related to changes in the fair value of the issuer’s equity shares.

The analysis of the range forward sale contract pursuant to the three conditions in ASC 480-10-25-14

follows:

• A fixed monetary amount — The issuer is required to deliver a variable number of shares with a fixed

value ($25) when the price of the issuer’s stock is between $25 and $30. However, if the stock price

is outside of that range, the issuer will deliver a fixed number of shares. Because the forward includes

a range in which the number of shares to be delivered is variable, but the monetary value of the

shares to be delivered is fixed, the instrument should be evaluated pursuant to ASC 480-10-25-14(a)

to determine whether liability classification is required. Specifically, the issuer should determine

whether such a fixed monetary amount is predominant with respect to the entire settlement

obligation that also includes obligations to issue (1) a fixed number of shares associated with the

downside range (price less than $25) and (2) a fixed number of shares associated with the upside

range (price greater than $30).

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Because the counterparty bears much of the potential the risks of a decreasing price for a share

(if the stock declines below $25) and much of the potential benefits from an increasing price for a

share (if the stock appreciates above $30), the probability of the share price at settlement being

outside the range, where a fixed number of shares with a variable settlement amount is delivered,

may be sufficient enough that such settlement obligation would not be considered predominant.

The determination of whether the fixed monetary amount settlement is predominant should consider

standard valuation theory, volatility and length to expiration, etc. Generally, the narrower the price

range requiring delivery of a variable number of shares equal to a fixed monetary amount, the less

likely this type of forward would be a liability pursuant to ASC 480-10-25-14(a).

• Variations in something other than the fair value of the issuer’s shares — The monetary value of the

obligation is based solely on the number of shares to be delivered and the share price of the issuer’s

common stock at settlement. Therefore, this instrument would not be classified as a liability pursuant

to ASC 480-10-25-14(b).

• Variations inversely related to changes in the fair value of the issuer’s equity shares — The payoff to

the counterparty of the forward sale contract fluctuates positively in relation to changes in the fair

value of the issuer’s common stock. Although there is a range within which the monetary value does

not change, outside that range they do move in a direction consistent with changes in share price.

Therefore, this instrument would not be a liability pursuant to ASC 480-10-25-14(c).

Based on the analysis above, if the range equity forward would not be a liability under ASC 480, further

analysis under the equity contract road map using the guidance in ASC 815-40 is necessary to determine

the instrument’s classification and measurement.

4.2.2 Box B — Equity contracts indexed to the issuer’s own stock

A contract that is not in the scope of ASC 480 is evaluated under the guidance in ASC 815-40. ASC 815-40

applies to both (1) instruments that meet the definition of a derivative and are evaluated for the exception

from derivative accounting pursuant to ASC 815-10-15-74(a) and (2) instruments that do not meet the

definition of a derivative and are evaluated for the appropriate classification. The guidance in ASC 815-

40 states that contracts should be classified as equity instruments (and not as an asset or liability) if they

are both (1) indexed to the issuer’s own stock and (2) classified in stockholders’ equity in the issuer’s

statement of financial position.

To determine whether an equity contract is indexed to the issuer’s own stock, it should be analyzed

pursuant to the indexation guidance in ASC 815-40-15-5 through 15-8, including the related

implementation guidance. There are two steps in evaluating an instrument. The first step evaluates any

contingent exercise provisions and the second step requires an analysis of provisions that could change

the instrument’s settlement amount.

In the first step, an exercise contingency (as defined in the indexation guidance) does not preclude an

instrument from being considered indexed to an entity’s own stock provided that it is not based on either

of the following:

a. An observable market, other than the market for the issuer’s stock (if applicable)

b. An observable index, other than an index calculated or measured solely by reference to the issuer’s

own operations (e.g., sales revenue of the issuer, earnings before interest, taxes, depreciation and

amortization of the issuer, net income of the issuer, or total equity of the issuer)

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In the second step, an instrument is considered indexed to an entity’s own stock if its settlement amount

equals the difference between (1) the fair value of a fixed number of the entity’s equity shares and (2) a

fixed monetary amount or a fixed amount of a debt instrument issued by the entity. While the second

step appears to be a strict fixed-for-fixed concept, an exception is provided such that if the instrument’s

strike price or the number of shares used to calculate the settlement amount is not fixed, the instrument

could still be considered indexed to an entity’s own stock if the only variables that could affect the

settlement amount would be inputs to a fair value valuation model for a fixed-for-fixed forward or option

on equity shares. Accordingly, any feature that adjusts the settlement amount of an equity contract

should be carefully analyzed.

If based on the indexation guidance the equity contract is not considered indexed to the issuer’s own

stock, it would be precluded from equity classification (i.e., asset or liability classification is required).

Refer to section B.3 for further discussion of the indexation guidance.

4.2.2.1 Adjustments affecting an equity contract’s settlement amount, including antidilution and

down round provisions

Equity contracts frequently contain provisions that adjust the instrument’s terms to protect the investor

(and sometimes the issuer) from a loss of value due to events that were not expected to occur or events

in the control of the issuer that could be detrimental to the holder, such as merger, tender offer,

nationalization, insolvency or delisting. In addition, certain other events such as a hedging disruption,

increased cost of hedging, inability to borrow stock and increased cost of stock borrowing could also

trigger adjustments. The basic equity instrument pricing models do not incorporate an expectation of

these events, and thus the possibility of these events occurring is usually excluded from the pricing. To

protect the parties from the impact of these events, the contractual agreement frequently provides that

if those identified events occur, the contract terms will be adjusted. If such a provision is triggered,

usually the strike price or the number of shares covered by the contract is adjusted such that the

settlement amount would change to protect one party to the contract.

ASC 815-40-15-7G clarifies that certain adjustments to the fixed-for-fixed notion that were designed to

compensate one of the parties to the instrument for changes in value that could not be incorporated into

a pricing model should not preclude a conclusion that an instrument is indexed to the issuer’s stock. It

states that:

“Standard pricing models for equity-linked financial instruments contain certain implicit assumptions.

One such assumption is that the stock price exposure inherent in those instruments can be hedged

by entering into an offsetting position in the underlying equity shares. For example, the Black-

Scholes-Merton option-pricing model assumes that the underlying shares can be sold short without

transaction costs and that stock price changes will be continuous. Accordingly, for purposes of

applying Step 2, fair value inputs include adjustments to neutralize the effects of events that can

cause stock price discontinuities. For example, a merger announcement may cause an immediate

jump (up or down) in the price of shares underlying an equity-linked option contract. A holder of that

instrument would not be able to continuously adjust its hedge position in the underlying shares due

to the discontinuous stock price change. As a result, changes in the fair value of an equity-linked

instrument and changes in the fair value of an offsetting hedge position in the underlying shares will

differ, creating a gain or loss for the instrument holder as a result of the merger announcement.

Therefore, inclusion of provisions that adjust the terms of the instrument to offset the net gain or

loss resulting from a merger announcement or similar event do not preclude an equity-linked

instrument (or embedded feature) from being considered indexed to an entity’s own stock.”

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Example 17 in ASC 815-40-55-42 and 55-43 illustrates that adjustments to the terms of an instrument

to offset the dilution caused by certain events would not preclude the contract from being considered

indexed to the issuer’s own equity. The variables (i.e., triggers) that affect the settlement amount in that

example are inputs (or underlying assumptions) to the fair value of a fixed-for-fixed option on equity

shares. It points out that an implicit assumption in standard pricing models for equity-linked financial

instruments is that such events that could dilute the counterparty will not occur or that the strike price of

the instrument will be adjusted to offset the dilution caused by such events.

For example, if the issuer were to issue shares for less than their then-current fair value, the current

investors are economically diluted (because the proceeds of the sale are less than the fair value of the

shares issued, the fair value per share outstanding after the issuance is reduced). Likewise, if the entity

purchased shares for more than their then-current fair value, existing shareholders are diluted (the entity

gives up assets with a fair value in excess of the shares repurchased, thereby reducing the fair value per

remaining share).

A down round feature adjusts the settlement amount of the instrument if the issuer subsequently sells

equity at a price lower than the strike price of the equity contract. Importantly, this adjustment provides

protection to a particular investor in promising to give the investor the lowest pricing available to any

other investors, rather than protecting against true economic dilution. The provision has been relatively

common in transactions between hedge funds, private equity funds, and venture capitalists and their

investees, as well as in many privately negotiated transactions by public companies (such as transactions

involving privately issued convertible debt and warrants). A down round provision by itself does not preclude

instruments from being considered indexed to a company’s own stock. Refer to section B.3.4.1 for additional

discussion of the application of the indexation guidance to instruments with down round provisions.

Refer to sections B.3.3.2, B.3.4.1 and related FAQs in Appendix B for additional discussion of

adjustments to a fixed-for-fixed contract.

4.2.2.2 Equity contracts executed in ISDA forms

Equity contracts that are executed using standard ISDA documentation should be carefully reviewed

because they frequently contain provisions that adjust the instrument’s terms, including the strike price

or the number of shares upon specified events such that the settlement amount would change. Those

adjustments are typically triggered upon the occurrence of antidilution or extraordinary events

(e.g., merger, tender offer, nationalization, insolvency, delisting). In addition, certain other events such as

hedging disruption, increased cost of hedging, loss of stock borrowing and increased cost of borrowing

could also trigger adjustments, depending on what the ISDA contract defines as the adjustment events.

By adjusting the terms (and thus the settlement amount) of the equity contract (or perhaps terminate the

instrument in some cases), the counterparty’s exposure to the risks embodied in those events is mitigated.

The second step of the indexation guidance, and the related examples, was in large part created to address

certain adjustment and termination provisions found in the standard ISDA forms. Upon triggering events,

the indexation guidance requires the calculation of the resulting adjustment to be commercially reasonable.

The ISDA agreements stipulate that the calculation agent (as named in the ISDA confirmation) is

responsible for making certain determinations, adjustments and calculations when required. The calculation

agent pursuant to the ISDA Equity Definitions must act or exercise judgment in good faith and in a

commercially reasonable manner. Additionally, the ISDA confirmation frequently explicitly states that

whenever an adjustment or determination is made, it should be made in a commercially reasonable

manner. Generally, these provisions comply with the indexation guidance but should be carefully analyzed.

Refer to section B.3.3.2 and related FAQs in Appendix B for additional discussion of adjustments to a

fixed-for-fixed contract.

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4.2.3 Box C — Equity contracts and the definition of a derivative

An equity contract that is not indexed to the issuer’s own stock should be classified as an asset or

liability. However, the subsequent measurement basis depends on whether the instrument meets the

definition of a derivative. If such an equity contract meets all of the characteristics of a derivative and

does not meet any other scope exceptions, ASC 815 requires the instrument to be measured at fair value

with changes recorded in earnings.

If the equity contract does not meet the definition of a derivative, subsequent measurement is not

directly addressed in the authoritative guidance. While it requires asset or liability classification for

such an instrument, the indexation guidance does not provide information on subsequent measurement.

Other guidance (e.g., the SEC staff’s view on written options for SEC registrants) should be considered

to determine the appropriate measurement basis.

To be a derivative pursuant to ASC 815, an equity contract should have all of the following characteristics:

• A derivative’s cash flows or fair value must fluctuate and vary based on the changes in one or

more underlyings.

• The contract contains one or more notional amounts or payment provisions or both.

• The contract 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 (1) provides for net settlement, (2) can be settled net through a market mechanism

outside the contract or (c) provides for delivery of an asset that, because the delivered asset is

readily convertible to cash, puts the recipient in a position not substantially different from net

settlement (a gross settlement that is economically equivalent to a net settlement).

Refer to section 1.2.3 of this publication and section 2.4 of our FRD publication, Derivatives and hedging ,

for additional guidance on the definition of a derivative.

4.2.4 Box D — Equity contracts not indexed to the issuer’s own stock and not

meeting the definition of a derivative

In some cases, an equity contract is not any of the following:

(a) A liability pursuant to ASC 480

(b) Indexed to the issuer’s own equity pursuant to the indexation guidance

As an example, private companies often issue equity contracts (especially warrants and forward sale

contracts) that require gross physical settlement where the shares transferred for cash are not publicly

traded, In that case the instruments are not within the scope of ASC 815 as there is no net settlement

(gross settlement for shares that are not readily convertible to cash). However, in many cases such

warrants or forward contracts for private companies will have favorable adjustment provisions to the

investors that are not compliant with the indexation guidance. In those cases, the indexation guidance

requires the instrument to be classified as an asset or liability (although it does not specify the subsequent

measurement). Generally, equity contracts are initially measured at fair value (or allocated value). Refer to

section 4.4.4 for subsequent measurement guidance. Importantly, for SEC registrants, ASC 815-10-S99-4

outlines the SEC staff’s belief that written options not classified in equity should be subsequently measured

at fair value through earnings.

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4.2.5 Box E — Equity contracts classified in equity

If an equity contract is considered indexed to the issuer’s own stock, it is next evaluated under the equity

classification guidance. To determine whether a freestanding equity contract would be classified in

stockholders’ equity, the equity classification guidance in ASC 815-40-25-1 through 25-43 should be

considered, including the related implementation guidance (primarily codified in ASC 815-40-55-1

through 55-18).

The equity classification guidance contains detailed criteria for an equity contract to be classified in

equity. That determination is heavily dependent on how the instrument settles and whether an

acceptable form of settlement is entirely within the control of the issuer.

The equity classification guidance generally indicates that an equity contract on a company’s own stock

would be considered to be classified in equity under either of the following types of settlement:

• Required physical settlement or net share settlement

• Issuer has a choice of net cash settlement or settlement in its own shares (physical settlement or net

share settlement), regardless of the intent of the issuer

However, an equity contract would not be considered classified in equity if either of the following

provisions is present:

• Required net cash settlement (including a requirement to net cash settle if an event occurs that is

outside the control of the issuer)

• Holder has choice of net cash settlement or settlement in shares (physical settlement or net share

settlement)

ASC 815-40-25-7 through 25-38 include additional conditions that should be met for equity classification.

These conditions are considered to test whether the issuer will have the ability, in all cases, to effect the

settlement in shares. Otherwise, net cash settlement is presumed (even if not contractually stated) and

equity classification is not appropriate. Each criterion (as summarized below) should be met, and the

failure to meet a single condition results in asset or liability classification:

• Settlement is permitted in unregistered shares

• Entity has sufficient authorized and unissued shares

• Contract contains an explicit share limit

• No required cash payments if entity fails to timely file

• No cash-settled top-off or make-whole provisions

• No counterparty rights rank higher than shareholder rights

• No collateral requirements

These criteria should be applied based on a theoretically possible standard (i.e., if it is theoretically possible

that the criteria could not be met outside of the issuer’s control, net cash settlement is presumed). Issuers

should also evaluate the implementation guidance in ASC 815-40-55-2 through 55-6 that discusses

circumstances where equity classification is appropriate despite the possibility of a cash settlement if

holders of the same class of underlying shares also would receive cash in exchange for their shares.

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Equity-classified contracts are initially measured at fair value (or allocated value). Subsequent changes in

fair value are not recognized as long as the contracts continue to be classified in equity. In contrast, if an

equity contract that was indexed to the issuer’s own stock fails the requirements for equity classification,

it should be classified as an asset or liability at fair value with subsequent changes in fair value recorded

in earnings.

Refer to section B.4 for a comprehensive discussion of the equity classification guidance.

4.2.5.1 Equity contracts executed in ISDA forms

Equity contracts executed using ISDA documentation usually contain provisions that could trigger an early

termination of the instrument. For example, in an event of default, extraordinary event (e.g., merger or

tender offer, etc.) or other market disruption events, one of the parties could terminate and request a

settlement of the contract. In those circumstances the standard ISDA terms often specify the default

settlement method.

When evaluating settlement provisions under early termination, the issuer should consider whether it has

the choice to select an equity-qualified settlement method in all situations, regardless of probability of the

situation occurring. Some of the standard provisions in the ISDA contract (either the Master Agreement or

the Equity Definitions) invoke a net cash settlement when early termination events have occurred.

For example, the contract may stipulate cancellation and payment as the settlement method upon a

tender offer. In practice, issuers may address this automatic trigger of net cash settlement by including

in the ISDA confirmation language that states, notwithstanding any other terms or settlement provisions

in the associated ISDA Master Agreement or Equity Definitions, that in all cases the issuer can override

those provisions and choose the form of settlement. The effect of these provisions should be carefully

considered in determining if conditions for equity classification are met.

Other provisions in ISDA agreements may also affect the determination of the instrument’s classification

and should be carefully evaluated. The following is a list of some common provisions and where they are

discussed in Appendix B:

• Settlement as a part of counterparty bankruptcy (section B.4.4.6)

• Netting or set-off of contracts (section B.4.4.6)

• Posting of collateral (section B.4.4.7)

4.2.5.2 Equity contracts issued in registered form

Companies may issue equity contracts using a registration statement. The most common type of equity

contract offered through a registration statement is a registered warrant.

Under existing securities law, the issuance of a warrant is an offer to sell the underlying share, and the

exercise and settlement of the warrant is the completion of the sale of the share. This construct for

registered warrants in the securities law has a significant effect on how they are analyzed under the

accounting guidance because, as a general rule under the securities law, a sale that “starts public” and

requires current financial information with its offer must “stay public” with similar current financial

information available at its completion. In other words, if a warrant is offered in a registered form (starts

public), settlement in registered shares is likely required under the securities laws (stays public).

In contrast, for a registered forward contract, the concept is slightly different. Because both parties

agree to buy and sell the shares at inception and are not required to make any subsequent decision

regarding the sale, the settlement of the forward is viewed as a delayed delivery of what was already

agreed to at inception rather than the completion of the sale. No additional funds are being placed at risk

and therefore current information in the form of timely filings is usually not necessary.

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4.2.5.2.1 Meeting the settlement in unregistered shares criterion for registered warrants

To satisfy the equity classification guidance, particularly the condition in ASC 815-40-25-11 through

25-18, the issuer of an equity contract should have the ability to settle the contract with unregistered

shares. That analysis involves consideration of both the terms of the instrument (especially the

settlement methods) and securities law when evaluating a registered warrant.

Securities counsel may need to be consulted to confirm the proper application of the securities laws to

the specific facts and circumstances. The following is a general discussion of the issues:

• If a registered warrant requires gross physical settlement, delivery of registered shares will likely be

required under the securities law, as additional consideration is transferred (put at risk) by the holder

in the completion of the sale. In this case, equity classification may still be appropriate if those shares

are registered at the inception of the transaction and there are no further timely filings or

registration requirements (ASC 815-40-25-16).

Generally, the issuer registers the shares into which the registered warrant would be exercised under

the same registration statement at inception of the transaction. Whether there are further timely

filing requirements under the securities laws depends on the terms of the warrant. If the expiration

date of the warrant runs past the due date for the next periodic filing (Form 10-Q or 10-K) for the

issuer, the issuer is required to meet the ongoing filing requirements to maintain an effective

registration statement covering the warrant and underlying shares. Generally, maintaining an effective

registration statement is not considered within the control of the issuer because the issuer does not

control all the factors necessary to ensure timely filings (e.g., the issuer is not assured of obtaining

an independent auditor’ review report). Even if the registered warrant explicitly states unregistered

shares could be issued, that contractual provision would likely be deemed non-operational under the

securities law. In this case, delivery of shares is not deemed within the issuer’s control and the

criteria under the equity classification guidance cannot be met.

In practice, to address the securities law requirement to settle registered warrants by delivering

registered shares, issuers insert language in the warrant agreement that states (1) the warrant

cannot be exercised except during periods where an effective registration statement is available or

(2) the issuer is not required to pay cash if it cannot deliver registered shares upon settlement. These

overriding clauses explicitly rebut the presumption of settlement in cash when the issuer is required

to deliver registered shares but maybe unable to do so.

• In contrast, if the registered warrant permits net share settlement (also called cashless exercise), it is

likely that registered shares can be issued under a specific exemption in the securities law for certain

exchanges of securities because no additional consideration is put at risk at settlement. Therefore,

settlement in registered shares is usually deemed to be within the control of the issuer in the case of

net share settlement, provided the issuer controls the choice of settlement form.

• If a registered warrant permits either gross physical settlement or net share settlement, one should

consider which entity (the issuer or the holder) controls the decision over the settlement form. If the

holder can select the settlement method, then physical settlement is assumed and the related

securities law considerations should be incorporated into the analysis as discussed above. This is

because the holder theoretically would have the ability to demand gross physical settlement and,

even though an economically equivalent net share settlement is permitted in the contract, would not

have to accept net share settlement if registered shares were not available for physical settlement of

There are differences of opinion as to when future timely filings are necessary to maintain the effectiveness of or issue shares

from an existing registration statement. Refer to section B.4.4.1 for further discussion.

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the warrant at the time of exercise. Therefore, it is theoretically possible (regardless of how remote)

that the issuer may be required to deliver registered shares, thus failing to meet the “settlement in

unregistered shares” criterion.

The following table summarizes the effect that various settlement provisions have on private issuances

and public issuances for comparison (assuming all other criteria for equity classification are met):

Form

Physical settlement

Net share settlement

Net cash settlement

Private issuance

Generally equity

classification

Generally equity

classification

Generally liability

classification if holder can

elect this, or if this is the

issuer’s only choice

Public issuance

Generally liability

classification as shares

issued must be covered by

an effective registration

statement, maintenance of

which is outside issuer’s

control

Generally equity

classification as shares

issued are covered by an

exemption in securities law

and may be considered

“registered”

Generally liability

classification if holder can

elect this form, or if this is

the only choice available to

the issuer

For the equity contract to be eligible for equity classification either (a) all the contractual settlement

methods must result in equity classification or (b) the issuer must have the choice of settlement methods

and at least one qualifies for equity classification.

Refer to section B.4.4.1 for additional discussion on the evaluation of the ability to settle in unregistered

shares.

4.2.5.3 Warrants issued in a PIPE transaction

A private issuance of public equity (PIPE) transaction is a form of equity offering under an exemption in

the securities law for qualifying private placements by issuers of publicly traded equity securities. These

issuances often include both common shares and warrants issued as a separable unit, and neither

instrument is registered when issued.

The warrant in a PIPE transaction is subject to all of the relevant guidance for equity contracts. As these

are private placements, unlike registered warrant offerings, the securities law does not require settlement

in registered shares (the general concept of “private stays private,” although discussion with securities

counsel is strongly encouraged). Provided the contract does not specify settlement in registered shares,

the criteria in ASC 815-40-25-11 through 25-18 will likely be met.

Because the investor may be receiving unregistered shares on settlement, a PIPE transaction typically

includes a registration rights agreement that requires the issuer to file a registration statement covering

the resale of the shares initially issued and the shares to be issued under the warrant (and perhaps even

the warrant itself). The purpose of a registration rights agreement is to provide the investor with liquidity

for its investment.

This subsequent registration process should not be confused with a transaction where the securities are

offered initially pursuant to an effective registration statement. In the case of registration at inception,

the issuance takes on a public characteristic and will have to be settled publicly. In the case of the filing of

a registration subsequent to initial issuance (e.g., to comply with a registration rights agreement), it is

the future resale transaction of the underlying shares, rather than the existing securities being offered,

that is registered. Therefore, a subsequent registration that is executed as required under a registration

rights agreement generally does not flip the initial private transaction to a public transaction. Securities

counsel may be needed to interpret the securities laws.

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A registration rights agreement frequently includes a penalty provision if the registration is not achieved

on a timely basis. That penalty provision is not relevant in assessing whether there are cash payments

required if an entity fails to timely file, provided the registration rights agreement meets all the criteria in

ASC 825-20, Financial Instruments — Registration Payment Arrangements. Refer to section 5.11 for a

discussion of registration rights agreements.

4.2.6 Boxes F and G — Equity contracts not meeting equity classification guidance

An equity contract that is either (a) an ASC 815 derivative but does not receive an exception from

derivative accounting pursuant to ASC 815-10-15-74(a) or (b) a non-derivative equity contract that does

not meet the criteria for equity classification, is classified as an asset or liability and measured at fair value

with subsequent changes in fair value recorded in earnings.

An equity contract that does not qualify for equity classification pursuant to the equity classification

guidance but meets the definition of a derivative and does not meet any other scope exceptions pursuant to

ASC 815 is subject to the provisions of that guidance as a derivative, including its disclosure requirements.

To be a derivative pursuant to ASC 815, an equity contract should have all of the following characteristics:

• A derivative’s cash flows or fair value must fluctuate and vary based on the changes in one or

more underlyings.

• The contract contains one or more notional amounts or payment provisions, or both.

• The contract requires no initial net investment or requires an initial net investment that is smaller

than would be required for other types of contracts expected to have a similar response to changes

in market factors.

• The contract (1) provides for net settlement, (2) can be settled net through a market mechanism

outside the contract or (3) provides for delivery of an asset that, because the delivered asset is

readily convertible to cash, puts the recipient in a position not substantially different from net

settlement (a gross settlement that is economically equivalent to a net settlement).

Refer to section 1.2.3 of this publication and section 2.4 of our FRD publication, Derivatives and hedging,

for additional guidance on the definition of a derivative.

4.3 Issuance costs

Companies often incur costs in connection with the issuance of equity contracts (e.g., underwriting fees,

legal costs). ASC 340-10-S99-1 states that specific incremental costs directly attributable to a proposed

or actual offering of equity securities may properly be deferred and charged against the gross proceeds

of the offering.

Analogizing to that guidance, specific incremental costs directly attributable to the issuance of an equity

contract to be classified in equity should generally be recorded as a reduction in equity. However, issuance

costs for equity contracts that are classified as assets and liabilities should be expensed immediately.

4.4 Subsequent accounting and measurement

The subsequent accounting and measurement of an equity contract depends on the instrument’s

classification. An equity contract is classified in one of the following ways:

• As an ASC 480 liability (or an asset in certain circumstances) if the contract met the conditions

pursuant to ASC 480-10-25-8 through 25-13 or ASC 480-10-25-14 (refer to section 4.4.1)

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• As an equity instrument if the contract (regardless of whether it met the definition of a derivative

pursuant to ASC 815 or not) met the requirements of the indexation and equity classification

guidance in ASC 815-40 (refer to section 4.4.2)

• As an asset or liability under one of the following scenarios:

(a) The contract meets the definition of a derivative and does not qualify for an exception from

derivative accounting pursuant to ASC 815-10-15-74(a) as it fails either the indexation or the

equity classification guidance in ASC 815-40 (refer to section 4.4.3).

(b) The contract does not meet the definition of a derivative and is considered indexed to the

issuer’s own equity pursuant to the indexation guidance but fails to meet all the criteria of the

equity classification guidance in ASC 815-40 (refer to section 4.4.3).

issuer’s own equity pursuant to the indexation guidance in ASC 815-40 (refer to section 4.4.4).

Equity contracts may require reclassification between equity and an asset or liability subsequent to

issuance. Additionally, from time to time, equity contracts may be modified or settled prior to maturity.

4.4.1 Equity contracts subject to ASC 480 liability classification

ASC 480 provides specific subsequent measurement guidance for forward contracts that require physical

settlement by repurchase of a fixed number of the issuer’s equity shares in exchange for cash. All other

equity contracts within the scope of ASC 480 are measured subsequently at fair value with changes in fair

value recognized in earnings, unless other accounting guidance specifies another measurement attribute.

4.4.1.1 Measurement of a physically settled forward contract

A physically settled forward contract to purchase a fixed number of the issuer’s shares for cash should be

measured initially at the fair value of the shares at inception, adjusted for any consideration or unstated

rights or privileges, with an offset to shareholder’s equity. This amount would generally be expected to

equal the present value of the amount to be paid at settlement.

If the settlement date and amount are both fixed, the forward should be measured subsequently at the

present value of the settlement amount (i.e., forward price), accruing interest cost using the implicit rate

in the forward contract. Accretion on the liability is treated as interest expense. We generally believe any

dividend paid on the underlying shares prior to actual settlement should also be expensed consistent with

its classification as a liability.

If a physically settled forward contract is subject to a variable redemption amount or the settlement date

varies, the contract subsequently should be recognized at the amount of cash that would be paid under

the specified conditions if the exchange occurred at the reporting date. The change in that amount from

the previous reporting date should be recognized as interest expense.

Refer to section A.5.2 for further discussion on the measurement of contracts within the scope of ASC 480.

4.4.2 Equity contracts classified as equity pursuant to ASC 815-40

For equity contracts classified in equity, the instrument is not subsequently remeasured, unless it

requires reclassification from equity to an asset or liability (refer to section 4.4.5).

Refer to section B.3.4.1 for discussions on the recognition and measurement of down round features in

equity contracts classified in equity.

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4.4.3 Equity contracts that meet the definition of a derivative and do not receive an

exception from derivative accounting and equity contracts indexed to the

issuer’s shares but failing the equity classification guidance

Equity contracts that meet the definition of a derivative and do not receive an exception from the

derivative accounting pursuant to ASC 815 are assets or liabilities and measured at fair value with

changes in fair value recorded in earnings.

Similarly, equity contracts (whether or not they meet the definition of a derivative) that are indexed to

the issuer’s shares but do not meet the equity classification guidance are classified as assets or liabilities

and measured at fair value with changes in fair value recorded in earnings.

4.4.4 Equity contracts that are not derivatives and also not indexed to the entity’s

own shares

The indexation guidance states that equity contracts not indexed to the issuer’s own shares should be

classified as an asset or liability, but does not provide subsequent measurement guidance.

In these circumstances, if the issuer is an SEC registrant, the SEC staff has a longstanding position that

written options that don’t qualify for equity classification should be initally recorded at fair value and

subsequently marked to fair value through earnings.

Otherwise, those instruments do not have a

defined measurement basis. In this case, the issuer may measure the equity contract at fair value (if the

fair value option is elected) or at cost in which case impairment should be considered.

4.4.5 Reclassification of equity contracts

ASC 815-40-35-8 requires an issuer to reassess the classification of an equity contract at each balance

sheet date. If the classification changes because of events occurring during the reporting period, the

instrument is reclassified as of the date of the event that caused the reclassification.

The classification conclusion could change due to changes in the issuer’s capital structure or other

transactions (e.g., issuance of new equity contracts, issuance of shares in another transaction) that

would affect whether there are a sufficient number of authorized and unissued shares for settlement of

the instrument. In addition, equity contracts that provide the issuer with the choice to elect net cash

settlement or settlement in its own shares may require reclassification upon the issuer’s irrevocable

election of net cash settlement during the settlement period. These equity contracts often have extended

settlement periods (e.g., 45 days) and require the issuer to make an irrevocable settlement election at

the beginning of the settlement period.

Equity contracts that do not initially meet the definition of a derivative pursuant to ASC 815 may

subsequently satisfy all the characteristics of a derivative and thus, should be evaluated pursuant to

ASC 815-40. For example, an equity contract may not have met the definition of a derivative if gross

settlement were required and the issuer was not a public company (i.e., the underlying shares were not readily

convertible to cash). That condition could change if the issuer underwent an IPO and its shares now were

readily convertible to cash. In that case, the equity contract would now meet the definition of a derivative.

If reclassification from equity to an asset or liability is required, the contract is reclassified at its then-

current fair value. The change in fair value of the contract during the period the contract was classified

as equity should be accounted for as an adjustment to stockholders’ equity. If a contract is reclassified

from an asset or a liability to equity, it is measured at fair value one last time through earnings and any

previous gains or losses recognized during the period that the contract was classified as an asset or a

liability are not reversed.

ASC 815-10-S99-4

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In some cases, partial reclassification may be required for an equity contract. Refer to section B.6 for

further discussion about reclassification.

4.4.6 Modification of equity contracts

An issuing entity may modify the terms of an equity contract from time to time. Among other potential

changes, modifications may involve an increase in the number of underlying shares or a reduction in the

exercise price of the equity contract (e.g., a warrant’s exercise price) to induce exercise and thus raise

new capital. Others may be made in connection with modifications to the issuer’s other capital transactions

(e.g., preferred stock).

The accounting for a modification to an equity contract depends primarily on whether the contract is

classified in equity or as an asset or liability.

4.4.6.1 Modification of equity-classified contracts

There is no specific guidance that addresses a modification of an equity-classified contract. We generally

believe the accounting for such a modification depends on the nature of, and reason for, the modification,

with measurement for the modification based on analogy to the share-based compensation guidance.

The model for a modified share-based payment award that is classified as equity and remains classified in

equity after the modification is addressed in ASC 718-20-35-3. Under that model, the incremental fair

value from the modification (the change in the fair value of the instrument immediately before and

immediately after the modification) is recognized as an expense in the income statement to the extent

the modified instrument has a higher fair value. Modifications that result in a decrease in the fair value of

an equity-classified share-based payment award are not recognized.

A similar model may be appropriate for measuring the effects of a modification to equity-classified

contracts. However, the charge may not always be recorded in the income statement. In some cases, it

may be more appropriate to record the charge in retained earnings (e.g., dividends to a particular class

of equity holders). In some limited cases, the effect of the modification could be capitalized, such as when

a company modifies a warrant with a third-party holder because that holder’s permission is needed in

order for the company to issue debt.

The accounting for modifications of equity-classified contracts requires professional judgment and

should be based on the individual facts and circumstances.

4.4.6.1.1 Modification or exchange of certain equity-classified written call options (after the adoption

of ASU 2021-04)

(added September 2022)

Issuers should account for modifications or exchanges of freestanding equity-classified written call

options (e.g., warrants) that remain equity classified after the modification or exchange based on the

economic substance of the modification or exchange. For modifications or exchanges of written call

options in the scope of another ASC topic, such as ASC 718, issuers should follow the guidance in those

topics to account for these transactions.

ASU 2021-04, Earnings Per Share (Topic 260), Debt — Modifications and Extinguishments (Subtopic 470-50), Compensation —

Stock Compensation (Topic 718), and Derivatives and Hedging — Contracts in Entity’s Own Equity (Subtopic 815-40): Issuer’s

Accounting for Certain Modifications or Exchanges of Freestanding Equity-Classified Written Call Options (a consensus of the

Emerging Issues Task Force). The ASU is applied prospectively to all modifications or exchanges that occur on or after the date of

adoption. It is effective for all entities for fiscal years beginning after 15 December 2021, and interim periods within those fiscal

years. Early adoption is permitted, but entities need to apply the guidance as of the beginning of the fiscal year that includes the

interim period in which they choose to early adopt the guidance.

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The guidance in ASC 815-40-35-14 through 35-18 requires an issuer to consider the facts and

circumstances of a modification or exchange of an equity-classified freestanding written call option and

applies the following guidance to account for the resulting change in fair value of the written call option

(measured as the difference between the fair value of the modified or exchanged written call option and

the fair value of the original written call option immediately before it is modified or exchanged), based on

the reason for the modification or exchange:

• To issue equity: Any increase in fair value is accounted for as an equity issuance cost that reduces

additional paid-in capital under ASC 340-10-S99-1.

• To issue debt: Any increase in fair value is accounted for as a debt issuance cost or a discount under

ASC 835.

• To modify an existing debt instrument: If the written call option is held by a creditor, any change

(increase or decrease) in fair value is (1) included in the 10% cash flow test in ASC 470-50 used to

determine whether to account for a modification or exchange of an existing debt instrument held by

that same creditor as an extinguishment and (2) considered a fee between the debtor and the

creditor when applying the guidance in ASC 470-50 on accounting for fees between a debtor and a

creditor as part of a modification or an exchange of a debt instrument and in 470-60 on troubled

debt restructurings. If the written call option is held by a third party that is directly involved with the

debt modification or exchange, an increase (but not a decrease) in the fair value of the modified or

exchanged written call option should be accounted for in the same manner as a third-party cost that

is directly related to the modification or exchange of a debt instrument under ASC 470-50.

• For other reasons: Any increase in fair value is accounted for as a deemed dividend that reduces

retained earnings and EPS, if the modification is not in the scope of any other US GAAP guidance.

If a modification or exchange falls into more than one of the categories listed above (e.g., equity issuance

and debt modification), the issuer must allocate any change in fair value among those aspects of the

transaction and account for the amounts as described above.

4.4.6.2 Modification of equity contracts classified as assets or liabilities

When an equity contract that is classified as an asset or liability and measured at fair value is subsequently

modified, the effect of the changed terms will be reflected in the subsequent measurement and thus will

generally be recognized in earnings. Similar to the discussion in section 4.4.6.1, depending on the facts

and circumstances, the change in fair value due to the modification may be classified differently from the

rest of the change in the fair value, and the classification may vary based on the nature of, and reason

for, the modification.

4.4.6.3 Modification of equity contracts resulting in a reclassification

Judgment should be applied in determining the appropriate accounting for a modification to an equity

contract that results in its reclassification between equity and assets or liabilities. Generally, if a contract is

modified such that it is reclassified to equity, an analogy to the guidance for reclassifications in ASC 815-40

would suggest that the contract be measured at fair value one last time and then reclassified. However, if

an equity-classified contract was modified to result in classification as an asset or liability, analogy to the

reclassification guidance in ASC 815-40 may not be appropriate. Rather, other guidance (ASC 718-20-35-3

or ASC 260-10-S99-2) might suggest recognition of some amount (for example, the difference between

the fair value before and after the modification) as an expense or deemed dividend.

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4.5 Settlement/termination

Upon settlement or termination, if an equity contract is classified as an asset or liability at fair value, the

instrument is marked to its fair value at the settlement date and then the asset is realized or liability settled.

• If cash is received or paid in the settlement, it is recorded as a debit or credit for the amounts transferred.

• Any shares received or delivered are recorded at that balance in equity as treasury stock (if shares

are received) or as shares issued (if shares are delivered) with appropriate allocation to common

stock at par and the remainder to APIC related to common shares. If the treasury shares are

considered retired, separate accounting is performed.

For certain contracts accounted for at an accreted value or settlement value (e.g., forward purchase

contracts pursuant to ASC 480), a debt extinguishment model is followed, with the consideration transferred

recognized at fair value, the liability relieved and any resulting difference resulting in a gain or loss.

If the instrument is classified as equity, any cash received or paid in the settlement is recorded as a debit

or credit for the amounts transferred with offset to APIC. If any shares are received or delivered they are

generally recorded in equity as treasury stock (if shares are received) or as shares issued (if shares are

delivered) with appropriate allocation to common stock at par and APIC. If the treasury shares are

considered retired, separate accounting is performed.

If an equity contract that is classified as equity is settled at an amount that is different from the contractual

settlement value, the issuer should consider whether there are stated or unstated rights or privileges that

should be given separate accounting consideration (similar to the treasury stock transactions described

in ASC 505-30).

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5 Selected transactions

5.1 Debt (or preferred share) exchangeable into common stock of another issuer

5.1.1 Overview and background

Debt (or preferred shares) that is exchangeable into common stock (exchangeable debt or exchangeable

preferred shares) of another issuer is a security that is structured to lock in the appreciation in the fair

value of the issuer’s investment in another entity’s common stock. These instruments have a variety of

trademarked names such as DECS (debt exchangeable into common stock) and PRIDES (preferred

redeemable increased dividend equity security). These instruments exclude debt (or preferred shares)

exchangeable into the common stock of a consolidated subsidiary that is a substantive entity, which

should be analyzed similar to convertible debt (or preferred shares). This section focuses on accounting

considerations for exchangeable debt. The accounting is similar for an exchangeable preferred share.

Exchangeable debt is in many ways similar to traditional debt (e.g., a stated interest rate, par value,

maturity date), except that at maturity the holders will receive either the common stock of another entity

(the referenced shares) based on a formula (driven by the fair value of the referenced shares) or a cash

payment in an amount equal to the fair value of the referenced shares. Therefore, the settlement

amount of the debt is generally different from the par or carrying amount of the exchangeable debt.

Typically, the issuer owns the referenced shares (which generally are publicly traded) and accounts for

them as equity investments measured at fair value, with changes in fair value recognized in net income

(FV-NI) pursuant to ASC 321. The proceeds from the issuance often approximate the fair value of the

referenced shares at issuance. The exchangeable debt permits the issuer to substantially reduce the risk

of a decline in the value of its investments in the referenced shares, while retaining some of the potential

appreciation through the settlement of the debt.

The following example summarizes the terms of a typical exchangeable debt transaction:

Illustration 5-1: Exchangeable debt

Assumptions:

• Company XYZ owns MNO stock, which are equity securities accounted for at FV-NI pursuant to

ASC 321. At the time of acquisition, Company XYZ paid $5 for each share of MNO stock. At the

date the exchangeable debt was issued, the fair value of MNO stock was $20.

• Company XYZ issues exchangeable debt with a $20 principal amount (per bond), which matures in

three years and bears interest at 6%. The interest is payable on a quarterly basis.

• At maturity, Company XYZ will settle the debt at its option either by (1) delivering a number of shares

of MNO stock based on the following formula or (2) paying cash equal to the fair value of the shares

determined in (1):

• If the market price of MNO stock is less than $20, Company XYZ will deliver one share of MNO

stock to debt holders. Company XYZ does not bear any risk of loss in the event of a decline in

MNO stock below $20 because the loss in the investment in MNO stock is offset by the

decrease in the settlement obligation in the debt. This provision represents an embedded

purchased put option on MNO stock at $20 per share.

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• If the market price of MNO stock is between $20 and $25, Company XYZ will deliver a

fractional share of MNO stock equal to $20 to debt holders. For example, if Company MNO

stock is trading at $22 per share, the exchangeable debt holder would receive 0.91 shares,

worth $20 ($22 x 0.91 shares). Company XYZ retains all appreciation between $20 and $25

of its investment in MNO stock.

• If the market price of MNO stock is greater than $25, Company XYZ will deliver 0.8 shares of

MNO stock to debt holders. For example, if MNO stock is trading at $30 per share, the

exchangeable debt holder would receive stock worth $24 in settlement of the debt. On a net

basis, the company would retain 0.2 shares of MNO stock worth $6 ($30 x 0.2 shares). Thus,

Company XYZ retains 20% of the MNO appreciation of MNO stock over $25. This provision is

considered to be an embedded written call option on 0.8 shares of MNO stock at a strike price

of $25 per share.

• In essence, the exchangeable debt holders incur the risk of loss when the market price of MNO

stock falls below $20 and receive 80% of any appreciation in the stock above $25 per share.

• The exchange feature comprises two derivatives: a purchased put option (i.e., Company XYZ sells

the MNO stock to the exchangeable debt holders at $20 per share if the share price is below $20)

and a written call option (i.e., Company XYZ sells the MNO stock to the exchangeable debt holders

at 80% of the then current fair value if the share price is above $25).

• The fair value of the embedded derivatives is determined to be $5 for the purchased put option

(an asset) and $5 for the written call option (a liability) at issuance.

The accounting discussion below uses the assumptions from the above example.

5.1.2 Analysis

5.1.2.1 At issuance

The exchange feature (viewed as two embedded options) is an equity-linked derivative embedded in a

debt instrument. It is not clearly and closely related to the host debt instrument because it is indexed

to another entity’s stock (and thus does not qualify for the scope exception in ASC 815-10-15-74(a)).

The issuer should bifurcate the exchange feature, unless the issuer elects the fair value option for the

exchangeable debt pursuant to the guidance in ASC 815-15-25-4, which would require the hybrid

instrument to be measured at fair value with any changes in fair value recognized in earnings.

ASC 815-15-25-7 through 25-10 requires separate embedded derivatives to be bundled together as a

single, compound derivative instrument that would be bifurcated from the host contract. For illustration

purposes, the journal entries below separately present the components of the embedded derivatives (the

purchased put option and the written call option) and changes in their fair value.

Pursuant to ASC 815-15, the derivative should be bifurcated at its fair value, with the residual recorded

as the carrying amount of the exchangeable debt instrument.

The transaction could potentially be decomposed differently. For example, the same economics could be expressed as the

combination of (1) a prepaid physically settled forward sale contract on one share of MNO for $20 plus (2) a net share settled

purchased call option with a $20 strike on one share of MNO plus (3) a net share settled written call option with a $25 strike price

on 0.8 shares of MNO. The prepaid physically settled forward would consist of a debt host contract and an embedded forward

contract. Thus, in this decomposition, there would be a debt host and a compound embedded derivative consisting of three

components (two call options and the forward).

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Illustration 5-2: Exchangeable debt – initial accounting

The issuer would record the exchangeable debt instrument at the proceeds from issuance ($20).

Pursuant to ASC 815, the embedded derivative would be bifurcated from the host instrument and

accounted for separately at fair value.

Cash

$ 20

Purchased put option

Debt

$ 20

Written call option

5.1.2.2 Subsequent accounting

Assume that as of the next balance sheet date, the fair value of MNO stock has increased to $30.

5.1.2.2.1 Exchangeable debt

Interest expense (including amortization of any issuance costs, premiums or discounts, etc.) would be

recognized using the effective interest method pursuant to ASC 835-30-35-2 through 35-5.

5.1.2.2.2 Bifurcated derivative

As the fair value of the MNO stock increases above $25, the liability for the written call option increases

in value while the asset for the purchased put option decreases in value.

Illustration 5-3: Exchangeable debt – subsequent accounting

Assume the fair value of the purchased put option decreased by $2 for time value decay (with no change

in intrinsic value) and the fair value of the written call option liability increased by $3, consisting of a $1

decrease in time value and a $4 increase in intrinsic value (as the shares increased to $30, the increase

in the intrinsic value of the written call option is calculated as 80% of the $5 gain in excess of $25).

Expense

$ 5

Purchased put option

$ 2

Written call option

5.1.2.2.3 Investment in MNO

Consistent with ASC 321, the MNO shares would continue to be accounted for as equity investments

measured at FV-NI.

Illustration 5-4: Exchangeable debt – subsequent accounting (continued)

Company XYZ would mark its investment in MNO stock to $30 per share and the incremental

unrealized gain of $10 ($30 current market price less the $20 market price at issuance of the

exchangeable debt) would be reflected in net income.

Investment in MNO

$ 10

Other income (expense)

$ 10

Only for illustration purposes, the journal entry separately presents the components of the embedded derivatives (the purchased

put option and the written call option) and changes in their fair value. Under US GAAP, they should be bifurcated and separately

accounted for from the host debt instrument as one compound derivative.

ASC 815 does not specify the classification of changes in the fair value of derivatives, but requires disclosure of where the

changes are reported in the statement of financial performance.

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5.1.2.3 At maturity

At maturity, the exchangeable debt obligation would be extinguished. The time value of the options

would have declined to zero. The exchange feature would be settled. Any delivery of shares of MNO stock

in satisfaction of the obligation would be recognized as a sale of equity investments. Because the

changes in fair value of MNO stock are reported in earnings as they occur, there is no gain or loss

recognized when these investments are sold.

Illustration 5-5: Exchangeable debt – accounting at maturity

Continuing with the example, assume the value of MNO stock remained at $30 per share.

As the remaining time value in the purchased put option decreased $3 to zero and the remaining time

value in the written call option liability decreased $4 to zero, with no further change in intrinsic value

as the fair value of MNO stock remained at $30, the embedded features would be adjusted through

income as follows

Written call option

$ 4

Purchased put option

$ 3

Income

The ending balance of the written call option is a $4 liability before settlement.

The settlement of the debt, exchangeable feature and the sale of investment in MNO stock would be

recorded as follows:

Debt

$ 20

Written call option

Investment in MNO (80% x $30)

$ 24

5.1.3 Exchangeable preferred shares

Typically, an exchangeable preferred share would likely be classified as a liability pursuant to ASC 480-10-25-4

because the share is mandatorily convertible into another entity’s shares or settled in cash and, therefore,

embodies an unconditional obligation to settle the preferred stock by transferring assets (i.e., either the

issuer’s investments in another entity’s stock or cash) at maturity. An exchangeable preferred share should

generally be analyzed similar to exchangeable debt.

5.2 Unit structures (updated September 2022)

5.2.1 Overview and background

Unit structures are a combination of (1) debt or preferred stock and (2) a warrant or a forward contract

to purchase the issuer’s common stock. When viewed on a combined basis, the instruments provide the

holder with the economics of a convertible instrument. Some recent structures have used convertible

preferred stock and a forward contract.

Below are examples of typical unit structures, each of which include a summary of the significant terms

of the unit structure and the related accounting analysis. For EPS considerations, refer to section 6.5 of

our FRD publication, Earnings per share.

Only for illustration purposes, the journal entry separately presents the components of the embedded derivatives (the purchased

put option and the written call option) and changes in their fair value. Under US GAAP, they should be bifurcated and separately

accounted for from the host debt instrument as one compound derivative.

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5.2.1.1 Unit structure — Debt instrument

Illustration 5-6: Unit structure with a senior unsecured note

Company A (the issuer) issues 1 million units to investors in a public offering at $100 per unit. Each

unit comprises (1) a three-year variable-share forward purchase contract (the forward contract) and

(2) a five-year senior unsecured note with a principal amount of $100. Key terms of the securities are

as follows:

• The note will pay interest at a fixed rate of 1% and mature in five years. At the end of three years,

the note will be remarketed. Company A has the option to remarket the notes beginning after two

years and nine months. Upon the remarketing, the interest rate of the note will be reset such that

the proceeds from the remarketing are equal to or greater than the $100 principal amount.

• The forward contract provides that, at the end of three years (the stock purchase date), investors will

purchase and the issuer will sell for $100 a number of shares of the issuer’s common stock as follows:

Common stock price*

Number of common shares delivered at settlement

Greater than or equal to $120

0.83 shares

Greater than $100 and less than $120

Variable number of shares equal to $100 in value

Equal to or less than $100

1 share

* Generally based on the weighted average common share price for a period immediately preceding the stock purchase date.

• The forward contract requires the issuer to make quarterly payments to the investors at an annual rate

of 6% during the term of the forward contract (the contract adjustment payments). The issuer has

the right to defer all or part of these payments until the stock purchase date. Any deferred contract

adjustment payments would accrue additional amounts at the rate of 7% (i.e., the rate of total

distributions on the units that includes the interest on the note of 1% plus the contract adjustment

payment of 6%) until paid, compounded quarterly to, but excluding, the stock purchase date. The

issuer can elect to settle these payments in cash, shares or a combination of both.

• The interest rate of 1% is the market rate for the issuer based on its credit rating and the terms of

the notes at issuance. Therefore, the fair value and par value of each note equals $100 (i.e., there

is no premium or discount). The forward contract has an assumed fair value of $16 per unit, which

equals the present value of the contract adjustment payments.

• Holders of the units will initially pledge their ownership interests in the notes to secure their

obligations to purchase common shares under the forward contracts. If a holder wants to

participate in the remarketing of the notes, they must substitute their ownership interests in the

notes with US Treasury securities.

5.2.1.1.1 Analysis

The first step is the unit of account evaluation. The issuer should determine whether the debt and the

forward contract should be accounted for as freestanding financial instruments. ASC 480 defines a

freestanding financial instrument as one that is entered into (1) separately and apart from any of the

entity’s other financial instruments or equity transactions or (2) in conjunction with some other

transaction and is legally detachable and separately exercisable.

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The debt and equity-linked instrument (warrant or forward) in a typical unit structure generally are

considered freestanding financial instruments because the holder can transfer and settle the equity-

linked instrument separately from the debt. However, in some circumstances, the economic substance of

multiple freestanding financial instruments issued in a single transaction may suggest that accounting for

them on a combined basis is more appropriate. ASC 815-10-15-9 provides a list of indicators that an

issuer should consider in determining whether two or more freestanding financial instruments should be

combined and accounted for as one unit. Furthermore, the non-authoritative guidance in pre-Codification

Emerging Issues Task Force (EITF) 02-2, When Certain Contracts That Meet the Definition of Financial

Instruments Should Be Combined for Accounting Purposes, discusses a similar concept related to

combination. Judgment is required given the facts and circumstances to determine whether freestanding

contracts should be combined for accounting purposes. Refer to section 1.2.1 for further discussion on

evaluating the unit of account when multiple instruments are issued in a single transaction.

In the unit structure described in Illustration 5-6, the debt and the forward contract do not share the

same risk because the debt does not include any embedded equity-linked features (e.g., conversion

option). Practice has developed that they are generally accounted for separately even though (1) the unit

holder may in certain circumstances use the proceeds received from the remarketing of the debt (or if

the remarketing is unsuccessful, the debt itself) to satisfy the exercise price of the forward contract and

(2) the unit holder typically will be required to post collateral to secure its obligation under the forward

purchase contract if the unit is separated and the debt transferred.

Once the unit of account is determined, the issuer should consider the allocation of proceeds and the

accounting for each instrument. Because there are two freestanding financial instruments issued in the

transaction, the proceeds should be allocated between them. The allocation method should be

determined after considering the instruments’ classification and measurement bases. In a unit structure,

the relative fair value method is normally applied to allocate proceeds because the equity-linked

instrument is generally classified in equity and the note is carried at amortized cost.

Next, the forward contract is analyzed as a freestanding equity-linked instrument. The guidance in ASC 480

related to determining whether certain contracts settled in shares are classified as a liability should be evaluated.

In this example, the issuer is required to deliver a variable number of shares with a fixed value of $100 when

the price of the company’s stock is between $100 and $120 at the end of three years (the stock purchase

date). However, if the stock price is outside of that range, the issuer will deliver a fixed number of shares.

Because the forward includes a range in which the number of shares to be delivered is variable, but the

monetary amount of the shares to be delivered is fixed, the instrument should be evaluated pursuant to

ASC 480-10-25-14 to determine whether liability classification is required. Specifically, the issuer should

determine whether the fixed monetary amount (when the share price is between $100 and $120) is

predominant with respect to the entire settlement obligation that also includes obligations associated with the

downside (share price equal to or less than $100) and upside (share price greater than or equal to $120) ranges.

Because the unit holder bears the risks of owning a share of stock if the stock declines below $100 and

much of the potential rewards of owning the stock if the stock appreciates above $120, the probability of

the share price at settlement being in the outer ranges may be sufficient such that the settlement

obligation would not be considered predominantly based on a fixed monetary amount known at

inception. The determination of whether the stock price falling in the fixed monetary amount settlement

range is predominant should consider all possible outcomes and information, such as the current stock

price, volatility, strike price and equity growth assumptions. Company A performs an assessment and

determines that the settlement outcome between $100 and $120 would not be the predominant

outcome, and the forward would not be classified as a liability under ASC 480.

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The forward contract should be further analyzed pursuant to ASC 815-40 to determine its appropriate

classification and measurement. Generally, the forward contract can be structured to meet the criteria for

equity classification and would not require subsequent remeasurement at fair value as an asset or liability.

Terms of the forward should be carefully considered in light of the indexation and equity classification

guidance in ASC 815-40 to ensure the appropriate classification of the forward.

The contract adjustment payments are accounted for as a liability as it embodies an obligation of the issuer

to make payments during the three-year contract period. As the present value of the contractual

adjustment payments essentially represents a financing of the premium that the issuer was required to pay

to enter into the forward contract, it typically approximates the initial fair value of the forward contract.

The accounting for the contract adjustment payments is in accordance with ASC 835-30, Interest —

Imputation of Interest. Accordingly, the present value of the contract adjustment payments is recorded as

a liability (with an offset in equity as it is a premium paid for the forward contract) and subsequently

accretes and settles periodically over the term of the forward contract, with the resulting expense

recognized as interest.

Under the relative fair value allocation method, the initial entry to record the issuance of the units

(assuming (1) the proceeds equal the fair value of the note, (2) the forward contract qualifies for equity

classification, and (3) the present value of the contract adjustment payments equals the fair value of the

forward contract) is as follows (in millions):

Cash $ 100

APIC (to recognize the forward contract) 16

Note payable $ 100

Contract adjustment payment liability 16

Any issuance costs incurred should generally be allocated to the two instruments issued concurrently.

In this example, the portion of issuance costs allocated to the note should be recorded as a direct reduction

from the note payable, resulting in a discount on the note payable that is amortized as interest expense

using the interest method as described in ASC 835-30. The portion of issuance costs allocated to the

forward contract should be recognized as a reduction in equity.

Refer to section 2.3 for further discussion on the allocation of issuance costs.

Refer to section 6.5 of our FRD publication, Earnings per share, for a discussion of related EPS issues.

5.2.1.2 Unit structure — Convertible preferred stock

Illustration 5-7: Unit structure with convertible preferred stock

Company A (the issuer) issues $100 million of units to investors in a public offering at $100 per unit.

Each unit consists of (1) a three-year variable-share forward purchase contract (the forward contract)

and (2) one share of 0% Series A Convertible Preferred Stock (the convertible preferred stock) of

Company A, with no par value and a liquidation preference of $100 per share. Key terms of the

securities are as follows:

Convertible Preferred Stock

• The convertible preferred stock has an initial dividend rate of 0%. At the end of three years, the

shares will be remarketed. Company A has the option to remarket the stock beginning after two

years and nine months. Upon the remarketing, key terms of the convertible preferred stock,

including dividend rate, conversion rate and optional redemption date may be modified to realize

proceeds from the remarketing equal to or greater than the $100 liquidation preference.

Dividends may be paid in cash, common stock or a combination of both at Company A’s option.

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• On or after three years, holders can convert the convertible preferred stock at any time. The

conversion rate is initially 0.83 common shares per preferred share, which equates to an initial

conversion price of $120 per share. The conversion rate is subject to adjustment in certain

circumstances (e.g., when dividends are paid to common shareholders above a stated per-share

amount equal to the issuer’s normal dividend). Upon conversion, the settlement amount can be

settled in cash, shares or a combination of both at Company A’s option.

• Company A can redeem the shares on or after three years at the liquidation price of $100 per

share plus any accumulated but unpaid dividends.

• Holders of the units will initially pledge their ownership interests in the convertible preferred stock

to secure their obligations to purchase common shares under the forward contracts. If a holder

wants to participate in the remarketing of the convertible preferred stock, they must substitute

their ownership interests in the convertible preferred stock with US Treasury securities.

Forward Purchase Contract

• The forward contract provides that, at the end of three years (the stock purchase date), investors

will purchase and the issuer will sell for $100 a number of shares of the issuer’s common stock as

illustrated in the following table. The number of shares to be delivered at settlement is subject to

adjustment in certain circumstances (e.g., when dividends are paid to common shareholders

above a stated per share amount equal to the issuer’s normal dividend).

Common stock price*

Number of common shares delivered at settlement

Greater than $100

Variable number of shares equal to $100 in value

Equal to or less than $100

1 share

* Generally based on the weighted average common share price for a period immediately preceding the stock purchase date.

• The forward contract requires the issuer to make quarterly payments to the investors at an annual rate

of 7% during the term of the forward contract (the contract adjustment payments). The issuer has

the right to defer all or part of these payments until the stock purchase date. Any deferred

contract adjustment payments would accrue additional amounts at the rate of 7% until paid,

compounded quarterly to, but excluding, the stock purchase date. The issuer can elect to settle these

payments in cash, shares or a combination of both.

• The forward contract has an assumed fair value of $16 per unit, which equals the present value of

the contract adjustment payments.

5.2.1.2.1 Analysis

Consistent with the analysis above for the unit structure with a debt instrument, the issuer first considers

the definition of a freestanding financial instrument under ASC 480. It determines that the convertible

preferred stock and the forward contract are freestanding financial instruments because the holder can

transfer and settle the forward separately from the stock. However, because the convertible preferred

stock and the forward contract were entered into in contemplation of one another and share the same

risk (i.e., they are both impacted by changes in the price of common stock), further evaluation of the

combination guidance in ASC 815-10-15-9 and EITF 02-2 is warranted. In making the determination of

whether the two freestanding financial instruments should be combined, the issuer should consider the

facts and circumstances and focus on the economic substance of the unit structure as a whole.

If, based on this assessment, the issuer concludes that combination is not required, it needs to separately

assess the two instruments for classification. However, if the issuer concludes that the instruments should

be combined, it needs to assess the forward as an embedded feature within the convertible preferred share.

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In this fact pattern, the convertible preferred stock and the forward contract are combined and accounted

for as one unit based on an analysis of the relevant facts (e.g., they share the same risk). In other words,

the forward contract is considered an embedded feature within the convertible preferred stock (together,

they are the unit structure). This evaluation will require significant judgment based on facts and

circumstances of the arrangement.

The combined instrument represents mandatorily convertible preferred stock with embedded equity-linked

features (the forward contract, conversion option and redemption option). Company A needs to evaluate the

combined instrument under ASC 480 and ASC 815 to determine how the unit structure should be classified

and whether any embedded features require bifurcation and derivative accounting. Refer to the following

flowchart to determine the classification of a unit structure that is accounted for as a combined instrument.

* If more than one feature requires bifurcation, bifurcate a single derivative that comprises all of the individual features requiring

bifurcation and classify that derivative as an asset or a liability.

Units that require settlement in a variable number of common shares with a monetary value equal to a

fixed or predominantly fixed amount may require liability classification pursuant to ASC 480. In this

example, the issuer is required to deliver a variable number of shares with a fixed value of $100 when

the price of the company’s stock is above $100 at the end of three years (the stock purchase date).

However, if the stock price is below $100, the issuer will deliver a fixed number of shares.

The feature does not require bifurcation. If all features do

not require bifurcation, the unit structure (including the

embedded features) is classified in equity.

If the host instrument is considered a debt host, the

embedded features are evaluated for bifurcation using

the debt model and the guidance in section 2.

Yes

The unit structure is classified and accounted for as an

ASC 480 liability.

The feature does require bifurcation. The host is

classified in equity. The feature is classified separately

from the equity host as a derivative.*

The unit structure is classified as permanent equity.

The unit structure is classified as temporary equity

(i.e., in the mezzanine).

For SEC registrants, do any of the features cause

the unit structure to be considered redeemable

pursuant to ASC 480-10-S99-3A?

Is the unit structure (including embedded

feature(s)) within the scope of ASC 480?

Evaluate the nature of the host instrument pursuant

to ASC 815-15-25-17(A). Is it an equity host?

Evaluate each embedded feature for bifurcation from

the equity host instrument. Is the feature clearly and

closely related to the equity host ( ASC 815-15-25-1)?

Does the feature meet the definition of a derivative

(assuming it is also not eligible for an exception

from derivative accounting) ( ASC 815-15-25-1)?

Yes

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Because the unit structure includes a range in which the number of shares to be delivered is variable, but

the monetary amount of the shares to be delivered is fixed, the unit structure should be evaluated

pursuant to ASC 480-10-25-14 to determine whether liability classification is required. The issuer should

consider all possible outcomes and information (such as the current stock price, volatility, strike price and

equity growth assumptions) in making the determination. Whether a settlement is based “predominantly”

on a fixed monetary amount known at inception requires judgment on the basis of facts and circumstances.

Refer to section 5.2.1.1.1 above for a detailed discussion of the evaluation under ASC 480-10-25-14.

If the unit structure is not classified as a liability under ASC 480 because settlement within the range of

the fixed monetary amount is not considered “predominant,” the unit structure should be further analyzed

pursuant to ASC 815. This includes determining (1) the nature of the host contract in the convertible

preferred stock; (2) whether the economic characteristics and risks of the embedded feature are clearly and

closely related to the host contract; (3) if they are not clearly and closely related to the host contract,

whether any embedded features meet the definition of a derivative; and (4) if any feature meets the

definition of a derivative, whether any scope exception from ASC 815 applies (e.g., ASC 815-10-15-74(a)).

Furthermore, the issuer may be required to consider the guidance in ASC 480-10-S99-3A to determine

whether temporary equity classification is required for the convertible preferred stock.

One acceptable view is that the present value of the contractual adjustment payments essentially represents

a financing of the premium that the issuer was required to pay to enter into the forward contract and is

recorded as a liability (with an offset to the preferred stock, since it is a premium paid for the forward

contract that is embedded in the preferred stock). The liability subsequently accretes and settles periodically

over the term of the forward contract, with the resulting expense recognized as interest.

The initial entry to record the issuance of the units (assuming (1) the $100 million of proceeds equals the

fair value of the stock, (2) the present value of the contract adjustment payments is $16 million, and (3)

there is no beneficial conversion feature (BCF)) is as follows (in millions):

Cash $ 100

0% Series A Convertible Preferred Stock 16

0% Series A Convertible Preferred Stock $ 100

Contract adjustment payment liability 16

Any issuance costs incurred may be allocated entirely to the convertible preferred stock on the basis that

the costs were primarily incurred to obtain equity financing or could be allocated to the preferred stock

and the contract adjustment payment liability. Refer to section 2.3 for further discussion on the

allocation of issuance costs.

Refer to section 6.5 of our FRD publication, Earnings per share, for a discussion of related EPS issues.

5.3 Auction rate securities (including failed reset auctions)

5.3.1 Overview and background

Traditional auction rate securities (ARSs) are typically issued by corporate entities as well as not-for-profit

entities, such as hospitals, municipalities or related governmental entities (e.g., cities, counties, school

districts, publicly owned airports and seaports) and educational institutions. Fund proceeds are used for

projects such as new facilities, housing for municipalities and student loan programs for various educational

institutions. ARSs are often regarded as attractive investments because they offer yields higher than

other liquid investments, particularly when investors benefit from the tax-exempt status of the issuer.

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ARSs are long-term (typically 20 years or longer) variable-rate securities with interest rates (or dividend

rates if issued in a form of preferred securities) that reset at short term intervals, usually 7, 14, 28 or

35 days through a “Dutch Auction” process. A Dutch Auction is a competitive bidding process used to

determine rates for ARSs on each auction date. Typically, bids are submitted to the auction agent. Each

bid and order size is ranked from lowest to highest minimum bid rate. The lowest bid rate at which all the

securities can be sold at par establishes the interest rate, otherwise known as the “clearing rate.” New

buyers wishing to purchase ARSs may submit a bid on the day of the auction. Investors that desire to

continue holding their ARSs are notified of the new market rate determined in the auction process.

Because the securities are frequently repriced through the auction process, they trade in the market like

short-term investments.

The issuer’s accounting for an auction rate security is similar to the accounting for variable-rate debt,

with the interest accrued based on the rate set at the most recent auction. However, if an auction fails

(i.e., not enough bids, therefore no auction clearing rate is available), the ARS often has a mechanism by

which the pre-auction holders continue to hold the instrument and the interest rate on the security defaults

to a formulaic rate (penalty interest).

Due to disruptions in the credit markets in late 2007 and early 2008, many auctions failed. Such events

raise several financial reporting issues for issuers, including balance sheet classification, accounting for

penalty interest expense, implications for continued use of hedge accounting and consideration of the

failed auction as an event of default or cross-default of other debt arrangements. In addition, issuers may

modify ARS indentures, raising issues related to extinguishment or modification accounting, debt issuance

costs and balance sheet classification.

5.3.2 Analysis

5.3.2.1 Entities sponsoring trusts or SPEs issuing ARSs

The market for traditional ARSs has evolved and ARSs have also been issued by trusts and other special-

purpose entities (SPEs) in various forms, including collateralized debt obligation (CDO) arrangements. In

these situations, various tranches of securities are issued with different levels of seniority, subordination

and risk. The most senior tranche issued typically represents an ARS while subordinate tranches are

lower rated non-ARS securities either retained by an entity sponsoring the trust or SPE or sold to third-

party investors. Sponsoring entities of trusts or SPEs issuing ARSs may provide financial support to

prevent an auction from failing by participating in auctions of those ARSs. Without this support, an

auction may fail due to insufficient demand. In those cases, sponsoring entities should evaluate whether

such support constitutes a variable interest that could require consolidation pursuant to ASC 810. See

section 5.4.12 of our FRD publication, Consolidation, for more guidance on identifying implicit variable

interests. If a trust or SPE is involved, the analysis below would apply to a sponsor if the sponsor

consolidates the trust or SPE after evaluating the provisions of the variable interest entity model.

5.3.2.2 Considerations when auction fails

5.3.2.2.1 Penalty interest

The terms of many ARSs provide for an increased interest rate in the event of a failed auction. In many

cases, that rate is a multiple of the typical auction reset rate. The higher rate is in effect until the next

auction. The issuer would account for this increased interest expense as incurred.

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5.3.2.2.2 Extinguishing or modifying ARSs

ARSs may be issued in the form of debt or preferred stock. The form of the instrument may determine

the accounting for any extinguishment or modification of the instrument.

If an issuer extinguishes ARSs issued in the form of debt, it should account for the extinguishment

pursuant to ASC 470-50-40-2. If an issuer modifies the terms of the ARS (e.g., by negotiating a change

to the failed auction default interest formula or even a different interest index entirely), the issuer should

determine whether the modification should be accounted for as a troubled debt restructuring pursuant

to ASC 470-60. If not a troubled debt restructuring, the guidance in ASC 470-50 requires a substantial

modification of the ARS terms for the modification to be accounted for as an extinguishment. This

guidance also addresses the accounting for fees exchanged between the issuer and investor, third-party

costs incurred as part of a debt restructuring, as well as whether an investment bank involved in a debt

restructuring is acting as an agent or a principal.

If an issuer decides to extinguish ARSs issued in the form of a preferred security, provided that the

preferred security is classified in equity, extinguishment accounting pursuant to ASC 260-10-S99-2

should be applied. However, any modification to the terms of preferred stock should be carefully

evaluated to determine if extinguishment accounting is appropriate.

Some ARSs may have existing contractual terms that can be invoked by the issuer under certain

circumstances, giving the issuer the ability to reset the interest rate mechanism of the instrument to a

market-based variable index or perhaps even a fixed rate. This is sometimes referred to as an “interest

mode change.” While this change is likely not a modification of the instrument, as the issuer is exercising

a contractual term (rather than amending the ARS), the specific facts and circumstances and contractual

terms of the ARS should be considered. If a provision is not present in the ARS security, yet the issuer

negotiates a modification to the contractual terms (either on its own initiative or after being contacted by

investors or an investment bank) or the ability to effectuate the mode change is not entirely within the

control of the issuer, the guidance on modification accounting should be considered.

If the ARS is being hedged under a cash flow hedge and the interest mode changes, the issuer should

consider the effect of adjusting the interest mode on the continuing hedge accounting assessment of

effectiveness and measurement of ineffectiveness.

5.3.2.2.3 Balance sheet classification

ARSs issued in the form of debt generally have legal maturities of at least 20 years and thus are

generally classified as long-term debt. ARS indentures and related documents should be reviewed to

determine if a failed ARS auction may trigger current classification (e.g., is deemed an event of default

permitting the investor to put the instrument to the issuer) or cross-defaults in other arrangements.

If financial statements have not been issued, an issuer’s actions subsequent to that balance sheet date

may affect whether the ARS should be classified as current or noncurrent as of that balance sheet date.

For example, subsequent to the balance sheet date but prior to the issuance of the financial statements,

assume an issuer extinguishes the outstanding ARS by either the use of current assets or funding with

short-term liabilities (e.g., the issuance of commercial paper) or tries to support the intent to refinance

with a financial arrangement that does not meet the criteria in ASC 470-10-45-14. In that case, the ARS

may require current classification as of the balance sheet date.

However, if the issuer modifies the ARS such that an extinguishment is deemed to occur, and the new

debt instrument would qualify as long-term, the modified ARS outstanding at that balance sheet date

would retain noncurrent classification. Issuers engaged in extinguishment or modification transactions

should provide appropriate disclosure of the subsequent events.

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5.3.2.2.4 Bidding on borrower’s own ARSs

In a letter dated 14 March 2008,

the SEC staff clarified that issuers could participate in bidding

activities without being considered market making for their own securities. To prevent failing auctions

that may trigger a frequently higher failed auction formula rate, issuers of ARSs began to participate

(i.e., bid) in the auction of their own ARSs.

Issuers should consult with their legal counsel in connection with any decision to participate in auctions

of their own securities, as well as on any related disclosures. If an issuer participates and wins the bid of

an auction for its ARSs, those acquired ARSs should be extinguished pursuant to ASC 405-20-40-1. As a

result of the issuer acquiring its own debt, the issuer is considered to have extinguished that portion of

the ARS liability. Any related issuance costs associated with the portion of ARSs that have extinguished

should be written off pursuant to ASC 470-50-40-2.

Before concluding on extinguishment accounting, however, an entity should consider whether it has bid

on and acquired debt that it actually issued. If the entity is the named issuer of the acquired debt (e.g., it

has acquired the specific instrument that is classified as debt in its own balance sheet) that instrument has

been extinguished. In contrast, many ARSs are issued through trust or SPE structures, and the sponsoring

entity is not the issuing entity of the ARSs. Rather, the sponsoring entity issues notes to the trust or SPE

in exchange for the proceeds the trust or SPE received from issuance of the ARSs to external investors.

If the sponsoring entity does not consolidate the issuing trust or SPE and thus does not recognize the ARSs

in its consolidated financial statements, the acquisition of these ARSs by the sponsoring entity may not

constitute an extinguishment of its liability. Judgment should be applied in these situations in determining

whether the issuer’s obligation has been extinguished.

5.4 Remarketable put bonds

5.4.1 Overview and background

A remarketable put bond is a security that typically has a long-term maturity (e.g., 10 years), but contains

put and call features that are exercisable prior to maturity (e.g., two years). A typical remarketable put

bond has put and call features with the same strike prices and exercise dates, but different counterparties

(with the issuer writing a put to the investor and the investment bank purchasing a call from the investor).

There is also an interest rate reset provision at the put/call date. These terms are described below:

• The put feature is an option written by the issuer to the investor and embedded in the bond. If interest

rates have increased at the put date, the investor will put the debt back to the issuer, generally at par.

• The call feature is purchased by the investment bank from the investor. It is bundled with the debt

issued to the investor but not embedded by the issuer, so it is not evaluated for the issuer’s accounting.

If interest rates decrease, an investment banker has the right to call the bonds from the current

investors, generally at par.

• The embedded interest rate reset feature automatically resets the bond’s interest rate if it is

outstanding (i.e., is not put) at the end of two years. This reset is typically based on (1) the yield, at

the issuance date of the puttable bond, of US Treasury bonds of the same maturity as the bond and

(2) the debtor’s credit spread at the put/call date. The interest rate reset feature generally results in

a new interest rate that is above market at the time of the reset because the investor will likely only

not exercise their put when interest rates have decreased.

http://www.sec.gov/divisions/corpfin/cf-noaction/2008/mars031408.pdf.

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At the end of the two-year term, the security is either put or called, regardless of changes in interest

rates. If put (by the investor), the bond will be settled; if called (by the investment bank), the bond’s

interest rate will reset and the investment bank will remarket the bond as a new debt with the same

remaining maturity as the bond (i.e., eight years).

Economically, the bond in its initial form is priced as a bullet obligation with a maturity at the put/call

date. For example, a remarketable put bond that has a 10-year maturity with put and call features

exercisable in two years, is priced based on a two-year interest rate at inception. The issuer is able to

lower its funding cost (in a form of reduced initial interest rate or receipt of premium) prior to the put

and call date by providing the investor with the interest reset feature and put feature.

If interest rates increase, the investor will likely exercise the put feature and the debt will be settled. The

issuer keeps the premium (or has enjoyed the lower interest rate), which reduces its overall borrowing

cost. If interest rates decrease, the investment bank will likely exercise the call, which will cause the

interest to reset and the bond to be remarketed. If remarketed successfully, the bond will continue to be

outstanding for the remaining life (eight years in the example above), but bear a rate higher than market

based on the reset mechanism.

The new rate on the bond is higher than the market rate at the time of remarketing due to the reset

formula starting with the US Treasury rates from the initial issuance. Thus, the bonds are reissued at a

premium and these additional proceeds allow the investment bank to monetize the value of the call

option it had exercised to purchase the bonds. However, since the bonds are issued at a premium, and a

holder has no rights in bankruptcy associated with the premium, the reset formula will provide an even

higher interest rate at reissuance for this added risk. Issuers may want to avoid this increased rate.

Therefore, the issuer may work with another investment bank (or perhaps the same investment bank

that holds the call option) to purchase the existing bonds and exchange them for new bonds that bear

interest at a current market rate but with a higher face amount. In this case, the investment bank

captures the call option’s intrinsic value through a higher face value in the new bonds.

5.4.2 Analysis

Initial accounting:

Remarketable put bonds are structured in a wide variety of forms and may contain different features.

Any puts or calls that are associated with the instruments should be closely evaluated to determine

(1) if the issuer of the debt is also a counterparty to that put or call and (2) if the put or call is embedded

in the debt or freestanding. Based on those conclusions, the embedded feature or freestanding instrument

would be evaluated pursuant to the derivatives guidance. ASC 815-15-55-26 through 55-53 provides

several examples of alternative remarketable put bond structures and describes at a high level the accounting

analysis of the embedded and freestanding features (refer to section 2.2.5 for guidance on evaluating

embedded put and call features). The interest rate reset feature is also an embedded feature that should

be evaluated for bifurcation pursuant to ASC 815-15.

Subsequent accounting:

As discussed above, in an increasing rate environment, the investor will likely exercise its put option,

resulting in settlement of the existing bonds. The derecognition guidance in ASC 405-20-40-1 should be

considered. Debt is extinguished if a debtor repays outstanding debt with existing funds or refinances an

old debt through issuance of a new debt to new creditors.

In a decreasing rate environment, the investment bank will likely exercise its call option, in which case the

bond’s interest rate will reset to a rate higher than market due to the reset mechanism. The investment

bank will then remarket (sell) the bond bearing the new interest rate to new investors at a premium

(premium bond). In some cases, issuers may modify the terms of the remarketed bond by increasing its

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face value (to an amount equal to the proceeds that would have been received by the investment bank on

the premium bond). Concurrent with the increase in the face value, the issuer would reduce the stated

interest rate on the bond to a market-based rate appropriate to the debt with the same maturity as the

remarketed bond. The investment bank would be indifferent between remarketing a premium bond with

an above-market interest rate and remarketing a bond with a higher face value issued at par with an at-

market rate of interest because the proceeds it receives from the remarketing would be the same.

Because these modifications (i.e., the increase in the face value and the decrease in the interest rate) are

not contemplated in the original terms of the bond, an evaluation of the debt modification guidance under

ASC 470-50 is required. More specifically, because a third-party intermediary is involved, a determination

must be made as to whether the investment bank is acting as (1) the borrower’s agent or (2) a principal.

• If the investment bank is concluded to be an agent in both purchasing the old bond and reselling the

modified bond, the remarketing should be accounted for as an extinguishment of the existing debt

and the issuance of new debt because there has been a change in creditors.

• If the investment bank acts as a principal in both purchasing the old bond and reselling the modified

bond, whether the remarketing should be accounted for as a modification or as an extinguishment

depends on if the difference between the present value of the cash flows associated with the old

bond and those associated with the modified bond exceeds 10%.

• If the investment bank acts as a principal only in one of the components (e.g., as a principal in the

acquisition of the old bond but as an agent in the reselling of the modified bond), the remarketing

should be accounted for as an extinguishment of the existing debt and the issuance of new debt

because there has been a change in creditors.

To determine whether the investment bank is acting as a principal or agent in the transaction, the four

indicators described in ASC 470-50-55-7 should be considered (refer to section 2.6.2.6). We generally

believe that the investment bank must commit its own funds and those funds should be at risk for a

sufficient period in order to be acting as a principal. Based on the aforementioned guidance and SEC staff

comments made at the 2003 AICPA National Conference on Current SEC Developments,

we generally

believe issuers may consider the following questions in determining whether the investment bank’s funds

are at risk in both the old bonds and new bonds:

• Has the investment bank obtained “soft bids” for the replacement bond prior to or concurrent with

its decision to exercise the call option on the old bond? “Soft bids” reduce the investment bank’s

exposure to market risk and may indicate the investment bank’s role is that of an agent.

• What period of time will the investment bank hold the bonds before reselling them? We generally do

not believe that there is a bright line for the number of days the investment bank must hold the

bonds in order to indicate it is acting as a principal. However, the period should generally be long

enough for the holder to be at risk for the type of instrument held.

• Has the investment bank been compensated for any costs associated with hedging its exposure to

market risk on the new bonds? Are all fees paid to the investment bank at market as an underwriter?

Payments to the investment bank through fees or other means to reduce its market risk may indicate

the investment bank’s role is that of an agent.

• How volatile is the market price of the bond? The combination of the bond’s underlying price

volatility and the length of time the investment bank will hold the bonds before reselling them may

provide an indicator as to whether the investment bank has substantive market risk.

Robert J. Comerford, 2003, https://www.sec.gov/news/speech/spch121103rjc.htm.

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The investment bank is generally considered a principal in the acquisition of the old bond as it generally

commits its own funds to purchase the old bond and will hold the old bond for a sufficient period of time.

In fact, in its speech, the SEC staff indicates that in modified remarketable put bond transactions the

investment bank’s role is that of a principal in the old bond. However, once the issuer modifies the debt,

the SEC staff states that the bank’s role in reselling the remarketed bond is that of the issuer’s agent.

While there is a general presumption that the investment bank is acting as an agent in the resale of

modified remarketed bonds, this presumption can be overcome. An issuer should evaluate all of the facts

and circumstances to determine whether the third-party intermediary has funds at risk with regard to the

new bond.

More recent remarketable put bonds may permit the issuer to select reset rates or terms upon

remarketing and allow the issuer some discretion on the terms of the new bonds. Careful evaluation of

those terms is necessary in determining whether a modification of the existing bond has occurred and

thus modification vs. extinguishment accounting pursuant to ASC 470-50 should be considered.

5.5 Share lending arrangements

5.5.1 Overview and background

An entity may enter into a share lending arrangement that is executed separately from, but in contemplation

of, a convertible debt offering (or some other convertible financing transaction). Although the convertible

debt instrument is ultimately sold to investors, the share lending arrangement is an agreement between

the convertible debt issuer (share lender) and the investment bank (share borrower) and is intended to

increase the availability of the issuer’s shares and facilitate the ability of the investors to hedge the

conversion option in the issuer’s convertible debt.

Investors in convertible debt (e.g., private equity or venture capital funds or other institutional investors)

will frequently seek to hedge the equity exposure in the convertible debt investment. An investment bank

is usually the counterparty to the investor’s hedge, and in turn desires to hedge its own risk. The ability

of the investment bank to hedge its own risk (generally by borrowing shares and selling them short)

depends on its ability to economically obtain shares in the stock lending market. For entities with shares

that are costly to borrow from the market (e.g., due to a lack of liquidity or extensive existing open short

positions in the shares), the pricing of a convertible debt offering (or even the ability to successfully

complete an offering at all), may depend on increasing the availability of shares in the market.

5.5.2 Analysis

The Own-Share Lending Arrangements Issued in Contemplation of Convertible Debt Issuance subsections

of ASC 470-20 addresses the accounting for an entity’s own-share lending arrangement initiated in

conjunction with a convertible debt or other financing offering and its effect on EPS. Additionally, the

share lending guidance addresses the accounting and EPS implications for defaults by the share

borrower when a default becomes probable of occurring and when a default actually occurs.

5.5.2.1 Scope

The share lending guidance in ASC 470-20 applies to equity-classified share lending arrangements.

A share lending arrangement is first evaluated pursuant to other guidance (e.g., ASC 480 for certain

liability-classified contracts and ASC 815-40 for contracts in an entity’s own equity) to determine its

balance sheet classification. Generally, share lending arrangements are structured to obtain equity

classification by the share lender.

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5.5.2.2 Classification of share lending arrangements as equity

In determining the classification of a share lending arrangement in conjunction with ASC 480, the issuer

should consider whether the share lending arrangement embodies any obligation on the part of the

issuer to either transfer assets or deliver equity shares after inception. In a typical share lending

arrangement, the contract requires the counterparty (usually an investment bank) only to return the

initial equity shares the issuer has loaned to the bank over the contract period. The issuer bears no

further obligation after inception to transfer assets or issue a variable number of its own equity shares.

Therefore, a share lending arrangement is generally not a liability within the scope of ASC 480.

The issuer should evaluate the share lending arrangement pursuant to ASC 815-40 to determine

whether equity classification is appropriate. Generally, a share lending arrangement is considered

indexed to the issuer’s own stock pursuant to the guidance in ASC 815-40-15. The terms of the

arrangement require the issuer to issue shares to the bank in exchange for a nominal loan processing

fee at inception. On the final settlement of the contract, generally upon maturity or conversion of the

convertible debt, the bank is required to return the loaned shares to the issuer for no additional

consideration. That is, the share lending arrangement requires physical settlement in a fixed number

of shares. The contract generally does not contain any adjustment provisions that would change the

number of shares to be delivered by the bank.

The evaluation of the share lending arrangement pursuant to the equity classification guidance in

ASC 815-40-25 focuses on any settlement alternatives provided in the contract. Share lending

arrangements generally stipulate that, in the event the bank defaults in returning the loaned shares,

the issuer is entitled to a cash payment equal to the fair value of the loaned shares.

We generally believe that this isolated scenario that results in a cash settlement by the bank does not

preclude the entire contract from equity classification, as the events that require cash settlement are

typically outside of either party’s control (usually as a result of legal obstacles or regulations such that

the bank is not permitted or unable to deliver shares).

However, this isolated cash settlement scenario could also be viewed as an embedded derivative within a

host equity contract (the receivable leg of the share lending arrangement) that is to be bifurcated. During

the deliberation of this guidance (pre-Codification EITF 09-1),

the EITF acknowledged that in a typical

share lending arrangement, the terms of the contract may require cash settlement by the bank instead of

delivery of the loaned shares in the event the bank is unable to deliver shares. The guidance addresses

this provision and states that if it becomes probable that the counterparty will default (i.e., not return

the borrowed shares or consideration equal to the then-current fair value of the borrowed shares at the

maturity of the arrangement), the issuer should recognize an expense (with an offset to APIC) equal to

the expected loss due to default. The EITF did not indicate that this provision would preclude the entire

contract from being classified as equity.

5.5.2.3 Initial measurement

The share lending guidance states that at the date of issuance, the share lending arrangement should be

measured at fair value and recognized as an issuance cost with an offset to equity (APIC). Issuance costs

should be accounted for consistent with other applicable guidance (e.g., allocating the issuance costs

between the debt and equity components if the associated convertible debt were within the scope of the

cash conversion guidance). Any issuance cost considered debt issuance costs are amortized as interest

expense generally over a period consistent with that of the associated convertible financing.

EITF Issue No. 09-1, Accounting for own-share lending arrangements in contemplation of convertible debt issuance or other

financing (EITF 09-1).

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5.5.2.4 Accounting for counterparty default

The share lending guidance states that if it becomes probable that the counterparty will default

(i.e., probable of not returning the borrowed shares or consideration equal to the then-current fair

value of the borrowed shares at the maturity of the arrangement), the issuer should recognize an

expense (with an offset to APIC) equal to the expected loss due to default. While some believe that any

loss on an equity contract should be recognized in equity (and should not affect earnings), the EITF noted

that the loss is not a result of changes in equity values, but in a failure of the counterparty to perform

under the contract. As the entity essentially gave away its shares for no (or insufficient) consideration

and that transaction should result in the recognition of a loss.

The expected loss is measured as the difference between the fair value of unreturned shares as of the

reporting date and the fair value of probable recoveries, if any. The issuer should remeasure the

expected loss at each reporting date until an actual default occurs and the settlement amount has

become fixed. Subsequent remeasurement would reflect both increases and decreases in the expected

loss in earnings, potentially including the complete reversal of the expected loss if it were no longer

probable that the share borrower would default at settlement.

5.5.2.5 Earnings per share

The share lending guidance in ASC 470-20-45-2A states that loaned shares under share lending

arrangements should be excluded from the computation of basic and diluted EPS (because absent a

default, the shares will be returned), unless an actual default by the share borrower has occurred. Thus,

there appears to be an inconsistency within the share lending guidance whereby the loss on default is

recognized when probable, but the shares are included in EPS only upon actual default. However, the

Task Force’s decision on the recognition of a loss is consistent with the requirements of ASC 450 while the

EPS conclusion is consistent with the treatment of contingently issuable shares pursuant to ASC 260.

If dividends on the loaned shares are not reimbursed to the entity (reimbursement typically is required in

those arrangements), any amounts, including contractual (accumulated) dividends and participation rights in

undistributed earnings, attributable to the loaned shares should be deducted in computing income available

to common shareholders, consistent with the two-class method set forth in ASC 260-10-45-60B. Upon

default by the share borrower, the shares are included in the denominator of both basic and diluted EPS.

Refer to section 6.2 of our FRD publication, Earnings per share, for further discussion of EPS

considerations under share lending arrangements.

5.5.2.6 Disclosures

The share lending guidance states the disclosures in ASC 505-10-50, Equity — Overall, are required for

share lending arrangements within the scope of the share lending guidance. It also requires specific

disclosures, as described in detail in ASC 470-20-50-2A through 50-2C. Those disclosures are specific to

the share lending arrangement in both annual and interim periods in which a share lending arrangement

is outstanding. In periods in which a share borrower default becomes probable, incremental disclosures

related to both the loss and the potential effect on EPS are also required.

5.6 Trust preferred securities

5.6.1 Overview and background

Trust preferred securities are a form of financing issued by a subsidiary (or trust) that is often treated as

debt for federal income tax purposes, but not for financial reporting or credit rating purposes. These types

of securities have different trademarked names, including MIPS (Monthly Income Preferred Securities),

QUIPS (Quarterly Income Preferred Securities) and TOPRS (Trust Originated Preferred Securities).

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In a typical structure, a company establishes a new entity in the form of a trust, which issues preferred

securities to investors (trust interests). The company purchases all of the trust’s common securities, and

may guarantee the obligations of the trust if in the future the trust cannot make payments. The trust

uses the proceeds from the issuance of the preferred securities and the amount it received for issuing

common securities (if any) to make a deeply subordinated loan to the company, with terms identical to

those of the trust preferred securities.

A trust preferred security is generally long-term (30 years or more). It generally has periodic fixed or

variable dividend payments and permits early redemption by the issuer. In addition, trust preferred

securities usually permit the deferral of dividend payments for up to five years.

5.6.2 Analysis

Application of ASC 810-10’s variable interest model generally would not result in the sponsoring entity

consolidating the trust that issues the preferred securities (refer to section 5.4.3 of our FRD publication,

Consolidation, for further discussion).

However, if the trust were consolidated by the sponsoring entity and the preferred securities were

outside the scope of ASC 480 (due to the scope exception provided for certain mandatorily redeemable

NCIs), the guidance in ASC 480-10-S99-3A should be considered to determine whether temporary equity

classification is required. If the preferred securities (NCI on a consolidated basis) are classified in

temporary equity, the SEC staff has requested registrants include specific descriptive language, such as

“Guaranteed Preferred Beneficial Interest in Company’s Subordinated Debenture.” In this case, dividends

are required to be reported as an allocation of income to the NCI holders in the income statement in

accordance with ASC 810-10-40-2 (see section 16.1.3 of our FRD publication, Consolidation, for more

guidance on the attribution of income or losses to noncontrolling interests held by preferred

shareholders).

Alternatively, the SEC staff historically permitted these instruments to be presented within the debt

caption in the balance sheet with an appropriate description in the footnotes. Under this presentation,

dividends would be recognized as interest expense. The SEC staff preferred, but did not require, that

the same caption as required for temporary equity classification be used even if the security were

classified as debt. However, in June 2007, through an amendment to EITF D-98,

the SEC staff indicated

they would no longer accept the presentation as debt. That SEC staff position was applied prospectively to

all affected financial instruments (or host contracts) that were entered into, modified or otherwise subject

to a remeasurement (new basis) event after a short transition period. It is possible, for longer dated

structures, that some grandfathered trust preferred securities may still be classified as debt.

5.7 Warrants for redeemable shares

5.7.1 Overview and background

Warrants may be issued on shares that, by the terms of the shares themselves, are redeemable at the

option of the shareholder. The redemption feature is embedded in the underlying shares, not a term in the

warrant, and may require shares to be mandatorily redeemed or redeemed at the option of the holder at

any time or only upon occurrence of certain designated events (e.g., change of control, delisting). The

accounting for a warrant for redeemable shares is similar to the accounting for a puttable warrant. Refer

to section 4.1.1.9 for a description of puttable warrants.

EITF Topic No. D-98, “Classification and Measurement of Redeemable Securities” (EITF D-98).

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5.7.2 Analysis

A warrant for a redeemable preferred share (a share with an embedded redemption feature) may be

required to be classified as a liability when the redemption feature of the underlying preferred share

potentially requires the issuer to repurchase its share by transferring assets. That warrant may require

liability classification even though the underlying preferred share itself is likely classified as equity

(or temporary equity) in the issuer’s financial statements.

This inconsistency is a direct result of the FASB’s explicit decision to require different classification for a

redeemable share and a warrant exercisable into that very same redeemable share. This accounting is

also followed for warrants on redeemable common shares.

5.7.2.1 Applicable guidance

Excerpt from Accounting Standards Codification

Distinguishing Liabilities from Equity — Overall

Implementation Guidance and Illustrations

480-10-55-33

A warrant for puttable shares conditionally obligates the issuer to ultimately transfer assets—the

obligation is conditioned on the warrant’s being exercised and the shares obtained by the warrant

being put back to the issuer for cash or other assets. Similarly, a warrant for mandatorily redeemable

shares also conditionally obligates the issuer to ultimately transfer assets—the obligation is conditioned

only on the warrant’s being exercised because the shares will be redeemed. Thus, warrants for both

puttable and mandatorily redeemable shares are analyzed the same way and are liabilities under

paragraphs 480-10-25-8 through 25-12, even though the number of conditions leading up to the

possible transfer of assets differs for those warrants. The warrants are liabilities even if the share

repurchase feature is conditional on a defined contingency.

The accounting for warrants on redeemable shares follows the guidance in ASC 480-10-25-8 through

25-13. Those paragraphs address the classification of instruments, other than an outstanding share,

that have both of the following characteristics:

• The instrument embodies an obligation to repurchase the issuer’s equity shares, or is indexed to such

an obligation.

• The instrument requires or may require the issuer to settle the obligation by transferring assets.

In ASC 480, the term “obligation” refers to either a conditional or unconditional obligation to transfer

assets or issue equity shares. In addition, ASC 480 uses the term “indexed to” interchangeably with the

phrase “based on variations in the fair value of.” Based on those two provisions, a warrant that permits

the holder to purchase redeemable shares (refer to discussion below on what makes a share redeemable)

is a liability pursuant to ASC 480 because (1) the warrant itself is indexed to an underlying share (i.e., the

option’s value varies with the fair value of the share) that embodies the issuer’s obligation to repurchase

the share and (2) the issuer has a conditional obligation to transfer assets if the shares are put back.

Those concepts also apply to a forward contract requiring the company to issue redeemable shares.

The following example is provided in ASC 480-10-55-32, which states:

Entity B issues a warrant for shares that can be put back by Holder immediately after exercise of the

warrant. The warrant feature allows Holder to purchase one equity share at a strike price of $10 on a

specified date. The put feature allows Holder to put the shares obtained by exercising the warrant

back to Entity B on that date for $12, and to require physical settlement in cash. If the share price on

the settlement date is greater than $12, Holder would be expected to exercise the warrant obligating

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Entity B to issue a fixed number of shares in exchange for a fixed amount of cash, and retain the

shares. That feature alone does not result in a liability under paragraphs 480-10-25-8 through 25-12.

However, if the share price is equal to or less than $12, Holder would be expected to put the shares

back to Entity B and could choose to obligate Entity B to pay $12 in cash. That feature does result in a

liability, because the financial instrument embodies an obligation to repurchase the issuer’s shares

and may require a transfer of assets. Therefore, those paragraphs require Entity B to classify the

warrant as a liability. A warrant to issue shares that will be mandatorily redeemable is also classified

as a liability, and should be analyzed under Topic 815.

This example is on “shares that can be put back to the Holder immediately after exercise” and that are

then puttable for a fixed price ($12 settled in cash). To address how to analyze a warrant for shares that

(1) could be put back at other times, (2) were contingently puttable or (3) could be put for a price other

than a fixed price, prior to Codification, the FASB issued FSP FAS (Financial Accounting Standard) 150-5,

Issuer’s Accounting under FASB Statement No. 150 for Freestanding Warrants and Other Similar

Instruments on Shares That Are Redeemable. This guidance indicated that a warrant for a redeemable

share is a liability, despite the share itself not being a liability. Not all of the FSP was codified, and certain

omitted portions are instructive.

FSP FAS 150-5 stated in part (selected footnote references retained and all others omitted):

5. Paragraph 11 of Statement 150 applies to freestanding warrants and other similar instruments on

that are either puttable or mandatorily redeemable regardless of the timing of the redemption

feature or the redemption price because those instruments embody obligations to transfer assets.

Therefore, paragraph 11 applies to warrants on shares that are redeemable immediately after exercise

of the warrants and also to those that are redeemable at some date in the future.

6. The phrase requires or may require in paragraph 11 encompasses instruments that either

conditionally or unconditionally obligate the issuer to transfer assets. If the obligation is conditional,

the number of conditions leading up to the transfer of assets is irrelevant.

Footnote 1 in paragraph 5 of FSP FAS 150-5 (indicated above) observed, in part, “Paragraph 11 of

Statement 150 requires warrants or similar instruments to acquire redeemable shares to be classified as

liabilities even though the underlying shares may be classified as equity under other accounting

guidance.” (Paragraph 11 of Statement 150

was codified as ASC 480-10-25-8, discussed above.)

While paragraph 5 of FSP FAS 150-5 and its footnote were not included in the Codification, the guidance

in paragraph 6 of the FSP was included in ASC 480-10-25-9. Additionally, an example from paragraph 7

in the FSP, which illustrated the concepts in paragraph 5, was included in ASC 480-10-55-33.

This guidance clarified that a warrant for a redeemable share is a liability, despite the share itself not

being a liability.

5.7.2.2 What makes a share ‘redeemable’

Warrants most frequently in the scope of ASC 480 are for preferred shares with triggers that permit or

may permit the investor to realize the liquidation preference prior to the liquidation of the issuer. The

same accounting analysis applies to warrants for redeemable common shares.

A preferred share is redeemable if there is any feature in the preferred share that will either (1) automatically

(unconditionally or mandatorily) or contingently (conditionally) require the issuer to redeem the share

or (2) permit the holder to compel the issuer to redeem (i.e., put) the share at any time or on the

Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.

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occurrence of a contingent event. The balance sheet classification of the preferred share (i.e., equity,

temporary equity or a liability) is not considered. A warrant on a redeemable preferred share that may

require the issuer to transfer assets is a liability unless the issuer can avoid triggering redemption by

controlling the exercise contingency (refer to section 5.7.2.2.2).

5.7.2.2.1 Mandatorily redeemable securities

ASC 480 defines a mandatorily redeemable financial instrument 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.” (Refer to section A.4 for further guidance on identifying mandatorily redeemable securities.)

A preferred share that is mandatorily redeemable is classified as a liability under ASC 480-10-25-4.

A warrant for a mandatorily redeemable preferred share is also a liability.

Importantly, a share may not be considered mandatorily redeemable because its terms specify that the

occurrence of an event — regardless of probability — could prevent the share from being redeemed.

However, a warrant on that share is still a liability pursuant to ASC 480 because the share embodies a

redemption obligation (even though it is conditional).

For example, if preferred shares require redemption on a date certain, but are also convertible into

common stock prior to that redemption date, the preferred shares are not considered mandatorily

redeemable, as redemption is conditioned on the shares not being converted prior to that date (refer to

the example in ASC 480-10-55-11). As a result, the preferred shares are not classified as a liability

pursuant to ASC 480 (but may be classified as temporary equity for SEC registrants). However, a

warrant for this share is classified as a liability because the shares are redeemable if the warrant is

exercised and the embedded conversion option is not exercised. As noted in ASC 480-10-25-9, the

number of conditions leading up to the transfer of assets is irrelevant.

5.7.2.2.2 Contingently redeemable securities

A preferred share that is not mandatorily redeemable may be either (1) automatically redeemed upon

the occurrence of a contingent event and/or (2) puttable at the option of the holder either currently, with

the passage of time or on the occurrence of a contingent event.

While the preferred share is not

classified as a liability pursuant to ASC 480, further evaluation of the redemption feature is necessary to

determine the accounting for the related warrant. If a preferred share is redeemable, a warrant to acquire

that share may embody an obligation and thus require liability classification pursuant to ASC 480.

Understanding the nature of the contingent event that requires or permits the redemption of an underlying

preferred share is important. If the future event that triggers the redemption (or possible redemption) of

the preferred shares is completely within the issuer’s control, an obligation does not exist and will not

exist until the issuer takes (or fails to take) action. Accordingly, the share is not considered redeemable.

All facts and circumstances should be considered to determine whether the issuer has complete control

over the event leading to redemption, regardless of probability.

In contrast, a preferred share that is not redeemable currently but may become redeemable with the

passage of time or on a contingent event that is not completely within the control of the issuer is

considered contingently redeemable. In that case, the issuer is obligated to redeem when or if called upon.

For example, consider a preferred share that is redeemable upon the completion of an IPO. A warrant for

that preferred share is not a liability, provided the issuer is considered to control (i.e., avoid) triggering

the redemption right in the preferred share by not initiating a public offering. However, a preferred share

Shares that become redeemable or puttable are referred to as “contingently redeemable” in this section.

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that is contingently redeemable if an IPO has not been completed by a specific date is considered redeemable

(and the warrant for that preferred share is a liability) because, while it is within the issuer’s control to

start the offering process, it is not within the issuer’s control to complete an offering by a specific date.

The redeemable equity guidance in ASC 480-10-S99-3A (refer to Appendix E for further discussion) may

be helpful in determining whether a triggering event is within the control of the issuer and therefore,

whether a warrant on such a share (i.e., contingently puttable share) may embody an obligation to

transfer assets. While ASC 480-10-S99-3A may be helpful in making that determination, we generally

believe that guidance is not necessarily determinative that instruments in its scope embody obligations of

the issuer (e.g., callable shares). The individual facts and circumstances should be considered in making

this determination.

For example, a feature in a preferred share may provide for the redemption of the security upon any

transaction in which the outstanding shares of common stock are exchanged for consideration and the

stockholders of the corporation immediately prior to such an event hold less than 50% of the voting

securities of the corporation (or surviving entity) immediately after such event.

If the issuer cannot control (i.e., cannot prevent) the occurrence of a transaction resulting in a change in

the shareholders as described above (e.g., by using corporate governance provisions under its articles

of incorporation or invoking state or federal securities law), the preferred share would be considered

redeemable. A warrant for that preferred share should be classified as a liability.

5.8 Tranched preferred share issuances

5.8.1 Overview and background

A tranched preferred share issuance, also referred to as a “delayed issuance of preferred shares” or a

“contingent issuance of preferred shares,” consists of multiple components, the first of which is an initial

issuance of preferred shares. The second component which is contractually committed to at the initial

closing date, is referred to as the “second” or “later” tranche or a “delayed issuance,” and results in

preferred shares issued at a specific future date or upon the occurrence of a future event or milestone.

Tranched preferred share transactions are commonly entered into by emerging entities (e.g., biotech

and technology) as a source of capital to fund research and development and general operations. The

later tranche(s) often are timed to coincide with a future expected need for capital to continue the

entity’s product development. For example, a later tranche may be contingent upon a biotech company

commencing a certain phase of clinical trials.

5.8.2 Analysis

The future right or obligation to issue preferred shares in a later tranche (referred to as the “future

tranche right or obligation”) should be evaluated as either (1) a freestanding financial instrument requiring

its own accounting or (2) a contractual feature that is embedded in the preferred shares issued at closing.

Once that determination is made, the accounting for the freestanding instrument or embedded feature

should be based on the contractual terms of the preferred share and the future right or obligation and

should consider the bifurcation guidance in ASC 815-15. For example, the preferred share may have

various dividend features and be (1) perpetual, (2) contingently redeemable or mandatorily redeemable or

(3) convertible. In addition, the future tranche right or obligation may (1) mandate the subsequent round

of investment, (2) permit the issuer the unilateral right to force the investment or (3) permit the investor

the unilateral right to invest. Each of those features and terms has a direct effect on the accounting.

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5.8.2.1 Freestanding or embedded

A tranched preferred share issuance may take the form of either a single instrument (e.g., the initial

issuance of preferred shares with an embedded feature providing for the future tranche right or

obligation) or multiple instruments (e.g., the initial issuance of preferred shares with a separate

freestanding instrument for the future tranche right or obligation).

ASC 480 defines a freestanding financial instrument as a financial instrument that meets either of the

following conditions: (1) it is entered into separately and apart from any of the entity’s other financial

instruments or equity transactions or (2) it is entered into in conjunction with some other transaction and

is legally detachable and separately exercisable. An instrument or feature not meeting these conditions is

generally considered a feature embedded in another contract or transaction.

Because both the initial issuance of preferred shares and the future tranche right or obligation are

entered into at the same time (as part of one agreement or multiple contractual agreements executed at

the same time) between the same counterparties, condition (2) above should be analyzed.

• Legally detachable — Generally, whether two instruments can be legally separated and transferred

such that the two instruments may be held by different parties. For example, if the initial investor can

sell its preferred shares and retain the future tranche right or obligation, the instruments are legally

detachable. In assessing this criterion, it is not relevant which instrument the initial investor can

transfer. For example, if the initial investor can transfer the preferred share but contractually cannot

transfer the future tranche right or obligation, the two instruments are still legally detachable. The

same would be true if the initial investor had to retain the preferred shares but could transfer the

future tranche right or obligation. If the investor is able to separate the two instruments, they are

generally considered legally detachable. However, if an instrument can be separately transferred

only with the consent of the counterparty, further analysis should be performed. We generally

believe that an instrument is not legally detachable if the counterparty can unilaterally prevent the

transfer in accordance with the contractual terms. On the other hand, the legal detachability criteria

may be met if the counterparty cannot unreasonably withhold consent. The determination of

whether two instruments can be legally separated and transferred such that the two components

may be held by different parties is a legal matter that may require advice from legal counsel.

• Separately exercisable — Generally, whether one instrument can be exercised without terminating

the other instrument (e.g., through redemption, simultaneous exercise, expiration). For example, if

the future tranche right or obligation can be exercised while the initial preferred shares continue to

be outstanding (which generally is the case with a tranched preferred share issuance), the

instruments are separately exercisable.

To conclude under condition (2) above that instruments are freestanding, they should be both legally

detachable and separately exercisable. For example, if either the initial preferred shares or the future

tranche right or obligation can be transferred to another party (separate from the other instrument), and

the initial preferred shares remain outstanding upon the exercise or fulfillment of the future tranche right

or obligation (i.e., upon the issuance of the later tranche of preferred shares), the instruments would be

freestanding. However, if the future tranche right or obligation cannot be transferred without the initial

preferred shares (or the initial preferred shares cannot be transferred without the future tranche right or

obligation), yet the initial preferred shares still remain outstanding upon the exercise or fulfillment of the

future tranche rights/obligations, the instruments would not be freestanding. That is, the future tranche

right or obligation would be an embedded feature (i.e., embedded in the initial preferred shares).

If there are multiple future issuances or tranches of preferred shares in a tranched preferred share

transaction, the issuer should also consider whether each subsequent issuance is an individual contract

or, instead, a portion of a single contract. For example, if a tranched preferred share issuance has a

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potential second, third and fourth tranche, the issuer should determine whether those are additional

embedded features or freestanding financial instruments and, if freestanding, whether they are

freestanding individually or as one combined instrument. That determination should also be made based

on the legally detachable and separately exercisable criteria.

Determining whether a future tranche right or obligation is an embedded feature or a freestanding

instrument requires an understanding of the contractual terms of the arrangement. In some cases,

advice from legal counsel may be required to understand the rights of each party. Although the parties to

the arrangement may have intended or expected that the future tranche right or obligation would remain

with the initial investor that purchased the preferred shares, the legal documents (e.g., securities

purchase agreement, investor rights agreement) may not require such coupling. That is, there may be no

contractual provisions in the transaction documents that prevent the initial investor from transferring one

component (either the initial preferred stock or the future tranche right or obligation) and retaining the

other component. The absence of such a contractual restriction often results in a conclusion that the future

tranche right or obligation is a freestanding financial instrument for financial reporting purposes.

5.8.2.2 Accounting for a freestanding future tranche right or obligation

If the future tranche right or obligation is determined to be a freestanding instrument, there are two

instruments requiring separate accounting (i.e., the preferred shares issued and the separate future

tranche right or obligation). The first step is to determine the proper classification of the freestanding

future tranche right or obligation instrument (as an asset or liability or in equity). This classification is

important because it determines the method for allocating the arrangement proceeds between the

freestanding future tranche right or obligation instrument and the preferred shares issued.

The freestanding future tranche component, which is an equity contract on the issuer’s own stock,

should be evaluated based on its contractual terms to determine if it is a forward contract (the issuer

must issue and the investor must purchase shares in the future, either on fixed or determinable dates or

potentially upon the resolution of future contingencies), a purchased put (issuer has the right but not the

obligation to issue additional shares) or a written call (investor has the right but not the obligation to

purchase additional shares) on the preferred shares.

The classification of the freestanding instrument is first analyzed under ASC 480 to determine if it is

classified as a liability. If the freestanding instrument imposes on the issuer a conditional (outside the

issuer’s control) or unconditional obligation to issue shares that are potentially redeemable, the freestanding

instrument is classified as a liability pursuant to ASC 480. This is an important evaluation because

frequently the underlying preferred shares to the future tranche right or obligation are redeemable,

either at the option of the holder or upon the occurrence of a contingent event outside the issuer’s

control, thus requiring liability classification for the freestanding future tranche component. Refer to

section 5.7 for a discussion on warrants with underlying shares that are redeemable.

If ASC 480 does not require liability classification for the freestanding future tranche component, it is

next analyzed under ASC 815-10 to determine if it meets the definition of a derivative, and if so, whether

it qualifies for an exception from derivative accounting. The most common exception from derivative

accounting for equity-linked instruments is in ASC 815-10-15-74(a) for instruments that are (1) indexed

to the company’s own stock and (2) would be classified in equity. The evaluation of those two criteria is

addressed in ASC 815-40. If the component does not meet the definition of a derivative, it is still evaluated

under the guidance in ASC 815-40, only this time for classification in its own right. Regardless, the

guidance in ASC 815-40 will help determine the classification of a freestanding future tranche right or

obligation that is not addressed by ASC 480. The classification should be reassessed at each reporting

date. Section 4 provides detailed guidance on evaluating the classification of a freestanding equity

contract, and is supplemented by the discussion in Appendix B.

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If the freestanding instrument is a liability under ASC 480, a derivative under ASC 815 (i.e., it meets the

definition of a derivative and does not qualify for the exception from derivative accounting) or an asset or

liability under ASC 815-40, and is subsequently marked to fair value through earnings at each reporting

date, the freestanding instrument is recognized at fair value from the proceeds received at issuance

(i.e., the proceeds received from the issuance of the initial preferred shares). This allocation method (as

opposed to a relative fair value method) is generally applied in practice when the instrument is subject to

ongoing fair value measurements to avoid a day-one loss on adjusting a liability from its allocated value

to its full fair value through earnings. If the freestanding instrument is classified in equity, it is allocated

its relative fair value from the proceeds and is not subsequently remeasured as long as it continues to be

classified in equity. The remaining proceeds are allocated to the preferred shares. Refer to section 1.2.7

for further discussion on the allocation of proceeds.

The preferred shares require their own evaluation to determine their (1) classification as debt or equity

(including temporary equity), (2) the nature of the host contract and (3) potential bifurcation of any

embedded features and potential BCFs. If the preferred shares are issued at a discount due to the allocation

of proceeds to the freestanding instrument (i.e., the future tranche component), the discount can affect the

accounting for any embedded redemption features (put or call options). The discount might also result in a

BCF (a conversion option that is determined to be in the money at inception and requires separate accounting

at intrinsic value in equity) if the preferred shares are convertible. Refer to section 3 for discussion of the

accounting for features in preferred shares and Appendix D for discussion of the BCF literature.

5.8.2.3 Accounting for an embedded future tranche right or obligation

If it is determined that a future tranche right or obligation is a feature embedded in the issued preferred

share, the guidance in ASC 815-15 should be applied to determine whether the embedded feature should

be bifurcated. That application of ASC 815, as above with a freestanding instrument, evaluates whether

the embedded feature meets the definition of a derivative, and if so, whether it qualifies for an exception

from derivative accounting.

Pursuant to ASC 815, embedded features are separated from their host non-derivative contracts and

accounted for as derivative instruments if, and 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 contract that embodies both the embedded derivative and the host contract is not remeasured

at fair value under otherwise applicable US GAAP with changes in fair value reported in earnings as

they occur.

• A separate, freestanding instrument with the same terms as the embedded derivative would be a

derivative instrument subject to the requirements of ASC 815.

When applying the bifurcation criteria to a tranched preferred share issuance, the last criterion is particularly

important. That criterion requires that the embedded future tranche right or obligation feature meet the

definition of a derivative pursuant to ASC 815 as if it were a freestanding instrument. Because companies

issuing tranched preferred shares are typically not publicly traded, the future tranche right or obligation

feature often does not meet the definition of a derivative in ASC 815 (i.e., it is not net settleable because

the underlying shares are not readily convertible to cash). In such situations, the embedded future tranche

right or obligation would not be bifurcated and would not receive separate accounting.

Any embedded future tranche right or obligation meeting the definition of a derivative would be evaluated

for the exception from derivative accounting ASC 815-10-15-74(a). The conclusion to bifurcate (or not)

should be reevaluated at subsequent reporting dates. Refer to section 3 for a discussion of accounting for

features in preferred shares.

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5.9 Accelerated share repurchase transactions

5.9.1 Overview and background

There are many reasons why an issuer may consider repurchasing its shares. For example, repurchasing

shares can be a tax-efficient way to return capital to shareholders, as compared to declaring cash dividends.

In addition, some may view a large repurchase as a signal that the issuer believes its shares are undervalued.

An issuer may also wish to offset the dilutive impact of (1) issuing shares to acquire another entity

(e.g., a merger or acquisition) or (2) exercises of employee stock options. Finally, an issuer may simply

wish to reduce its outstanding share count, thereby increasing EPS or other related measures.

There are various ways an issuer may repurchase its own shares. Each alternative has its own benefits

and considerations. Although several alternatives are discussed, this section focuses on the accounting

considerations for accelerated share repurchase (ASR) programs due to their complexity.

Open market repurchase programs

One alternative an issuer may choose to repurchase its own shares is an open market repurchase

program (OMR). These programs typically involve the issuer engaging an investment bank (the “dealer”)

to make spot purchases of the issuer’s shares on the issuer’s behalf over an extended period of time.

Depending on the type of program, purchases may occur only when the issuer instructs the dealer, or

pursuant to a schedule or formula. For example, the terms of the OMR may define certain dollar amounts

the dealer shall use to purchase shares on a given trading day based on the price of the issuer’s shares

on that day, up to a maximum dollar amount for the entire program. Typically, the dollar amount

permitted each trading day increases as the issuer’s stock price decreases.

Tender offers

Another alternative is a tender offer, which is a broad solicitation by the issuer to purchase a substantial

percentage of its shares for a limited period of time. The tender offer is typically for a fixed price and

contingent on shareholders tendering a certain number of their shares. Some tender offers are in the

form of a “Dutch auction” whereby the issuer offers to repurchase a fixed maximum number of shares

within an identified range of prices.

Tender offers generally allow the issuer to retire a much larger number of shares than an OMR and over

a shorter period of time. In addition, the market typically views tender offers as a stronger signal than an

OMR that the issuer believes its shares are undervalued. However, a tender offer typically requires the

issuer to pay a significant premium over the current price (e.g., 10%) and may involve more significant

transaction costs than an OMR. Also, the level of participation and, therefore, the number of shares the

issuer will be able to retire, is uncertain.

Accelerated share repurchase

A third alternative is an ASR, also known as an accelerated share buyback. An ASR may take many

forms, but most provide the benefit of an immediate share count reduction similar to a tender offer,

while ultimately only requiring the issuer to pay a price per share equal to an average share price over an

extended period of time, as is the case with an open market share repurchase plan. Further, depending

on the structure, the issuer may actually pay a discount to an average price, as opposed to a price in

excess of a market price after considering commissions or premiums. The most basic forms of these

arrangements are often referred to as “fixed-dollar” (i.e., the amount of cash paid is fixed and the

number of shares purchased varies based on the stock price observed during the life of the contract) or

“fixed-share” (i.e., number of shares is fixed and amount of cash paid varies based on the stock price

observed during the life of the contract).

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Although most ASRs are documented as a single transaction (i.e., forward purchase contract with up-front

delivery), from an accounting perspective, they are most commonly viewed as (1) an initial spot purchase

and receipt of shares and (2) a forward sale contract with a forward price equal to the shares’ initial

purchase price. The following example illustrates the economics of a traditional ASR (i.e., a basic uncollared

fixed-dollar ASR) from an issuer’s perspective. This example, and the remaining part of section 5.9, also

discusses some of the dealer’s activities to manage and hedge their side of the transaction as those

activities may impact the contractual terms of the ASR and thus significantly impact the economics of

and accounting for the ASR.

Assume that an issuer enters into a traditional ASR when its stock price is $10, and pays a dealer

$100 million in exchange for 10 million shares (note that the initial share delivery typically occurs no

more than three days after executing the agreement). To make such a large share delivery possible

without impacting the share price, the dealer borrows the issuer’s shares from third-party securities

lenders. The significant initial share delivery (resulting in an immediate reduction in shares outstanding)

is one of the key benefits of an ASR over the other share repurchase alternatives. This represents the

“spot purchase” component of the ASR.

Following the initial share delivery, the dealer purchases shares from the market to cover its short

position created by borrowing the shares from securities lenders. Those purchases typically occur over a

period that may range anywhere from a few weeks to several months depending primarily on the size of

the transaction and the daily trading volume of the issuer’s shares. This period of time is often referred

to as a “calculation period” because the arithmetic average of the VWAP observed on each day during

this time is used to calculate the price the issuer will ultimately pay for the aggregate number of shares

received. For example, if the calculation period is three days and the daily VWAP for those days is $10,

$11 and $12, respectively, the “average VWAP” for the calculation period is $11, which is simply the

sum of the daily amounts divided by three. While the daily VWAP prices are usually volume-weighted for

shares purchased that day, the average VWAP is the simple average of all the daily VWAPs during the

calculation period (as opposed to volume weighting the daily VWAPs).

At the end of the calculation period, the average VWAP is used to determine a final settlement amount.

The ultimate number of shares repurchased (i.e., initial “spot” share delivery plus or minus the shares

received or delivered upon settlement of the forward contract) equates to using the prepaid amount to

repurchase shares at the average VWAP price. If the average VWAP during the calculation period

declines from inception, the issuer will receive additional shares from the dealer at maturity. For

example, if the issuer paid the average VWAP over the period — assume that was $8 — and the share

price of the spot purchase was $10, the issuer overpaid for each share by $2 and is due back some

consideration to be paid in the form of shares. The opposite is generally true (i.e., the issuer will return

shares to the dealer at maturity) if the average VWAP increases during the calculation period.

Continuing the above example, if the average VWAP during the calculation period is $8, the issuer will

receive an additional 2.5 million shares from the dealer. This amount is determined by the difference

between 1) the number of shares the issuer would have received had it paid the average VWAP of $8 and

2) the number of shares it actually received at inception ($100 million prepayment divided by $8 less the

10 million initial share delivery). The net effect of the arrangement is that the issuer paid $100 million to

purchase 12.5 million shares at a price per share of $8. This puts the issuer in a similar economic

position as simply purchasing the shares in the open market throughout the calculation period; however,

the ASR allows the issuer to receive a large number of these shares at inception. Refer to section 5.9.2.4

for the accounting for this ASR.

From the dealer’s perspective, if the entire $100 million prepayment was used to purchase shares during

the calculation period at an average VWAP of $8, it would have covered the 10 million shares it

borrowed, as well as the 2.5 million additional shares owed to the issuer upon settlement. If, on the other

hand, the average VWAP was $12.50, the dealer would only have been able to purchase 8 million shares.

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This is 2 million shares less than the 10 million shares borrowed. However, as the dealer also would have

been owed 2 million shares from the issuer upon settlement ($100 million payment divided by $12.50

less the 10 million initial share delivery), it would have enough shares to cover the shares borrowed.

Therefore, the calculation period and corresponding settlement mechanics are also important to the

dealer as they are designed and negotiated to act as a hedge of the dealer’s exposure to stock price while

it covers the borrowing of the issuer’s shares.

The following summarizes these three share repurchase alternatives:

OMR

Tender offer

ASR

Description

Issuer has discretion to

purchase shares over time

at market prices on a ‘best

execution’ basis (i.e., at

the lowest price the dealer

can reasonably obtain

during the trading day).

Issuer purchases a large

number of shares within a

specified price range.

Issuer can purchase a

large number of shares at

inception, with the final

price settled at a

later date.

Benefits

Simple to implement with

minimal execution costs.

Issuer can be opportunistic

with purchases as it

controls timing and sizing.

Allows for purchase of a

large number of shares

quickly and may indicate

to the market that the

issuer believes its shares

are undervalued. Specific

price range also reflects

issuer’s view on the value

of its shares.

Results in an immediate

purchase of a large number

of shares, which may

positively impact EPS and

may indicate to the market

that the issuer believes its

shares are undervalued.

Many variations to the basic

structure provide the issuer

flexibility (e.g., discount to

VWAP, collared pricing).

Considerations

Requires an extended

period of time to purchase

a significant number of

shares and is less visible

to the market.

Repurchases may have to

be curtailed during certain

blackout periods under

securities laws.

Involves significant

execution costs and

typically requires a

premium to the current

share price to induce

participation. No control

over number of shares

purchased. Tender offers

may not be allowed during

certain blackout periods

under securities laws.

Provides minimal

flexibility to terminate

program once executed,

and issuer is exposed to

market fluctuations during

contract period.

Because there are many variations of ASRs, their terms should be carefully evaluated in determining

the accounting.

5.9.2 Analysis

The accounting for ASRs is explicitly discussed in ASC 505-30-25-5 and 25-6 (and implementation

guidance in ASC 505-30-55-1 through 55-7 and 60-2). This guidance states that an issuer should account

for the ASR as two separate transactions:

• Common stock acquired in a treasury stock transaction

• A forward contract indexed to its own stock

The first transaction (i.e., the spot repurchase of treasury shares) results in a reduction in equity and in

the number of the shares in the denominator for EPS on the trade date. The second transaction is a

forward contract on the issuer’s equity shares. Because the forward contract would require the issuer to

provide the dealer with additional consideration (i.e., in the form of cash or shares) if the company’s stock

price increases, it is commonly viewed as a forward sale contract. It is evaluated under the equity contract

road map (refer to section 4) to determine its classification and measurement.

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The following discussion applies to both fixed-share and fixed-dollar ASRs, unless otherwise specified.

5.9.2.1 ASC 480 considerations

As with all equity contracts, an ASR’s forward contract should first be considered under ASC 480. The basic

forward sale contract referenced in ASC 505-30 generally does not fall under the scope of ASC 480 because:

• ASC 480-10-25-8 through 25-13 requires liability (or asset) classification for freestanding financial

instruments that represent, or are indexed to, an obligation to buy back the issuer’s shares. A forward

contract to sell shares does not embody an obligation of the issuer to buy back shares. However, if

the ASR involves shares that are themselves redeemable, the forward sale would embody an obligation

of the issuer to buy back its own shares by virtue of the redemption feature in the shares.

• ASC 480-10-25-14 states that 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, should be classified as a

liability (or asset) if, at inception, the monetary value of the obligation is based solely or predominantly

on one of three conditions. The monetary value of the issuer’s settlement obligation under the forward

contract does not meet any of those conditions.

The monetary value of any obligation embodied in the forward sale contract is not predominantly

fixed at inception since the settlement amount the issuer may be obligated to pay to the

counterparty fluctuates based on the market price of the issuer’s equity shares. Variations in the

settlement amount are indexed to the fair value of the issuer’s own stock. Lastly, variations in the

obligation are not inversely related to changes in the fair value of the issuer’s own stock, as the

dealer gains when the issuer’s share price goes up and loses when the issuer’s share price falls.

5.9.2.2 Contracts in an entity’s own equity (ASC 815-40)

Typically, the forward sale contract meets the definition of a derivative. The issuer’s share price is the

underlying, the number of shares received in the initial share delivery is generally the notional, there is

typically no, or a minimal, initial investment in the forward sale contract and the forward contract

contractually provides for net settlement. As a result, all of the criteria pursuant to the indexation

guidance (ASC 815-40-15) and equity classification guidance (ASC 815-40-25) should be evaluated to

determine if the forward contract qualifies for the equity scope exception from derivative accounting

pursuant to ASC 815-10-15-74(a).

Indexation considerations under ASC 815-40-15

ASR agreements (often executed in a standard ISDA form) include many provisions that protect the dealer

against risks related to both executing the transaction and subsequently maintaining a standard hedge

position over the life of the contract (see section 1.3.1 for information regarding the various agreements

that should be reviewed when evaluating transactions executed in a standard ISDA form). For example,

certain provisions address how the ASR should settle if it becomes unlawful for the dealer to transact in the

issuer’s shares, or when a significant transaction occurs that creates discontinuities in the issuer’s stock

price (e.g., a tender offer). In these circumstances, the dealer cannot adjust its hedge position effectively

and would otherwise be exposed to risks that they did not price into the transaction at inception.

ASC 815-40-55-30 includes an example of a provision that adjusts the settlement amount of an equity

derivative to offset the effect of a merger announcement on the net change in the fair value of the instrument

and of an offsetting hedge position in the underlying shares. The specific provision described in the example

does not preclude the equity derivative from being indexed to the issuer’s own stock as the ability to maintain

a standard hedge position is an input to an option pricing model pursuant to ASC 815-40-15-7E and 15-7G.

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However, a critical fact in the example is that the adjustment is not affected by the dealer’s actual hedge

position, but rather, is based on a commercially reasonable or standard hedge of the transaction. That is,

the adjustment allowed in the contract cannot differ in circumstances when the dealer is over-hedged or

under-hedged. Accordingly, it is important that all adjustment provisions in the agreements are thoroughly

evaluated to understand the extent the dealer’s actual hedge position or hedging activity can impact the

terms of the transaction, as these could violate the concepts in ASC 815-40-15-7E and 15-7G.

Equity classification under ASC 815-40-25

A key consideration in evaluating the forward contract pursuant to ASC 815-40 is determining whether

the form of contractual settlement supports a conclusion of equity classification. If the issuer is able, in

all circumstances, to settle the forward in net shares, the forward qualifies for equity classification. If,

however, the contract must be net cash settled or the holder has a choice of cash or share settlement,

then the forward is precluded from being classified in equity.

Similar to indexation considerations, provisions within the agreements should be carefully reviewed to

determine whether the criteria for equity classification are met. For example, standardized settlement

provisions in the Master Agreement and Equity Definitions of ISDA contracts may invoke net cash

settlement (i.e., ”cancellation and payment”) upon the occurrence of an extraordinary event that

triggers an early termination (e.g., merger, tender offer, delisting).

In practice, issuers may address this automatic trigger of net cash settlement by including provisions in the

confirmation that override the default settlement mechanics in the Master Agreement or Equity Definitions.

An example is a provision stating that the issuer has the right, in its sole discretion, to choose the form of

settlement (cash or shares) for any amount paid or received upon early termination and certain extraordinary

events. The issuer should also be sure that the other conditions of ASC 815-40-25 are met (e.g., issuer may

deliver unregistered shares, there is a limit to the number of shares that the issuer could possibly deliver).

Refer to sections 4.4 and 4.5 for discussions on the subsequent accounting and settlement accounting

for equity contracts, respectively.

5.9.2.3 Effects on EPS as a potential participating security under ASC 260

Entities that enter into an ASR should consider whether the forward sale contract is a participating

security under ASC 260. Some ASRs provide the dealer with value in the event an issuer’s actual dividend

exceeds its ordinary dividend (e.g., historically paid dividend). This may be accomplished through a

reduction of the forward price

of the forward contract. Such a provision would cause the forward to be a

participating security if the transfer of value upon declaration of a dividend is not contingent (as it would

be for an option contract). A participating security under ASC 260 requires the use of the two-class method

for calculating the ASR’s impact on EPS. Refer to section 5.2.3 of our FRD publication, Earnings per share,

for further guidance on the EPS impact of ASRs.

Similarly, if the occurrence of an extraordinary dividend does not explicitly require an adjustment to the

forward price of the forward contract, but instead triggers an early termination of the transaction, it

should be clear whether the amount determined upon the final settlement would include the economic

effect of the extraordinary dividend. If so, the ASR would be a participating security as the dealer would

obtain the benefit of the dividend.

Under ASC 815-40-55-37, this adjustment to the forward price would not preclude the forward from being indexed to the issuer’s

own shares because it is based on a variable (i.e., dividends) that would be an input to the fair value of a fixed-for-fixed forward

contract on equity shares.

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5.9.2.4 Illustration (added September 2022)

Illustration 5-8: Fixed dollar ASR

On 1 January 20X1, Company A executes an ASR agreement when its common stock price is $10 with

Dealer B. The key terms are:

• Prepayment amount: $100 million

• Prepayment date: 1 January 20X1

• Initial shares: 10 million shares of Company A’s common stock

• Termination date: 30 April 20X1 (after 15 February 20X1, Dealer B has the option to accelerate

the terminate date)

• Calculation period: From 1 January 20X1 to 30 April 20X1

• Forward price: The average of the VWAP for the dates in the calculation period

• Settlement methods:

• If Company A is entitled to receive upon settlement: Share settlement

• If Company A is obligated to deliver upon settlement: Cash settlement or share settlement at

Company A’s election

Company A makes the prepayment of $100 million on 1 January 20X1 and receives 10 million shares

of common stock. Dealer B does not elect to accelerate the termination date. On 30 April 20X1,

Company A calculates the average VWAP over the calculation period and determines the average

VWAP during the contract period is $8. Accordingly, the settlement amount is determined to be 2.5

million shares ($100 million/$8, less the 10 million shares initially delivered). In this case, Dealer B is

obligated to deliver the 2.5 million additional shares to Company A.

Company A accounts for the ASR contract as two separate transactions: (1) common stock acquired in

a treasury stock transaction and (2) a forward sale contract. Company A concludes that the forward

contract is not a liability under ASC 480 and meets the requirements for equity classification under

ASC 815-40.

Company A records the following journal entries upon the execution of the ASR agreement and the

settlement of the forward contract.

1 January 20X1

Company A records the treasury stock transaction as follows:

Treasury stock $ 100 million

Cash $ 100 million

There is no entry for the forward sale contract at inception. Because the forward is classified in equity,

it is not subsequently remeasured as long as the forward continues to be classified in equity.

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30 April 20X1

Under the terms of the ASR, Company A is entitled to receive a settlement from Dealer B because the

average of the VWAP for the calculation period is less than the initial purchase price of $10. In this

case, Company A will receive and Dealer B will deliver the settlement amount in shares.

On the settlement date (typically T+1 after the termination date), Company A’s stock price is $7 per

share. Company A records the following entry to reflect the additional shares it receives (2.5 million

shares x the $7 per share price) as a treasury stock transaction:

Treasury stock $ 17.5 million

Additional paid-in capital $ 17.5 million

The net effect of the arrangement is that Company A paid $100 million to purchase 12.5 million

shares at a price of $8 per share. The ASR places Company A in a similar economic position as if it had

purchased the shares in the open market throughout the calculation period, but the arrangement

allows it to receive most of the shares at inception.

5.9.3 Collared ASRs

In a traditional ASR, the issuer’s exposure to deliver shares or cash to the dealer at maturity increases as

the stock price rises during the calculation period. To reduce this exposure, an ASR may include a cap that

sets a maximum price at which the issuer will purchase the shares and, therefore, a minimum number of

shares the issuer will purchase under the entire ASR. Economically, this is equivalent to a purchased call

option from the issuer’s perspective, because it may give the issuer the ability to ultimately repurchase its

shares at a price (the cap price) that is less than the average VWAP if the average VWAP exceeds the cap price.

As the issuer must pay for this protection (i.e., pay a premium to purchase this cap), it is not uncommon

to see an ASR also include a floor to offset some or all of the cost of the cap. Incorporating a floor sets a

minimum price at which the issuer will purchase shares and, therefore, a maximum number of shares

that the issuer will purchase for the entire ASR. Economically, this is equivalent to a written put option

from the issuer’s perspective, because it may ultimately require the issuer to purchase shares at a price

(the floor price) that is greater than the average VWAP if the average VWAP falls below the floor. Rather

than collecting a premium for the option that is written to the dealer, the issuer effectively offsets the

premium due for the written floor against the premium owed for the purchased cap. The combination of

a cap and floor is often referred to as a “collar.”

When optionality is incorporated into an ASR, the dealer typically establishes a hedge of this exposure. For

example, by selling a cap to the issuer, the dealer is economically short the issuer’s shares, and therefore, it

typically accumulates a long position in the issuer’s shares to offset its exposure on the cap. Similar hedging is

common if the ASR includes a floor. These hedges, which are dynamically managed for the duration of the

ASR, are established in the first few days or weeks after inception, often referred to as the “hedging period.”

The cap and floor are typically defined at inception as a percentage of the average VWAP during the hedging

period, therefore the actual cap and floor prices are not known until the end of the hedging period.

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Another element to collared ASRs is the use of interim deliveries of shares. To ensure the issuer will not

have any share delivery obligation to the dealer upon settlement (and thus, alleviate the dealer’s burden

of selling these shares upon receiving them), it is common for collared ASRs to require an initial share

delivery that is smaller than a traditional ASR (e.g., issuer may only receive 50% of the shares as opposed

to 80—100% under a traditional ASR), and a subsequent delivery (i.e., interim delivery) after the hedging

period equal to the excess of the minimum number of shares over the initial share delivery.

Example — Interim share delivery

Assume an issuer enters into a collared ASR when its stock price is $10. At inception, the issuer prepays

$100 million in exchange for 5 million shares (50% delivery) at inception. The cap and floor prices are

defined as 110% and 90% of average VWAP during the dealer’s hedging period, respectively. Assume

that the average VWAP during the hedging period is $12. Therefore, the cap price would be $13.20

($12 multiplied by 110%) and the floor price would be $10.80 ($12.00 multiplied by 90%). The minimum

number of shares that the issuer is required to purchase under the cap would be approximately

7.58 million ($100 million divided by $13.20). As a result, the dealer would make an interim delivery

of approximately 2.58 million shares at the end of the hedging period, resulting in a total of 7.58 million

shares having been delivered cumulatively since inception. Thereafter, absent an unusual or

extraordinary event,

the issuer would have no obligation to deliver any shares to the dealer upon

settlement of the ASR, and could only receive additional shares up to the maximum. In this example,

the maximum number of shares would be approximately 9.26 million ($100 million prepayment divided

by the $10.80 floor price).

See section 5.9.3.1 below for more information regarding potential obligations of the issuer to return

shares that may arise in certain unusual scenarios.

5.9.3.1 Accounting for collared ASRs

ASC 480 considerations

Similar to traditional ASRs discussed in section 5.9.2, collared ASRs would not typically meet the conditions

in ASC 480-10-25-8 through 25-13 requiring liability (or asset) classification. However, if an ASR involves

shares that are themselves redeemable, the forward sale would embody an obligation to the issuer to

buy back its own shares by virtue of the redemption feature in the shares.

In evaluating whether a collared ASR is in the scope of ASC 480, particular consideration should be given to

ASC 480-10-25-14. That guidance is applicable only if the issuer has an obligation to issue a variable number

of shares. If the issuer never would have to issue shares, this guidance would not apply. Depending on

magnitude of the initial share delivery, the issuer could be required to deliver shares to the dealer. As a result,

ASC 480-10-25-14 should be considered to determine if the collared ASR is within the scope of ASC 480.

The following discussion focuses on the application of this guidance to a collared ASR with an interim

delivery up to the minimum number of shares (refer to example in section 5.9.3). While the likelihood at

inception that the issuer will be required to deliver any shares to the dealer is generally low, there are

two primary scenarios where this could occur as follows:

• Stock price increases significantly during the hedging period. For example, assume that the issuer

pays $100 million at inception when its stock price is $10 and receives 5 million shares (50% initial

delivery). If average VWAP during the hedging period increased such that the cap price was eventually

set at a price greater than $20, the minimum shares the issuer could receive in the ASR transaction,

For example, many ASRs include provisions that allow the dealer to adjust the terms of the ASR for events such as mergers, tender

offers, nationalizations, insolvencies and delistings, among others. In these events, based on share prices and terms of the agreement, there

may be small possibility of the issuer having to deliver shares in an early termination under the contractual terms of the arrangement.

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could be less than 5 million shares received in the initial share delivery (e.g., $100 million divided by

$20.01 is approximately 4.99 million shares). As a result, even without an interim delivery, it would

be possible for the initial share delivery to exceed the minimum number of shares the issuer could

receive under the ASR and, therefore, the issuer could be required to issue a variable number of

shares to the dealer in settlement of the ASR. However, this would be a highly unlikely scenario

because, (1) the cap price would have to double the spot price at inception in this fact pattern (2) the

hedging period typically only lasts one or two weeks (so absent extreme volatility such an increase is

not likely) and (3) the cap and floor are set on the average for the period, therefore, the stock price

would have to be at a very high level for most of the hedging period.

• Extraordinary event occurs that results in an adjustment to the terms of the ASR. As noted above,

ASRs include provisions that allow the dealer to adjust the terms of the ASR to allow it to maintain a

standard hedge of the transaction. For example, if a merger event or tender offer occurs that creates

discontinuities in the issuer’s stock price, the dealer generally can adjust the terms of the ASR to

capture the economic effect of these events. This could involve the dealer increasing the cap price,

thereby reducing the minimum number of shares.

While these scenarios are possible of occurring, they do not represent an obligation with a monetary value

that is predominantly fixed, inversely related to the issuer’s stock price or unrelated to the issuer’s share price.

While these scenarios generally would not cause an ASR to be classified as a liability under ASC 480, the

specific facts and circumstances of the ASR and issuer should be evaluated. Any obligation or contingent

obligation that is deemed substantive should be further evaluated as to whether it 1) may be settled in a

variable number of shares and 2) has monetary value that is predominately fixed, inversely related to the

issuer’s share price or unrelated to the issuer’s share price.

ASC 480 provides limited interpretive guidance on the term “predominantly.” The determination of

whether a settlement obligation’s monetary value is predominant will depend on the specific facts and

circumstances and requires judgment. In making that determination, the issuer should consider the

terms of the forward contract and all applicable information at inception, which include its current stock

price and volatility, the forward price of the instrument and other factors.

Contracts in an entity’s own equity (ASC 815-40)

As with a traditional ASR, the forward contract component of a collared ASR will typically meet the

definition of a derivative. However, it is common for a collared ASR to involve a relatively smaller initial

share delivery (see section 5.9.3). This partial share delivery feature may affect whether the forward

contract should be viewed as a freestanding derivative or a hybrid instrument with an embedded forward

contract (prepaid forward). Under either case, derivative accounting would generally not be required if the

requirements of ASC 815-40 are met.

Indexation considerations under ASC 815-40-15

The majority of the provisions in a collared ASR confirmation are typically consistent with a traditional

ASR and, therefore, the same care should be given to the evaluation. One difference is the provisions that

facilitate the establishment of the collar. As discussed above, the confirmation will typically define the cap

and floor prices as fixed percentages of average VWAP during the hedging period (e.g., 110% and 90%,

respectively). However, as the dealer often has some discretion to determine the length of the hedging

period, the dealer’s hedging activity impacts the cap and floor prices and, therefore, the ultimate

settlement amount. For example, if the dealer used one week establishing its hedge, the cap and floor

prices would likely be different than had the dealer used two weeks.

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As discussed in section 5.9.2.2, the guidance in ASC 815-40-15-7E and 15-7G (as described by

ASC 815-40-55-30) permits adjustments to a contract to allow the dealer to maintain a standard hedge

position. However, these adjustments cannot be based on the dealer’s actual hedge. Therefore, it is

important that the hedging period is explicitly based on a commercially reasonable period of time that

would be necessary to establish a commercially reasonable hedge, rather than an arbitrary period of time

or type of hedge that the dealer may choose at its sole discretion.

Equity classification under ASC 815-40-25

Although there is typically a low probability that the issuer will ever have to issue shares under any

settlement in a collared ASR with an interim delivery up to the minimum shares (e.g., in an early

termination), it is still necessary to ensure that the issuer can choose to settle in shares under all possible

settlement scenarios regardless of how remote.

Refer to sections 4.4 and 4.5 for discussions on the subsequent accounting and settlement accounting

for equity contracts, respectively.

5.10 Equity contracts on noncontrolling interests

5.10.1 Overview and background

NCI is the portion of equity (net assets) in a subsidiary not attributable, directly or indirectly, to the

parent. It is sometimes called a minority interest. NCI is created, among other ways, when a parent

acquires a controlling interest in a target company and leaves an NCI with other investors, or when a

parent decides to sell a portion of its wholly owned subsidiary but retains a controlling interest.

Refer to sections 4.6 and A.2.4 of our FRD publication, Business combinations, for further discussion on

the initial recognition of NCI in a business combination and an asset acquisition, respectively. Refer to

section 13 of our FRD publication, Consolidation, when the subsidiary is a variable interest entity, and refer

to section 18 of that publication for further discussion on the initial recognition of NCI in other transactions.

Like equity contracts on the shares of a parent company, equity contracts may also be written or purchased

on shares of a consolidated subsidiary. For example, in acquiring a target company, the former controlling

shareholders may want to retain a portion of their shares for a period of time but have the ability to sell

their equity interests to the controlling interest holder on certain dates or upon certain trigger events. A

parent and the NCI holders of a subsidiary may enter into such arrangements for the following reasons:

• Tax planning — A seller may want to defer capital gains that would result from selling 100% of an entity

by selling a controlling interest with a put option giving it the right to sell the remaining interest or a

call option giving the buyer the right to acquire the remaining interest (or both) in the future.

• Flexibility for the buyer — Call options and forward contracts provide flexibility for the buyer in

financing an acquisition.

• Liquidity to the seller — Put options and forward contracts give the seller an exit strategy for its

retained interest.

• Seller retention — Call options, put options or forward contracts with a fair value exercise price create

an incentive for the seller to remain involved with the business and help make it successful.

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Those arrangements can take the form of options (written or purchased, puts or calls), forwards (date

certain or contingent) or even swap-like contracts and may include one or more of the following:

• Grant the NCI holders an option to sell their equity interests in the subsidiary to the parent (i.e., a

written put option from the parent’s perspective)

• Grant the parent an option to acquire the equity interests in the subsidiary held by the NCI holders

(i.e., a purchased call option from the parent’s perspective)

• Obligate the parent to acquire and the NCI holders to sell their equity interests in the subsidiary

(i.e., a forward contract to purchase shares from the parent’s perspective)

• Grant the parent a purchased call option and grant the NCI holders a written put option (often these

two instruments have the same strike price and expiration dates making them similar to, but not

exactly the same as, a forward contract)

In some cases, the arrangements may be papered between the parent and the NCI holders, and in other

cases between the subsidiary and the NCI holders.

5.10.2 Analysis

NCI, which is generally in the form of common shares or preferred shares issued by the subsidiary,

should be classified as a separate component of consolidated equity pursuant to ASC 810-10-45. To be

classified as equity in the consolidated financial statements, the instrument issued by the subsidiary

should be classified as equity by the subsidiary based on other authoritative literature. If the instrument

is classified as a liability in the subsidiary’s financial statements (e.g., under any of the guidance in

ASC 480), it cannot be presented as NCI in the consolidated entity’s financial statements because that

instrument does not represent an ownership interest in the consolidated entity under US GAAP.

For example, if mandatorily redeemable preferred shares issued by a subsidiary were classified as a

liability in the subsidiary’s financial statements pursuant to ASC 480, the preferred shares would not be

classified as NCI in the consolidated financial statements.

The various options and forwards described above are contracts on the shares (common or preferred) of

a subsidiary. If the underlying share is classified in equity (as NCI), the equity contracts on the NCI should

be separately evaluated to determine their classification.

The accounting in this area can be complex because of the variety of authoritative guidance that should

be considered and the terms of the transaction. For example, (1) the equity contract may be entered into

contemporaneously with the creation of the NCI or subsequent to its creation, (2) the equity contract on

the NCI may be considered embedded or freestanding and (3) the strike price of the equity contract may

be set at either a fixed or variable (formulaic) price, or at fair value. Each of those variations can affect

the accounting. Additionally, equity contracts on NCI may be issued as share-based payments to employees

or nonemployees. In these cases, entities should consider the guidance in ASC 718 and their accounting

policy for stock options on subsidiary stock (see section 18.5.1 of our FRD publication, Consolidation).

Refer to our FRD publication, Share-based payment, for further guidance related to accounting for share-

based payment arrangements.

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The following summarizes, at a high level, the relevant accounting considerations applicable to equity

contracts associated with NCI that are not issued in a share-based payment arrangement. A parent that

has entered into equity contracts on NCI also should carefully evaluate how these arrangements affect

future earnings and EPS.

5.10.2.1 Road map for initial classification of equity contracts over NCI

The following flowchart provides a road map for determining the classification of equity contracts over NCI

and should be used in conjunction with the interpretive guidance that begins after the flowchart.

This includes assessment of whether equity contracts embedded in the NCI should be deemed financing arrangements pursuant

to ASC 480-10-55-59 through 55-62.

This includes determining whether the economic characteristics and risks of the embedded feature are clearly and closely related to the

host contract and, if not, whether the embedded feature is eligible for a scope exception from ASC 815 (e.g., ASC 815-10-15-74(a)).

Redemption features (e.g., put options) embedded in the NCI, regardless of whether they are bifurcated and accounted for

separately from the NCI, are considered in determining whether the NCI is subject to ASC 480-10-S99-3A.

If the freestanding equity contract is a fixed-priced forward to buy NCI at a stated future date that requires physical settlement,

the transaction is effectively a financing of the parent’s purchase of the NCI and consequently, the parent consolidates 100% of

the subsidiary and does not recognize the NCI at the consolidated entity level.

The NCI (including the embedded feature)

is classified as equity.

The NCI (including the embedded feature)

is classified as a liability.

Yes

The equity contract is freestanding and is

accounted for separately from the NCI

(see flowchart in section 4.2).

The feature is classified separately from

the NCI as a derivative asset or liability.

The NCI is classified as permanent equity.

The NCI is classified as temporary equity

(i.e., in the mezzanine).

Does the feature cause the NCI to be

considered redeemable pursuant to

ASC 480-10-S99-3A?

Is the equity contract embedded

in the NCI?

Is the NCI (including the embedded

feature) within the scope of

ASC 480?

Does the embedded feature meet the

definition of a derivative pursuant to

ASC 815?

Does the feature require bifurcation

from the NCI?

Yes

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5.10.2.2 Is the equity contract embedded in the NCI or freestanding?

The first step in accounting for an equity contract associated with an NCI is to determine whether the

equity contract is an embedded feature in the NCI or a freestanding financial instrument, because the

accounting can be significantly different. For example, the accounting for a freestanding written put on a

subsidiary’s shares is different than that for puttable shares issued by the subsidiary. While ASC 480

provides little interpretive guidance on the definition of a “freestanding” financial instrument, we believe

that the substance of a transaction should be considered in making this determination.

The determination of whether an instrument is embedded or freestanding involves understanding both

the form and substance of the transaction, and may involve substantial judgment. In this regard,

documenting an instrument in a separate contract is not necessarily determinative that it is freestanding,

particularly when a contract is entered into in conjunction with another transaction. Similarly, an instrument

that is documented in the same contract isn’t necessarily embedded. If the transactions are entered

contemporaneously between the same parties and involve the same underlying (in this context, the

issuer’s shares), it is important to assess whether the instruments are (1) legally detachable and

(2) separately exercisable. Those concepts can be further described as follows:

• Legally detachable — Generally, whether two instruments can be legally separated and transferred

such that the two components may be held by different parties.

• Separately exercisable — Generally, whether one instrument can be exercised without terminating

the other instrument (i.e., through redemption, simultaneous exercise or expiration).

If the exercise of one instrument must result in the termination of the other, the instruments would

generally not be considered freestanding pursuant to ASC 480. On the other hand, if one instrument can

be exercised while the other instrument continues to be outstanding, the instruments would be

considered freestanding under ASC 480, if it is also legally detachable from the other instrument.

For example, if a parent enters into a contract with the only noncontrolling shareholder of its privately

held subsidiary that permits the shareholder to put its shares in the subsidiary to the parent at a fixed

price, that put option generally would be considered to be embedded in the related shares. This is

because the shares held by the NCI holder are the shares that must be delivered upon exercise of the put

option by the NCI holder. In contrast, if the same parent enters into a put option on publicly traded

common stock of a different subsidiary, and that put option permits the counterparty to put any common

shares of the subsidiary to the parent at a fixed price (e.g., the counterparty could put shares of the

subsidiary already owned or buy shares in the market), that written put option would be considered

freestanding, provided that it is also legally detachable from the shares.

It is not uncommon for a parent to enter into options or forward contracts with the NCI holders to acquire the

NCI after the NCI was initially recognized. These contracts may still be considered embedded in or attached

to the NCI, based on the individual facts and circumstances. For example, if the parent subsequently enters

into a nontransferable equity forward contract with the only noncontrolling shareholder to acquire that

holder’s equity interest and the contract requires physical settlement, the transaction may, in substance,

represent an embedded or attached redemption feature. In certain circumstances, the addition of options or

forward contracts may represent a modification of the NCI, requiring additional analysis. Refer to section 3.6

for more information regarding modifications or exchanges of stock instruments.

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5.10.2.2.1 Equity contracts considered embedded

If the equity contract is considered a feature embedded in the subsidiary’s shares, that embedded

feature should first be analyzed to determine whether the NCI should be a mandatorily redeemable

financial instrument subject to ASC 480. Because a forward contract embedded in NCI shares represents

an obligation of the parent to mandatorily redeem the NCI for cash, the NCI (including the embedded

forward contract) generally is recognized as a liability within the scope of ASC 480. Conversely, a call or put

option embedded in the NCI shares usually does not result in the shares being considered mandatorily

redeemable because the contract conveys an option rather than an obligation.

If the shares are not a liability, then the NCI should be classified in equity and the embedded feature

analyzed for bifurcation pursuant to ASC 815. Likewise, if the shares are classified as a liability (and not

subsequently measured at fair value), then any embedded features should be analyzed for bifurcation. To

determine whether the embedded feature should be bifurcated, the hybrid instrument (the subsidiary’s

shares and embedded feature) should be evaluated under ASC 815-15. As part of that analysis, if the

hybrid instrument is classified as equity (i.e., it is not a mandatorily redeemable financial instrument

subject to ASC 480), the nature of the host contract (debt-like or equity-like) should first be determined.

If the nature of the host is more akin to debt, the embedded feature (i.e., the redemption feature) should

be analyzed using the debt instrument model (refer to section 2.2.5).

If the host is more akin to equity, in many cases, unless the subsidiary itself is a publicly traded entity, the

feature will not meet the definition of a derivative pursuant to ASC 815-10-15 because those features

usually require gross physical settlement or the transfer of the full amount of consideration payable in

exchange for the full number of underlying nonpublic subsidiary shares. As the underlying nonpublic

shares are not readily convertible to cash, this gross physical settlement does not meet any of the forms

of net settlement pursuant to ASC 815-10-15-99. However, if the instrument meets the definition of a

derivative, it should be evaluated under ASC 815-10-15-74(a) to determine if an exception from

bifurcation is available.

The exception in ASC 815-10-15-74(a) is applicable if the feature is considered indexed to the issuer’s

own stock and would be classified in equity. ASC 815-40 includes guidance that should be considered in

making this determination. There are special considerations as to whether the feature is considered

indexed to the issuer’s own stock when subsidiary shares are involved, as discussed in ASC 815-40-15-5C.

If the embedded feature (e.g., call option, put option) does not require bifurcation pursuant to

ASC 815-15, it remains with the NCI host instrument and no amount should be allocated to the

embedded feature. On the other hand, if the embedded feature requires bifurcation, a single derivative

(or a compound derivative comprising all the bifurcatable features) should be separated from the NCI and

recorded at fair value, which would reduce the amount allocated to NCI at the transaction date. The

NCI classified in equity is subsequently accounted for in accordance with ASC 810.

When the NCI is classified in equity (because it is not considered to be mandatorily redeemable) and

contains an embedded redemption feature (regardless of whether the redemption feature is bifurcated),

the redeemable equity guidance discussed below in section 5.10.2.4, should be considered.

Refer to section 3.2.4 for further guidance in evaluating shares with embedded features.

The embedded feature would be considered a derivative if the underlying shares were publicly traded. If the feature meets the

net settlement criterion by way of a required or alternative settlement in net cash or net shares, the conclusion that the feature

was embedded should be revisited.

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5.10.2.2.2 Equity contracts considered freestanding

An equity contract that is considered a freestanding financial instrument from the NCI should be evaluated

pursuant to ASC 480 to determine whether liability classification is required as, for the purposes of

ASC 480, an issuer’s equity share includes the equity shares of any entity whose financial statements are

included in the consolidated financial statements. Instruments that may require the issuer to transfer cash

or other assets in exchange for its own shares are among those classified as liabilities pursuant to ASC 480.

For example, a physically settled forward contract that requires the parent to pay cash in exchange for

the subsidiary’s shares is within the scope of ASC 480. Further, a freestanding written put option on the

subsidiary’s shares is also a liability under ASC 480 regardless of whether it settled gross or net.

If the equity contract is not a liability pursuant to ASC 480, the instrument should be evaluated to

determine whether it is a derivative pursuant to ASC 815. Similar to the analysis of an embedded feature

in the subsidiary’s shares, frequently, it will not meet the definition of a derivative because it lacks net

settlement. Even if the contract meets the definition of a derivative, it may still qualify for a scope

exception from derivative accounting pursuant to ASC 815-10-15-74(a), which considers the guidance

in ASC 815-40. If the equity contract does not meet the definition of a derivative, that same guidance in

ASC 815-40 is applied to determine the contract’s classification.

The NCI, as a separate freestanding financial instrument, would be classified in equity and subsequently

accounted for in accordance with ASC 810.

Refer to section 4 for detailed guidance on evaluating the classification of a freestanding equity contract.

5.10.2.3 Equity contracts deemed to be financing arrangements

In limited situations, a parent may enter into an equity contract to acquire a subsidiary’s shares that

should be accounted for as a financing of the parent’s purchase of the NCI. In those situations, equity

contracts are entered into between the parent and NCI holder at the inception of NCI that require

physical settlement. The contracts may be either (1) a fixed-priced forward to buy the remaining interest

in the subsidiary at a stated future date and the forward is considered freestanding or (2) a combination

of a purchased call option and written put option with same (or not significantly different) fixed strike

price and same fixed exercise date that are embedded in the shares.

Essentially, the parent does not recognize the NCI for the proportion of shares that is subject to the

financing but rather recognizes a liability for the financing (i.e., the future purchase of the NCI). In those

circumstances, the risks and rewards of owning the NCI have been obtained by the parent during the

period of the equity contract, even though the legal ownership of the NCI is still retained by the NCI

holders. Combining the equity contract and the NCI reflects the substance of the transaction; that is, the

NCI holder is financing the noncontrolling interest.

ASC 480-10-55-53 through 55-62 discuss equity contracts indexed to the noncontrolling interest of a

consolidated subsidiary that may be accounted for as financing arrangements. Further, ASC 480-10-55-54

states that the forward contract should be recognized as a liability, initially measured at the present

value of the fixed forward price. Subsequently, the liability is accreted to the fixed forward price over the

term of the forward contract with the resulting expense recognized as interest cost. Similar accounting

and measurement would be applied to the combined NCI and embedded options.

The initial measurement guidance in ASC 480-10-55-54 is not consistent with the general initial

measurement requirement of ASC 480 for physically settled forward purchase contracts. The general

measurement guidance in ASC 480-10-30-3 states that a freestanding physically settled forward

contract should be measured initially at the fair value of the underlying shares at inception, adjusted for

any consideration or unstated rights or privileges. While the methods are different, we generally believe

that they should result in approximately the same initial measurement. Any significant differences would

require additional analysis to determine if there are additional rights or privileges in the transaction.

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5.10.2.4 Application of the redeemable equity guidance

Generally, an embedded feature, whether or not bifurcated, that permits or requires the NCI shareholder

to deliver the subsidiary’s interests in exchange for cash or other assets from the controlling entity (or the

subsidiary itself) will result in the NCI being considered redeemable equity if the NCI is not presented as a

liability. Public entities should consider the SEC staff’s guidance on redeemable equity securities (included

in Codification at ASC 480-10-S99-3A) when classifying and measuring redeemable NCI. Those interests

should first follow the accounting and measurement guidance in ASC 810-10 (including allocation of

earnings, adjustments for dividends, etc.). The SEC staff’s guidance should then be considered, which

could affect the classification (presented in the mezzanine rather than in equity), and if so, may also adjust

the measurement of any NCI and the related EPS calculations.

In certain instances, the issuer may be required, or may have a choice, to exchange the subsidiary’s

interests by delivery of its own shares, rather than cash or other assets. In those instances, the SEC staff’s

guidance requires the issuer to consider the guidance in ASC 815-40-25-7 through 25-35 to determine

whether it can deliver the shares that could be required under the settlement of the exchange. If the issuer

does not completely control settlement by delivery of its own shares (i.e., it cannot satisfy the settlement in

shares), cash settlement would be presumed and temporary classification may be required for the NCI.

Refer to Appendix E for further discussion on the application of the redeemable equity guidance in

ASC 480-10-S99-3A.

5.10.2.4.1 Measurement and reporting issues related to redeemable equity securities

(updated September 2022)

ASC 480-10-S99-3A requires redeemable NCI to be initially recognized in temporary equity at the initial

carrying amount of the NCI determined in accordance with ASC 805-20-30. That guidance applies to business

combinations and requires the acquirer to measure the NCI in the acquiree at fair value on the acquisition date.

Refer to section 4.6 of our FRD publication, Business combinations, for further discussion on the initial

recognition of NCI in a business combination.

ASC 480-10-S99-3A does not address the initial measurement of a redeemable NCI if it is not created as

part of a business combination subject to the guidance in ASC 805. For example, consider when a parent

sells a 5% NCI in a subsidiary while retaining a controlling financial interest. If that transaction is

determined to be in the scope of ASC 810, it would be accounted for as an equity transaction under

ASC 810-10-45-21A through 45-24, in which case the carrying amount of the NCI should reflect the NCI

holder’s ownership in the subsidiary’s net assets, inclusive of any consideration received by the

subsidiary. However, if the NCI is redeemable and subject to ASC 480-10-S99-3A, we generally believe

that the redeemable NCI should be initially measured at fair value. Whether or not any adjustment to

bring the initial carrying amount of the NCI under ASC 810 to fair value will affect EPS will depend on

facts and circumstances.

Refer to section A.2.4 of our FRD publication, Business combinations, for further discussion on the initial

recognition of NCI in an asset acquisition. Also, refer to section 13 of our FRD publication, Consolidation,

when the subsidiary is a variable interest entity, and refer to section 18 of that publication for further

discussion on the accounting for subsequent changes in the ownership interest under ASC 810.

For all companies, both public and nonpublic, NCI is subsequently accounted for pursuant to ASC 810. If

the NCI is considered redeemable pursuant to ASC 480-10-S99-3A, the redeemable NCI is presented in

temporary equity. The measurement guidance in ASC 480-10-S99-3A is not applied in lieu of the accounting

for NCI under ASC 810. Rather, it is an incremental measurement that starts with the carrying amount

pursuant to ASC 810 and adjusts for any increase (but not decrease) to the carrying amount of temporary

equity. Paragraph 16e of ASC 480-10-S99-3A states that the amount in temporary equity should not be

less than the redeemable instrument’s initial amount reported in temporary equity. It further states that

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reductions in the carrying amount of a temporary equity instrument are appropriate only to the extent of

increases in the redeemable instrument’s carrying amount from the application of the SEC staff’s

guidance. We generally believe only the incremental measurement pursuant to the SEC staff’s guidance is

subject to this requirement. An issuer could potentially adjust a redeemable NCI’s balance below its initial

carrying amount when applying ASC 810 (e.g., for allocated losses or dividends paid).

As a result, a parent should first attribute net income or loss of the subsidiary and related dividends to

the NCI pursuant to ASC 810. After that attribution, the issuer should consider the provisions of

ASC 480-10-S99-3A to determine whether any further adjustments are necessary to increase the

carrying value of redeemable NCI. Adjustments to the carrying amount of redeemable NCI from the

application of the SEC staff’s guidance are charged to retained earnings (or to additional paid-in capital if

there are no retained earnings) and do not affect net income or comprehensive income in the consolidated

financial statements. The amount presented in temporary equity should be the greater of the NCI balance

determined under ASC 810 or the amount determined under ASC 480-10-S99-3A.

The illustration below demonstrates the application of the guidance in ASC 480-10-S99-3A to redeemable

NCI that is created in an equity transaction accounted for under ASC 810-10.

Illustration 5-9: Redeemable NCI created in an ASC 810 transaction without loss of control

Subsidiary A has 10,000 shares of common stock outstanding, all of which are owned by Parent B.

Parent B is a calendar-year entity and has $4,000,000 of retained earnings as of 1 January 20X1. The

carrying amount of Subsidiary A’s equity is $2,000,000.

On 1 January 20X1, Parent B sells 2,000 shares of Subsidiary A’s common stock to Company C for

$500,000 (representing the fair value of 20% ownership interest in Subsidiary A), reducing its ownership

interest to 80%. The 20% ownership interest is redeemable by Company C at fair value at any time.

Parent B retains its controlling financial interest in Subsidiary A and therefore accounts for the sale as

an equity transaction pursuant to ASC 810-10-45-23. In addition, Parent B determines that the NCI

recognized under ASC 810 does not require a liability classification because it is not mandatorily

redeemable, and that the redemption option is an embedded feature that does not require bifurcation

and derivative accounting under ASC 815. Because the NCI is redeemable at the option of Company C,

it is therefore subject to ASC 480-10-S99-3A.

Initial recognition and measurement

On 1 January 20X1, Parent B records a noncontrolling interest of $400,000 ($2,000,000 x 20%),

which reflects the NCI holder’s ownership in the subsidiary. The $100,000 excess of cash received over

the carrying amount of the NCI is recorded as an increase to APIC. Parent B records the following entry:

Cash $ 500,000

Additional paid-in capital $ 100,000

Noncontrolling interest 400,000

Under ASC 480-10-S99-3A, the redeemable NCI is initially measured at fair value. Parent B records the

following entry to adjust the NCI’s carrying amount to fair value (i.e., the amount of the cash received):

Retained earnings (or APIC) $ 100,000

Noncontrolling interest $ 100,000

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Subsequent measurement

On each subsequent reporting date, Subsidiary A’s net income or loss is attributed to the controlling

interest and NCI in accordance with ASC 810-10. Parent B also performs a valuation of the

redeemable NCI as of each reporting date. Because the NCI is currently redeemable, once the

ASC 810-10 attribution adjustment is recorded, the NCI should be adjusted to its maximum

redemption amount at the balance sheet date pursuant to paragraph 14 of ASC 480-10-S99-3A.

The following table provides the ASC 810-10 adjustments for each year, the cumulative ASC 810-10

adjustments, the NCI’s fair value and the NCI’s carrying amount (after the ASC 810-10 and ASC 480

adjustments) at each year end:

Year

Net income (loss)

attributable to NCI

under ASC 810-10

NCI at 31 December

after cumulative

ASC 810-10

adjustments

Fair value of NCI at

31 December

Carrying amount of

NCI at 31 December

after ASC 810-10

and ASC 480

adjustments

20X1

$ 20,000

$ 520,000

$ 530,000

20X2

$ 40,000

$ 560,000

$ 520,000

$ 560,000

20X3

$ (100,000)

$ 460,000

$ 440,000

$ 460,000

20X4

$ (24,000)

$ 436,000

$ 450,000

31 December 20X1

Pursuant to ASC 810-10, Parent B adjusts the $500,000 initial carrying amount of the NCI for the net

income attributable to the redeemable NCI for the period:

Income attributable to noncontrolling interest $ 20,000

Noncontrolling interest $ 20,000

However, under the SEC staff’s guidance on redeemable equity securities, the amount of NCI should be

the greater of the balance determined under ASC 810 (reflecting the cumulative attribution adjustments)

or the redemption amount determined under ASC 480-10-S99-3A. The NCI is currently redeemable at

its fair value of $530,000, which is greater than its adjusted carrying amount of $520,000 pursuant

to ASC 810-10. Therefore, Parent B records the following entry to increase the NCI’s carrying amount

to its redemption amount (which is based on fair value) under ASC 480-10-S99-3A:

Retained earnings (or APIC) $ 10,000

Noncontrolling interest $ 10,000

31 December 20X2

Pursuant to ASC 810-10, Parent B adjusts the $530,000 carrying amount of the NCI for the net

income attributable to the redeemable NCI for the period:

Income attributable to noncontrolling interest $ 40,000

Noncontrolling interest $ 40,000

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After the ASC 810-10 adjustment, the carrying amount of the NCI on 31 December is $570,000. However,

that amount exceeds both (1) $560,000, which is the $500,000 initial carrying amount of the NCI

determined under ASC 810, adjusted for the $60,000 of cumulative net income attributed under ASC 810,

and (2) $520,000, which is the redemption amount of the NCI determined under ASC 480-10-S99-3A.

Parent B records the following entry to decrease the carrying amount of the NCI to $560,000, which

represents the greater of the NCI balance under ASC 810 and the redemption amount under

ASC 480-10-S99-3A. Note that this decrease is limited to the previous increase in the NCI’s carrying amount

(i.e., $10,000) due to the application of the subsequent measurement guidance in ASC 480-10-S99-3A:

Noncontrolling interest $ 10,000

Retained earnings (or APIC) $ 10,000

31 December 20X3

Pursuant to ASC 810-10, Parent B adjusts the $560,000 carrying amount of the NCI for the net loss

attributable to the redeemable NCI for the period:

Noncontrolling interest $ 100,000

Loss attributable to noncontrolling interest $ 100,000

After the ASC 810-10 adjustment, the carrying amount of the NCI on 31 December is $460,000,

which is greater than its fair value of $440,000 at the reporting date. The NCI’s carrying amount of

$460,000 is less than its initial carrying amount of $500,000. Although ASC 480-10-S99-3A states

that the amount in temporary equity should not be less than the redeemable instrument’s initial amount

reported in temporary equity, the reduction in the NCI’s carrying amount below its initial carrying

amount is appropriate because it is due to the application of ASC 810-10 rather than to adjustments

under ASC 480-10-S99-3A. No adjustment under ASC 480-10-S99-3A is required for the period.

31 December 20X4

Pursuant to ASC 810-10, Parent B adjusts the $460,000 carrying amount for the net loss attributable

to the redeemable NCI for the period:

Noncontrolling interest $ 24,000

Loss attributable to noncontrolling interest $ 24,000

After the ASC 810-10 adjustment, the carrying amount of the NCI on 31 December is $436,000,

which is less than its fair value of $450,000. Parent B records the following entry to increase the NCI’s

carrying amount to its redemption amount as required by ASC 480-10-S99-3A:

Retained earnings (or APIC) $ 14,000

Noncontrolling interest $ 14,000

The NCI’s carrying amount of $450,000 remains below its initial carrying amount of $500,000,which

is appropriate because it is due to the application of ASC 810-10 rather than adjustments under

ASC 480-10-S99-3A.

Pursuant to ASC 480-10-S99-3A, a security (including NCI) that is currently redeemable is measured at

the current redemption amount. For a security that is not redeemable currently, but probable of

becoming redeemable in the future, the SEC staff’s guidance permits the following two methods of

adjusting the carrying amount of the redeemable security:

• Method 1 — Accrete the carrying amount of the redeemable security to the redemption amount over time,

to the date it is probable it will become redeemable, using an appropriate method (e.g., the interest method).

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• Method 2 — Adjust the carrying amount of the redeemable security to what would be the redemption

amount assuming the security was redeemable at the balance sheet date.

The SEC staff’s guidance does not specify which method is required. We generally believe issuers should

evaluate the specific facts and circumstances of the applicable redemption feature and the level of

subjectivity and assumptions necessary and apply the method that best presents the economics of the

redeemable NCI. Once the method is selected, it should be consistently applied.

If the NCI is not currently redeemable and also not probable of becoming redeemable (e.g., it is not

probable a contingency that triggers redemption will be met), the NCI should be classified in temporary

equity, but adjustment to the initial carrying amount is not necessary until it is probable that the NCI will

become redeemable.

Refer to section E.4.2 for a discussion of the measurement of redeemable NCI pursuant to the SEC

staff’s guidance.

5.10.2.5 Earnings per share considerations

As noted in ASC 480-10-S99-3A paragraph 22, adjustments to the carrying amount of redeemable NCI from the

application of the SEC guidance do not affect net income or comprehensive income in the consolidated financial

statements. However, the adjustments may affect EPS. The effect, if any, will depend on (1) whether the NCI

is represented by the subsidiary’s common shares or preferred shares and (2) if common shares, whether

the redemption amount is at the then-current fair value or some other value (e.g., a fixed amount).

If the redemption of NCI in the form of common stock is at fair value, adjustments to the carrying amount of

redeemable NCI that result from applying the guidance in ASC 480 do not affect EPS because redemption

at fair value does not result in the NCI shareholder receiving a distribution different from what other common

shareholders would receive in an arms-length transaction.

However, if the redemption amount is anything other than fair value (e.g., fixed), the NCI shareholder will

receive a distribution that is different from what other common shareholders could receive if selling their

shares. In those cases, the increases and decreases (only to the extent that those decreases reflect recoveries

of amounts previously reflected in the computation of EPS) in the carrying amount of redeemable NCI are

treated in the same manner as dividends on nonredeemable common stock.

There are two acceptable approaches for computing EPS for the effect of NCI in the form of common

stock that is redeemable at other than fair value:

• Treat the entire periodic adjustment resulting from the SEC’s guidance to the instrument’s carrying

amount like a dividend

• Treat only the portion of that periodic adjustment to the instrument’s carrying amount that reflects

redemption in excess of fair value like a dividend

These alternative approaches are accounting policy elections that should be applied consistently and

disclosed in the notes to the financial statements.

In addition, the parent has two alternatives to present the effect of adjustments to the carrying amount

of redeemable NCI that result from applying the guidance in ASC 480: (1) adjust net income attributable

to the parent (as reported on the face of the income statement) for changes in the carrying amount of

the redeemable NCI, or (2) do not adjust net income attributable to the parent and consider only the

effect of the redemption feature in the calculation of income available to common shareholders of the

parent (which may be disclosed on the face of the income statement under SEC guidance). These

approaches affect presentation and disclosure only. They do not affect the amount of reported EPS. The

approach selected should be applied consistently.

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Refer to section 3.2.2 of our FRD publication, Earnings per share, for further discussion of the EPS

effects of redeemable equity instruments (including redeemable NCI).

5.10.2.6 Examples of the presentation of NCI with equity contracts issued on those interests

The following table summarizes the accounting for certain common equity contracts used to acquire

interests in a subsidiary, assuming that the equity contracts are issued on all of the outstanding NCI

(i.e., for the fixed number of shares not held by the parent) and are entered into by the controlling interest.

This accounting described in the table should be applied only after determining (1) when the equity contract

was entered into relative to the creation of the NCI

(2) whether its price is fixed, variable or at fair value

and (3) whether the instrument is embedded or freestanding. The guidance in the table should be used as a

starting point in applying the literature. Parenthetical references cite the relevant literature. Application of

ASC 480-10-S99-3A is not specifically addressed in the table, but references to SEC staff guidance that

require additional consideration are included.

This guidance in the table does not contemplate all possible instruments and assumes subsidiaries

represent substantive entities as contemplated in ASC 815-40-15-5C. Careful consideration of the facts and

circumstances will be necessary to determine the appropriate accounting for any instrument issued on NCI.

Instrument

Entered into

Redemption amount

Accounting

Written put option

permitting the NCI

holder to put its

interest to the

controlling interest

Contemporaneous

with creation of

NCI

Fixed, fair value or

variable

If embedded and not bifurcated

If the embedded written put option does not require

bifurcation pursuant to ASC 815-15, the put option

is recognized as part of the NCI. Changes in the fair

value of the option over its life are not recognized.

Earnings are generally attributed to the controlling

interest and NCI without considering the put option.

If the embedded put option is exercised, the NCI is

reduced and APIC is adjusted for any difference

between the NCI’s carrying value and the

consideration paid.

For SEC reporting, additional consideration of

ASC 480-10-S99-3A is required for the NCI.

If freestanding

ASC 480 requires the written put option to be

classified as a liability and measured at fair value with

the changes in value recognized in earnings.

The exercise of the option results in the acquisition

of NCI and any difference between the cash paid and

the combined value of the freestanding instrument and

the NCI’s carrying value would be recorded to APIC.

If embedded and bifurcated

The written put option is bifurcated and reported

separately at fair value with changes in fair value

recorded in earnings. The NCI is recognized and

measured pursuant to ASC 810.

For SEC reporting, additional consideration of ASC 480-

10-S99-3A is required for the host equity contract.

This table assumes the equity contracts issued after the creation of the NCI are freestanding. Depending on the facts and

circumstances, certain equity contracts issued after the creation of the NCI could be considered embedded. If the instrument is

considered to be embedded, the guidance on equity contracts embedded in the NCI should be applied, and the guidance in

ASC 480-10-S99-3A should be considered.

ASC 810-10 requires transactions between the controlling interest and NCI that do not result in consolidation or deconsolidation

to be recognized in equity. See section 18 of our FRD publication, Consolidation, for additional guidance.

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Instrument

Entered into

Redemption amount

Accounting

Written put option

permitting the NCI

holder to put its

interest to the

controlling interest

(continued)

After creation of

NCI

Fixed, fair value or

variable

The written put option is recognized as a liability that

is initially and subsequently measured at fair value

pursuant to ASC 480. The NCI is recognized and

measured in accordance with ASC 810.

Purchased call

option permitting

the controlling

interest to acquire

the NCI

Contemporaneous

with creation of

NCI

Fixed, fair value or

variable

If embedded and not bifurcated

If the embedded purchased call option does not

require bifurcation pursuant to ASC 815-15, the call

option is recognized as part of the NCI. Changes in the

fair value of the option over its life are not recognized.

Earnings are generally attributed to the controlling

interest and NCI without considering the call option.

If the embedded call option is exercised, the NCI is

reduced and APIC is adjusted for any difference

between the NCI’s carrying value and the

consideration paid.

If (1) freestanding and in the scope ASC 815-10 or

(2) embedded and bifurcated

Follow ASC 815-40 to determine the appropriate

classification and subsequent measurement of the

instrument as an asset or equity (ASC 815-40-25-1

through 25-43). If it were determined that the

purchased call option is not classified in equity, it is

reported separately and measured at fair value with

changes in value recognized in earnings. The NCI is

recognized and measured pursuant to ASC 810.

If freestanding and not in the scope of ASC 815-10

Follow ASC 815-40 to determine the appropriate

classification and subsequent measurement of the

instrument as an asset or equity (ASC 815-40-25-1

through 25-43).

If it were determined that neither 815-10 nor 815-

40 applied, the parent may measure the purchased

call option at fair value (if the fair value option is

elected) or at cost in which case impairment should be

considered.

The NCI continues to be recognized and measured

pursuant to ASC 810.

For a freestanding call option classified as equity

pursuant to ASC 815-40, if the call option was

entered into by the parent and expires unexercised,

the carrying amount of the instrument should be

reclassified from the NCI to the controlling interest. If

it was entered into by the subsidiary and expires

unexercised, there is no reclassification to be made.

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Instrument

Entered into

Redemption amount

Accounting

Purchased call

option permitting

the controlling

interest to acquire

the NCI (continued)

After creation of

NCI

Fixed, fair value or

variable

If freestanding and in the scope of ASC 815-10

Follow ASC 815-40 to determine the appropriate

classification and subsequent measurement of the

instruments as an asset or equity (ASC 815-40-25-1

through 25-43).

If it were determined that the purchased call option is

not classified in equity, it is reported separately and

measured at fair value with changes in value

recognized in earnings. The NCI is recognized and

measured pursuant to ASC 810.

If freestanding and not in the scope of ASC 815-10

Follow ASC 815-40 to determine the appropriate

classification and subsequent measurement of the

instrument as an asset or equity (ASC 815-40-25-1

through 25-43).

If it were determined that neither 815-10 nor 815-

40 applied, the parent may measure the purchased

call option at fair value (if the fair value option is

elected) or at cost in which case impairment should be

considered.The NCI continues to be recognized and

measured pursuant to ASC 810.

For a freestanding call option classified as equity

pursuant to ASC 815-40, if the call option was

entered into by the parent and expires unexercised,

the carrying amount of the instrument should be

reclassified from the NCI to the controlling interest. If

it was entered into by the subsidiary and expires

unexercised, there is no reclassification to be made.

Forward contract

to acquire the NCI

Contemporaneous

with creation of NCI

Payment amount

and settlement date

are fixed

If embedded

The NCI would be a mandatorily redeemable financial

instrument classified as a liability pursuant to

ASC 480-10-30-1 and measured initially at fair

value. NCI is not recognized and no earnings are

allocated to the NCI. The parent accounts for this

transaction as a financing and recognizes 100% of

the subsidiary’s assets and liabilities.

If freestanding

The forward contract is classified as a liability and initially

measured at an appropriate value.

The liability is

accreted to the settlement amount over the term of the

forward contract with the resulting expense recognized

as interest cost. NCI is not recognized and no earnings

are allocated to the NCI. The parent accounts for this

transaction as a financing and recognizes 100% of the

subsidiary’s assets and liabilities (ASC 480-10-30-3

and ASC 480-10-55-53 through 55-54).

When the forward contract is settled, the liability

is derecognized.

When addressing the initial measurement of a forward contract on shares of a subsidiary, there are three measurement models. A

freestanding forward contract under ASC 480-10-30-3 is initially measured at the fair value of the shares to be repurchased, adjusted

for any consideration or unstated rights or privileges. A freestanding forward contract under ASC 480-10-55-54 is initially

measured at the present value of the contract amount, which we believe should be discounted using a market-based rate reflecting

the issuer’s own credit risk. A mandatorily redeemable NCI is measured at fair value under ASC 480-10-30-1. We generally believe

that these methods should result in approximately the same initial measurement. Any significant differences would require additional

analysis to determine whether there were additional rights or privileges granted in the transaction.

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Instrument

Entered into

Redemption amount

Accounting

Forward contract

to acquire the NCI

(continued)

Contemporaneous

with creation of NCI

(continued)

Payment amount or

settlement date vary

based on certain

conditions

If embedded

The resulting mandatorily redeemable financial

instrument is a liability pursuant to ASC 480 and

measured initially at fair value.

NCI is not recognized

and no earnings are allocated to the NCI. The parent

accounts for this transaction as a financing and

recognizes 100% of the subsidiary’s assets and liabilities.

If freestanding

The forward contract is not subject to ASC 480-10-

55-54 as the settlement price is not fixed. Pursuant

to other sections of ASC 480, a liability should be

recognized at the fair value of the shares at

inception, adjusted for any consideration or unstated

rights or privileges. The liability is subsequently

measured at the amount that would be paid on the

reporting date with any change in value from the

previous reporting date recognized as interest cost.

NCI is not recognized and no earnings are allocated

to the NCI. The parent accounts for this transaction

as a financing and recognizes 100% of the

subsidiary’s assets and liabilities.

After creation of

NCI

Payment amount

and settlement date

are fixed

Pursuant to ASC 480, the freestanding forward

contract is recognized as a liability at the date on

which the forward contract was entered into. The

liability is initially measured at the fair value of the

shares at inception adjusted for any consideration or

unstated rights or privileges. Subsequent

measurement is at the present value of the amount to

be paid at settlement, accruing interest cost using the

rate implicit at inception based on the initial

measurement. The previously recognized NCI is

derecognized and any difference between the amount

of the liability and the NCI’s carrying amount is

recognized in APIC. No further attribution of earnings

is necessary because there is no NCI.

Payment amount or

settlement date

varies based on

certain conditions

The accounting is the same as if the settlement date is

fixed except that the liability is subsequently measured

at the amount that would be paid on the reporting date

with any change in value from the previous reporting

date recognized as interest cost. No further attribution

of earnings is necessary because there is no NCI.

Whether the subsequent measurement requirements of ASC 480-10 or ASC 480-10-S99 would be required depends on the scope

exception provided in ASC 480-10-15-7E(b) (refer to section A.3.5.2 for further discussion). If the measurement guidance under

ASC 480-10 is applicable, the liability is subsequently measured at the settlement amount as if settlement occurred at the reporting

date. Facts and circumstances should be considered in determining the measurement amount that best represents economics of the

mandatorily redeemable NCI.

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Instrument

Entered into

Redemption amount

Accounting

Written put option

and purchased call

option with

same (or not

significantly

different) strike

price and same

exercise date

Contemporaneous

with creation of NCI

Fixed price

If embedded and not bifurcated

Pursuant to ASC 480-10-55-59 through 55-62, the

options are viewed on a combined basis with the NCI.

The combined instrument is classified as a liability,

initially measured at the present value of the settlement

amount.

Subsequently, the liability is accreted to the

strike price with the accretion recognized as interest

expense. NCI is not recognized and earnings are not

attributed. The parent accounts for this transaction as a

financing and consolidates 100% of the subsidiary

(ASC 480-10-55-55, 55-59 and 55-62).

If embedded and bifurcated

Pursuant to ASC 480-10-55-59 through 55-62, the

options are viewed on a combined basis with the NCI.

The combined instrument is classified as a liability,

initially measured at the present value of the

settlement amount. In accordance with ASC 815-15,

any option requiring bifurcation from the liability is

separated at fair value, which creates a discount to the

liability. Changes in fair value of any separated option

are recorded in earnings.

Subsequently, the liability is accreted to the strike

price with the accretion recognized as interest

expense. NCI is not recognized and earnings are not

attributed. The parent accounts for this transaction as

a financing and consolidates 100% of the subsidiary

(ASC 480-10-55-55, 55-59 and 55-62).

If freestanding

The written put and purchased call should be

evaluated to determine whether they are a single

instrument or two instruments. If they are viewed as a

single instrument, the combined instrument containing

a written put is recognized as a liability (or assets in

certain instances) and measured at fair value. If they

are viewed as two freestanding instruments, the

written put option is recognized as a liability pursuant

to ASC 480 and the purchased call option is evaluated

pursuant to ASC 815-10 and ASC 815-40 and may be

recognized as an asset or equity (refer to discussion in

the table above for separate written puts and

purchased calls).

This instrument is not considered mandatorily redeemable, since it is possible (though highly unlikely) that on the exercise date

the NCI will have a fair value equal to the strike price in the options and neither party will be economically motivated to exercise (as

opposed to an embedded forward contract that requires settlement and renders the shares mandatorily redeemable). Therefore,

the guidance in ASC 480-10-30-1 is not applicable. However, refer to footnote 53 in section 5.10.2.6, which discusses why the

various initial measurement methods in ASC 480-10 should result in approximately the same measurement.

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Instrument

Entered into

Redemption amount

Accounting

Written put option

and purchased call

option with

same (or not

significantly

different) strike

price and same

exercise date

(continued)

Contemporaneous

with creation of NCI

(continued)

Other than fixed

price

If embedded and not bifurcated

The NCI with the embedded options is not subject to

ASC 480-10-55-59 through 55-62. NCI is not

mandatorily redeemable, and no liability should be

recognized at inception. The options are recognized

as part of the NCI. Changes in the fair value of

options are not recognized. Earnings are generally

attributed to the controlling interest and NCI without

considering the options.

For SEC reporting, additional consideration of

ASC 480-10-S99-3A is required.

If embedded and bifurcated

The combined option is reported separately at fair

value with changes in fair value recorded in earnings.

The NCI is recognized and measured pursuant to

ASC 810.

For SEC reporting, additional consideration of

ASC 480-10-S99-3A is required for the host equity

contract.

If freestanding

The written put and purchased call should be

evaluated to determine whether they are a single

instrument or two instruments. If they are viewed as a

single instrument, the combined instrument containing

a written put is recognized as a liability (or assets in

certain instances) and measured at fair value. If they

are viewed as two freestanding instruments, the

written put option is recognized as a liability pursuant

to ASC 480 and the purchased call option is evaluated

pursuant to ASC 815-10 and ASC 815-40 and may be

recognized as an asset or equity (refer to discussion in

the table above for separate written puts and

purchased calls).

After creation of

NCI

Fixed price or other

than fixed price

Refer to freestanding analysis above.

5.10.2.7 Redeemable or convertible equity securities and UPREIT structures

A real estate investment trust (REIT) with an “umbrella partnership REIT” structure (UPREIT) will typically

have a consolidated operating partnership (OP) that has issued ownership units to noncontrolling parties.

Based on the features typically found in the OP units, a REIT should carefully consider the guidance in

ASC 480-10-S99-3A when classifying and measuring noncontrolling OP units in the consolidated

financial statements.

When a REIT acquires a property, it may issue redeemable OP units to the seller (OP units generally are

used to defer a taxable event for the sellers). Those sellers become noncontrolling investors in the OP.

The structure of redemption features as part of the OP units or the unit holder agreement with the

investor can vary based on various legal considerations for the parent REIT and the OP, including the

state of incorporation or organization for the legal entity, interpretations of tax law or other factors.

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For example, arrangements vary as to with which entity the investor can redeem the units (e.g., only with

the OP or only with the parent REIT or with the parent REIT deciding which entity will redeem the units).

Typically, the redeeming entity (parent REIT or OP) will have the choice of the redemption consideration,

which could be cash or shares of the parent REIT. The amount of the redemption could be based on a

fixed amount, a formulaic amount, or most frequently, a fixed exchange ratio of OP units for parent REIT

shares (or the then-current value of those public shares in cash).

As the OP units are redeemable (or exchangeable) at the option of the investor, the OP units potentially

represent redeemable NCI in the consolidated financial statements. Pursuant to the redeemable equity

guidance in ASC 480-10-S99-3A, if the OP units may be redeemed for cash outside the control of the

reporting entity (the consolidated REIT in this case), the NCI should be classified in the mezzanine section

and measured in accordance with the SEC staff’s guidance. Therefore, identifying what settlement

alternatives exist and whether they are solely within the control of the reporting entity is important.

Based on discussions with the SEC staff, for the consolidated financial statements, we believe that the

parent REIT and OP can be considered essentially a single decision maker in evaluating the redemption

provisions if both of the following conditions are met:

• The parent REIT is the general partner in the operating partnership and the entities share the same

corporate governance structures.

• The parent REIT can freely exercise all choices afforded it without conflicting with its fiduciary duties

to its shareholders.

This will often result in a conclusion that the parent REIT/OP can elect share settlement upon redemption

of the OP units. However, as discussed in ASC 480-10-S99-3A, the guidance in ASC 815-40-25 should

be evaluated to determine whether the parent REIT/OP controls the actions or events necessary to issue

the maximum number of parent REIT shares that could be required to be delivered under share settlement

of the contract. If the parent REIT/OP controls those actions or events, the OP units would not be within

the scope of the SEC staff’s guidance. However, if those actions or events are not completely within their

control, the presentation and measurement guidance in ASC 480-10-S99-3A would apply. Refer to

Appendix E for further discussion on the application of ASC 480-10-S99-3A.

There may be separate SEC reporting requirements for the OP. For example, if the OP has public debt

outstanding, many of the concepts described above would be considered in determining the classification

of the OP units in the stand-alone financial statements of the OP. However, it is important to realize that

the OP units would be redeemable equity instruments rather than redeemable NCI, and thus there would

be different elements of ASC 480-10-S99-3A to be considered.

5.10.2.8 Redeemable NCI denominated in a foreign currency

When a redeemable NCI is denominated in a foreign currency, additional consideration should be given to

the interaction of ASC 830 and ASC 480-10-S99-3A’s measurement guidance. Neither ASC 830 nor

ASC 480-10-S99-3A provide specific guidance. Judgment is required to determine whether and, if so,

how to adjust the carrying amount of the redeemable NCI for the effect of currency exchange rate

movements while also respecting the redeemable equity measurement guidance. Refer to Question 3.8

of our FRD publication, Foreign currency matters, for additional guidance.

5.10.2.9 Illustrative examples of equity contracts on NCI

Illustrations 5-10 through 5-15 demonstrate the application of the concepts discussed above to some of

the more common business combination scenarios involving the use of equity contracts over NCI. The

analysis section in each illustration follows the flowchart depicted in section 5.10.2.1.

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Illustration 5-10: Written put option embedded in NCI created in a business combination

On 1 January 20X7, Company P (an SEC registrant) acquires 80% of the outstanding common shares

of Target, a private company, from Company Y for cash consideration in a business combination as

defined in ASC 805. Company Y retains a 20% noncontrolling interest in Target. In connection with the

acquisition, Company P and Company Y enter into an agreement that permits Company Y to sell its

remaining 20% interest in Target to Company P on or after 1 January 20X9 for $475 in cash. The put

option is non-transferrable and terminates if Company Y sells its shares.

At the acquisition date, the fair value of the NCI is $500. Target recognized net losses of $250 for

20X7. Company P has adopted an accounting policy of treating the entire periodic adjustment to the

redeemable NCI’s redemption amount like a dividend.

Analysis

Is the put option embedded in the NCI?

Yes. The put option is not legally detachable from the NCI because it is non-transferrable. Further, it is

not separately exercisable because the NCI terminates upon exercise of the option. As a result, the put

option would be considered embedded in the underlying NCI.

Is the NCI (including the embedded feature) within the scope of ASC 480?

No. The put option permits but does not require the NCI to be redeemed at a specified or determinable

date or upon occurrence of an event certain to occur. Therefore, the NCI, with the embedded put

option, is not considered a “mandatorily redeemable” financial instrument within the scope of ASC 480.

Does the put option require bifurcation under ASC 815?

No. Company P considered the guidance in ASC 815-15 and determined the nature of the host

contract to be more akin to equity. Although a redemption feature in an equity host is generally not

considered to be clearly and closely related to the host contract, the put option does not meet the

definition of a derivative (as it requires gross physical settlement and the shares of Target are not

publicly traded — i.e., not readily convertible to cash). Therefore, the put option does not require

bifurcation under ASC 815.

Does the put option cause the NCI to be redeemable under ASC 480-10-S99-3A?

Yes. Because the put option permits Company Y to sell its equity interest to Company P (which is an

SEC registrant) for cash, the NCI is considered to be redeemable equity under ASC 480-10-S99-3A.

Therefore, the NCI is classified as “mezzanine” (between liabilities and equity) on Company P’s

balance sheet.

At the acquisition date, the cash consideration transferred plus the fair value of the NCI determined

pursuant to ASC 805-20-30 would be used to determine the amount of goodwill. The NCI balance of

$500 would be presented as “mezzanine” equity. After the acquisition date, the amount presented in

“mezzanine” would be determined first by applying the guidance in ASC 810 and attributing the losses

of Target to the controlling and noncontrolling interest. Therefore, at 31 December 20X7, before

applying the guidance in ASC 480-10-S99-3A, the carrying amount of the NCI would be $450 ($500 —

(20% x $250)).

While the NCI is not currently redeemable, it will become redeemable only with the passage of time

(i.e., on 1 January 20X9). As discussed above, ASC 480-10-S99-3A permits two methods of adjusting

the carrying amount of the redeemable security. For purposes of this illustration, assume that

Company P elects to accrete the carrying amount for changes in the redemption value over time using

the effective interest method, and that the accreted redemption value as of 31 December 20X7 is $470.

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Accordingly, Company P adjusts the carrying amount of its redeemable NCI from $450 to

its redemption value of $470 with a $20 credit to the NCI and a corresponding debit to retained

earnings (or if there were no retained earnings, to additional paid-in capital).

That $20 debit to retained earnings would reduce the numerator in the EPS calculation. This is

because the redemption value of the NCI in the form of common stock is a fixed amount (i.e., not at

fair value). This reduction could be presented either as an adjustment on the income statement in

determining net income attributable to the parent (refer to Alternative 1 below) or through the

calculation of income available to common shareholders when deriving EPS (refer to Alternative 2

below). The manner in which the reduction is treated is an accounting policy election that should be

applied consistently and disclosed in the notes to the financial statements.

The following is an excerpt from Company P’s income statement for the year ended 31 December 20X7.

Alternative 1

Alternative 2

Net income

1,750

Plus: Net loss attributable to redeemable noncontrolling

interest

Net income attributable to Company P

1,780

1,800

Earnings per share — basic:

Net income attributable to Company P common stockholders

$1.78

Earnings per share — diluted:

Net income attributable to Company P common stockholders

$1.41

Weighted average shares outstanding:

Basic

1,000

Diluted

1,264

The following table is an excerpt from the notes to the financial statements where basic and diluted

net income attributable to Company P common stockholders per share has been computed:

31 December 20X7

Alternative 1

Net income attributable to Company P common shareholders

1,780

Alternative 2

Net income attributable to Company P

1,800

Accretion of redeemable noncontrolling interest, net of tax

(20)

Net income attributable to Company P common shareholders after accretion of

redeemable noncontrolling interest

1,780

Basic:

Weighted average shares outstanding and used in the computation of basic net income

per share

1,000

Net income attributable to Company P common shareholders per share — basic

$1.78

Diluted:

Shares used in the computation of basic net income per share

1,000

Dilutive effect of stock options

264

Shares used in the computation of diluted net income per share

1,264

Net income attributable to Company P common stockholders per share — diluted

$1.41

Comprised of loss attributable to noncontrolling interest in Target (calculated as $250 x 20%) less accretion of redeemable

noncontrolling interest (calculated as $470 accreted redemption value as of 31 December 20X7 — $450 carrying amount

prior to adjustment)

$250 x 20%

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$470 accreted redemption value as of 31 December 20X7 — $450 carrying amount prior to adjustment

Illustration 5-11: Purchased call option embedded in NCI created in a business combination

On 1 January 20X7, Company P (an SEC registrant) acquires 80% of the outstanding common shares

of Target, a private company, from Company Y for cash consideration in a business combination as

defined in ASC 805. Company Y retains a 20% noncontrolling interest in Target. In connection with the

acquisition, Company P and Company Y enter into an agreement that permits Company P to purchase

the remaining 20% interest in Target from Company Y on or after 1 January 20X9 for $525 in cash.

The call option is non-transferrable and terminates if Company P purchases the shares.

At the acquisition date, the fair value of the NCI is $500. Target’s earnings for 20X7 are $200.

Analysis

Is the call option embedded in the NCI?

Yes. The call option is not legally detachable from the NCI because it is non-transferrable. Further, it is

not separately exercisable because the NCI terminates upon exercise of the option. As a result, the call

option would be considered embedded in the underlying NCI.

Is the NCI (including the embedded call option) within the scope of ASC 480?

No. The NCI is not mandatorily redeemable because the redemption is at the option of Company P.

Does the call option require bifurcation under ASC 815?

No. Company P considered the guidance in ASC 815-15 and determined the nature of the host

contract to be more akin to equity. Although a redemption feature in an equity host is generally not

considered to be clearly and closely related to the host contract, the call option does not meet the

definition of a derivative (as it requires gross physical settlement and the shares of Target are not

publicly traded — i.e., not readily convertible to cash). Therefore, the call option does not require

bifurcation under ASC 815.

Does the call option cause the NCI to be redeemable under ASC 480-10-S99-3A?

No. Because the exercise of the embedded call option is within the control of Company P

(i.e., Company P is not obligated to transfer cash to Company Y unless Company P exercises the call

option), the embedded call option does not cause the NCI to be a redeemable equity instrument under

ASC 480-10-S99-3A.

Therefore, the call option is recognized as part of the NCI in equity. Changes in the fair value of the call

option are not recognized. At the acquisition date, the cash consideration transferred plus the fair

value of the NCI determined pursuant to ASC 805-20-30 would be used to determine the amount of

goodwill. After the acquisition date, earnings would be attributed to the controlling and noncontrolling

interests without consideration of the call option. Accordingly, the carrying amount of the NCI at

31 December 20X7 would be $540 ((20% x $200) + $500).

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Illustration 5-12: Forward contract embedded in NCI created in a business combination

On 1 January 20X7, Company P (an SEC registrant) acquired 80% of the outstanding common shares

of Target, a private company, from Company Y for cash consideration in a business combination as

defined in ASC 805. Company Y retains a 20% noncontrolling interest in Target. In connection with the

acquisition, Company P and Company Y executed a forward contract that requires Company P to

purchase Company Y’s remaining 20% interest in Target on 1 January 20X9 for a fixed price of $300.

The forward contract is non-transferrable and will terminate when Company P acquires the shares.

Analysis

Is the forward contract embedded in the NCI?

Yes. The forward contract is not legally detachable from the NCI because it is non-transferrable.

Further, it is not separately exercisable because the NCI terminates through its settlement. As a result,

the forward contract would be considered embedded in the underlying NCI.

Is the NCI (including the embedded feature) within the scope of ASC 480?

Yes. Because the forward contract embodies an obligation of Company P to redeem the NCI for cash

on a date certain (1 January 20X9), the NCI (including the embedded forward contract) is considered

a mandatorily redeemable financial instrument that would be classified as a liability under ASC 480.

As a result, Company P will account for this transaction as a financing, which means that Company P

will not recognize any NCI. Instead, it will recognize a liability for the future purchase of the NCI.

Because the NCI is mandatorily redeemable, the liability is initially measured at fair value. Company P

would subsequently measure the liability at the present value of the amount to be paid at settlement,

accruing interest using the rate implicit at inception. At the acquisition date, the cash consideration

transferred plus the fair value of the liability would be used to determine the amount of goodwill.

Because NCI is not recognized, no earnings would be allocated to the NCI after the acquisition date.

The accretion of the NCI liability would be presented as interest expense in the income statement.

Illustration 5-13: A combination of call and put options with the same fixed price and exercise

date embedded in NCI created in a business combination

On 1 January 20X7, Company P (an SEC registrant) acquired 80% of the outstanding common shares

of Target, a private company, from Company Y for cash consideration in a business combination as

defined in ASC 805. Company Y retains a 20% noncontrolling interest in Target. In connection with the

acquisition, Company P and Company Y enter into an agreement that permits Company P to purchase

the remaining 20% interest from Company Y for a fixed price of $300 on 1 January 20X9 and permits

Company Y to sell its remaining 20% interest to Company P under those same terms. The call and put

options are non-transferrable and will terminate if Company P purchases the shares or Company Y

sells the shares.

Analysis

Are the call and put options embedded in the NCI?

Yes. For purposes of this step, Company P’s call option and Company Y’s put option are evaluated

separately to determine whether the features are embedded in or freestanding from the 20% NCI. The

call and put options are not legally detachable from the NCI because they are non-transferrable.

Further, they are not separately exercisable because the NCI terminates upon exercise of the options.

As a result, the call and put options would be considered embedded in the underlying NCI.

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Is the NCI (including the embedded feature) within the scope of ASC 480?

Yes. Pursuant to ASC 480-10-55-59 through 55-62, the call and put options are viewed on a

combined basis with the NCI

. Because the risks and rewards of owning the NCI have been retained by

Company P during the period that the options are outstanding (notwithstanding the legal ownership of

the NCI by Company Y), combining the two transactions reflects the economic substance of the

transaction. That is, Company Y’s investors are providing financing to Company P for the acquisition

of 20% NCI. Under this approach, Company P consolidates 100% of Target and does not recognize the

NCI. Instead, it will recognize a liability for the financing (i.e., the future purchase of the NCI).

Pursuant to ASC 480, the liability is measured initially at the present value of the settlement amount.

Subsequently, the liability is accreted to the strike price with the accretion recognized as interest

expense. At the acquisition date, the cash consideration transferred plus the present value of the

settlement amount of the liability would be used to determine the amount of goodwill.

Because NCI is not recognized, no earnings are allocated to the NCI after the acquisition date. The

accretion of the NCI liability would be presented as interest expense in the income statement.

This instrument is not considered mandatorily redeemable, since it is possible (though highly unlikely) that on the exercise date

the NCI will have a fair value equal to the strike price in the options and neither party will be economically motivated to exercise

(as opposed to an embedded forward contract that requires settlement and renders the shares mandatorily redeemable).

Illustration 5-14: A combination of call and put options with a strike price at fair value

embedded in NCI created in a business combination

On 1 January 20X7, Company P (an SEC registrant) acquires 80% of the outstanding common shares

of Target, a private company, from Company Y for cash consideration in a business combination as

defined in ASC 805. Company Y retains a 20% noncontrolling interest in Target. In connection with the

acquisition, Company P and Company Y enter into an agreement that permits Company P to purchase

the remaining 20% interest from Company Y at fair value on 1 January 20X9 and permits Company Y

to sell its remaining 20% interest to Company P under those same terms. The call and put options are

non-transferrable and will terminate if Company P purchases the shares or Company Y sells the shares.

At the acquisition date, the fair value of the NCI is $500. Target’s earnings for 20X7 are $200.

Analysis

Are the call and put options embedded in the NCI?

Yes. For purposes of this step, Company P’s call option and Company Y’s put option are evaluated

separately to determine whether the features are embedded in or freestanding from the 20% NCI. The

call and put options are not legally detachable from the NCI because they are non-transferrable.

Further, they are not separately exercisable because the NCI terminates upon exercise of the options.

As a result, the call and put options would be considered embedded in the underlying NCI.

Is the NCI (including the embedded feature) within the scope of ASC 480?

No. Unlike in Illustration 5-13, the NCI (including the embedded feature) is not subject to

ASC 480-10-55-59 through 55-62, which applies only to situations in which the embedded put and call

options have the same (or similar) fixed exercise price and exercise date. In addition, the combination of

the call and put options does not cause the NCI to be considered mandatorily redeemable because it is

possible that neither party will exercise. Therefore, the redemption is not unconditional.

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Do the call and put options require bifurcation under ASC 815?

No. Company P considered the guidance in ASC 815-15 and determined the nature of the host

contract to be more akin to equity. While the combination of a purchased call option and written put

option with the same strike price and exercise date embedded in NCI is economically similar to a

forward purchase obligation, generally resulting in the determination of a debt host, the nature of the

host contract in this example is determined to be more akin to equity because the strike price is the

fair value of the non-controlling shares on the exercise date, which reflects the risk and return

characteristics of an equity holder.

Although a redemption feature in an equity host is generally not considered to be clearly and closely

related to the host contract, the call and put options do not meet the definition of a derivative (as they

require gross physical settlement and the shares of Target are not publicly traded — i.e., not readily

convertible to cash). Therefore, the call and put options do not require bifurcation under ASC 815.

Do the call and put options cause the NCI to be redeemable under ASC 480-10-S99-3A?

Yes. Because the put option permits Company Y to sell its equity interest to Company P for cash, the

NCI is considered to be redeemable equity under ASC 480-10-S99-3A. Therefore, the NCI (including

the embedded options) is classified as “mezzanine” (between liabilities and equity) in Company P’s

balance sheet.

At the acquisition date, the cash consideration transferred plus the fair value of the NCI would be used to

determine the amount of goodwill. The NCI balance of $500 would be classified as “mezzanine.” After

the acquisition date, the amount presented as “mezzanine” would be determined first by applying the

guidance in ASC 810 and attributing the earnings of Target to the controlling and noncontrolling

interests. Therefore, at 31 December 20X7, before applying the guidance in ASC 480-10-S99-3A, the

carrying amount of the NCI would be $540 ((20% x $200) + $500).

While the NCI is not currently redeemable, it will become redeemable only with the passage of time

(i.e., on 1 January 20X9). As discussed above, ASC 480-10-S99-3A permits two methods of adjusting

the carrying amount of the redeemable security. For purposes of this illustration, assume that

Company P elects to adjust the carrying amount of the NCI to what the redemption amount would be if

the NCI was redeemable at 31 December 20X7. Assume that the redemption amount (fair value) is

$590 at 31 December 20X7.

Accordingly, Company P adjusts the carrying amount of its redeemable NCI to its redemption value of

$590 with a $50 credit to the NCI and a corresponding debit to retained earnings (or if there were no

retained earnings, to additional paid-in capital).

Unlike in Illustration 5-10, because the redemption

amount is at fair value, the adjustment to the carrying amount of the redeemable NCI in the form of

common stock does not affect EPS.

Illustration 5-15: Freestanding written put option in a business combination

Company Y owns 85% of the outstanding common shares of Target, an SEC registrant, with public

shareholders holding the remaining 15% of the outstanding common shares. On 1 January 20X7,

Company P acquires 80% of the outstanding common shares of Target from Company Y for cash

consideration. Company Y retains a 5% noncontrolling interest in Target, with the public shareholders

continuing to hold the remaining 15% interest. In connection with the acquisition, Company P and

Company Y enter into an agreement that permits Company Y to sell its retained 5% interest in Target

to Company P on or after 1 January 20X9 for $100 in cash. The put option is transferable without

restriction, and Company Y can use any shares of Target (e.g., shares it currently owns or shares it

subsequently acquires in the public market) to satisfy the put option.

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At the acquisition date, the fair value of the NCI, representing 20% of Target, is $500. Target’s

earnings for 20X7 are $75.

Analysis

Is the put option embedded in the NCI?

No. The put option is legally detachable from the NCI because it is transferrable. Further, because the

NCI will not necessarily terminate upon the settlement of the put option (because Company Y could

purchase shares in the open market to satisfy the put option), it is separately exercisable. As a result,

the put option would not be considered embedded in the underlying NCI (5% interest held by Company

Y), but would be considered a freestanding financial instrument and accounted for separately from the

5% NCI held by Company Y.

Does the freestanding written put option require liability classification under ASC 480?

Yes. The written put option is classified as a liability under ASC 480 and measured initially at fair

value. Pursuant to ASC 480-10-25-8, any financial instrument, other than an outstanding share, is

classified as a liability if it (1) embodies an obligation to repurchase the issuer’s equity shares, or is

indexed to such and obligation, and (2) requires or may require the issuer to settle the obligation by

transferring assets. At the acquisition date, the cash consideration for the 80% controlling interest in

Target plus the fair value of the NCI plus the fair value of the put option liability forms the total

consideration transferred and affects the amount of goodwill recorded.

Because the put option is freestanding from the 5% NCI held by Company Y, the NCI would continue to

be classified in equity and subsequently accounted for in accordance with ASC 810. Therefore, at

31 December 20X7, the carrying amount of the NCI would be $515 ((20% x $75) + $500). The

freestanding written put option would be classified as a liability and marked to fair value through

earnings at each subsequent reporting date.

5.11 Registration rights agreements

5.11.1 Overview and background

Concurrent with many financing transactions (e.g., the issuance of equity shares, warrants, debt

instruments), issuers may enter into a registration payment arrangement (or registration rights

agreement) under which the issuer agrees to one or more of the following:

• A registration statement must be filed for the resale of specified financial instruments or for the resale

of equity shares that are issuable upon exercise or conversion of those financial instruments. The

registration statement must be declared effective by the SEC (or other applicable securities regulator

if the registration statement will be filed in a foreign jurisdiction) within a specified grace period.

• The effectiveness of the registration statement must be maintained for a specified period of time (or

in perpetuity).

Those arrangements frequently specify that the issuer must use its best efforts or apply commercially

reasonable efforts to undertake those actions. If the registration statement is not declared effective

within the grace period or its effectiveness is not maintained for the specified period, the issuer must

transfer consideration to the investors. That consideration may be payable in a lump sum or periodically

(i.e., as additional interest). The form of the consideration may vary but is typically in cash (and cannot

be in the form of an adjustment to a conversion ratio to be in the scope of ASC 825-20, Financial

Instruments — Registration Payment Arrangements).

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Illustration 5-16: Registration rights agreement

Assume that in connection with an issuance of convertible notes, Company A enters into a registration

rights agreement. Under that agreement, for the benefit of the holders of the convertible notes issued,

Company A agrees to use its reasonable best efforts to file with the SEC within 90 days after the

issuance of the notes, and cause to become effective within 120 days after that filing deadline, a shelf

registration statement with respect to the resale of the underlying common stock issuable upon

conversion of the notes. The stated interest on the notes may be increased by 0.50% per annum if

Company A fails to comply with its obligations under the registration rights agreement. The increased

rate continues until Company A complies with its registration obligations. Alternatively, the registration

rights agreement may specify a 0.50% “liquidated damages” payment (rather than expressing it as

incremental interest on the convertible notes).

5.11.2 Analysis

ASC 825-20 addresses an issuer’s accounting for registration payment arrangements.

Registration payment arrangements, as defined in ASC 825-20, include most registration rights

agreements in security issuances and certain contingent interest features in debt instruments. Also

included are arrangements that require the issuer to obtain and/or maintain a listing on a stock exchange

if the remaining characteristics in the guidance are met. Importantly, the guidance is not applicable by

analogy to the accounting for contracts that are not registration payment arrangements based on the

criteria (e.g., contingent interest payable if an issuer fails to timely file a Form 10-Q or 10-K, which is not

the same as maintaining the effectiveness of a registration statement).

ASC 825-20 specifies that the contingent obligation to make future payments or otherwise transfer

consideration under a registration payment arrangement, whether issued as a separate agreement or

included as a provision of a financial instrument or other agreement, should be separately recognized and

measured in accordance with ASC 450-20, Contingencies — Loss Contingencies. Pursuant to ASC 450-20,

a liability for the contingent obligation under the registration rights agreement is recognized at inception

if it is probable that a payment under the registration rights agreement would be required and the

amount of payment can be reasonably estimated. That contingent liability is included in the allocation of

proceeds from the related financing transaction.

If the transfer of consideration under a registration payment arrangement was not probable or could not

be reasonably estimated at inception but becomes probable and reasonably estimable in a subsequent

period, or if the measurement of a previously recognized contingent liability increases or decreases in a

subsequent period, the new contingent liability or the change in the measurement of the previously

recognized contingent liability (in accordance with ASC 450-20) is recognized in earnings. Further, a

registration rights agreement is provided a specific exception from derivative accounting pursuant

to ASC 815-10-15-82.

The registration payment arrangement guidance further clarifies that a financial instrument subject to

a registration payment arrangement should be accounted for pursuant to other applicable US GAAP

without regard to the contingent obligation to transfer consideration pursuant to the registration

payment arrangement (e.g., convertible debt instruments are evaluated pursuant to the guidance in

ASC 470-20).

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ASC 825-20 does not apply to arrangements that require registration or listing of convertible debt

instruments or convertible preferred stock if the form of consideration that would be transferred to the

counterparty is an adjustment to the conversion ratio. For example, the guidance does not apply if the

consideration to be transferred upon the issuer’s failure to obtain an effective registration statement is an

increase in the conversion ratio (e.g., by 3%). In this case, the indexation guidance in ASC 815-40-15 (refer

to section B.3) and the guidance on contingent BCFs in ASC 470-20 (refer to section D.3.2) should be

considered for the contingently adjustable conversion ratio.

The accounting also does not apply to arrangements in which the amount of consideration transferred is

determined by reference to (1) an observable market other than the market for the issuer’s stock or

(2) an observable index. For example, an arrangement would not be in the scope of ASC 825-20 if the

consideration to be transferred is determined by reference to the price of a commodity (e.g., gold) if the

issuer is unable to obtain an effective registration statement. Additionally, ASC 825-20 does not apply to

arrangements in which the financial instrument subject to the arrangement is settled at the same time

that the consideration is transferred. For example, it would not apply to a warrant that is contingently

puttable if an effective registration statement for the resale of the equity shares that are issuable upon

exercise of the warrant is not declared effective by the SEC within a specified grace period.

5.12 Overallotment provisions (or ‘greenshoes’)

5.12.1 Overview and background

Many public debt and equity securities offerings contain features that provide the underwriter with the

option to obtain more of the securities being sold (i.e., a written call option). These provisions permit the

underwriter to fill orders slightly in excess of the planned amount of an offering to promote market

efficiencies. These options are commonly referred to as “overallotment provisions” or “greenshoes,”

after the Green Shoe Manufacturing Company, which was the first company to include this type of

feature in a public equity offering. Those features may be found in both equity and debt offerings.

Overallotment provisions have historically been used to accommodate potential investor demand in

excess of the base offering amount, which may not be known until the issuance date. Therefore, the

greenshoe provision permits the issuer to issue more securities without the time and expense of an

additional filing. For example, an issuer may hope to issue $100 million of securities but discovers at the

issuance date that there is additional demand in the marketplace for the instruments. An overallotment

provision permits additional securities to be sold at issuance.

The underwriter or initial investors often are also permitted to purchase additional securities at the

offering price for a defined period subsequent to the closing date of the initial offering. The underwriter

uses the greenshoe provision as a mechanism to facilitate market stabilization activities.

For example, if $100 million of securities are sold into the market, the underwriter will often reserve the

right with the issuer (or in some cases may commit) to enter into market transactions to buy and sell the

securities to stabilize the market price for a period of time thereafter (typically 30 days). If the

underwriter sells an additional $10 million of securities (short position) and buys $7 million (long

position) during that period, the underwriter will exercise its overallotment provision at its expiration

date to cover its net $3 million short position in the underlying securities.

Entities will sometimes include greenshoe provisions that permit the issuance manager (in some cases,

an investment manager or large initial investor in a private offering) to obtain additional shares for its

own purposes at a favorable price if the market price rises subsequent to the initial issuance. This

approach has sometimes been referred to as a “manager’s option.” The exercise period for a manager’s

option may be longer (45 or more days) than that of a more traditional greenshoe (usually 30 days or less).

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The following are examples of the mechanics of the arrangements typically found in the marketplace:

• A traditional overallotment option permits the underwriter to purchase up to a specified amount of

the securities issued within a specific time frame (typically 30 days) after the original offering. The

underwriter shorts the notional amount of the greenshoe in order for the option to become exercisable

later. The notional amount is permanently reduced by any short position that is covered by the

underwriter’s purchases in the open market. For example, if the greenshoe notional amount is

$15 million, representing 150,000 shares at an offering price of $100 per share (which is shorted at

issuance), and the underwriter subsequently repurchases 70,000 shares in the market during the

stabilization period, then the notional amount of the greenshoe is permanently reduced to 80,000 shares.

• A reload overallotment option permits the underwriter to purchase up to a specified amount of the

securities issued within a specific time frame (typically 30 days) after the original offering. The

notional amount of the greenshoe is shorted at issuance in order for the option to become

exercisable later. The notional amount is reduced by any short that is covered by open market

transactions, but it is increased if those securities are resold during that same stabilization period.

For example, if the greenshoe notional amount is $15 million, representing 150,000 shares at an

offering price of $100 per share (which is shorted at issuance), and the underwriter repurchases

70,000 shares in the market to cover its short because the market price of the securities has

declined, the notional amount is temporarily reduced to 80,000 shares. Subsequently, if the

underwriter resells an additional 30,000 shares because the market price of the securities has

increased, the greenshoe notional amount is adjusted to 110,000 shares.

• A manager’s option permits the underwriter to purchase up to a specified amount of the securities

issued within a specific time frame (typically 30 to 60 days, but it can be longer) after the original

offering. The notional amount of the greenshoe is not required to be shorted at issuance in order

for the option to become exercisable later and is not affected by any short that is covered by open

market transactions. A manager’s option is not found in registered offerings, because the exercise of

the option would violate the securities law. Those instruments are essentially written options for

additional securities. The options may be held by the underwriter at issuance or transferred to the

initial investors.

5.12.2 Analysis

5.12.2.1 Freestanding or embedded

Manager’s options may be freestanding or embedded in the related securities. The option is freestanding

if it can be transferred separately from the related securities. For example, if the underwriter holds the

option, while the ultimate investors receive the securities, the option would be freestanding. Similarly, if

an investor receives both the option and the security yet could sell or transfer the option and the security

separately, the option would be considered a freestanding financial instrument. Conversely, if the

manager’s option and related securities cannot be separated it would be considered an embedded

feature in the initial securities issued.

Unlike manager’s options, the traditional overallotment and reload overallotment options are considered

freestanding because they remain with the underwriter when the securities are sold to the ultimate investor.

If a greenshoe is considered a feature embedded in the securities initially issued, that embedded feature

should be analyzed to determine whether it should be bifurcated from the host instrument. That

determination will involve evaluating the hybrid instrument (the security and embedded greenshoe

feature) in accordance with ASC 815-15 (refer to section 3 of our FRD publication, Derivatives and

hedging, for additional information on embedded derivatives). Generally, the greenshoe option would not be

bifurcated from the host instrument because the economic characteristics and risks of the embedded

written call option are considered to be clearly and closely related to the economic characteristics and risks

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of the host contract. The underlying to the greenshoe option is the same security as the host instrument.

The following discussion focuses on the accounting considerations for a greenshoe option that is

determined to be a freestanding financial instrument.

5.12.2.2 Evaluating greenshoes as ASC 480 liabilities

If greenshoes involve equity shares of the issuer, the issuer should evaluate the options in accordance

with ASC 480. A greenshoe option is likely an ASC 480 liability if it was part of an issuance of redeemable

equity instruments, such as mandatorily redeemable preferred shares or preferred shares that are

redeemable at the option of the holder or otherwise outside the control of the issuer. The evaluation

would be similar to that for warrants on redeemable equity shares, which are usually determined to be

liabilities in accordance with ASC 480.

If the greenshoe is deemed a liability in accordance with ASC 480, it should be evaluated based on

whether it should be allocated proceeds from the offering (if it was passed on to the investors) or

accounted for as a separate instrument issued for no proceeds (with the offset to expense or deferred

equity issuance cost) considering the facts and circumstances.

5.12.2.3 Evaluating greenshoes as derivatives

If the greenshoe is not an ASC 480 liability, it should be evaluated as a potential derivative in accordance

with ASC 815. If it is a derivative, it should be further evaluated to determine whether it meets any of the

conditions to be exempt from derivative accounting.

The underlying of a greenshoe is the price of the underlying securities, as with any option. However,

some believe the greenshoe does not have a notional amount, which has resulted in diversity in practice.

ASC 815-10-55-6 through 55-7 provides guidance for determining the notional amount of a contract.

The guidance states that when the terms of the contract call for a maximum amount, the notional amount

cannot be more than that maximum amount. The guidance also specifies that when a minimum greater

than zero exists, the contract has a notional amount of at least that minimum amount. The guidance

further explains that penalties for nonperformance and other terms should be considered to determine

the notional amount. The conclusion that a notional amount exists can be reached only if a reliable means

to determine such a quantity exists (e.g., this would be the case if a notional amount can be determined

based on the provisions within a contract or within agreements contemporaneous to the contract).

We generally believe the traditional overallotment options and reload overallotment options do not have

a notional amount in accordance with ASC 815 because the underwriter can purchase up to a specified

amount (a maximum) within a specified period following the offering, but the actual amount that may be

permitted is not known because the final amount is based on subsequent issuance and stabilization

activities. Therefore, a notional amount is not readily determinable, since the notional amount of

greenshoes can be between zero and the maximum.

In addition, we understand that securities law prevents the exercise of the option unless it is to cover the

short position, so the underwriter is not able to economically exercise the overallotment to its benefit

(i.e., the underwriter cannot exercise the option to purchase the underlying securities to benefit its

proprietary trading activities).

However, the manager’s option would have a notional amount equal to the maximum amount because

the notional amount is not affected by the underwriter’s subsequent activities in the open market. The

manager’s option functions like any other option contract where a rational holder will exercise the option

to its fullest extent if it is in the money at the expiration date.

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To the extent that a manager’s option is deemed to have a notional amount (some believe it is the

contractual maximum), the remaining characteristics of a derivative should be evaluated. Typically,

greenshoe options meet the little or no initial net investment criteria, similar to other options. Because the

overallotment option is issued together with other securities, its initial investment is considered to be the

fair value of the option. The net settlement characteristic may be satisfied because the securities that are

delivered upon exercise of the option are themselves readily convertible to cash by virtue of the market

in which they are offered (publicly traded or immediately eligible for a Rule 144A transaction). For a

private company, consideration of the net settlement characteristic may require additional analysis.

5.12.2.4 Exceptions available for greenshoes meeting the definition of a derivative

There are several potential exceptions from derivative accounting in accordance with ASC 815 that are

available if an issuer concludes a greenshoe meets the definition of a derivative.

While some believe a traditional overallotment option for either debt or equity securities that expires on

the issuance date may not be subject to derivative accounting because of a specific exemption for

regular-way security transactions in ASC 815-10-15-15, we do not believe this is the preferable view.

Greenshoes for equity securities deemed to be derivatives may qualify for the scope exception

in ASC 815-10-15-74(a) for issuers because the options are settled in the issuer’s underlying equity

security. They would be classified as equity if they are both (1) indexed to its own stock and (2) classified

in stockholders’ equity in its statement of financial position in accordance with ASC 815-40.

For the debt securities of public companies, a greenshoe that is deemed to be a derivative and can be

exercised over a period of time does not have any available exceptions from derivative accounting.

A traditional overallotment option that is short term and has an at-the-money strike price at the issuance

date may have minimal value, but changes in the volatility of the stock or the stock price, will affect the

value of the option over its life.

5.12.2.5 Accounting for greenshoes determined to be derivatives

Similar to greenshoes that are classified as a liability in accordance with ASC 480, greenshoes

determined to be derivatives are accounted for at fair value at issuance and subsequently adjusted to fair

value through earnings. Judgment is required in determining whether the issuer should (1) allocate a

portion of the gross issuance proceeds to the greenshoe or (2) deem the greenshoe to be issued for no

proceeds and record an immediate expense (or perhaps an issuance cost) as the other side of the entry to

recognize the instrument. The facts and circumstances should be considered in making this determination.

The allocation of proceeds to the greenshoe would be appropriate when a derivative greenshoe and

securities are issued to the same party (e.g., investors), and the greenshoe is freestanding. However, a

greenshoe is typically issued as a separate instrument to the underwriter, while the securities are

purchased by the investors through the underwriter. In this case, allocating a portion of those proceeds

to the greenshoe would not be necessary.

Any portion of the initial proceeds allocated to the derivative would affect the initial carrying amount of

the securities, which can have further accounting implications depending on the security issued. For

example, if the issued securities are debt securities (or preferred stock) and some of the proceeds are

allocated to the greenshoe, the initial carrying amount may include a discount to be reflected as a yield

adjustment over the security’s life. Further, if the security has conversion features, the initial allocated

carrying amount (i.e., proceeds) should be evaluated to determine whether there is a BCF. BCFs often

arise when proceeds are allocated to multiple instruments. Refer to section 1.2.7 for further discussion

on the allocation of proceeds.

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5.12.2.6 Application of the SEC staff’s longstanding view on written options

While the SEC staff has a longstanding position that written options that don’t qualify for equity

classification should be recorded at fair value and marked to fair value through earnings,

we are not

aware that the SEC staff has applied this view to greenshoes.

5.13 Pre-funded (‘penny’) warrants (added September 2022)

Pre-funded warrants, commonly known as “penny” warrants, are a type of warrant that allows the

holders to acquire a specified number of the issuer’s shares at a nominal exercise price (typically $0.01).

Pre-funded warrants allow the issuers to receive, as part of the warrant’s purchase price, the exercise

price that would be due for a traditional warrant, except for the nominal exercise price, at the time of the

warrant’s issuance.

One of the purposes of issuing pre-funded warrants is to accommodate the needs of the investor who

may be subject to ownership restrictions in the issuer’s shares. For example, an investor may be subject

to a designated ownership threshold of 9.99% or 19.99% in the issuing entity. A pre-funded warrant

provides the investor flexibility in acquiring additional beneficial ownership interest when it is ready to do

so without exceeding the designated ownership threshold.

Although the payoff of a penny warrant is essentially the same as actually holding the underlying share,

we generally believe that a penny warrant should be accounted for as an equity contract. That’s because

the warrant contains all of the characteristics of an equity option as described in section 4.1.1.1 and

usually lacks the other legal characteristics of a share (such as the ability to vote). An issuer should

evaluate the equity contract guidance discussed in section 4 in determining the accounting for penny

warrants, including the considerations of ASC 480, ASC 815 and ASC 815-40.

Specifically, a penny warrant should be evaluated to determine whether it is a derivative in its entirety

under ASC 815. To be a derivative, an instrument must contain (1) one or more underlyings, (2) one or

more notional amounts or payment provisions or both (that together with the change in the underlying,

determine the settlement amount), (3) no (or little) initial net investment and (4) allows for net settlement.

A penny warrant will likely not meet the “no or little initial net investment” criterion because the initial

investment by the investor generally equals the price of the underlying shares. That is, the initial net

investment is equal to the amount that would be exchanged to acquire the asset related to the underlying.

If a penny warrant does not meet the definition of a derivative, the entire instrument is considered a

hybrid instrument that contains an embedded written call option. The hybrid instrument is analyzed

pursuant to ASC 815-15-25-1 to determine whether the embedded written call option requires

bifurcation and separate accounting. Specifically, the embedded option (assume it meets the definition of

a derivative) is evaluated under ASC 815-40 to determine whether it qualifies for equity classification if it

were freestanding. If the embedded written call option meets the requirements of ASC 815-40, separate

accounting as a derivative would not be required. Conversely, if it fails to meet the requirements of

ASC 815-40, derivative accounting would be required.

There is no specific guidance on the classification of the hybrid instrument. In practice, issuers classify

the hybrid instrument as either a liability or equity based on whether the instrument, through the

embedded written option, meets the requirements of ASC 815-40. That is, if the instrument contains a

feature that potentially fails to meet the requirements of ASC 815-40 for equity classification, the entire

instrument would be accounted for as a liability.

Any conclusion on the accounting for a penny warrant should be based on the individual facts

and circumstances.

ASC 815-10-S99-4

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5.14 Preferred equity certificates, convertible preferred equity certificates

In some jurisdictions, instruments may be issued with characteristics of both debt and equity. If an

instrument is legal form equity, it is evaluated pursuant to ASC 480 to determine whether it should be

classified as debt for financial reporting purposes. However, US GAAP does not contemplate that legal form

debt would be classified in equity. Several concepts in the guidance indicate that legal form debt, and

instruments that provide creditor rights, are not considered equity. For example, shares analyzed pursuant

to ASC 480 are limited to those that are not liabilities in form under the definition of a “share.” As another

example, ASC 470-10-S99-2 states that subordinated debt must not be presented as a component of

equity. Therefore, we believe that legal form debt instruments should be classified as liabilities.

A common example of an instrument with characteristics of both debt and equity is a preferred equity

certificate (PEC) and related instruments (e.g., convertible preferred equity certificate (CPEC) and

various others) issued by entities (often financing subsidiaries) in Luxembourg. Those instruments are

perpetual, usually without any optional or mandatory redemption dates and are nominally titled as equity

instruments. However, we understand that these instruments provide creditor rights to the holder in

certain events, the dividends are tax deductible as interest expense, and, most importantly, historically the

instruments have generally been considered legal form debt in that country. As a result, these instruments

would not be deemed legal form equity instrument eligible for equity classification, but rather legal form

debt, unless appropriate support was provided that the instruments were equity in legal form in the

jurisdiction in which they are issued.

The accounting evaluation for a debt instrument differs from the considerations for an equity instrument.

Refer to section 2 and section 3 for detailed discussions on each instrument.

5.15 Liabilities with an inseparable third-party credit enhancement

5.15.1 Overview and background

Liabilities are often issued with credit enhancements obtained from a third party. The most common

example is credit-enhanced debt. In those issuances, the issuer purchases a guarantee from a third party

(usually a monoline insurer or other financial guarantor) that requires the third party to make payments

on the issuer’s behalf in the event the issuer fails to meet its payment obligations. To the extent the

guarantor is required to make payments, the issuer becomes obligated to the guarantor for the payments

(i.e., the guarantor becomes the creditor). As a result, investors typically evaluate the credit risk of the

instrument based on the third-party guarantor’s creditworthiness (rather than the issuer’s) assuming that

the guarantor’s credit rating exceeds that of the issuer. This credit enhancement usually will enable the

issuer to more easily market the debt instrument.

When permitted under other US GAAP, issuers of debt with an inseparable third-party credit enhancement

may elect to subsequently measure the debt at fair value. For those issuers, the “Liabilities Issued with

an Inseparable Third-Party Credit Enhancement” subsection of ASC 825 (the “credit-enhanced liability

guidance”) requires that the measurement of those liabilities at fair value on a recurring basis exclude the

effect of the credit enhancement for accounting purposes. This guidance is also applicable for credit-

enhanced liabilities that are not subsequently measured at fair value but are disclosed at fair value.

5.15.2 Analysis

5.15.2.1 Scope

The credit-enhanced liability guidance applies to liabilities measured at fair value on a recurring basis, either

under a fair value election or some other US GAAP such as ASC 815. For example, derivatives accounted

for at fair value pursuant to ASC 815 for which the entity obtained a guarantee from a third party for its

potential liability to the counterparty under the derivative instruments would be within the scope.

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This guidance does not apply to credit enhancements provided by a government or government agency

(e.g., those provided by the FDIC) and credit enhancements provided to a parent or a subsidiary or

between entities under common control.

This guidance is applicable only to the issuer of a liability with an inseparable third-party credit

enhancement. It does not apply to the holder of the issuer’s credit-enhanced liability. That is, the investor

is not required to account for two components: the liability from the issuer and the guarantee from the

third-party guarantor.

5.15.2.2 Measuring liabilities with third-party credit enhancement

Pursuant to ASC 820-10-35-18A, an issuer considers its own credit standing, and not that of the third-

party guarantor, in measuring the fair value of a liability with a third-party guarantee, regardless of

whether the fair value measurement is used for recognition or solely for disclosure purposes. In other

words, the unit of accounting for the liability measured or disclosed at fair value does not include the

third-party credit enhancement.

Because the credit enhancement is obtained for the benefit of the holder of the issuer’s liability, the

guarantee does not represent an asset of the issuer. Any payments made by the guarantor to the

creditor or holder of the liability result in a transfer of the issuer’s obligation from the creditor to the

guarantor. However, the amount of the issuer’s obligation is not affected in the event of guarantor’s

payments. The only change is that the guarantor now stands to collect from the issuer. Therefore, the

fair value of that liability should reflect the issuer’s creditworthiness.

Proceeds received for the issuance of liabilities with a third-party credit enhancement represent consideration

for both the liability issued and the guarantee purchased on the investor’s behalf. Because the unit of

accounting for the liability does not include the guarantee, the proceeds from the issuance should be

allocated between the premium for the guarantee and the liability based on their respective fair values.

The following example illustrates this concept, and contrasts the accounting for a credit-enhanced

liability under a fair value model with that of a credit-enhanced liability under an amortized cost model.

Illustration 5-17: Debt with an inseparable third-party credit enhancement

The assumptions are as follows:

• Borrow Co., whose credit rating is BB, raised $1,000 on 1 January 20X0 by issuing notes that

included a third-party guarantee issued by Bond Company whose credit rating is AA

• The notes bear a fixed interest rate of 7% payable annually in arrears on 31 December, with that

rate based largely on the higher credit rating of the bond insurer

• The notes mature on 31 December 20X4 (five years after issuance)

At the issuance date:

• The market interest rate for similar five-year debt without a third-party guarantee is 9% based on

Borrow Co.’s credit standing

• The premium paid to the guarantor for its guarantee was $75

• Other debt issuance costs (e.g., attorney’s fees, rating agency fees), excluding the guarantee

premium, were $25

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Initial recognition and measurement — amortized cost accounting

Assuming the debt is not accounted for at fair value on a recurring basis (i.e., a fair value election has

not been made), Borrow Co. would follow traditional amortized cost accounting, wherein a liability is

initially measured based on the proceeds received. The total debt issuance costs incurred (the

premium paid and the other debt issuance costs) are deferred and amortized over the term of the

debt. Thus, Borrow Co. would record the following journal entries at issuance:

Deferred debt issuance costs (guarantee premium)

$ 75

Cash

$ 75

To record cash paid to bond insurer for guarantee on debt to be issued

Deferred debt issuance costs (attorney’s fees and other)

$ 25

Cash

$ 25

To record cash paid for external costs related to the debt

Cash

$ 1,000

Debt

$ 1,000

To record proceeds received upon issuance of debt

Initial recognition and initial measurement — fair value accounting

Now assume Borrow Co. elected, upon issuance of the debt, to apply the fair value option, and accounts for

the debt at fair value as determined pursuant to ASC 820 on a recurring basis. Also, assume the fair value of

the debt upon issuance was $925, computed by excluding the effect of the credit enhancement and using

Borrow Co.’s own credit standing. Thus, Borrow Co. would record the following journal entries at issuance:

Prepaid asset (guarantee premium)

$ 75

Cash

$ 75

To record cash paid to bond insurer for guarantee asset on debt to be transferred to the investor

Expense (attorney’s fees and other)

$ 25

Cash

$ 25

To record cash paid for debt issuance costs, which are charged to expense under the fair value model

Cash

$ 1,000

Prepaid asset (guarantee premium)

$ 75

Debt

925

To record proceeds on issuance of debt, including allocation of proceeds to guarantee asset

transferred to investors

The net effect of those entries is to recognize the debt at its fair value of $925 and recognize as

expense debt issuance costs. The guarantee has been transferred to the investor, as Borrow Co.

purchased it for the investor’s benefit and paid for by the investor with a portion of the issuance

proceeds. In this example, the fair value of the guarantee premium exactly equals the difference

between the fair value of the debt and the gross proceeds received upon issuance of the debt. In

reality, there may be some difference (generally insignificant) between (1) the gross proceeds of

issuance of the debt and (2) the sum of the fair value of the debt and the guarantee premium. That

difference could result in recognizing a small gain or loss upon the issuance of the debt.

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Subsequent measurement — amortized cost accounting

If the debt is not accounted for at fair value on a recurring basis, Borrow Co. would record the

following cumulative journal entry for the first year (31 December 20X0) to record interest expense

and amortize the debt issuance costs:

Interest expense

$ 90

Cash

$ 70

Deferred debt issuance costs

To record interest expense on debt (assuming straight-line amortization approximates the effective

interest method)

This entry results in an effective interest rate in excess of 9%.

Subsequent measurement — fair value accounting

If the debt is accounted for at fair value on a recurring basis, Borrow Co. would record the following

cumulative journal entry for the first year (31 December 20X0)) to record interest expense and

remeasure the debt at fair value (assumed to be $875 as Borrow Co.’s creditworthiness has declined):

Interest expense

$ 70

Debt

Cash

$ 70

Other comprehensive income (remeasurement at fair

value)

To record interest expense on debt and remeasure the debt to fair value under the fair value option

This entry results in the recognition of interest expense equal to the cash interest paid (based on the

stated rate in the debt) and the carrying amount of the debt at its current fair value.

Note that if Borrow Co. repays the debt pursuant to its terms, the ultimate expense recognized will be

the same under the amortized cost and fair value models. That is, under both methods, the carrying

amount at maturity will equal the par amount of the debt ($1,000 in this example). Under the fair

value method, Borrow Co. recognized debt issuance costs of $25 as an expense immediately. Although

the carrying amount of the debt could increase or decrease in any given reporting period, at maturity,

the initial $75 difference between the par and allocated proceeds would ultimately have been recognized

in earnings, bringing the cumulative charge in earnings to $100. Under the amortized-cost method,

Borrow Co. would amortize the $100 of debt issuance costs, including the guarantee premium, over the

term of the debt.

Disclosure at year end 20X0

Regardless of whether Borrow Co. subsequently measures the debt at amortized cost or fair value, it would

disclose the fair value of the debt in the 31 December 20X0 financial statements as $875, which incorporates

the issuer’s creditworthiness. This fair value would likely be different than any quoted fair value of the

bond, which would look to the creditworthiness of Bond Company (if it were higher than Borrow Co.’s).

__________________________

Assume that the entire change in fair value of the debt was caused by a change in instrument-specific credit risk (own credit risk).

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5.16 Convertible debt with call spread

5.16.1 Overview and background

A popular financing structure in recent years has been convertible debt with a freestanding call spread. In a

typical call spread transaction, the issuer purchases a call option (also referred to as the “bond hedge” or

“low strike call option”) from the underwriter (an investment bank), with an exercise price and notional

number of shares equal to the conversion price and potential conversion shares of its convertible debt. The

payoff on the call option economically offsets the conversion option in the debt because it has the same

strike price. The issuer also writes a call option to the underwriter, at a higher strike price to partially

finance the purchased call option (also referred to as the “high strike call option”). The combined economics

of the convertible debt and the call spread is a synthetic increase of the strike price of the financing. In

certain cases, the issuer can integrate the proceeds from the issued debt with the cost of the low strike call

option for tax purposes, providing an original issue discount on the debt from a tax perspective.

A call spread can either be documented as two separate instruments (the purchased call and the written

call) or as a single, integrated call spread (i.e., a capped call option). A capped call is a call option purchased

by the issuer with a strike price equal to the conversion price but the settlement price is capped at an

amount equal to what would be the strike price of the separate high strike call option. This mirrors the

economics of the two separate instruments. The benefit of using a capped call option is that the issuer

generally would not be subject to the dilution effect of the written call option as the purchased option is

generally antidilutive overall, and thus not considered for EPS purposes.

5.16.2 Analysis

5.16.2.1 Unit of account

When documented in two separate instruments, the purchased call and written call option are viewed as

separate freestanding financial instruments from the convertible debt (not embedded features) because

there are separate counterparties to the contracts. The counterparty to the options is the investment bank,

which acts as the underwriter or placement agent for the debt but generally does not hold the convertible

debt. The counterparties to the debt are the individual convertible debt investors. ASC 815-15-25-2 states

that the notion of an embedded derivative in a hybrid instrument refers to provisions incorporated into a

single contract, and not to provisions in separate contracts between different counterparties.

In addition, ASC 480 defines a freestanding financial instrument to be a financial instrument that is

(1) entered into separately and apart from any of the entity’s other financial instruments or equity

transactions or (2) entered into in conjunction with some other transaction and is legally detachable and

separately exercisable. Because the exercise of either the purchased call option or the written call option

does not automatically result in the redemption of the convertible debt, the two options are considered

separately exercisable, which is a factor that points to them being considered freestanding from the debt.

ASC 815-10-15-9 states that two or more freestanding financial instruments should be viewed as a unit

(and not accounted for separately) based on certain indicators. Those indicators should be evaluated to

determine whether the convertible debt should be considered with the call spread structure as one unit

of account. While an analysis should be based on the individual facts and circumstances, following are

general considerations:

• There is a substantive business reason to have the convertible debt and call spread executed

separately. Convertible debt investors prefer a lower conversion price while issuers prefer a higher

conversion price. The call spread economically transforms a lower conversion price convertible debt

to a higher conversion price convertible debt, as the separately purchased call option economically

offsets the embedded written conversion option.

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• The convertible debt and call spread do not have the same counterparties. The convertible debt is

issued to investors while the underwriters are the counterparties to the call spread.

• The instruments do not relate to the same risk. Convertible debt contains both interest and equity

risks but the call spread has only the equity risk of the issuer. Also, the convertible debt and written

call option (as part of the call spread) have different maturities, as their settlement dates are usually

intentionally different.

Based on this evaluation, we generally believe the options should not be combined with the convertible

debt for accounting purposes.

In addition, the two options should be evaluated for potential combination provided neither is in the

scope of ASC 480. The options (documented in different contracts) are generally considered two

separate freestanding financial instruments because they intentionally have expiration dates that are

sufficiently separated (the purchased call option settles at each conversion of the debt and the written

call option settles at some period of time after the maturity of the debt) and are settled separately.

However, the options could be combined if the settlement dates are aligned as the factors for

combination pursuant to ASC 815-10-15-9 would be present.

When the call spread is executed in a form of capped call option, the analysis is similar. The capped call

option is generally not combined with the convertible debt for the reasons discussed above. Because it is

documented in a single contract, the capped call is considered a single financial instrument.

5.16.2.2 Classification

The issuer should evaluate and determine whether the conversion option in the convertible debt requires

bifurcation as a derivative or whether the convertible debt is subject to the cash conversion guidance or

BCF guidance pursuant to ASC 470-20. Refer to section 2 for further discussion.

The two options, which represent separate freestanding financial instruments on the issuer’s own shares,

should be analyzed individually to determine the accounting (if structured as a single capped call, it would

be analyzed as a single instrument under the same literature).

ASC 480 applies only to freestanding financial instruments that embody obligations of the issuer. The

purchased call option would not be a liability pursuant to that guidance because it does not embody an

obligation of the issuer. It permits, but does not require, the issuer to buy its own shares.

In contrast, the written call option embodies an obligation to the issuer to deliver shares or transfer assets

upon the counterparty’s exercise. Pursuant to ASC 480-10-25-8 through 25-13, if a financial instrument,

other than outstanding shares, embodies an obligation of the issuer to transfer assets, the instrument

would be a liability. Typically, the written call option does not embody an obligation by the issuer to

repurchase its equity shares, as its terms entitle the counterparty the right to acquire shares from the

issuer. However, additional consideration is necessary when the written call option involves shares that are

themselves redeemable or the written option embeds a written put feature that permits the underwriter to

put the option back to the issuer for cash. In those cases, the written call option would be a liability pursuant

to ASC 480. Refer to sections 5.7 and A.6.1.4 for further guidance.

ASC 480-10-25-14 should also be considered for the written call option if it involves variable shares. Pursuant

to that guidance, liability classification would be required if at inception, the monetary amount of the

obligation to deliver variable shares is based solely or predominantly on any one of the following conditions:

• Has a fixed value

• Derives its value predominantly from some underlying other than the fair value of the issuer’s shares

• Has a value to the counterparty that moves in the opposite direction as the issuer’s shares

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Generally, the written call option requires the issuer to deliver a fixed number of shares if the

counterparty exercises. However, if the written call option involves a variable number of shares, it

generally does not meet any one of the three conditions described in ASC 480-10-25-14.

The options generally meet the definition of a derivative. However, they are often structured to qualify

for equity treatment pursuant to the exception in ASC 815-10-15-74(a), which considers the guidance in

ASC 815-40. In addition, those instruments are frequently executed in a standard ISDA form. In those

circumstances, additional consideration should be given to evaluate early termination, adjustment and

settlement provisions in the ISDA agreements and their effects on meeting the requirements of ASC 815-40

to ensure equity classification is appropriate. Refer to section 4 for further guidance.

Additional consideration should be given to call spread transactions in debt issuances that involve a

greenshoe (or overallotment provision). In those transactions, the issuer provides the underwriter with

the option to obtain more of the convertible debt being sold (refer to section 5.12 for additional

discussion). The call spread likely considers any overallotment option on the convertible debt, with an

automatic adjustment to the number of shares underlying the call spread if the size of the debt offering

increases to maintain the appropriate alignment of debt to call spread. As an example, the written call

option frequently includes a provision that states (with a similar provision in the purchased call option):

If the Initial Purchasers exercise their right to receive additional Convertible Notes as set forth in the

Purchase Agreement, then on the Additional Premium Payment Date, the Number of Warrants will

be automatically increased by additional Warrants in proportion to such Additional Convertible Notes

and an additional premium shall be paid by Bank to the issuer on the closing date for the purchase

and sale of the Additional Convertible Notes.

Because the number of shares increases upon an event that is not an input to a fixed-for-fixed equity

option or forward valuation model (the underwriter exercising its overallotment option), the options

would fail the indexation guidance in ASC 815-40-15 and therefore, would not be considered indexed to

the issuer’s own stock at inception. Equity classification would be precluded for the options at issuance.

However, the adjustment provision expires upon the underwriter’s exercise of the overallotment option

or upon its expiration, and typically the period is for only up to 30 days. In practice, the underwriter

frequently exercises the option within an even shorter time frame (e.g., one or two weeks after the

issuance). Once the adjustment provision is triggered or expired, the number of shares will be adjusted

(or cease being adjustable) and become fixed. Subsequently, the call spread would be considered indexed

to the issuer’s own equity, provided that there are no other adjustment provisions that would violate the

indexation guidance.

5.16.2.3 Allocation of proceeds

Allocation of proceeds is usually unnecessary in a convertible debt with call spread structure as each

instrument is exchanged for its fair value. If fair value were not exchanged, an allocation method should

be considered for the transactions between the same counterparties (i.e., the call spread instruments).

Refer to section 1.2.7 for guidance on the allocation of proceeds.

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5.17 Prepaid written put option

5.17.1 Overview and background

A prepaid written put option is a written put option on the issuer’s own shares in which the issuer has

prepaid the strike price of the option at inception of the transaction. Some refer to this instrument by its

original commercial product names of “Dragon” (due to the shape of the payoff diagram) or “CAESAR”

(cash enhanced share repurchase).

In a typical transaction, often executed in a form of European option, the issuer (the option writer) makes

an up-front payment to the counterparty (an investment bank, also the option purchaser) in an amount

equal to the strike price of the option (generally the spot price on trade date) less the option premium the

issuer is entitled to receive from the counterparty (the option purchaser). At maturity, the put option will

be automatically exercised and settled in one of the following two ways:

• If the share price on the settlement date is below the strike price, the counterparty will deliver to the

issuer the specified number of shares underlying the option. No cash is paid by the issuer as the

strike was prepaid at inception.

• If the share price on the settlement date finishes above the strike price, the issuer will receive from

the counterparty a payment equal to the option strike price (i.e., a return of the prepaid strike price).

The payment can be settled in the form of cash or a number of the issuer’s shares equal to the

amount due, at the issuer’s option.

Economically, a prepaid written put option is equivalent to a combination of a purchased call option with

a $0 strike price (such that it is always in the money) and written call option with a strike price that is

normally the price of the issuer’s shares at inception of the contract. Each contract is for the same

number of underlying shares. The initial prepayment reflects the premium to be paid for the deep in-the-

money purchased call option less the premium to be received for the written call option. Any share price

above zero will result in the issuer exercising the purchased call and repurchasing the shares. At any

price above the higher strike of the written call option, both parties will exercise their options.

With the written call option, the issuer receives cash equal to that strike price from the counterparty and

delivers the shares. Under the purchased call with a $0 strike, the issuer simply receives its own shares

at the same time. The shares to be received and the shares to be delivered are usually netted such that

the issuer simply receives cash. The issuer’s return in that case is the difference between the cash paid

at the inception of the contract for the $0 strike call and the cash received at exercise for the written

call option.

In summary, the issuer will either (1) retire its shares if the stock price goes below the share price at

inception or (2) receive a return on its investment if the share price goes up. Companies often use a

prepaid put option to lower the overall cost of their repurchase programs. In certain cases, the prepaid

put option is structured such that option premium received by the issuer upon settlement is not taxable.

Consider the following example of a prepaid written put option that is documented in the form of a

combination of a purchased call and a written call:

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Illustration 5-18: Prepaid written put option structured as a combination of a purchased call

and a written call

Company A enters into an equity-linked contract that is indexed to its own common stock with an

investment bank. The contract consists of a purchased call option on 100,000 shares of Company A’s

common stock with a strike price of $0 and a written call option on 100,000 shares of Company A with

a strike price of $10 (current share price at inception of the contract). Under the terms of the

agreement, Company A pays the investment bank $800,000 upon execution of the contract, which

reflects the fair value of the purchased call option, net of the fair value of the written option. Upon

settlement in one year, either of the two scenarios will take place:

• If Company A’s stock price is greater than $10 per share, Company A will deliver 100,000 shares of

its common stock in exchange for $10 per share pursuant to the written call and the counterparty

will deliver 100,000 shares to Company A for $0 pursuant to the purchased option. As the

obligations by the counterparties to deliver shares of common stock are offsetting, the net result of

the instrument is that the company will receive $1 million in cash from the investment bank.

• If Company A’s stock price is less than or equal to $10 per share, Company A will receive 100,000

shares of its common stock from the investment bank pursuant to the purchased option; the out-

of-the-money written option expires without exercise.

In summary, if the stock is greater than $10 per share, Company A has received a return of $200,000

on its original $800,000 investment. If the stock is less than or equal to $10 per share, Company A

has effectively purchased its shares for a per share cost of $8 ($800,000/100,000 shares), which

compares favorably with the $10 per share price at inception of the contract.

The following example illustrates a single prepaid written put option that is frequently executed by issuers:

Illustration 5-19: Prepaid written put option structured as a single instrument

Company A writes a put option on its own stock to an investment bank. The put option permits the

bank to sell 100,000 shares of Company A’s common stock to the company at a strike price of $10,

which is the current share price at inception of the contract. Under the terms of the agreement,

Company A pays the investment bank $800,000 upon execution of the contract, which represents the

net amount of the strike price ($10 x 100,000) less the option premium ($200,000). Upon maturity in

six months, the option will be automatically exercised and either of the two scenarios will take place:

• If Company A’s stock price is greater than $10 per share, the company will receive $1 million in

cash or in shares, at the company’s option, from the investment bank.

• If Company A’s stock price is less than or equal to $10 per share, Company A will receive 100,000

shares of its common stock from the investment bank.

The net effect of this single written put option is the same as the effect of a combined purchased call

and written call as illustrated above.

5.17.2 Analysis

Each of the above structures is an equity-linked contract that is indexed to an issuer’s own stock. While

the individual facts and circumstances should be considered, the combination of call options would

generally meet the criteria to be combined as a single contract for accounting purposes. The equity

contract guidance discussed in section 4 should be considered. The following analysis highlights

considerations specific to prepaid written put options.

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5.17.2.1 ASC 480 considerations

ASC 480 applies only to freestanding financial instruments that embody obligations of the issuer.

Generally, a written put option is a liability pursuant to ASC 480 because it embodies an obligation by the

issuer to purchase its shares by transferring assets. However, in a prepaid written put option, because

the issuer prepays the strike price of the option up-front, the contract no longer embodies any obligation

on the part of the issuer to transfer assets or to issue shares after the inception of the transaction (the issuer

either receives shares or receives cash). Therefore, the prepaid put option is not subject to ASC 480.

5.17.2.2 Definition of a derivative

The prepaid put option is also assessed to determine whether it is a derivative instrument in its entirety,

or a hybrid instrument that contains embedded features requiring analysis for bifurcation pursuant to

ASC 815. To be a derivative, all of the following criteria should be met:

• A notional amount and an underlying

• No or little initial net investment

• Net settlement

Generally, the prepaid written put option has a notional amount and an underlying (a number of equity

shares and the market price of those equity shares). Although it requires physical settlement, the

underlying (i.e., the issuer’s equity shares) is in many cases considered readily convertible to cash.

(There may be cases where the underlying equity shares are not readily convertible to cash because the

shares are not publicly traded or there is not an active market that can rapidly absorb the quantity

underlying the contract, etc.) Therefore, the net settlement criterion is also met.

However, the issuer’s prepayment of the option strike price (or most of it) raises the question of whether

the instrument meets the initial net investment criterion and whether that large initial prepayment is less,

by more than a nominal amount, than the amount that would be exchanged to acquire the underlying

shares at the inception of the contract. If not a derivative, the prepaid written put option would be viewed

as a hybrid instrument (e.g., receivable for the prepaid option strike price) containing an embedded

equity-linked feature (i.e., written put option) requiring potential bifurcation.

In evaluating the initial net investment criterion, ASC 815-10-15-96 states that:

If the initial net investment in the contract (after adjustment for the time value of money) is less, by

more than a nominal amount, than the initial net investment that would be commensurate with the

amount that would be exchanged either to acquire the asset related to the underlying or to incur the

obligation related to the underlying, the characteristic in paragraph 815-10-15-83(b) is met. The

amount of that asset acquired or liability incurred should be comparable to the effective notional

amount of the contract. This does not imply that a slightly off-market contract cannot be a derivative

instrument in its entirety. That determination is a matter of facts and circumstances and shall be

evaluated on a case-by-case basis.

ASC 815-10-15-97 further elaborates this concept by providing:

A contract that requires an initial net investment in the contract that is in excess of the amount determined

by applying the effective notional amount to the underlying is not a derivative instrument in its entirety.

Diversity exists in practice as to whether a prepaid written put option in its entirety meets the initial net

investment criterion in ASC 815-10-15-83(b). Some believe the contract has little initial net investment

because the initial payment ($800,000) is less, by more than a nominal amount, than the initial net

investment that would be commensurate with the amount that would be exchanged to acquire the number

of underlying equity shares at inception ($1 million). Under this view, the contract would be a derivative.

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Others believe the prepaid written put option has an initial net investment (and is not a derivative)

because the prepayment at inception is equal to the notional amount of the underlying equity shares at

the inception adjusted by the time value of money and the premium for the value of the embedded

written option. That is, the $800,000 prepayment represents the $1 million notional amount adjusted

for the time value of money and the premium for the value of the embedded written option. Therefore,

under this view, the prepaid written put option does not meet the definition of a derivative in its entirety

pursuant to ASC 815. We generally support this view.

If the prepaid written put option is considered to be a derivative because it meets all the characteristics

of a derivative, the entire instrument would be assessed to determine whether it qualifies for equity

classification pursuant to ASC 815-40. Generally, the instrument is structured to meet the requirements

of ASC 815-40 and classified in equity. In the example, if Company A’s stock finishes above the strike

price of $10 at maturity, the investment bank would be required to make a payment of $1 million to the

company. Company A can choose to settle the $1 million in either cash or shares. If cash settlement is

the only settlement option, equity classification would be precluded.

Alternatively, if the prepaid written put option does not meet the definition of a derivative, the entire

instrument is considered a hybrid instrument that contains an embedded written put option. The hybrid

instrument is analyzed pursuant to ASC 815-15-25-1 to determine whether the embedded option requires

bifurcation and separate accounting. Generally, the embedded put option meets the requirements to be

classified as an equity instrument if it were freestanding. Therefore, separate accounting would not be

required. The entire instrument would be accounted for as either an asset or equity on the balance sheet. Any

conclusion on the accounting for the instrument should be based on the individual facts and circumstances.

5.17.2.3 Classification of the hybrid instrument

ASC 815-10-55-73 through 55-76 illustrates an example of a prepaid forward contract (albeit to

purchase shares of another entity) and concludes that the prepaid forward contract is a hybrid

instrument that is composed of a debt instrument as the host contract and an embedded derivative

based on equity prices. (The host contract is a debt instrument because the holder has none of the rights

of a shareholder, such as the ability to vote the shares and receive distributions to shareholders.)

The concept may equally apply to a prepaid written put option on an issuer’s own shares. However, we

generally believe that equity classification is appropriate for the hybrid instrument because the contract’s

economic substance is a capital stock transaction that requires physical settlement in equity shares and

generally does not require the counterparty to return any portion of the prepayment to the issuer.

5.18 Advanced bond refunding

5.18.1 Overview and background

In advanced bond refunding (also referred to as “defeasance”), an issuer deposits cash or permitted

financial assets into an irrevocable trust

sufficient to enable the issuer to discharge fully its obligations

under the indenture. Health care organizations commonly extinguish debt through this process whereby

they issue new bonds prior to the first call date of the existing debt and remit the proceeds (or a portion of

the proceeds) to an irrevocable trust in an amount that is sufficient to meet the existing debt’s service

requirements. The existing debt agreement provides that the trust assumes the obligation to service the

debt from the proceeds it has received, and the creditor agrees to release the issuer as the primary

obligor and to look to the trust for repayment of the debt. Generally, the trustee uses the proceeds

received to purchase US Treasury or other government securities.

A trust that cannot be modified or terminated without the permission of the beneficiary (in this case, the beneficiary is the creditor).

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5.18.2 Analysis

To extinguish the existing debt, the issuer must be legally released from being the primary obligor. In

addition, pursuant to ASC 860, the transfer of financial assets must be evaluated to determine whether

they may be derecognized.

5.18.2.1 Legal defeasance of the issuer

For liabilities in the scope of ASC 405, ASC 405-20-40-1 permits a liability to be derecognized only when

the debtor (1) pays the creditor and is relieved of its obligation for the liability or (2) is legally released

from being the primary obligor under the liability, either judicially or by the creditor. In an advanced bond

refunding, because the issuer has not paid the creditor in satisfaction of the liability, to derecognize the

obligation, the issuer must be legally released from being the primary obligor. Whether the issuer is legally

released from its obligation is a matter of law. Generally, a legal opinion should be obtained to determine

whether the issuer has been legally released.

While there is no direct guidance as to the form and content of a typical legal letter governing legal

defeasance, the principles outlined in AICPA Professional Standards Section AU 9336, The Use of Legal

Interpretations As Evidential Matter to Support Management’s Assertion That a Transfer of Financial

Assets Has Met the Isolation Criterion in Paragraph 9(a) of Financial Accounting Standards Board

Statement No. 140, could be considered. The legal analysis should consider under what circumstances

the issuer would continue to remain liable for the outstanding obligation (e.g., failure of the bond trustee

to perform its obligations under the terms of the original bond indenture). We generally believe that an

attorney’s basis for concluding that the issuer is released as the primary obligor should be based on the

provisions in the indenture that explicitly or implicitly provide for legal defeasance.

There are situations where the debt may be novated in that a new debtor takes the place of the existing

debtor and is accepted by the creditor, who agrees to discharge the existing debtor from the obligation.

A legal opinion for a novation should indicate that the original debtor has been discharged by the creditor

from the original liability in order for the debt to be derecognized by the original debtor.

If the issuer remains secondarily liable, the provisions of ASC 460, should be applied through recognition

of a guarantee liability that is initially measured at fair value.

5.18.2.2 Transfer of cash to the trust

Although a transfer of cash is outside the scope of ASC 860, we generally believe the substance of the

transfer is that the bond trustee is acting as agent for the issuer (based on the conditions in ASC 470-50-

55-7) when it purchases the US Treasury securities or other high credit quality assets using the cash

transferred by the issuer. As a result, it should generally be assumed that the issuer purchased the

US Treasury securities or other high credit quality assets and transferred those securities to the bond

trustee, thus making the transfer subject to ASC 860’s derecognition criteria.

Under those criteria, derecognition of transferred financial assets is appropriate only if the available

evidence provides reasonable assurance that the transferred financial assets are legally isolated from the

transferor (refer to ASC 860-10-40-5(a) and 40-7 through 40-14). Because the determination of

whether the legal isolation criterion is met is largely a matter of law, a legal opinion may be required to

support the assertion for derecognition of the transferred financial assets. However, a legal opinion may

not be necessary in all cases, and an entity should consider the facts and circumstances of each

transaction to determine whether a legal opinion is needed. For example, a legal opinion may not be

necessary to support legal isolation when the transferor (the debtor) has no continuing involvement with

the transferred financial assets). Each of ASC 860’s criteria should be evaluated to determine whether

the transferor should derecognize the transferred financial assets.

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5.19 Classification and disclosure of certain trade accounts payable transactions

involving an intermediary (updated August 2023)

5.19.1 Overview and background

Companies looking for ways to maximize working capital sometimes negotiate extended payment terms

with suppliers and enter into supplier financing programs (also referred to as structured payable

arrangements, reverse factoring or payables financing) with third-party intermediaries, such as banks or

other financial institutions.

While the terms of these arrangements vary, a supplier finance program generally involves a finance

provider or intermediary (e.g., a bank) processing a company’s payments for purchases from suppliers.

The program typically allows a company to pay its invoices when due (under the extended terms negotiated

with a supplier) and gives the supplier the option to accelerate collection through a separate factoring

arrangement it negotiates with the third-party intermediary. Under the separate factoring arrangement,

the supplier sells its receivables (i.e., invoices) from the company to the intermediary typically at a

discount. The company is then legally obligated to pay the intermediary in full (i.e., the amount specified

in the original invoice) since the intermediary is now the legal owner of the receivables. Such an

arrangement may better enable a supplier to monetize the receivable that has extended payment terms.

Supplier finance programs raise questions about whether a company can continue to classify the liability

related to the supplier’s invoice as a trade payable or whether it must reclassify the liability as debt. In

general, trade payables may need to be reclassified as debt if the nature of the payables changes after a

company enters into the supplier finance program.

5.19.2 Analysis

5.19.2.1 Balance sheet classification (updated August 2023)

Excerpt from SEC Rules

Regulation S-X, Article 5 Commercial and industrial companies

Rule 5-02, Balance Sheets

19. Accounts and notes payable.

(a) State separately amounts payable to

(1) banks for borrowing;

(2) factoring or other financial institutions for borrowing;

(3) holders of commercial paper;

(4) trade creditors;

(5) related parties (see § 210.4–08(k));

(6) underwriters, promoters, and employees (other than related parties); and

(7) others.

Amounts applicable to (1), (2) and (3) may be stated separately in the balance sheet or in a note

thereto.

Rule 5-02 of Regulation S-X requires certain items to be classified separately on the balance sheet,

including but not limited to, borrowings and trade payables. Because terms vary, a thorough analysis of

the terms of an arrangement must be performed to determine the appropriate classification of the liability.

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While there is no specific guidance that addresses how to evaluate the accounting implications of a

supplier finance program, an SEC staff member

discussed the classification and disclosure of certain

trade payable transactions involving an intermediary in two speeches.

The SEC staff member’s remarks in both cases involved an arrangement in which a bank paid amounts

due to a supplier within the time period necessary to secure the supplier’s normal trade discount (e.g., 2/10,

net 30). The company was then obligated to pay the intermediary on more favorable terms than the

original invoice (i.e., an amount less than the invoice or on a date later than the due date of the invoice).

While acknowledging that a thorough analysis of all of the facts and circumstances specific to the transaction

must be considered, the SEC staff objected to the continued classification of amounts due to the intermediary

as a trade payable in this case. Because the company ultimately settled the invoice under terms different

from the original invoice (either at a later date than the due date of the invoice or at a lower amount), the

SEC staff understood that the substance of the transaction was a secured financing from the intermediary

to pay suppliers.

In evaluating a structured payable arrangement, the SEC staff member stated that companies should

determine the classification based on the substance of the transaction in its totality. This includes an

evaluation of responses to the following questions about the arrangement:

• What are the roles, responsibilities and relationships of each party (i.e., the company, intermediary

and supplier) involved in the structured payable arrangement?

• Have any discounts or rebates been received by the company that would not have otherwise been

received without the intermediary’s involvement?

• Has the intermediary reduced the amount due from the company, such that the amount due is less

than the amount the company would have had to pay to the vendor on the original payable due date?

• Has the intermediary extended the date on which payment is due from the company beyond the

invoice’s original due date?

The SEC staff member’s analysis focused on whether the terms of the payable change as a result of the

involvement of the intermediary. If the payment terms do not change (i.e., the company must pay the

intermediary according to the original terms of the invoice), the characteristics of the payable may not

have changed and would not reflect a financing. If the terms of the payable have changed as a result of

the intermediary’s involvement, the characteristics of the liability have changed, and it may no longer be

appropriate to classify the liability as a trade payable. If an entity has a supplier financing program

involving an intermediary, it should carefully evaluate the terms of the program to determine whether

they have altered the nature of the trade payable in a way that necessitates classifying the amount

payable as debt. This analysis generally requires considerable judgment and an understanding of both the

program and all other relevant facts and circumstances.

The following table lists items a company may consider in the analysis. It is important to note that no

individual factor is determinative. When conducting the evaluation, all relevant evidence should be

considered, including arrangements between the company and its suppliers, those between the company

and the intermediary, and any additional agreements (e.g., side letters) made between the company and

its suppliers. Due to the subjective nature of the evaluation and the absence of specific guidance,

diversity in views may exist.

Robert J. Comerford, 2003 and 2004 — Refer to the SEC website at https://www.sec.gov/news/speech/spch121103rjc.htm

and https://www.sec.gov/news/speech/spch120604rjc.htm.

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Supplier participation

Considerations

Debt-like

Trade payable-like

Who can participate in the

program?

The program is offered to only certain

suppliers (e.g., only those with whom

payment terms have been extended

can participate in the program).

The program is offered to a broad base

of suppliers across many jurisdictions

and with varying payment terms and

provisions. Some suppliers participate,

and others choose to forgo

involvement.

Is there an obligation to

participate in the program?

Participation in the program is

mandated, or lack of participation will

cause payment terms to not be

extended.

Participation in the program is

voluntary, and lack of participation will

not impact the relationship or existing

payment terms.

Roles and responsibilities

Considerations

Debt-like

Trade payable-like

Is the company involved in

negotiations of the

contractual arrangement

between the supplier and the

intermediary?

The company is directly involved in

negotiations between the supplier and

the intermediary.

The supplier and intermediary

negotiate independently and the

company is not involved in the

negotiations.

Is the company a party to the

contract between the

supplier and intermediary?

All parties involved, including the

company, the intermediary and the

supplier, have collectively negotiated

and agreed upon the terms, rights and

obligations, which are documented in a

single tri-party agreement or a

combination of agreements to

accomplish the intended objective.

Separate agreements exist between

the company and the intermediary, as

well as between the intermediary and

the supplier. For instance, a payable

processing agreement is established

between the company and the

intermediary, while a factoring

agreement is entered into between the

intermediary and the supplier.

Payment terms

Considerations

Debt-like

Trade payable-like

Are payment terms or

amounts due under the

original invoice being

modified in conjunction with

implementing the supplier

finance program?

Terms of the payable between the

company and the supplier have

changed (e.g., the due date is

extended if the supplier chooses to

participate in the program and factor

its receivables with the intermediary,

or the supplier is reimbursed by the

company for a portion of the

difference between the invoice

amount and the factored amount it

receives from the intermediary).

No changes were made to the invoice

or payment terms, or, in cases where

payment terms were modified, these

changes were implemented uniformly

across all suppliers, regardless of

whether the supplier opts to

participate in the program and factor

its receivable with the intermediary.

Are the payment terms with

the suppliers consistent with

industry standards, peer

companies and/or company

standards?

Payment terms are either (1) not

consistent with industry standards, (2)

different from those used by peer

companies or (3) outside of company

standards.

Payment terms are consistent with

industry and company standards and

those used by peer companies.

How are fees calculated for

the company’s use of the

intermediary to process

payments?

Fees are variable, based on factors

such as the number of suppliers that

participate in the program or the dollar

amount of receivables that are

factored in a period.

There is a fixed fee paid for the

company’s use of the intermediary to

process payments.

Can the company remit

payment to the intermediary

on a date later than the

original due date of the

invoice?

The company has the ability to remit

payment to the intermediary after the

original due date of the invoice, which

provides a benefit to the company that

it would not have received without the

intermediary’s involvement

Payment must be remitted to the

intermediary by the original due date

of the invoice, providing no benefit the

company.

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Credits and discounts

Considerations

Debt-like

Trade payable-like

Does the company receive a

fee, commission, refund or

discount from the

intermediary?

The company receives a fee,

commission, refund, discount or other

type of consideration from the

intermediary that relates to its trade

payables factored by its supplier.

The company does not receive any

fees, commissions, refunds, discounts

or other type of consideration from

the intermediary.

Does the company still have

access to early pay discounts

(e.g., 2/10 net 30)?

The company loses the ability to take

advantage of early pay discounts

associated with factored invoices.

The company retains the right to early

pay discounts.

What are the company’s

rights if there are returns or

defective product?

The company does not have the right

to negotiate returns of damaged

goods with the supplier or is not able

to withhold payment related to the

disputed invoice as it would otherwise

be able to in the normal course of

business.

The company retains all of its rights,

including the right to offset credits

against payables related to the

disputed invoice or negotiate directly

with the supplier returns of damaged

goods.

Legal rights

Considerations

Debt-like

Trade payable-like

Are the intermediary’s rights

to collection of the payable

from the company the same

as the supplier’s rights to

collection of the original

invoice?

The intermediary’s rights to collection

of the original invoice are senior to

those of the supplier’s in the normal

course of business (e.g., collateral

must be posted by the company).

The intermediary’s rights to collection

of the original invoice are the same as

those of the supplier’s in the normal

course of business.

Have additional guarantees

or other credit

enhancements been

introduced?

The parent or another subsidiary

guarantees the payable and provides

protective rights to the intermediary

or is jointly and severally liable for the

company’s obligation. Such

guarantees are generally not provided

for the company’s trade payables in

the normal course of business.

No additional guarantees or other

credit enhancements have been

introduced for the payables factored

to the intermediary.

Other factors to be considered include:

• Whether the company is obligated to maintain cash balances or whether there are credit facilities or

other borrowing arrangements with the intermediary outside of the supplier finance program that

the intermediary can draw upon in the event of non-collection of the invoice from the company

• Whether the intermediary can determine which invoices to pay or has the ability to prioritize which

invoices to pay based on available funds

• Whether the terms of the supplier finance program require the company to pay interest on the

payable to the intermediary

• More generally, which classification most accurately reflects the future obligation of the company to

transfer assets

It is important to understand the role each party plays in the overall arrangement. Typically, a company

negotiates the terms of its purchases from suppliers directly with those suppliers, and the intermediary

has no involvement. Also, under a traditional factoring arrangement, the intermediary and the supplier

negotiate independently of the company.

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To continue classifying the liability as a trade payable, the company must remain liable to the supplier

under the original terms of the invoice, and the intermediary must have assumed only the rights to the

receivable it purchased.

Under normal circumstances, a factoring arrangement between a company’s supplier and an intermediary

does not benefit the company. That’s why it is important to understand whether the company receives any

benefit as a result of the structured payable arrangement. For example, an intermediary may purchase a

supplier’s receivables in a factoring arrangement at 95% of its face amount. However, rather than collect

the full amount payable from the company, the intermediary may require the company to pay only 98%

of that amount. In this case, the company has received a benefit that it would not have received without

the intermediary’s involvement, indicating that the liability may be more akin to a financing arrangement.

Some supplier finance programs require that, as a condition for the intermediary to accept an invoice

from a supplier (i.e., the receivable) for factoring, a company must separately promise the intermediary

that it will pay the invoice regardless of any disputes that might arise over goods that are damaged or

don’t conform with agreed-upon specifications. In the event of a dispute, a company that agrees to such

a condition would need to seek recourse through other means, such as adjustments on future purchases.

This provision is typical in supplier finance programs since it provides greater certainty of payment to the

intermediary. However, this provision may indicate that the economic substance of the trade payable has

been altered to reflect that of a financing.

It is important to consider the substance of any such condition in the context of the company’s normal

practices. For a company that buys enough from a supplier to routinely apply credits for returns against

payments on future invoices, this condition might not be viewed as a significant change to existing

practice. Similarly, this provision may not be viewed as resulting in a significant change to the terms of

the original trade payable if failure by the company to pay on the invoice due date does not entitle the

intermediary to any recourse or remuneration beyond what is stipulated in the terms of the invoice.

In some factoring arrangements, the intermediary may require that the company maintain collateral or

other credit facilities with the intermediary. These requirements aren’t typical in factoring arrangements

and may indicate that the economic substance of the liability has changed to be more akin to a financing

arrangement, especially if a company’s failure to maintain an appropriate cash balance would trigger

cross-collateralization events on the company’s other debt instruments held by the intermediary.

However, if an existing credit facility with the intermediary provides overdraft protection as part of a

company’s broader relationship with the intermediary, the credit facility may not affect the substance of

the liability until the overdraft protection triggers. For the liability to be considered a trade payable, the

intermediary generally can collect the amount owed by the company only through its rights as owner of

the receivable it purchased from the supplier.

We have also observed that in practice, companies sometimes enter into side agreements with their

suppliers to incentivize them to participate in a factoring program established by the intermediaries.

Terms of the side agreements may include the reimbursement of finance charges incurred by the supplier

(through its factoring arrangement with the intermediary) or a change in payment terms (e.g., from 90

days to 30 days) if the arrangement between the supplier and the intermediary terminates. We generally

believe terms such as those indicate that the nature of the supplier finance program has changed and is

now more akin to a financing arrangement. Companies should consider the terms included in these side

agreements when evaluating the classification of the supplier finance programs.

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5.19.2.2 Statement of cash flow presentation

There are other possible financial reporting implications to consider, including the impact on the company’s

statement of cash flows. For example, if a trade payable is required to be reclassified to borrowings

(because the intermediary remitted payment to the supplier in an arrangement that is deemed more akin to

a financing arrangement), the company should report an operating cash outflow for the reduction in the

trade payable balance and a financing cash inflow for the financing being provided by the financial

institution. The subsequent payment of the invoice to the intermediary should be reported as a financing

cash outflow. This approach is consistent with the SEC staff’s view as discussed at the 2005 AICPA National

Conference on Current SEC and PCAOB Developments as follows:

“The situation addressed by the staff dealt with a transaction similar to the purchase of non-

[company X] products financed through [company X]. For example, say a dealer purchases [company Y

and company Z products] financed under a floor-plan arrangement with [company X]. [Company X]

pays the supplier directly and then is repaid later by the dealer. In this case, the financing arrangement

is not with the supplier, as it was when the dealer purchased [company X] products; therefore, it does

not represent a trade loan. It represents a third-party financing arrangement. Not a big deal, except

that the inventory purchase, an operating activity, has taken place without the dealer physically

delivering the cash. Based on the view that the financing entity effectively has acted as the dealer’s

agent, we concluded that upon purchase of the inventory, the dealer should report the increase in

the third-party loan in substance as a financing cash inflow, with a corresponding operating cash

outflow for the increase in inventory. Upon repayment, the cash outflow would be reported as a

financing activity. Here, the cash flows statement would depict the substance of the transactions — with

the end result being similar to the previous example where the net effect on operating cash flows is the

amount of gross profit generated.”

Refer to section 5.2.4 of our FRD publication, Statement of cash flows, for further discussion on

classification of cash flows related to similar financing structures.

5.19.2.3 Disclosure considerations

5.19.2.3.1 Disclosure about supplier finance program obligations (after the adoption of ASU 2022-04

)

(added August 2023)

5.19.2.3.1.1 Overview

The FASB issued ASU 2022-04 to require entities to disclose the key terms of supplier finance programs

they use in connection with the purchase of goods and services along with information about their

obligations under these programs, including a rollforward of those obligations.

The guidance, as codified in ASC 405-50, does not affect the recognition, measurement or financial

statement presentation of supplier finance program obligations by the buyer, which are classified as either

trade payables or bank debt, depending on the terms of the program (refer to section 5.19.2.1 for further

discussion on the balance sheet classification). The guidance also does not affect the accounting or

disclosures by suppliers or third-party intermediaries involved in such programs.

Joel Levine, 2005 — Refer to the SEC website at https://www.sec.gov/news/speech/spch120605jl.htm.

ASU 2022-04, Liabilities — Supplier Finance Programs (Subtopic 405-50): Disclosure of Supplier Finance Program Obligations.

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5.19.2.3.1.2 Scope

The guidance applies to all entities that use supplier finance programs in connection with the purchase of

goods and services. ASC 405-50-15-2 describes a supplier finance program that is subject to the

disclosure requirements as an arrangement with the following characteristics;

• The buyer enters into an agreement with a finance provider or intermediary

• The buyer confirms supplier invoices as valid to the finance provider or intermediary

• The supplier has the option to request early payment from a party other than the buyer for the

invoices the buyer has confirmed as valid

In the Background Information and Basis for Conclusions of ASU 2022-04, the Board said this

confirmation can be either positive or negative. That is, a buyer can confirm an invoice by saying it is

valid or by not responding to the request for confirmation.

To determine whether a supplier finance program has been established and is in the scope of the

disclosure requirements, the guidance requires an entity to consider all available evidence, including

arrangements between the entity and both (1) the finance provider or intermediary and (2) suppliers

whose invoices have been confirmed as valid. Under the guidance, a buyer’s commitment to pay a party

other than the supplier for confirmed invoices “without offset, deduction or any other defenses to

payment” is an indicator that the entity may have a supplier finance program, but it would not be

determinative.

In the Basis for Conclusions of ASU 2022-04, the Board said that the guidance does not extend to credit

card, payment processing and normal factoring arrangements.

5.19.2.3.1.3 Disclosures

The guidance in ASC 405-50-50-3 through 50-4 requires an entity that uses supplier finance programs to

disclose the following information in the annual financial statements to help users understand the nature

of the program, activity during the period, changes from period to period and the potential magnitude of

the programs:

• The key terms of the programs, including (1) a description of the payment terms, such as payment

timing and the basis for its determination, and (2) assets pledged as security or other forms of

guarantees provided for the committed payment to the finance provider or intermediary

• The amount of the obligations outstanding at the end of the reporting period that the entity has

confirmed as valid to the finance provider or intermediary (i.e., the amount of obligations that the buyer

has confirmed as valid that remains unpaid by the buyer), where those obligations are presented in the

balance sheet and the amounts presented in each line item in the balance sheet if they are presented in

more than one line item

• A rollforward of those obligations presenting, at a minimum, the amount outstanding at the beginning of

the reporting period, the amount added to the program during the reporting period, the amount settled

during the reporting period and the amount outstanding at the end of the reporting period

If an entity has more than one program, it can aggregate the disclosures, as long as useful information is

not obfuscated.

In interim periods, the guidance requires entities to provide the amount of the obligations outstanding at

the end of the reporting period that the entity has confirmed as valid to the finance provider or intermediary

(i.e., the amount of obligations that the buyer has confirmed as valid that remains unpaid by the buyer).

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5.19.2.3.1.4 Effective date and transition

ASU 2022-04 is effective for all entities for fiscal years beginning after 15 December 2022, including

interim periods within those fiscal years, except for the rollforward requirement, which is effective for

fiscal years beginning after 15 December 2023. Early adoption is permitted.

During the fiscal year of adoption, entities are required to disclose in each interim period the key terms of

the programs and the balance sheet presentation of the program obligations. Entities apply the guidance

retrospectively to all periods in which a balance sheet is presented, except for the rollforward

requirement, which is applied prospectively.

5.19.2.3.2 SEC staff disclosure guidance on supplier finance programs

The SEC staff has commented about the increased use of supplier finance programs and the lack of

transparency on an entity’s use of these arrangements. At the 2019 AICPA Conference on Current SEC and

PCAOB Developments, a member of the SEC staff noted that while the use of these programs frequently

improved companies’ liquidity and operating cash flows, companies did not always disclose their use of this

strategy. At the 2021 AICPA Conference, a member of the SEC staff reminded the audience that the staff

had mentioned the use of supplier finance programs in its guidance

on making robust and transparent

disclosures about financing activities companies were undertaking in response to COVID-19. This

guidance states that if a company is relying on supplier finance programs that have a material impact on the

company’s balance sheet, statements of cash flows or short-term and long-term liquidity, the following

questions should be considered when determining the appropriate disclosures to include in MD&A:

• How are these arrangements impacting the balance sheet, statement of cash flows or short-term and

long-term liquidity?

• What are the material terms of the arrangement?

• Are there guarantees provided (either by the company or a subsidiary) related to the arrangement?

• Is there material risk if a party to the arrangement terminates it?

• What amounts payable at the end of the period related to these arrangements and what portion of

these amounts has an intermediary already settled on behalf of the company?

When determining the appropriate disclosures, the facts and circumstances specific to the company

should be considered, and judgment is generally required.

5.19.3 Purchasing cards

There are other programs that require considerations similar to those for supplier finance programs. For

example, reporting entities often use purchasing cards, or P-cards, to make payments for goods

and services. P-cards are a form of corporate charge card. They allow companies to make electronic

payments for business expenses, without using the onerous and expensive traditional purchasing process

(e.g., issuing purchase orders). The cards sometimes may also be used to pay invoices issued by vendors.

Because P-cards are generally issued by a bank, when a reporting entity uses a P-card to purchase goods or

services from its vendor, it is legally obligated to make payment to the bank (rather than its vendor).

Accordingly, reporting entities generally should classify obligations arising from the use of P-cards as debt,

rather than vendor payable, on their statement of financial position. In limited circumstances, classification

of an obligation arising from the use of a P-card as vendor payable may be appropriate if an entity only uses

SEC Division of Corporation Finance CF Disclosure Guidance: Topic 9A, Coronavirus (COVID-19) — Disclosure Considerations

Regarding Operations, Liquidity, and Capital Resources.

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the P-card as a convenience to pay for incidental expenses (e.g., travel expenses, meals, entertainment)

that arose from normal operating purchases and must make full payment of the outstanding balance on the

P-card at the end of each billing cycle pursuant to the terms of the P-card (generally within one month).

5.20 Joint and several liabilities

5.20.1 Overview and background

An entity may enter into borrowing arrangements under which it is identified as a co-borrower and is jointly and

severally liable for the entire amount of the borrowing. Under a joint and several liability arrangement, the

lender can demand payment for the full amount of the outstanding borrowings from any one, or a combination,

of the co-borrowers. This raises the question of whether a co-borrower in a joint and several liability

arrangement should recognize all outstanding borrowings under the arrangement as a liability or instead some

other amount (e.g., under a contingent liability accounting model). Joint and several liability arrangements

may be executed between entities that are under common control or between unrelated parties.

5.20.2 Scope

ASC 405-40 provides guidance on the recognition, measurement, and disclosure of obligations resulting from

joint and several liability arrangements. The guidance applies to obligations resulting from joint and several

liability arrangements for which the total amount under the arrangement is fixed at the reporting date.

As clarified in ASC 405-40-15-2, the obligation that must be fixed from the joint and several liability

arrangement is the total amount of the obligation, not the entity’s portion of the obligation.

The following obligations are outside of the scope of ASC 405-40 and accounted for under other topics:

• Asset Retirement and Environmental Obligations (ASC 410)

• Contingencies (ASC 450)

• Guarantees (ASC 460)

• Compensation–Retirement Benefits (ASC 715)

• Income Taxes (ASC 740)

For the total amount of an obligation under an arrangement to be considered fixed at the reporting date,

there can be no measurement uncertainty at the reporting date relating to the total amount of the obligation

under the arrangement. However, the total amount under the arrangement may change subsequently due to

factors that are unrelated to measurement uncertainty (e.g., the amount was fixed at the reporting date but

may change because an additional amount was borrowed or the interest rate changed).

Liabilities subject to a measurement uncertainty are excluded from the scope of ASC 405-40 and should

continue to be accounted for under the guidance in ASC 450 or other US GAAP.

Examples of obligations that could be within the scope of this guidance include debt arrangements, other

contractual obligations, and settled litigation and judicial rulings.

5.20.3 Recognition and measurement

Obligations resulting from joint and several liability arrangements included in the scope of ASC 405-40

are initially and subsequently measured at the sum of:

a. The amount the reporting entity agreed to pay on the basis of its arrangement among its co-obligors

b. Any additional amount the reporting entity expects to pay on behalf of its co-obligors

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In measuring any additional amount an entity expects to pay on behalf of its co-borrowers, the entity

should record its best estimate of that amount. If a range of additional amounts is developed, and one

amount in the range is a better estimate than any other amount within the range, that amount should be

the additional amount included in the measurement of the obligation. If no amount within the range is a

better estimate than any other amount, then the minimum amount in the range is the additional amount

included in the measurement of the obligation.

Under this guidance, a reporting entity is not required to record the full amount of the obligation as a

liability, unless the reporting entity expects to pay the full amount of the obligation on behalf of its co-

borrowers. At a minimum, the entity should record the portion of the joint and several liability arrangement

it agreed to pay based on the arrangement among the co-borrowers, even if it does not expect to pay.

ASC 405-40 does not include specific guidance about the corresponding entry or entries when

recognizing and measuring a liability resulting from a joint and several liability arrangement. Rather, the

corresponding entry (or entries) depends on the facts and circumstances of the arrangement. Following

are examples of entries included in ASC 405-40:

• Cash for proceeds from a debt arrangement

• An expense for a legal settlement

• A receivable (that is assessed for impairment) for a contractual arrangement

• An equity transaction with an entity under common control

In instances in which a legal or contractual arrangement exists to recover amounts funded under a joint

and several obligation from the co-obligors, a receivable could be recognized at the time the corresponding

liability is established and then subsequently assessed for impairment. However, when no such legal or

contractual arrangement exists to recover amounts from co-obligors, an entity should consider all relevant

facts and circumstances to determine whether the gain contingency guidance in ASC 450-30 or other

guidance would apply in recognizing a receivable for potential recoveries.

5.20.4 Disclosures

ASC 405-40-50 requires certain disclosures for obligations resulting from joint and several liability

arrangements, including:

• The nature of the arrangement, including how the liability arose, the relationship with other co-

borrowers, and the terms and conditions of the arrangement.

• The total amount outstanding under the arrangement, which should not be reduced by the effect of

any amounts that may be recoverable from other entities.

• The carrying amount, if any, for an entity’s liability and the carrying amount of a receivable

recognized, if any.

• The nature of any recourse provision that would enable recovery from other entities of the amounts

paid, including any limitations on the amounts that might be recovered.

• In the period the liability is initially recognized and measured or in a period the measurement

changes significantly, the corresponding entry and where it was recorded in the financial statements.

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5.21 Breakage for certain prepaid stored-value products

Prepaid stored-value products are products in physical and digital forms with stored monetary values that are

issued for the purpose of being commonly accepted as payment for goods or services. These products

generally include prepaid gift cards issued on a specific payment network and redeemable at network-

accepting merchant locations, prepaid telecommunication cards and traveler’s checks, among other things.

When an entity sells this type of prepaid stored-value product, it recognizes a liability for its stand-ready

obligation to provide payment to the third party when the consumer redeems the product for goods, services,

or cash. However, these products may result in breakage, which represents the value that is not redeemed by

consumers (because, for example, the remaining amount is negligible or the product has been lost).

ASC 405-20-40-4 provides guidance on the accounting for breakage (i.e., derecognize the liability) related

to prepaid stored-value products (in physical and digital forms) with stored monetary values that are

redeemable for goods, services or cash at third-party merchants. It does not apply to prepaid stored-value

products that can only be redeemed for cash (e.g., nonrecourse debt, bearer bonds, trade payables).

Further, the derecognition guidance in ASC 405-20-40-4 does not apply to liabilities related to prepaid

stored-value products that are subject to unclaimed property (or escheatment) laws or those that are

attached to a segregated bank account (e.g., debit cards). It also does not apply to customer loyalty programs,

which do not meet the definition of a prepaid stored-value product, and to transactions within the scope of

other topics in the Codification (e.g., the derecognition guidance for gaming chips in ASC 924-405).

5.21.1 Recognition and measurement

Entities must recognize liabilities related to the sale of prepaid stored-value products that are within the

scope of ASC 405-20 as financial liabilities. ASC 405-20-40-4 requires breakage to be recognized for

these liabilities in a way that is consistent with how gift card breakage is recognized under the revenue

guidance in ASC 606.

Under the derecognition guidance, an entity that expects to be entitled to a breakage amount for a

liability resulting from the sale of a prepaid stored-value product within the scope of the guidance has to

derecognize the liability related to expected breakage in proportion to the pattern of rights expected to

be exercised by the consumer only if it is probable that a significant reversal of the recognized breakage

amount will not occur. If an entity does not expect to be entitled to a breakage amount, it has to derecognize

the related liability when the likelihood of consumer exercising its remaining rights becomes remote.

Illustration 5-20: Expectation of breakage

Card Issuer ABC (ABC) sells a prepaid gift card with a load value of $500 that the cardholder can only

use at Content Provider XYZ (XYZ). The card is not subject to unclaimed property laws and is not

attached to a segregated bank account. ABC is required to remit the card’s load value to XYZ if and when

the cardholder uses the card. Otherwise, the load value remains with ABC in perpetuity. To simplify this

example, we are ignoring fees and commissions ABC and other parties would earn.

By analyzing historical redemption rates and determining how those rates may change, given current

facts and circumstances, ABC estimates that 10% of the load value for this card will go unredeemed.

Further, ABC has objective evidence to support that its prepaid cards are typically redeemed on a pro-

rata basis over a 24-month period. Assuming a significant reversal of the recognized breakage amount

is not probable, ABC would recognize the estimated breakage amount of $50 ratably over the 24-month

redemption period (i.e., approximately $2 of the liability per month).

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Illustration 5-21: No expectation of breakage

Assume the same fact pattern as above except that virtually all of ABC’s cardholders have historically

redeemed 100% of the load value of their cards. ABC has the same objective evidence to support that its

prepaid cards are typically redeemed on a pro-rata basis over a 24-month period.

Also assume that, after 24 months, $8 of the $500 load value remains on a prepaid card and the

cardholder has not used the prepaid card in the last 14 months. As a result, ABC determines that the

likelihood of the cardholder using the remaining $8 is remote. ABC would therefore derecognize the

remaining balance of $8 at that time.

At the end of each reporting period, an entity is required to update the estimated breakage amount to

reflect circumstances present at the end of the period and any changes during the period. Changes to

an entity’s estimated breakage amount must be accounted for as a change in accounting estimate in

accordance with ASC 250-10-45-17 through 45-20.

5.21.2 Disclosures

An entity is required under ASC 405-20-50 to disclose the methodology and significant judgments used

to recognize breakage for prepaid stored-value products. These liabilities are not subject to the

disclosure requirements for financial liabilities (e.g., those required by ASC 825).

5.22 Credit facilities issued with warrants

5.22.1 Overview and background

Many early-stage entities obtain credit facilities to meet their liquidity needs. In some cases, a credit

facility is structured as a term loan (or a series of term loans), plus a warrant (or a series of warrants)

that gives the lender the right to buy the borrower’s shares. The warrant provides the lender with the

potential for enhanced returns and reduces the borrower’s coupon rate on the term loan. There is

generally a “draw period” during which the borrower may draw or borrow from the facility. Upon each

draw, the borrower issues debt (i.e., the term loan) and a warrant in exchange for cash.

The term loans typically have maturities of three to five years and may have interest-only periods. The

warrants, which expire seven to 10 years after issuance, typically give the lender the option to make an

investment in the equity of the borrower equal to a percentage of the loan amount drawn (i.e., warrant

coverage). The number of common or preferred shares the lender can purchase under the warrant is

usually determined by dividing the warrant coverage amount by the warrant exercise price. The exercise

price of each warrant is usually based on the price of the underlying shares at the time the warrant is

issued (i.e., the warrant is issued at the money).

For example, consider a $10 million credit facility that provides 5% warrant coverage. When the borrower

draws $10 million, it is required to issue a warrant that is exercisable into a number of shares determined

by dividing $500,000 ($10 million x 5%) by the contractually specified exercise price.

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When a borrower draws a portion of the available facility at the initial closing (i.e., upon entering the

credit facility), three instruments are issued: (1) a term loan, (2) a warrant based on the warrant

coverage and (3) the financial commitment asset (FCA), which is the right the borrower has to borrow

subsequent tranches under the facility by issuing additional debt and warrants.

The following illustration provides an example of a typical credit facility issued with warrants.

Illustration 5-22: Credit facility issued with warrants

An entity raised $20 million by issuing Preferred Series A shares a year ago. Based on projected cash-burn,

the entity has approximately 11 months of cash on hand before it will need to raise its next round of equity

financing. To extend its cash runway, the entity enters into a credit facility with a bank (the lender) on 30 June

20X2. The facility will provide the entity with additional time to achieve milestones, which increases its

chances of raising its next round of equity financing at a higher valuation. The facility has the following terms:

• The entity may draw up to $6.5 million during the draw period, which expires on 30 June 20X3

subject to customary default provisions.

• Term loans issued upon each draw will have a stated interest rate of the bank’s prime rate plus

3.50%, payable quarterly.

• The term loans mature four years from the draw date.

• The bank receives warrant coverage of 8%, with the exercise price of each warrant equal to the

fair value of the underlying common shares on each warrant’s issuance date.

• The warrants are exercisable for seven years.

On 30 June 20X2, the entity drew $2.5 million. On that date, its common stock price is $5 a share.

Based on the terms of the credit facility, the following components exist at initial closing:

• Term loan of $2.5 million at the bank’s prime rate plus 3.50% maturing on 30 June 20X6

• Warrant for 40,000 common shares [ ($2.5M x 8%) / $5 ] exercisable at $5 per share for seven years

• The entity’s right to draw an additional $4 million under the facility over the 12-month draw period

by issuing additional term loans and warrants (i.e., the FCA)

5.22.2 Analysis

Entities that enter into credit facilities with warrants should first determine the appropriate unit of

account by determining which components are freestanding financial instruments (e.g., whether the

warrant and/or FCA is embedded in the term loan). Then, the accounting analysis should be based on the

contractual terms of each freestanding financial instrument. The following table summarizes the relevant

accounting considerations for applying this two-step approach:

In limited cases, the issuer may be required to draw an amount under the facility and issue additional debt and warrants either on

a fixed or determinable date or upon reaching a milestone.

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Accounting considerations

Step 1: Identify the

freestanding financial

instruments

(section 5.22.2.1)

• Is the warrant freestanding or embedded in the term loan?

• Is the FCA freestanding or embedded in the term loan?

• If neither the warrant nor the FCA is embedded in the term loan, are the

warrant and FCA attached to each other?

Step 2: Analyze each

freestanding financial

instrument based on

its contractual terms

(section 5.22.2.2)

• An entity should follow the analysis in section 2.2 to initially account for the

term loan. If the warrant is considered embedded in the term loan, the

entity should follow the guidance on accounting for conversion options

embedded in debt hosts in section 2.2.4. If the FCA is considered embedded

in the term loan, the entity should follow the analysis in section 5.22.2.2.1

below (and section 5.22.2.2.3, as applicable).

• If the warrant is considered freestanding (i.e., it is not embedded in the

term loan), the entity should follow the analysis in section 4.2 on the initial

accounting for freestanding equity contracts.

• If the FCA is considered freestanding (i.e., it is not embedded in the term

loan), the entity should follow the analysis in section 5.22.2.2.2 below (and

section 5.22.2.2.3, as applicable).

Entities should be aware that the terms of credit facilities issued with warrants vary. For example, instead

of issuing a warrant at each draw, the borrower may issue a warrant (or warrants) up-front in exchange

for the lender’s commitment to provide funds during the draw period. In these cases, entities will need to

consider the facts and circumstances when determining the appropriate accounting for credit facilities

issued with warrants.

5.22.2.1 Identify the freestanding financial instruments (step 1)

As discussed in section 1.2.1, when companies issue multiple instruments to the same counterparty in a

single transaction, the first step is to identify all freestanding financial instruments. ASC 480 defines a

freestanding financial instrument as a financial instrument that is entered into either (1) separately and

apart from any of the entity’s other financial instruments or equity transactions or (2) in conjunction with

some other transaction and is legally detachable and separately exercisable. An instrument or feature

that does not meet these conditions is generally considered a feature embedded in another instrument.

The credit facility in Illustration 5-22 involves multiple financial instruments issued contemporaneously at

inception: the initial term loan, the initial warrant and the FCA. Because the three instruments are issued

in conjunction with one another, the second condition of the definition of a freestanding financial

instrument (above) applies. Accordingly, the borrower must determine whether the warrants and/or FCA

are both legally detachable and separately exercisable from the initial term loan. The analysis of whether

a financial instrument is a freestanding instrument or an embedded feature should consider all relevant

facts and circumstances. Once that determination is made, the accounting for the freestanding

instruments or embedded features is based on the contractual terms of the three financial instruments.

Warrant — freestanding or embedded in the term loan?

Although the facts and circumstances of each transaction may differ, the initial warrant is often

considered freestanding from the term loan because it generally can be (1) transferred separately to

another party and (2) exercised without terminating the term loan. In fact, the warrant could continue to

be outstanding after the term loan matures. That’s because the typical maturity of a term loan in these

credit facilities is three to five years, while the warrant issued with the term loan typically expires seven

to 10 years after issuance.

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However, if the warrants cannot be transferred to another party separately from the term loan, or if the

warrants can only be exercised by surrendering the term loan, the warrants would be considered

embedded in the debt instrument.

FCA — freestanding or embedded in the term loan?

The issuer’s analysis of whether the FCA is a freestanding instrument can be more challenging. Because

the initial warrant is often considered freestanding from the term loan and FCA, the analysis of the FCA

generally focuses on whether it is considered freestanding or embedded in the initial term loan.

Generally, two instruments issued together are considered legally detachable from one another if they

can be legally separated and transferred to a third party. For example, if the lender can sell the term loan

without also transferring its obligation under the FCA to make future advances, the FCA is considered

legally detachable from the term loan. In this analysis, it does not matter which instrument the lender can

transfer. For example, if the lender can transfer the term loan but contractually cannot transfer the FCA,

the FCA is still legally detachable from the term loan. The same would be true if the lender had to retain

the term loan but could transfer the FCA.

A careful analysis of the terms of the agreements must be performed, and the company’s legal counsel

may need to be involved in determining whether the FCA can be transferred separately from the initial

term loan. Because performance on the FCA (i.e., the funding of future advances) is affected by the

creditworthiness of the lender, the issuer may (and often does) restrict the ability of the lender to

transfer its obligation under the FCA. In those cases, as long as the lender can sell the initial term loan

while remaining the counterparty to the FCA (or vice versa), the FCA is legally detachable. Alternatively,

if the lender cannot transfer the term loan to a third party without that party also becoming the

counterparty to the FCA, the FCA would not be considered legally detachable from the term loan.

Exercising the FCA generally does not result in the termination of the initial term loan. In these

circumstances the FCA would be viewed as being separately exercisable.

FCA and warrant — attached to each other?

If the FCA and warrant are both freestanding from term loan, the same analysis as discussed above

should be performed to determine whether the FCA is legally detachable from the warrant. If the lender

is able to separately transfer these instruments, they are generally considered legally detachable.

Although the facts and circumstances of each transaction may differ, the FCA is often considered

freestanding from the warrant because the warrant generally can be (1) transferred separately to

another party and (2) exercised without terminating the FCA (and vice versa).

5.22.2.2 Analyze each freestanding financial instrument (step 2)

Entities should evaluate the accounting for credit facilities issued with warrants by analyzing each

freestanding financial instrument based on its contractual terms.

The accounting for the term loan generally should follow the analysis for an issuer’s initial accounting for

debt instruments, as described in section 2.2. If the issuer determines that the warrant is embedded in the

term loan (based on the analysis in 5.22.2.1 above), it will need to consider the guidance on evaluating

conversion options embedded in debt hosts in section 2.2.4 to account for the combined instrument.

Alternatively, if the issuer determines that the warrant is freestanding from the term loan, it should consider

the guidance in section 4.2 on an issuer’s initial accounting for equity contracts to account for the warrant.

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Accounting for the FCA may be more challenging because of the lack of specific guidance. The

accounting will depend on whether the FCA is considered freestanding, embedded in the term loan or

attached to the warrant, as well as an evaluation of the substance of the FCA as a loan commitment. We

discuss the accounting for an FCA that is considered embedded in the term loan in section 5.22.2.2.1

and an FCA that is considered a freestanding financial instrument in 5.22.2.2.2 as these fact patterns

are the most common in practice. Additionally, we discuss the accounting for FCAs (freestanding and

embedded) that are considered loan commitments in section 5.22.2.2.3.

Although infrequent, there may be scenarios where the warrant and FCA are freestanding from the term

loan but attached to each other (as a combined instrument). In these cases, judgment will be required to

determine the appropriate accounting, however we expect that the analysis discussed in 5.22.2.2.2

should generally be followed for the combined instrument. That is, the combined instrument should be

first assessed under ASC 480 (see Appendix A). If not in the scope of ASC 480, the combined unit should

be analyzed under ASC 815 to determine whether it meets the definition of a derivative (see section

4.2.3) and if not, whether any features embedded in the combined unit require bifurcation. The

combined unit is unlikely to meet the criteria for equity classification in ASC 815-40 because the

settlement of the FCA includes the issuance of a term loan.

5.22.2.2.1 FCA considered embedded

If an entity determines that the FCA is a feature embedded in the initial term loan, the entity should

evaluate the FCA under ASC 815-15-25-1 to determine whether the embedded FCA requires bifurcation.

Under that guidance, embedded features must be separated from their host non-derivative contracts and

accounted for as derivative instruments if, and 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 contract that embodies both the embedded derivative and the host contract is not remeasured at fair

value under otherwise applicable US GAAP with changes in fair value reported in earnings as they occur.

• A separate, freestanding instrument with the same terms as the embedded derivative would be a

derivative instrument subject to the requirements of ASC 815.

The last criterion is particularly important when considering FCAs. One of the characteristics necessary

for a contract to meet the definition of a derivative in ASC 815 is that the terms of the contract require

or permit net settlement, it can readily be settled net by means outside the contract or it provides for

delivery of an asset that puts the recipient in a position not substantially different from net settlement

(i.e., the asset is readily convertible to cash or is itself a derivative instrument).

The FCA in Illustration 5-22 requires delivery of two underlying financial instruments (i.e., subsequent

issuance of a term loan and warrant) in exchange for cash from the lender. For the FCA to meet the

definition of a derivative, a determination must be made as to whether delivery of the term loan and

warrant puts the recipient in a position not substantially different from net settlement. ASC 815-10-15-119

through 15-139 provides guidance on the application of the net settlement criterion when settlement

involves the delivery of a derivative instrument or an asset readily convertible to cash. However, it does

not provide guidance for circumstances where there are multiple underlyings and one of them is not

considered readily convertible to cash while another is a derivative instrument.

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With respect to the FCA, a term loan underlying is generally not considered readily convertible to cash

because the term loan is a privately issued instrument that usually cannot be transferred to another

party. The warrant, on the other hand, often meets the definition of a derivative because the terms of

the warrant frequently provide for net settlement (e.g., it either requires physical delivery of shares that

are readily convertible to cash or net-cash settlement), and the warrant also has the other characteristics

of a derivative instrument (i.e., an underlying, a notional amount and little to no initial net investment).

Judgment is required to determine whether the FCA meets the definition of a derivative. In practice,

entities apply one of the following two interpretations of the guidance to determine whether the net

settlement criterion is met.

Under one view, the entity focuses on whether any underlying of the FCA is a derivative instrument or an

asset that is readily convertible to cash. Under this view, if the warrant underlying the FCA is itself a

derivative instrument under ASC 815, delivery of the warrant would constitute net settlement of the

FCA, even though the settlement of the FCA also includes the delivery of a debt instrument that is not

readily convertible to cash.

Under the other view, the entity focuses on whether the predominant underlying of the FCA is a

derivative instrument or an asset that is readily convertible to cash. Because there is no specific guidance

on evaluating the net settlement criteria for an instrument with multiple underlyings, an entity that uses

this view analogizes to the guidance in ASC 815-10-15-59 to 15-60 on derivative scope exceptions

related to certain contracts that are not traded on an exchange. Under that guidance, when a contract

has more than one underlying and some, but not all, of them qualify for the scope exceptions, the

contract is evaluated based on its predominant characteristics.

The primary underlyings of the FCA generally can be broken down into (1) the risk-free interest rate and

the borrower’s credit risk for the term loan and (2) the borrower’s stock price for the warrant. To

determine which underlying is predominant, an issuer may consider how each underlying affects the fair

value or cash flows of the FCA under a range of reasonably possible scenarios over the life of the FCA.

For example, an issuer might compare its estimates of how the value of the warrant would change due to

stock price fluctuations and how the value of the term loan would change due to fluctuations in risk-free

interest rates and the credit risk of the borrower. The volatility of each underlying, as well as the relative

size of the notional amounts of the term loan and warrants the entity may issue in connection with the

FCA should also be considered.

An embedded feature that meets the definition of a derivative in ASC 815 still might not be subject to the

requirements of ASC 815 (and, therefore, not meet the third criterion above for bifurcation) if it qualifies

for a scope exception. The most relevant scope exceptions for the FCA are the scope exception for contracts

indexed to a company’s own stock (ASC 815-10-15-74(a) — which considers the guidance in ASC 815-40)

and the scope exception for certain loan commitments. With respect to the scope exception for contracts

indexed to a company’s own stock, the FCA would not be considered indexed to the issuer’s own equity

because one of the underlyings of the FCA is a debt instrument (i.e., term loan). Consequently, the FCA

would not meet that scope exception. See section 5.22.2.2.3 for a discussion of the FCA as a loan commitment.

As a result, an FCA that meets the definition of a derivative and does not meet any scope exception

would generally be bifurcated and accounted for separately from the debt host because the FCA would

not be considered clearly and closely related to the debt host. This is because the FCA has economic risks

and characteristics that are, in part, related to the entity’s stock price and not solely to an interest rate

index or the borrower’s credit risk.

An FCA that does not meet the definition of a derivative in ASC 815 would not be bifurcated and

accounted for separately from the debt host.

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5.22.2.2.2 FCA considered freestanding

If the FCA is considered a freestanding instrument, it should first be evaluated under ASC 480-10-25 to

determine whether it is classified as a liability. The contractual terms should be carefully considered to

determine whether the FCA represents a right or an obligation to issue additional debt and warrants.

Generally, the FCA is exercisable at the issuer’s sole discretion and, therefore, it is not considered an

“obligation” in the scope of ASC 480. However, if the FCA represents a conditional or unconditional

obligation in which the issuer must issue the additional debt and warrant either on a fixed or

determinable date or upon an event that is outside the control of the issuer, the instrument may require

ASC 480 liability classification (or as an asset in some circumstances) if the additional warrant involves

the issuance of redeemable shares. Refer to section 5.7 for a discussion on warrants where the shares

underlying the warrant are redeemable.

If ASC 480-10-25 does not apply to the FCA, the issuer next analyzes the FCA under ASC 815 to

determine whether it meets the definition of a derivative and, if so, whether it qualifies for a scope

exception from the requirements of ASC 815. Refer to section 5.22.2.2.1 for further discussion on that

determination. If the FCA does not meet the definition of a derivative, the issuer would apply the

guidance in ASC 815-40 to determine whether the FCA should be classified in equity or as a liability (or

an asset in some circumstances). Because one of the underlyings of the FCA is a debt instrument, the

FCA would not be considered indexed to the issuer’s own equity and must be classified as a liability (or an

asset in some circumstances).

If the FCA is not in the scope of ASC 480-10-25 and does not meet the definition of a derivative in ASC 815, it

does not have a defined measurement basis. In this case, the issuer may measure the FCA at fair value (if

the fair value option is elected) or at cost, which requires the consideration of impairment.

If the FCA is a liability (or an asset in some circumstances) under ASC 480-10-25 or meets the definition

of a derivative in ASC 815 (and doesn’t meet any of the ASC 815 scope exceptions), it is subsequently

measured at fair value through earnings. In that case, the entity allocates proceeds from the issuance of

the initial term loan and warrant to the FCA at its fair value as discussed in section 1.2.7. Depending on

whether the FCA is an asset or liability, it creates a corresponding premium or discount, respectively, on

the debt that would subsequently be amortized as interest.

5.22.2.2.3 FCA considered a loan commitment

Typically, the purpose of the FCA is to provide additional funds to the borrower on demand (or in some

cases, upon the occurrence of certain events), and the warrant is considered an ancillary element of the

financing. If the warrant is considered ancillary, an alternative approach to analyze the FCA is to focus on

the substance of the FCA as a loan commitment, which is eligible for the scope exception from derivative

accounting in ASC 815-10-15-69.

Under this approach, a term loan issued under the facility is recognized only when an amount is drawn.

The warrant issued concurrently with the term loan is also recognized only when the related term loan is

drawn. The treatment of the warrants is similar to lender fees that are paid when the issuer borrows

money. These lender fees are generally not recognized until the liability has been incurred. This approach

is also supported by analogy to the guidance in ASC 505-50-S99-1, which states that equity instruments

issued as consideration for future services should be treated as unissued for accounting purposes until

the future services are received. Therefore, under this approach, the warrants will not be recognized

until the draw occurs and the lender performs the service of lending money to the issuer.

When it draws additional term loans and issues warrants under the facility, the borrower should allocate

the proceeds received to the two instruments using a relative fair value or fair value method, depending

on whether the warrants are subsequently measured at fair value through earnings. Refer to section 1.2.7

for further discussion of the allocation of proceeds when multiple instruments are issued concurrently.

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5.23 Bridge loans

5.23.1 Overview and background

Private companies commonly use a form of financing referred to as a bridge loan. As suggested by its name,

these loans are typically used to “bridge” a gap in liquidity until a more permanent means of financing

can be arranged. For example, a company may be planning an initial public offering, the completion of

which requires significant effort over an extended period. Accordingly, the company may enter into a

bridge loan to make sure that it has sufficient cash flows to maintain its operations in the interim.

Bridge loans are typically short-term loans of as short as a few weeks or months but the term may be

longer. Given that bridge loans are generally provided when a company is at risk of meeting its liquidity

requirements, an investor may not recover all of its investment in the bridge loans if the company is

unable to obtain permanent or longer-term financing. Therefore, interest rates on bridge loans are often

established at relatively high rates to compensate investors for greater exposure to credit risk.

In section 2, we discussed the guidance for analyzing settlement features in debt arrangements. The

following sections discuss features commonly included in bridge loans, such as fixed and variable share

settlement alternatives, and the application of the guidance discussed in section 2.

5.23.1.1 Variable-share settlement

Many contractual terms in a bridge loan are similar to those in other debt instruments. However, one

feature often included in a bridge loan is the ability for the issuer to settle its obligation by delivering a

variable number of its own shares (i.e., variable-share settlement). Specifically, many bridge loans

include a provision that permits (or requires) the borrower to settle the outstanding principal and

accrued interest by issuing a variable number of the shares issued in its next round of equity financing, if

and when that equity financing occurs.

Although variable-share settlement is often documented in the loan agreement as a “conversion,” the

feature does not expose the holder to any equity risk of the issuer upon settlement. This is because the

number of shares the holder will receive is a function of the price (i.e., fair value) of the shares issued in

the financing and the debt’s outstanding principal amount (plus accrued interest). The “conversion price”

is variable and will always equal the price (or a percentage thereof) of the shares issued in the next round

of financing, which results in the issuance of a variable number of shares.

For example, assume a bridge loan’s outstanding principal amount is $1,000, which will be settled in

shares using the issue price in the next round of equity financing. The following table calculates the

number of shares that would be delivered and their fair value, assuming various share issuance prices.

(A)

Principal

(B)

Price per share

(A)/(B)=(C)

Shares delivered

(C)*(B)=(D)

Fair value of shares delivered

$1,000

200

$1,000

$10

100

$1,000

$20

$1,000

$25

$1,000

$40

$1,000

The next round of equity financing may be referred to in loan agreements as a “qualified financing” or a similar term and would

be defined. For example, it might be defined as a transaction or series of transactions in which the issuer raises at least a certain

dollar amount (e.g., $10 million) in net proceeds. The “next round” may also be defined as the issuer’s initial public offering.

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As indicated in the last column, regardless of the issuance price of the shares, the aggregate fair value

transferred to the lender under variable-share settlement is fixed at the outstanding principal amount of

the bridge loan.

A common variation to the variable-share settlement illustrated above incorporates a percentage

discount to the issuance price (e.g., 20%) of the shares in the next round of equity financing. This results

in the issuer transferring a fixed amount of value upon settlement at an amount that will include a

premium in excess of the outstanding principal. For example, assume the bridge loan’s outstanding

principal amount is $1,000 and it will be settled in shares at 80% of the share issuance price in the next

round of equity financing (i.e., 20% discount). The following table illustrates the calculation of the number

of shares that would be delivered and their fair value, assuming various share issuance prices.

(A)

Principal

(B)

Price per share

(A)/((B)*80%)=(C)

Shares delivered

(C)*(B)=(D)

Fair value of shares delivered

$1,000

250

$1,250

$1,000

$10

125

$1,250

$1,000

$20

62.5

$1,250

$1,000

$25

$1,250

$1,000

$40

31.25

$1,250

The last column shows that, regardless of the price at which the shares are issued in the next round of

equity financing, the aggregate fair value transferred to the lender is fixed to include a premium to the

outstanding principal amount of the bridge loan.

5.23.1.2 Additional settlement features

Fixed-share conversion

Bridge loans may also include fixed-share conversion features. These conversion features typically

provide the lender with an option to convert the loan into a class of shares (e.g., common or preferred

shares of a particular class) that existed when the bridge loan was issued. The conversion price is often

fixed at the fair value of those shares when the bridge loan is issued. Because the number of shares the

lender would receive is fixed, this is a true conversion option that exposes the lender to fluctuations in

the fair value of the underlying shares.

These conversion features are often exercisable at the option of the lender only if an equity financing does

not occur by the stated maturity of the bridge loan. Sometimes, these conversion features are exercised

automatically at maturity (even if the lender receives less than the outstanding principal upon conversion).

Regardless of whether the conversion is optional or automatic, settlement of these features under their

original terms is accounted for as a conversion of the bridge loan as described in section 2.5.2.

Occasionally, the shares the lender will receive in a conversion do not exist when the bridge loan is

issued. Instead, the lender is entitled to receive shares of a new series of preferred stock. In these cases,

the bridge loan agreement may specify the terms of the “new preferred” shares. For example, the bridge

loan agreement may define the new preferred stock to be pari passu with the most senior series of

preferred stock outstanding at the time of conversion and to have all the same terms, rights, privileges

and restrictions as these most senior series of preferred stock.

Although settlement often includes any accrued but unpaid interest, it is excluded from this example for simplicity.

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Combination of fixed and variable share settlement

Bridge loans may include share-settlement features with a combination of a fixed and variable conversion

prices upon the next round of equity financing. These share-settlement features provide the lender with

an option (or an automatic obligation) to convert the loan into shares issued in the next round of equity

financing. The conversion price may be defined as the lesser of (1) a fixed price and (2) the share

issuance price in the next round of equity financing (or a percentage thereof). In this case, the lender is

only exposed to fluctuations in the fair value of the shares above the fixed price.

As an example, assume the conversion price is the lesser of $10 and the price per share in the next

round of equity financing. If the next stock issuance price is at or below $10, settlement will be

consistent with the variable-share-settlement discussed above. In that case, the lender receives a

variable number of shares but the value it receives will always equal the outstanding principal amount.

However, if the price per share in the next round of equity financing is above $10, settlement will be

consistent with the fixed-share conversion feature discussed above. The value of the shares the lender

receives will fluctuate with changes in the fair value of the shares. In this case, the lender will always

receive a settlement with a value at least equal to the principal amount and will receive additional value

when the price of the next round of equity financing is above $10.

5.23.2 Analysis

The accounting analysis for bridge loans follows the debt roadmap outlined in section 2. The following

illustration provides an example of a typical bridge loan issuance. Issuers should carefully consider the

different terms and features, as well as all relevant facts and circumstances, when determining the

appropriate accounting for bridge loans.

Illustration 5-23: Bridge loan with variable-share settlement and conversion features

An entity plans to raise $75 million through an IPO in the next year. To maintain operations and make

sure it has adequate funding to cover expenses it expects to incur prior to the IPO, the entity decides

to borrow $8 million by issuing a bridge loan with the following terms:

• The maturity is 18 months.

• The stated annual interest rate is 14% payable monthly.

• The principal amount is $8 million.

• If the entity completes an equity financing (including an IPO) that raises at least $20 million in net

proceeds (“qualified financing”), the principal and accrued interest outstanding as of that date

(“repayment amount”) automatically converts into shares of capital stock sold by the entity in the

qualified financing:

• The number of shares of capital stock to be delivered equals the repayment amount divided by

the purchase price for each share of capital stock the entity issued in a qualified financing.

• At maturity, if a qualified financing does not occur, the lender has the option to convert the bridge

loan into 1,000,000 common shares (i.e., conversion price of $8 per share).

The entity identifies the various features embedded in the bridge loan. It determines that the settlement

upon a qualified financing is a variable-share settlement feature as described in section 5.23.1.1. The

entity also determines that the optional conversion at maturity is a fixed-share conversion feature as

described in 5.23.1.2.

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5.23.2.1 ASC 480 considerations

Because the legal form of a bridge loan is debt, it would be recognized as a liability. However, because

bridge loans frequently contain variable-share settlement features (as described in section 5.23.1.1), an

analysis is required to determine whether the bridge loan is within the scope of ASC 480-10-25-14.

ASC 480-10-25-14 requires liability accounting for (1) any financial instrument that embodies an

unconditional obligation to transfer a variable number of shares or (2) a financial instrument other than

an outstanding share that embodies a conditional obligation to transfer a variable number of shares,

provided that, in both cases, the monetary value of the obligation is based solely or predominantly on,

among other things, a fixed monetary amount known at inception.

Evaluating whether a financial instrument is an obligation is the starting point in determining the

appropriate classification of the instrument under ASC 480. Because the event that may trigger variable-

share settlement is the occurrence of the next round of equity financing, which is considered in the

issuer’s control because the issuer may choose not to proceed with the financing, the issuer would not be

considered to have an obligation to deliver a variable number of shares. For example, the issuer may

begin to generate positive cash flows and, therefore, no longer need the next round of financing, or the

issuer may refinance the bridge loan with different lenders.

Alternatively, if the triggering event is determined not to be in the control of the issuer, further

consideration under ASC 480-10-25-14 would be required because the variable-share settlement would

be considered a conditional obligation of the issuer to deliver a variable number of shares. Issuers should

carefully consider all possible settlement outcomes under the bridge loan when evaluating whether the

instrument is a conditional obligation to deliver a variable number of the issuer’s shares with a monetary

value based predominantly on a fixed monetary amount.

If a bridge loan (1) obligates the borrower (either conditionally or unconditionally) to issue a variable

number of shares equal to a fixed monetary amount and (2) this obligation is the predominant settlement

outcome at inception, the bridge loan would be in the scope of ASC 480. In that case, the instrument is

initially recorded at fair value pursuant to ASC 480-10-30-7.

As discussed in section A.6.2.1, we generally believe that some of these obligations are, in substance,

“traditional” debt arrangements with the stock of the issuer used as the form of currency for repayment.

Therefore, the accounting guidance in ASC 835-30 (i.e., accrue to the redemption amount using the

interest method) may be applied unless some other accounting guidance permits or specifies another

measurement attribute (e.g., the fair value option is elected pursuant to ASC 825-10-15).

5.23.2.2 Embedded derivatives

If the bridge loan is not subsequently measured at fair value, any embedded derivative features should be

evaluated for bifurcation pursuant to ASC 815-15.

5.23.2.2.1 Variable-share settlement features

Although variable-share settlement features are often described as “conversion” features, they generally

do not expose the lender to changes in the fair value of the company’s shares. Therefore, they should be

evaluated as redemption features, not conversion features. The settlement upon a qualified financing in

Illustration 5-23 is a variable-share settlement feature.

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Accordingly, the guidance in section 2.2.5 should be applied to determine whether such features are

clearly and closely related to the debt host contract. If settlement of those features involves a substantial

premium or discount, the features are not considered clearly and closely related to the debt host because

they are also contingently exercisable (e.g., upon the occurrence of the next round of financing). The

lender may receive a substantial premium upon settlement if a discounted share price is used in determining

the number of shares to be issued. Additionally, if the bridge loan is issued contemporaneously with another

instrument (e.g., a warrant), an allocation of proceeds may create a substantial discount on the debt.

Further, although those features result in the settlement of the bridge loan in shares of a private company

that are generally not readily convertible to cash, they will meet the definition of a derivative pursuant to

ASC 815-10-15-107 through 15-109. That guidance states that the settlement of the debtor’s obligation

to the creditor upon exercise of a redemption feature meets the net settlement criterion.

If they are not bifurcated, variable-share settlement features generally should not be evaluated under the

beneficial conversion feature guidance as discussed in section D.3.2.3. An exception would be when

there is a fixed-share conversion element to the settlement feature as discussed in section 5.23.2.2.2.

Also, regardless of whether variable-share settlement features are bifurcated, the debt extinguishment

guidance in ASC 405-20 should be applied if the features are exercised because they represent

redemption features (see section 2.5.1 for more information).

5.23.2.2.2 Fixed-share conversion features

The bridge loan in Illustration 5-23 permits the lender to convert the bridge loan into common stock at a

fixed conversion price of $8 per share, if a qualified financing does not occur prior to maturity. Because

this settlement would be a true conversion, this type of feature should be evaluated for bifurcation

pursuant to ASC 815 and a beneficial conversion feature (BCF) pursuant to ASC 470-20.

If the shares that would be received under the conversion option are not readily convertible to cash, as is

the case with shares of most private companies, the conversion option would generally not meet the

definition of a derivative in ASC 815 (and therefore, bifurcation under ASC 815 would not be required).

In these cases, a determination will need to be made about whether a BCF should be recognized. Because

this conversion option is not considered contingently exercisable (i.e., it will become exercisable assuming

there are no changes to the current circumstances except for the passage of time), the recognition and

measurement of any BCF is required at inception. Refer to section D.3.1 for a discussion of a BCF that is

accounted for at inception.

However, as discussed above, some conversion features settle in a fixed number of new, to-be-issued

shares. In such cases, judgment is required to determine the appropriate recognition and measurement

of any BCF that may exist. Depending on the facts and circumstances, we generally believe reasonable

approaches may include:

• Estimate the fair value of the new, to-be-issued shares at inception — This approach may be possible

if the bridge loan agreement provides enough details for the issuer to reasonably determine the fair

value of the new shares. For example, if the bridge loan describes the shares as including all of the

same terms, rights and privileges as the previous round except for a few discrete matters, enough

information may exist. If this is not the case, this approach may not be appropriate.

• View the lack of information about the terms of the new, to-be-issued shares as a contingency — If

the entity is unable to reliably determine the fair value of the new, to-be-issued shares at inception,

there may be no commitment date as defined in the guidance on BCFs (see section D.3.1.1 for

further discussion). As a result, it may be appropriate to treat the feature as a contingent BCF. Refer

to Appendix D for further discussion.

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5.23.2.2.3 Combination of variable-share and fixed-share settlement features

Bridge loans may include settlement features that result in the delivery of a number of shares

determined based on a combination of fixed and variable conversion prices. For example, the feature

may define the “conversion price” as the lesser of (1) a fixed price and (2) the price at which the shares

are sold in the next round of financing. Judgment is required in these cases to determine whether the

settlement feature should be accounted for as a redemption or a conversion or, if the features are

deemed to be separate embedded features, as a redemption and a conversion.

ASC 815 does not explicitly address the unit of account at which an embedded feature should be

evaluated. We generally believe the combination of settlement features should be accounted for based

on its substance — that is, whether the combination is in substance a conversion feature or a redemption

feature as of the issuance date. This determination requires judgment based on the facts and

circumstances. For example, a bridge loan may be issued with a combination of settlement features that

has a fixed price per share that is extremely high in relation to the fair value of shares on the date of

issuance (i.e., ”out of the money”). In this case, the issuer may determine that the substance of the

combination of settlement features is a redemption feature because it is highly unlikely the share price

will appreciate above the fixed price per share during the expected life of the bridge loan. Said

differently, it is more likely the combination of settlement features will result in share-settled redemption

rather than fixed-share conversion.

However, it is frequently unclear at inception whether settlement as a fixed-share conversion or as a

share-settled redemption is more likely. Therefore, we believe one acceptable approach may be to

evaluate a combination of settlement features as separate embedded features:

• A variable-share settlement feature that is contingently exercisable if the price at which the shares

sold in the next round of equity financing is below the fixed price

• A fixed-share settlement feature that is contingently exercisable if the price at which the shares sold

in the next round of financing is at or above the fixed price

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A Distinguishing liabilities from equity

A.1 Summary and overview

While ASC 480 does not define an equity instrument or a liability, it does require three types of

freestanding instruments to be classified as liabilities (or assets in some cases), including:

• Shares that are mandatorily redeemable (refer to section A.4)

• Financial instruments other than a share that represent or are indexed to obligations to repurchase

the issuer’s equity shares by transferring assets (refer to section A.5)

• Certain obligations to issue a variable number of shares (refer to section A.6)

ASC 480 addresses only freestanding instruments and is not applied to embedded features in

instruments that are not derivatives in their entirety. Embedded features in instruments that are

classified as a liability pursuant to ASC 480 should be evaluated for potential embedded derivatives that

should be bifurcated pursuant to in ASC 815-15.

Redeemable shares and instruments that are generally related to an issuer’s own shares that are not

classified as liabilities pursuant to ASC 480 are subject to the following guidance:

• ASC 815-40-15-5 through 15-8 and 55-26 through 55-48 which is referred to throughout this

publication as “the indexation guidance.” Refer to section B.3 for a discussion of the

indexation guidance.

• ASC 815-40-25-1 through 25-38, 35-1 through 35-13, 40-1 and 40-2, and 55-2 through 55-18,

which is referred to throughout this publication as “the equity classification guidance.” Refer to

section B.4 for a discussion of the equity classification guidance.

• ASC 480-10-S99-1 (the Codification reference for the SEC’s Accounting Series Release 268,

Redeemable Preferred Stocks), and its interpretive guidance in ASC 480-10-S99-3A, which is

referred to throughout this publication as “the SEC staff’s redeemable equity guidance.” Refer to

Appendix E for a discussion of the SEC staff’s guidance on redeemable instruments.

A.2 Background and prior accounting

Excerpt from Accounting Standards Codification

Distinguishing Liabilities from Equity — Overall

Overview and Background

General

480-10-05-1

The Codification contains separate Topics for liabilities and equity, including a separate Topic for debt.

The Distinguishing Liabilities from Equity Topic contains only the Overall Subtopic. This Subtopic

establishes standards for how an issuer classifies and measures in its statement of financial position

certain financial instruments with characteristics of both liabilities and equity. Section 480-10-25

requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in

some circumstances) because that financial instrument embodies an obligation of the issuer.

Appendices

A Distinguishing liabilities from equity

Financial reporting developments Issuer’s accounting for debt and equity financings | A-2

480-10-05-2

All of the following are examples of an obligation:

a. An entity incurs a conditional obligation to transfer assets by issuing (writing) a put option that

would, if exercised, require the entity to repurchase its equity shares by physical settlement.

(Further, an instrument that requires the issuer to settle its obligation by issuing another instrument

[for example, a note payable in cash] ultimately requires settlement by a transfer of assets.)

b. An entity incurs a conditional obligation to transfer assets by issuing a similar contract that

requires or could require net cash settlement.

c. An entity incurs a conditional obligation to issue its equity shares by issuing a similar contract that

requires net share settlement.

480-10-05-3

In contrast, by issuing shares of stock, an entity generally does not incur an obligation to redeem the

shares, and, therefore, that entity does not incur an obligation to transfer assets or issue additional

equity shares. However, some issuances of stock (for example, mandatorily redeemable preferred

stock) do impose obligations requiring the issuer to transfer assets or issue its equity shares.

480-10-05-4

For certain financial instruments, Section 480-10-25 requires consideration of whether monetary

value would remain fixed or would vary in response to changes in market conditions.

480-10-05-5

How the monetary value of a financial instrument varies in response to changes in market conditions

depends on the nature of the arrangement, including, in part, the form of settlement.

480-10-05-6

For purposes of this Subtopic, three related terms—shares, equity shares, and issuer’s equity shares—

are used in the particular ways defined in the glossary.

Objectives

General

480-10-10-1

The objective of this Subtopic is to require issuers to classify as liabilities (or assets in some

circumstances) three classes of freestanding financial instruments that embody obligations for the issuer.

Prior to the issuance of Statement 150, Accounting for Certain Financial Instruments with Characteristics

of both Liabilities and Equity (Statement 150, now the guidance in ASC 480), instruments that required

the transfer of cash by the issuer upon settlement were inconsistently classified. For example, instruments

that are equity in legal form may require the issuer to redeem the instrument in certain circumstances that

are outside of the issuer’s control (e.g., a mandatory redemption or a contingent redemption). While public

companies had to consider the SEC staff’s redeemable equity guidance, the instruments were not classified

as liabilities. Instead, the redemption amount of those instruments was presented outside of permanent

equity (i.e., between liabilities and permanent equity, referred to as “temporary equity” or “mezzanine”).

As another example, many freestanding equity contracts that are indexed to, and potentially settled in,

the issuer’s own shares could have received equity classification pursuant to the then-existing EITF

guidance (codified in ASC 815-40), even though the instruments could require cash settlement by the

issuer (e.g., if physical settlement required the transfer of cash by the issuer).

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Statement 150 addressed the classification of certain instruments, including: (1) mandatorily redeemable

shares (2) certain equity contracts that represent obligations or potential obligations to repurchase the

issuer’s shares (e.g., written put options that permit the counterparty to sell shares to the issuer at a

specified price) and (3) obligations that could be settled in shares but with a value that was not indexed to

the issuer’s shares (e.g., an obligation to deliver shares with a fixed value on the settlement date, sometimes

referred to as “stock-settled debt”).

A.3 Scope of ASC 480

Excerpt from Accounting Standards Codification

Distinguishing Liabilities from Equity — Overall

Scope and Scope Exceptions

480-10-15-1

The Scope Section of the Overall Subtopic establishes the pervasive scope for the Distinguishing

Liabilities from Equity Topic.

480-10-15-2

The guidance in the Distinguishing Liabilities from Equity Topic applies to all entities.

480-10-15-3

The guidance in the Distinguishing Liabilities from Equity Topic applies to any freestanding financial

instrument, including one that has any of the following attributes:

a. Comprises more than one option or forward contract

b. Has characteristics of both a liability and equity and, in some circumstances, also has

characteristics of an asset (for example, a forward contract to purchase the issuer’s equity shares

that is to be net cash settled). Accordingly, this Topic does not address an instrument that has

only characteristics of an asset.

480-10-15-4

For example, an instrument that consists of a written put option for an issuer’s equity shares and a

purchased call option and nothing else is a freestanding financial instrument (paragraphs 480-10-55-18

through 55-20 provide examples of such instruments). That freestanding financial instrument embodies

an obligation to repurchase the issuer’s equity shares and is subject to the requirements of this Topic.

480-10-15-5

Because paragraph 480-10-15-3 limits the scope of this Topic to freestanding instruments, this

Topic does not apply to a feature embedded in a financial instrument that is not a derivative

instrument in its entirety.

480-10-15-6

Paragraphs 480-10-55-53 through 55-58 apply to the specific circumstances described by those

paragraphs in which a majority owner enters into a transaction in the shares of a consolidated

subsidiary and a derivative instrument indexed to the noncontrolling interest in that subsidiary.

480-10-15-8A

The guidance in this Topic does not apply to the following instruments:

a. Registration payment arrangements within the scope of Subtopic 825-20.

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Recognition

480-10-25-1

The guidance in this Section shall be applied to a freestanding financial instrument in its entirety. Any

nonsubstantive or minimal features shall be disregarded in applying the classification provisions of this

Section. Judgment, based on consideration of all the terms of an instrument and other relevant facts

and circumstances, is necessary to distinguish substantive, nonminimal features from nonsubstantive

or minimal features.

480-10-25-2

For purposes of applying paragraph 815-10-15-74(a) in analyzing an embedded feature as though it

were a separate instrument, paragraphs 480-10-25-4 through 25-14 shall not be applied to the

embedded feature. Embedded features shall be analyzed by applying other applicable guidance.

Glossary

480-10-20

Employee Stock Ownership Plan

An employee stock ownership plan is an employee benefit plan that is described by the Employee

Retirement Income Security Act of 1974 and the Internal Revenue Code of 1986 as a stock bonus

plan, or combination stock bonus and money purchase pension plan, designed to invest primarily in

employer stock. Also called an employee share ownership plan.

Equity Shares

Equity shares refers only to shares that are accounted for as equity.

Financial Instrument

Cash, evidence of an ownership interest in an entity, or a contract that both:

a. Imposes on one entity a contractual obligation either:

1. To deliver cash or another financial instrument to a second entity

2. To exchange other financial instruments on potentially unfavorable terms with the second entity.

b. Conveys to that second entity a contractual right either:

1. To receive cash or another financial instrument from the first entity

2. To exchange other financial instruments on potentially favorable terms with the first entity.

The use of the term financial instrument in this definition is recursive (because the term financial

instrument is included in it), though it is not circular. The definition requires a chain of contractual

obligations that ends with the delivery of cash or an ownership interest in an entity. Any number of

obligations to deliver financial instruments can be links in a chain that qualifies a particular contract as

a financial instrument.

Contractual rights and contractual obligations encompass both those that are conditioned on the

occurrence of a specified event and those that are not. All contractual rights (contractual obligations)

that are financial instruments meet the definition of asset (liability) set forth in FASB Concepts

Statement No. 6, Elements of Financial Statements, although some may not be recognized as assets

(liabilities) in financial statements—that is, they may be off-balance-sheet—because they fail to meet

some other criterion for recognition.

For some financial instruments, the right is held by or the obligation is due from (or the obligation is

owed to or by) a group of entities rather than a single entity.

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Freestanding Financial Instrument

A financial instrument that meets either of the following conditions:

a. It is entered into separately and apart from any of the entity’s other financial instruments or

equity transactions.

b. It is entered into in conjunction with some other transaction and is legally detachable and

separately exercisable.

Issuer

The entity that issued a financial instrument or may be required under the terms of a financial

instrument to issue its equity shares.

Issuer’s Equity Shares

The equity shares of any entity whose financial statements are included in the consolidated financial

statements.

Obligation

A conditional or unconditional duty or responsibility to transfer assets or to issue equity shares.

Because Topic 480 relates only to financial instruments and not to contracts to provide services and

other types of contracts, but includes duties or responsibilities to issue equity shares, this definition of

obligation differs from the definition found in FASB Concepts Statement No. 6, Elements of Financial

Statements, and is applicable only for items in the scope of that Topic.

Shares includes various forms of ownership that may not take the legal form of securities (for

example, partnership interests), as well as other interests, including those that are liabilities in

substance but not in form. (Business entities have interest holders that are commonly known by

specialized names, such as stockholders, partners, and proprietors, and by more general names, such

as investors, but all are encompassed by the descriptive term owners. Equity of business entities is,

thus, commonly known by several names, such as owners’ equity, stockholders’ equity, ownership,

equity capital, partners’ capital, and proprietorship. Some entities [for example, mutual organizations]

do not have stockholders, partners, or proprietors in the usual sense of those terms but do have

participants whose interests are essentially ownership interests, residual interests, or both.)

A.3.1 Obligations

ASC 480 applies only to freestanding financial instruments that embody obligations of the issuer.

ASC 480 defines an obligation as “a conditional or unconditional duty or responsibility on the part of the

issuer to transfer assets or to issue its equity shares.” Accordingly, purchased options do not embody

obligations to the purchaser because they permit, but do not require, the purchaser to buy or sell shares

(whether on a gross or net basis). As a result, purchased options on their own are not subject to ASC 480.

On the other hand, contracts that require or could require the issuer to purchase or issue its shares

(e.g., forward contracts, written options, mandatorily redeemable shares) do represent obligations.

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Certain freestanding instruments that include a written option component may also represent obligations.

For example, a purchased call option and a written put option on the issuer’s shares may be combined in

a single instrument. Even though the value of the purchased call option may exceed the value of the written

put option at inception (i.e., resulting in a premium being paid for a net purchased option), the written

put component of the instrument imposes a conditional obligation on the issuer and is, therefore, within

the scope of ASC 480. The investment would be an asset if the fair value of the purchased call option

exceeds the fair value of the written put option, and would represent a liability if the opposite were true.

An understanding of the contractual terms is important in determining whether the issuer has an

obligation. An obligation does not exist when the obligation is triggered by a future event completely

within the issuer’s control. The obligation will be evaluated when the issuer takes (or fails to take) action.

Determining whether an obligation is triggered by an event within the issuer’s control — regardless of

probability, is a matter of facts and circumstances.

However, if certain criteria are met (as discussed in section A.4), some obligations in the form of

redeemable shares may be classified as equity rather than liabilities.

A.3.2 Freestanding financial instruments

ASC 480 applies only to freestanding financial instruments. As a result, ASC 480 does not apply to

features embedded in debt or equity instruments. However, this scope restriction does not apply to the

extent that the debt or equity host is non-substantive or minimal.

Refer to Question 1 in section A.8 — How does the scope of ASC 480 interact with other areas of the

financial instrument guidance?

A.3.2.1 Identifying ‘nonsubstantive or minimal’ features

While ASC 480 provides little guidance about what constitutes a “nonsubstantive or minimal” host

contract, the provision is intended to prevent circumvention of its requirements by embedding what

otherwise would be a freestanding instrument into a nominal host. For example, if an entity wanted to

write a put option on its own shares but avoid liability accounting for that option, it could embed that

option in a share of preferred stock that has minimal value apart from the option. To the extent that the

host is relatively inconsequential or has little value when compared to the embedded feature, the host

instrument should be ignored and the entire instrument should be accounted for as a liability (a written

put option) pursuant to ASC 480.

While the determination of what constitutes a non-substantive or minimal feature included in an

instrument will require significant judgment, we believe that the reason for embedding the feature in a

host contract should be considered. If there is no apparent business purpose for embedding the feature

in a minimal host contract, other than to obtain a specific accounting result, the host instrument should

likely be ignored. This determination should be made based on the individual facts and circumstances.

Additional guidance on evaluating non-substantive or minimal features is included in section A.4.1.3.

Refer to Question 2 in section A.8 — What is an example of an option to redeem shares embedded in a

minimal host?

A.3.2.2 Determining whether an instrument is freestanding

ASC 480 provides little interpretive guidance on the definition of a “freestanding” financial instrument.

We believe that the substance of a transaction should be considered in making this determination.

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In this regard, whether an instrument is documented in a separate contract is not necessarily

determinative that it is freestanding, particularly when a contract is entered into in conjunction with

another transaction. If the transactions are with the same party and involve the same underlying (in this

context, the issuer’s shares), it is important to assess whether the instruments are (1) legally detachable

and (2) separately exercisable. If both conditions are met, the instrument is considered freestanding.

• Legally detachable — Generally, whether two instruments can be legally separated and transferred

such that the two instruments may be held by different parties. As long as an investor is somehow

able to separate the instruments, they are considered legally detachable. However, if an instrument

can be separately transferred only with the consent of the counterparty, we generally believe that

the instrument is not legally detachable. On the other hand, the legal detachability criteria may be

met if the counterparty cannot unreasonably withhold consent. The determination of whether two

instruments can be legally separated and transferred such that the two instruments may be held by

different parties is a legal matter that may require advice from legal counsel.

• Separately exercisable — Generally, whether one instrument can be exercised without terminating

the other instrument (i.e., through redemption, simultaneous exercise or expiration).

If the exercise of one instrument must result in the termination of the other, the instruments would

typically not be considered freestanding pursuant to ASC 480. In contrast, if one instrument can be

exercised while the other instrument continues to be outstanding (e.g., if a forward can be satisfied with

any outstanding shares of the issuer or can be net settled), provided the instruments are also legally

detachable, the instruments would be considered freestanding.

For example, if a parent company enters into a contract with the only minority shareholder of its

privately held subsidiary that allows the shareholder to put its shares to the parent at a fixed price (gross

settlement), that put option generally would be considered to be embedded in the related shares. As a

result, the redeemable equity securities would not be subject to ASC 480 (although if the parent is a

public company, the SEC staff’s redeemable equity guidance would apply to those redeemable shares).

However, if the same parent writes a put option on publicly traded common stock of a different

subsidiary, and that put option allows the counterparty to put any common shares of the subsidiary to

the parent at a fixed price (e.g., the counterparty could put shares of the subsidiary already owned or

buy shares in the public market to exercise the put), that written put option would be considered

freestanding and classified as a liability pursuant to ASC 480.

A.3.3 Definition of issuer’s shares (including shares of subsidiaries)

ASC 480 applies to certain financial instruments that are based on variation in the fair value of, or

potentially settled in, equity shares (i.e., shares that are accounted for as equity) of the issuer. ASC 480

defines the concept of “issuer’s shares” broadly. All forms of ownership interests, including partnership

interests and residual interests in mutual enterprises, are considered issuer’s equity shares pursuant to

ASC 480. Further, instruments deriving value from any form of the issuer’s equity shares, regardless of

whether those shares take the legal form of securities, are within the scope of this guidance.

ASC 480-10-15 states that instruments issued by members of a consolidated group that are indexed to

the equity shares of another member of the consolidated group are within the scope of ASC 480. In other

words, for instruments subject to its scope, ASC 480 considers equity shares of any member of a

consolidated group to be the issuer’s equity shares.

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A.3.4 Prohibition against combining separate contracts

Excerpt from Accounting Standards Codification

Distinguishing Liabilities from Equity — Overall

Recognition

480-10-25-15

A freestanding financial instrument that is within the scope of this Subtopic shall not be combined with

another freestanding financial instrument in applying paragraphs 480-10-25-4 through 25-14 unless

combination is required under the provisions of Topic 815. For example, a freestanding written put

option that is classified as a liability under this Subtopic shall not be combined with an outstanding

equity share.

ASC 480 prohibits the combination of any freestanding financial instrument within its scope with any

other instrument unless ASC 815 requires the combination of those instruments.

In paragraphs B50 and B51 of the Basis for Conclusions of Statement 150, the FASB indicated it

precluded combining separate instruments because of ASC 815’s prohibition on combining separate

instruments (i.e., synthetic accounting). This prohibition also avoids the inadvertent or planned

circumvention of the requirements of ASC 480.

Combining an instrument that is a liability within the scope of ASC 480 with another freestanding

instrument might (1) cause a freestanding instrument to be outside the scope of ASC 480, (2) change

the reported amount of the liability or (3) change the required measurement. For example, although a

freestanding written put option would be a liability on its own pursuant to ASC 480, if combined with an

equity share, it would be classified in equity with the share unless the embedded derivative guidance

required the put to be bifurcated.

We generally believe the decision to combine two instruments that are issued contemporaneously should

be made pursuant to the following framework:

• Combine the instruments if required pursuant to ASC 815, then evaluate the combined instrument

pursuant to ASC 480 and ASC 815.

• If both (1) ASC 815 does not require the combination of the two instruments and (2) one of the

instruments is within the scope of ASC 480, do not combine the two instruments.

• If both (1) ASC 815 does not require the combination of the two instruments and (2) neither of the

instruments is within the scope of ASC 480, combine the instruments under the basic concepts

around combination if applicable.

Refer to section 1.2.1.1 for a discussion of the concepts of combining financial instruments.

For example, if an issuer writes a put option on its own shares and simultaneously purchases a separate

call option on its own shares with the same counterparty, those separate instruments would first be

considered pursuant to the guidance in ASC 815 for combination. If not combined pursuant to that

guidance, those instruments would not be combined pursuant to ASC 480 because the written put is

classified as a liability pursuant to ASC 480. The purchased call would be classified either as an asset or

as equity, depending on the specific terms of the instrument, based on the requirements of ASC 815-40.

Refer to Question 3 in section A.8 — What are examples of various combinations of a share, a written put

and a purchased call to illustrate the assessment of combinations of instruments?

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A.3.5 Instruments not within the scope of certain classification, measurement and

disclosure provisions

Excerpt from Accounting Standards Codification

Distinguishing Liabilities from Equity — Overall

Scope and Scope Exceptions

Instruments Not within Scope of Certain Classification, Measurement, and Disclosure Provisions

of This Subtopic

Certain Mandatorily Redeemable Financial Instruments of Nonpublic Entities

480-10-15-7A

The classification, measurement, and disclosure guidance in this Subtopic does not apply to

mandatorily redeemable financial instruments that meet both of the following:

a. They are issued by nonpublic entities that are not Securities and Exchange Commission (SEC)

registrants.

b. They are mandatorily redeemable, but not on fixed dates or not for amounts that either are fixed or

are determined by reference to an interest rate index, currency index, or another external index.

480-10-15-7B

Mandatorily redeemable financial instruments issued by an SEC registrant are not eligible for the scope

exception in paragraph 480-10-15-7A, even if the entity meets the definition of a nonpublic entity.

480-10-15-7C

Some entities have issued shares that are required to be redeemed under related agreements. If the

shares are issued with a redemption agreement and the required redemption relates to those

specific underlying shares, the shares are mandatorily redeemable. If an entity with such shares

and redemption agreement is a nonpublic entity that is not an SEC registrant, those mandatorily

redeemable shares meet the scope exception in paragraph 480-10-15-7A if they meet the conditions

specified in that paragraph.

480-10-15-7D

Although the disclosure requirements of this Subtopic do not apply for those mandatorily redeemable

instruments of certain nonpublic companies that meet the scope exception in paragraph 480-10-15-7A,

the requirements of Subtopic 505-10 still apply. In particular, paragraph 505-10-50-3 requires

information about the pertinent rights and privileges of the various securities outstanding, which

includes mandatory redemption requirements. Paragraph 505-10-50-11 also requires disclosure of

the amount of redemption requirements for all issues of stock that are redeemable at fixed or

determinable prices on fixed or determinable dates in each of the next five years.

Certain Mandatorily Redeemable Noncontrolling Interests

480-10-15-7E

The guidance in this Subtopic does not apply to mandatorily redeemable noncontrolling interests (of all

entities, public and nonpublic) as follows:

a. The classification and measurement provisions of this Subtopic do not apply to mandatorily

redeemable noncontrolling interests that would not have to be classified as liabilities by the

subsidiary, under the only upon liquidation exception in paragraphs 480-10-25-4 and 480-10-25-6,

but would be classified as liabilities by the parent in consolidated financial statements.

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b. The measurement provisions of this Subtopic do not apply to other mandatorily redeemable

noncontrolling interests that were issued before November 5, 2003, both for the parent in

consolidated financial statements and for the subsidiary that issued the instruments that result in

the mandatorily redeemable noncontrolling interest. For those instruments, the measurement

guidance for redeemable shares and noncontrolling interests in other predecessor literature (for

example, in paragraph 480-10-S99-3A) continues to apply.

480-10-15-7F

All public entities as well as nonpublic entities that are SEC registrants with mandatorily redeemable

noncontrolling interests subject to the classification and measurement scope exception in paragraph

480-10-15-7E are required to follow the disclosure requirements in paragraphs 480-10-50-1 through

50-3 as well as disclosures required by other applicable guidance.

Recognition

Mandatorily Redeemable Financial Instruments

480-10-25-4

A mandatorily redeemable financial instrument shall be classified as a liability unless the redemption is

required to occur only upon the liquidation or termination of the reporting entity.

The following table summarizes the exceptions to the guidance in ASC 480-10 for certain mandatorily

redeemable financial instruments. Sections A.3.5.1, A.3.5.2 and A.4.1 provide further discussions on

these exceptions.

Does ASC 480-10 apply?

Exception

Reporting entity

Classification

Measurement

Disclosure

Refer to

section

Certain mandatorily

redeemable financial

instruments

Nonpublic entities that

are not SEC registrants

A.3.5.1

Mandatorily redeemable NCI

that are redeemable only upon

the liquidation of the subsidiary

Parent (consolidated

financial statements)

Yes

A.3.5.2

Mandatorily redeemable NCI

issued before 5 November 2003

Parent (consolidated

financial statements)

and subsidiary

Yes

A.3.5.2

Financial instruments that

are mandatorily redeemable

only upon the liquidation

or termination of the

reporting entity

All entities

Yes

A.4.1

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SEC registrants should note that even if they issue instruments that qualify for an exception from ASC 480-10,

certain SEC guidance may apply. In a speech

at the 2003 AICPA National Conference on Current SEC

Developments, an SEC staff member said entities with instruments that qualify for the deferral of certain

provisions of ASC 480 (which became scope exceptions that were later codified in ASC 480-10-15-7A

through 15-7F) should refer to the SEC staff guidance in ASC 480-10-S99-3A on how to classify and/or

measure securities that will not be fully accounted for under ASC 480-10. In the speech, the SEC staff stated:

“Entities with instruments that qualify for the deferral in FSP FAS 150-3

should refer to Topic D-98

for guidance related to classification and/or measurement, as applicable, for those securities that … will

not be fully accounted for in accordance with Statement 150.

In other words, if both the classification

and measurement guidance in Statement 150 has been deferred for an instrument, look to Topic D-98

for both classification and measurement guidance. If only the measurement guidance in Statement 150

has been deferred for an instrument, look to Topic D-98 for continued measurement guidance.”

Refer to Appendix E for further discussion on the application of ASC 480-10-S99-3A.

A.3.5.1 Scope exception for certain mandatorily redeemable shares of nonpublic companies

The classification, measurement and disclosure provisions of ASC 480 do not apply to certain mandatorily

redeemable financial instruments issued by nonpublic entities that also are not SEC registrants. These

financial instruments are mandatorily redeemable, but not on fixed dates or for amounts that either are

fixed or determined by reference to an interest rate index, currency index or another external index.

For purposes of this scope exception, SEC registrants are defined as entities, or entities that are

controlled by entities, that (1) have issued or will issue debt or equity securities that are traded in a public

market (a domestic or foreign stock exchange or an over-the-counter market, including local or regional

markets), (2) are required to file financial statements with the SEC or (3) provide financial statements for

the purpose of issuing any class of securities in a public market. The definition of a “nonpublic” entity in

the ASC Master Glossary that applies to ASC 480 includes any entity other than one that (1) has equity

securities trade in a public market, either on a stock exchange (domestic or foreign) or in the over-the-

counter market, including securities quoted only locally or regionally, (2) makes a filing with a regulatory

agency in preparation for the sale of any class of equity securities in a public market or (3) is controlled

by an entity covered by (1) or (2). As a result, an issuer that is an SEC registrant only by virtue of the fact

that it has debt that is registered with the SEC would be considered nonpublic pursuant to ASC 480 but

could not apply the scope exception described in this section.

Some nonpublic entities have issued shares that are required to be redeemed pursuant to related

agreements (e.g., a forward contract). If the shares are issued with the redemption agreement and the

required redemption relates to those specific underlying shares, the shares are mandatorily redeemable

(i.e., the forward contract is not considered freestanding). If an entity with such shares and a redemption

agreement is a nonpublic entity that is not an SEC registrant, the scope exception in ASC 480-10-15-7A

applies to those mandatorily redeemable shares.

Gregory A. Faucette, 2003 – Refer to SEC website at http://www.sec.gov/news/speech/spch121103gaf.htm.

Codified in ASC 480-10-15-7A through 15-7F

Codified in ASC 480-10-S99-3A

Codified in ASC 480-10

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Although the disclosure requirements of ASC 480 do not apply to mandatorily redeemable instruments of

non-SEC registrants, the requirements of ASC 505-10 still apply. In particular, ASC 505-10-50-3 requires

information about the rights and privileges of the various securities outstanding (including mandatory

redemption requirements) and ASC 505-10-50-11 requires disclosure of the amounts payable on stock that

is redeemable at fixed or determinable prices on fixed or determinable dates in each of the next five years.

A.3.5.2 Scope exception for certain mandatorily redeemable noncontrolling interests

ASC 480-10-15-7E provides the following scope exception for mandatorily redeemable NCI for all

entities (public and nonpublic):

a. For NCI that are classified as equity in the financial statements of the issuing subsidiary but would be

classified as a liability in the parent’s financial statements pursuant to ASC 480 (e.g., NCI in limited-

life subsidiaries), the application of the classification and measurement guidance in ASC 480 does

not apply. However, the disclosure requirements of ASC 480 continue to apply.

b. For mandatorily redeemable NCI that are classified as liabilities in the financial statements of the

subsidiary (i.e., NCI that are not subject to the scope exception of ASC 480’s classification

requirements because they must be redeemed prior to the liquidation of the subsidiary) that were

issued before 5 November 2003, the measurement provisions of ASC 480 do not apply, both for the

parent in consolidated financial statements and for the subsidiary that issued the instruments that

result in the mandatorily redeemable NCI. However, the classification and disclosure requirements of

ASC 480 continue to apply.

Refer to the following Questions in section A.8:

• Question 6 — If the NCI of a consolidated limited-life subsidiary is mandatorily redeemable, how does

that affect the consolidated financial statements? Are such interests affected by the scope exception

in ASC 480?

• Question 9 — How does the scope exception in ASC 480 affect trust preferred securities?

• Question 12 — How should an entity measure and present mandatorily redeemable NCI classified as

liabilities that were issued before 5 November 2003?

A.3.6 Contingent consideration in a business combination

Excerpt from Accounting Standards Codification

Distinguishing Liabilities from Equity

Scope and Scope Exceptions

480-10-15-9

Subtopic 805-30 provides guidance on the recognition and initial measurement of consideration

issued in a business combination, including contingent consideration.

480-10-15-10

However, when recognized, a financial instrument within the scope of this Topic that is issued as

consideration (whether contingent or noncontingent) in a business combination shall be classified

pursuant to the requirements of this Topic.

Subsequent Measurement

480-10-35-4A

Contingent consideration issued in a business combination that is classified as a liability in accordance

with the requirements of this Topic shall be subsequently measured at fair value in accordance with

805-30-35-1.

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The recognition and measurement guidance for contingent consideration in ASC 805 requires an

acquirer to recognize contingent consideration at fair value as of the acquisition date as part of the

consideration transferred in exchange for the acquired business. ASC 480’s provisions should be

considered in classifying contingent consideration issued in the form of a financial instrument (and may

also indirectly affect its subsequent measurement).

If the contingent consideration arrangement pursuant to ASC 805 requires the transfer of or is indexed

to equity instruments of the acquirer, ASC 480 and the indexation and equity classification guidance in

ASC 815-40 generally should be considered to determine whether to classify the arrangement in equity

or as a liability (or asset). Refer to sections 6.4.3 and 8.3.2 of our FRD publication, Business

combinations, for further discussion of the classification and presentation of contingent consideration in

a business combination, respectively.

Pursuant to ASC 805-30-35-1(a), if a contingent consideration arrangement meets the criteria to be

classified as equity, the carrying amount (i.e., the acquisition date fair value) of the contingent

consideration is not subsequently remeasured unless adjustments are made during the measurement

period to the provisional initial fair value due to the discovery of additional facts and circumstances that

existed as of the acquisition date (i.e., the adjustments qualify as measurement period adjustments, as

discussed in section 7.3.3 of our FRD publication, Business combinations).

Pursuant to ASC 805-30-35-1(b), if a contingent consideration arrangement is classified as a liability (or

an asset), the carrying amount should be remeasured to fair value at each reporting date. Except for

qualifying measurement period adjustments (see above), subsequent changes in the fair value of the

liability should be recognized in earnings unless the contingent consideration is designated as a hedging

instrument in a qualifying hedge within the scope of ASC 815.

Refer to section 6.4 of our FRD publication, Business combinations, for further discussion of the

accounting for contingent consideration.

A.3.7 Share-based compensation

Excerpt from Accounting Standards Codification

Distinguishing Liabilities from Equity — Overall

Scope and Scope Exceptions

480-10-15-8

The guidance in the Distinguishing Liabilities from Equity Topic does not apply to an obligation under

share-based compensation arrangements if that obligation is accounted for under Topic 718. For

example, employee stock ownership plan shares or freestanding agreements to repurchase those

shares are not within the scope of this Topic because those shares are accounted for under Subtopic

718-40 through the point of redemption. However, this Topic does apply to a freestanding financial

instrument that was issued under a share-based compensation arrangement but is no longer subject to

Topic 718. For example, this Topic applies to a mandatorily redeemable share issued upon a grantee’s

exercise of a share option. (Topic 718 provides accounting guidance for dividends on allocated shares,

redemption of shares, recognition of expense, and computing earnings per share [EPS].) However,

employee stock ownership plan shares that are mandatorily redeemable or freestanding agreements to

repurchase those shares continue to be subject to other applicable guidance related to Subtopic 718-40.

For the classification of a contingent consideration arrangement settled in or indexed to equity instruments of the acquirer in an

asset acquisition, refer to section A.2.3.2 of our FRD publication, Business combinations.

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ASC 480 does not apply to obligations incurred pursuant to stock compensation arrangements accounted

for in accordance with ASC 718. However, ASC 480 does apply to a freestanding financial instrument that

is issued under a share-based compensation arrangement that is no longer subject to ASC 718. For

example, ASC 480 applies to mandatorily redeemable shares issued upon an employee’s exercise of an

employee stock option.

While ASC 480 excludes share-based payments from its scope, certain concepts in ASC 480 apply to

share-based payments accounted for under ASC 718. ASC 718 states that share-based payments that

would be classified as liabilities under ASC 480 (absent ASC 480’s exemption for share-based payments)

must be classified as liabilities under ASC 718, unless ASC 718 specifically requires equity classification.

Refer to section 5 of our FRD publication, Share-based payment, for further discussion on the

accounting for liability instruments.

A.4 Mandatorily redeemable financial instruments — recognition and measurement

Excerpt from Accounting Standards Codification

Distinguishing Liabilities from Equity — Overall

Recognition

480-10-25-4

A mandatorily redeemable financial instrument shall be classified as a liability unless the redemption is

required to occur only upon the liquidation or termination of the reporting entity.

480-10-25-5

A financial instrument that embodies a conditional obligation to redeem the instrument by transferring

assets upon an event not certain to occur becomes mandatorily redeemable if that event occurs, the

condition is resolved, or the event becomes certain to occur.

480-10-25-6

In determining if an instrument is mandatorily redeemable, all terms within a redeemable instrument

shall be considered. The following items do not affect the classification of a mandatorily redeemable

financial instrument as a liability:

a. A term extension option

b. A provision that defers redemption until a specified liquidity level is reached

c. A similar provision that may delay or accelerate the timing of a mandatory redemption.

480-10-25-7

If a financial instrument will be redeemed only upon the occurrence of a conditional event, redemption

of that instrument is conditional and, therefore, the instrument does not meet the definition of

mandatorily redeemable financial instrument in this Subtopic. However, that financial instrument

would be assessed at each reporting period to determine whether circumstances have changed such

that the instrument now meets the definition of a mandatorily redeemable instrument (that is, the

event is no longer conditional). If the event has occurred, the condition is resolved, or the event has

become certain to occur, the financial instrument is reclassified as a liability.

Initial Measurement

480-10-30-1

Mandatorily redeemable financial instruments shall be measured initially at fair value.

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480-10-30-2

If a conditionally redeemable instrument becomes mandatorily redeemable, upon reclassification the

issuer shall measure that liability initially at fair value and reduce equity by the amount of that initial

measure, recognizing no gain or loss.

Subsequent Measurement

480-10-35-3

Forward contracts that require physical settlement by repurchase of a fixed number of the issuer’s

equity shares in exchange for cash and mandatorily redeemable financial instruments shall be

measured subsequently in either of the following ways:

a. If both the amount to be paid and the settlement date are fixed, those instruments shall be

measured subsequently at the present value of the amount to be paid at settlement, accruing

interest cost using the rate implicit at inception.

b. If either the amount to be paid or the settlement date varies based on specified conditions, those

instruments shall be measured subsequently at the amount of cash that would be paid under the

conditions specified in the contract if settlement occurred at the reporting date, recognizing the

resulting change in that amount from the previous reporting date as interest cost.

480-10-35-4

Cash (as that term is used in the preceding paragraph) includes foreign currency, so physically settled

forward purchase contracts in exchange for foreign currency shall be measured as provided in the

preceding paragraph then remeasured under Topic 830.

Glossary

480-10-20

Mandatorily Redeemable Financial Instrument

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.

Noncontrolling Interest

The portion of equity (net assets) in a subsidiary not attributable, directly or indirectly, to a parent. A

noncontrolling interest is sometimes called a minority interest.

A.4.1 General applicability

ASC 480 requires that financial instruments that are issued in the form of shares and are mandatorily

redeemable on a specified or determinable date or upon an event certain to occur (e.g., the death of the

holder) be classified as liabilities. One exception is if the instrument is required to be redeemed only upon

liquidation or termination of the reporting entity. Shares are considered mandatorily redeemable if they

are subject to an unconditional obligation to be redeemed by transferring assets (e.g., cash or other

assets). That redemption requirement must be applicable to both parties (i.e., the issuer must redeem

and the holder must surrender), as opposed to “mandatory to the issuer if the holder decides to redeem.”

However, if the instruments are redeemable only upon the liquidation or termination of the reporting

entity, those instruments are not considered mandatorily redeemable.

In practice, the use of the terms “puttable,” “callable” and “redeemable” is often imprecise and different than how those terms

are defined and used in the authoritative accounting guidance. The terminology as defined in the authoritative guidance should

be carefully and consistently used to determine an instrument’s accounting.

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The FASB concluded that, regardless of the form of an instrument, an instrument that is mandatorily

redeemable requires a nondiscretionary transfer of assets as a result of a past transaction and, therefore,

meets the definition of a liability in FASB Concepts Statement No. 6, Elements of Financial Statements.

A mandatorily redeemable instrument that contains a provision to defer redemption to a future date, but

not indefinitely, may change the timing of redemption but does not remove the obligation to redeem the

instrument and, therefore, does not alter the requirement for liability classification.

ASC 480-10-25-6 describes a circumstance in which mandatory redemption is deferred “until a specified

liquidity level is reached.” In this circumstance, the FASB concluded that the instrument is mandatorily

redeemable and must be classified as a liability. It is inferred in the guidance that it is inevitable that the

issuer will ultimately have sufficient liquidity to be able to meet its obligations (i.e., the issuer is a going

concern) and, therefore, the instrument is mandatorily redeemable rather than contingently redeemable

and should be classified as a liability. As a result, provisions that defer redemption until a specified level of

liquidity is achieved generally should be viewed differently from other contingencies when applying ASC 480.

The existence of any mechanisms to fund the redemption of mandatorily redeemable shares does not affect

their classification. For example, as discussed in paragraph 3(g) of ASC 480-10-S99-3A, the SEC staff has

not historically required temporary equity classification of shares subject to repurchase upon the death

of the holder if the issuer has acquired insurance on the holder’s life sufficient to fund the redemption.

However, such mandatorily redeemable shares are liabilities pursuant to ASC 480, notwithstanding the fact

that the issuer is reasonably assured of having the funds necessary to satisfy the redemption obligation.

The terms of convertible instruments should be carefully evaluated in determining whether the instrument

is mandatorily redeemable. For example, if an instrument has a stated redemption date, but may be

converted into an equity instrument (e.g., common stock) at the option of the holder, that instrument is not

mandatorily redeemable until that conversion option expires. Rather, if the conversion option is considered

substantive, the instrument is considered contingently or optionally redeemable. The accounting for those

instruments is discussed further in section A.4.1.1.

Scope exceptions are provided for certain mandatorily redeemable instruments issued by certain

entities. Refer to section A.3.5 for further discussion of these scope exceptions.

Refer to the following Questions in section A.8:

• Question 4 — What are examples of various combinations of NCI with (1) a forward contract, (2) a

combination of put and call options and (3) a total return swap?

• Question 5 — Does the increasing-rate nature of increasing-rate preferred stock cause it to be

considered mandatorily redeemable pursuant to ASC 480?

• Question 6 — If the NCI of a consolidated limited-life subsidiary is mandatorily redeemable, how does

that affect the consolidated financial statements? Are such interests affected by the scope exception

in ASC 480?

A.4.1.1 Contingently or optionally redeemable shares

Many instruments that are in the form of shares are characterized as redeemable equity instruments

because redemption can be (1) required automatically upon the occurrence of certain contingent events

(e.g., an IPO, change in control or an achievement of a performance condition) or (2) at the option of the

holder at any time or on the occurrence of a contingent event. Such shares may also be referred to as

“contingently redeemable” or “puttable” because they often have triggers that allow the investor to realize

its return (e.g., a liquidation preference on preferred shares) prior to the actual liquidation of the issuer.

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However, if redemption of the instrument is not certain to occur, the instrument is not required to be

classified as a liability pursuant to ASC 480 (although public companies may be required to classify the

redemption amount as temporary equity pursuant to the SEC staff’s redeemable equity guidance

(refer to Appendix E for further discussion)). The convertible redeemable preferred share discussed

above in section A.4.1 is an example of a contingently redeemable share as it is contingent on the holder

not converting.

Refer to section A.5.1.2 for a discussion of the application of ASC 480 to warrants that are exercisable

for contingently redeemable shares.

Refer to the following Questions in section A.8:

• Question 4 — What are examples of various combinations of NCI with (1) a forward contract, (2) a

combination of put and call options and (3) a total return swap?

• Question 7 — What are the accounting considerations for contingently redeemable instruments?

A.4.1.2 Contingently redeemable shares that become mandatorily redeemable

While a share that must be redeemed upon or after an event that is not certain of occurrence is not

required to be accounted for as a liability pursuant to ASC 480, once the event becomes certain to occur,

that instrument should be reclassified to a liability. The term “certain of occurrence” should not be

confused with “probable” or even “highly probable.” “Certain” means certain. Often, an event will not be

certain of occurrence until it actually occurs.

The assessment of whether a contingently or optionally redeemable share has become mandatorily

redeemable should be made throughout the life of the instrument. The amount to be reclassified on the

date that the contingent event becomes certain of occurrence is the fair value of the share as of that

date. No gain or loss is recognized upon such a reclassification (i.e., the entire fair value is reclassified

from equity to a liability).

However, for SEC registrants, the guidance in ASC 260-10-S99-2 that addresses the SEC staff’s views on

redemptions of preferred stock is also applicable to the reclassification of the instrument. That guidance

states that if an equity-classified preferred stock is subsequently reclassified as a liability based on other

US GAAP, the equity instrument is considered redeemed through the issuance of a debt instrument. As

such, the difference between the carrying amount of the preferred share in equity and the fair value of

the preferred share (now a debt instrument) is treated as a dividend for EPS purposes. It is important to

note that the scope of this SEC staff’s guidance is limited to preferred shares.

Contingently redeemable shares become mandatorily redeemable when the holder notifies the issuer that

the holder is exercising its put option, even if the issuer is allowed a specified time period (e.g., 30 days) to

satisfy the put. Once the holder has notified the issuer of its put, the instrument is no longer contingently

redeemable and should be reclassified to a liability. Mandatorily redeemable shares with a substantive

embedded conversion option that expires prior to the mandatory redemption date should be classified to

a liability once the conversion option expires.

Refer to Question 8 in section A.8 — What is an example of a contingently redeemable share that is

reclassified when it becomes mandatorily redeemable?

A.4.1.3 Non-substantive or minimal features in otherwise mandatorily redeemable instruments

ASC 480 prohibits circumventing its objectives by including non-substantive or minimal features in the

instrument. For example, if a conversion feature were added to an otherwise mandatorily redeemable

share and that feature permitted conversion into a small number of shares or the conversion price was

extremely high relative to the then-current share price, rendering the likelihood of conversion extremely

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remote, the conversion option should be viewed as non-substantive and the instrument should be

classified as a liability. However, despite being non-substantive, the conversion option would be analyzed

for bifurcation as an embedded derivative pursuant to ASC 815.

While determining whether a conversion option is substantive is a matter of facts and circumstances,

one consideration is estimating the fair value of the conversion option. If, for example, the value of the

conversion option is de minimis, it may be indicative that the conversion option is not substantive.

We believe that the assessment of whether a feature is minimal or non-substantive should be made at the

inception of the instrument. If substantive, it should be considered substantive for the life of the instrument

(absent any modifications to the instrument). For example, a redeemable instrument initially may include

a substantive conversion option that, because of a subsequent significant decline in the issuer’s stock

price, may have little value later in the life of the instrument. We generally do not believe it is appropriate

to reconsider whether the conversion feature is substantive and potentially reclassify the instrument

after issuance (although, as discussed above, if the conversion option expires before the instrument

must be redeemed, it should be reclassified as a liability at its fair value on that date).

A.4.2 Recognition and measurement

Mandatorily redeemable instruments are recognized initially at their fair value. In most cases, the fair value

of an instrument at its issuance date will be the gross proceeds received upon issuance. We generally believe

that issuance costs should be accounted for as a separate deferred charge (refer to section A.4.2.1).

A mandatorily redeemable instrument that has a fixed redemption amount (that exceeds its initial fair

value) and a fixed redemption date should be accreted to the redemption amount using the effective

interest method, similar to the accounting for debt issued at a discount pursuant to ASC 835-30. If the

redemption amount varies (e.g., the redemption amount is based on a formula or is equal to the

instrument’s fair value) or the redemption date is unknown (e.g., redemption is upon the death of the

holder), the instrument should be carried at the amount of cash that would be paid pursuant to the

conditions specified in the contract (i.e., the settlement amount) if the shares were repurchased or

redeemed at the reporting date. We generally believe that the carrying amount of a mandatorily

redeemable instrument should not be adjusted below its initial carrying amount.

Some mandatorily redeemable preferred securities include a feature that allows the issuer to call the security

at various times (or the holder to redeem) at an amount that may differ from the fixed mandatory

redemption amount. Although this feature could be viewed as resulting in a settlement amount that is not

fixed, we generally believe the instrument should still be considered to have a fixed settlement amount based

on its fixed mandatory redemption amount. This approach is consistent with the accounting for debt. The

call (or put) feature would be separately evaluated for potential bifurcation from the debt host contract.

If the redemption amount is denominated in a currency other than the entity’s functional currency, mandatorily

redeemable shares should be measured as described above and then remeasured pursuant to ASC 830.

Because mandatorily redeemable instruments are classified as liabilities pursuant to ASC 480, any

dividends or accretion on instruments that have a legal form of equity should generally be presented as

interest expense.

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Refer to the following Questions in section A.8:

• Question 10 — How should an entity account for a stock required to be redeemed upon death of a holder?

• Question 11 — How should an entity measure and present mandatorily redeemable instruments when

the entity has no equity-classified instruments?

• Question 12 — How should an entity measure and present mandatorily redeemable NCI classified as

liabilities that were issued before 5 November 2003?

A.4.2.1 Accounting for costs to issue mandatorily redeemable shares

ASC 480 does not explicitly address the accounting for costs incurred that are directly related to issuing

mandatorily redeemable shares. Because the accounting for those instruments pursuant to ASC 480

generally is the same as for debt instruments, we generally believe that direct and incremental issuance

costs should be accounted for in a manner similar to debt issuance costs. That is, if the fair value option

is not elected, costs should be deferred and amortized using the interest method, by analogy to

ASC 835-30. Under that guidance, entities are required to present debt issuance costs related to a

recognized liability on the balance sheet as a direct deduction from that liability rather than as an asset,

consistent with the presentation of a debt discount.

A.4.2.2 Accounting for modifications or exchanges of mandatorily redeemable shares

ASC 480 does not address the accounting for modifications or exchanges of mandatorily redeemable

shares. Because the accounting for mandatorily redeemable shares under ASC 480 generally is similar to

the accounting for debt instruments, we believe entities should apply the guidance in ASC 470-60 and

470-50 to account for modifications or exchanges of mandatorily redeemable shares. Refer to section 2.6

for further guidance on debt modifications or exchanges.

A.5 Obligations to repurchase an entity’s own shares by transferring assets —

recognition and measurement

Excerpt from Accounting Standards Codification

Distinguishing Liabilities from Equity — Overall

Recognition

480-10-25-8

An entity shall classify as a liability (or an asset in some circumstances) any financial instrument, other

than an outstanding share, that, at inception, has both of the following characteristics:

a. It embodies an obligation to repurchase the issuer’s equity shares, or is indexed to such an obligation.

b. It requires or may require the issuer to settle the obligation by transferring assets.

480-10-25-9

In this Subtopic, indexed to is used interchangeably with based on variations in the fair value of. The

phrase requires or may require encompasses instruments that either conditionally or unconditionally

obligate the issuer to transfer assets. If the obligation is conditional, the number of conditions leading

up to the transfer of assets is irrelevant.

480-10-25-10

Examples of financial instruments that meet the criteria in paragraph 480-10-25-8 include forward

purchase contracts or written put options on the issuer’s equity shares that are to be physically settled

or net cash settled.

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480-10-25-11

All obligations that permit the holder to require the issuer to transfer assets result in liabilities,

regardless of whether the settlement alternatives have the potential to differ.

480-10-25-12

Certain financial instruments that embody obligations that are liabilities within the scope of this

Subtopic also may contain characteristics of assets but be reported as single items. Some examples

include the following:

a. Net-cash-settled or net-share-settled forward purchase contracts

b. Certain combined options to repurchase the issuer’s shares.

Those instruments are classified as assets or liabilities initially or subsequently depending on the

instrument’s fair value on the reporting date.

480-10-25-13

An instrument that requires the issuer to settle its obligation by issuing another instrument (for

example, a note payable in cash) ultimately requires settlement by a transfer of assets, accordingly:

a. When applying paragraphs 480-10-25-8 through 25-12, this also would apply for an instrument

settled with another instrument that ultimately may require settlement by a transfer of assets

(warrants for puttable shares).

b. It is clear that a warrant for mandatorily redeemable shares would be a liability under this Subtopic.

Initial Measurement

Certain Physically Settled Forward Purchase Contracts

480-10-30-3

Forward contracts that require physical settlement by repurchase of a fixed number of the issuer’s

equity shares in exchange for cash shall be measured initially at the fair value of the shares at

inception, adjusted for any consideration or unstated rights or privileges.

480-10-30-4

Two ways to obtain the adjusted fair value include:

a. Determining the amount of cash that would be paid under the conditions specified in the contract

if the shares were repurchased immediately

b. Discounting the settlement amount, at the rate implicit at inception after taking into account any

consideration or unstated rights or privileges that may have affected the terms of the transaction.

480-10-30-5

Equity shall be reduced by an amount equal to the fair value of the shares at inception.

480-10-30-6

Cash (as that term is used in paragraph 480-10-30-3) includes foreign currency, so physically settled

forward purchase contracts in exchange for foreign currency shall be measured as provided in

paragraphs 480-10-30-3 through 30-5 and 480-10-35-3, then remeasured under Topic 830.

All Other Financial Instruments

480-10-30-7

All other financial instruments recognized under the guidance in Section 480-10-25 shall be measured

initially at fair value.

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Subsequent Measurement

Certain Physically Settled Forward Purchase Contracts and Mandatorily Redeemable Financial

Instruments

480-10-35-3

Forward contracts that require physical settlement by repurchase of a fixed number of the issuer’s

equity shares in exchange for cash and mandatorily redeemable financial instruments shall be

measured subsequently in either of the following ways:

a. If both the amount to be paid and the settlement date are fixed, those instruments shall be

measured subsequently at the present value of the amount to be paid at settlement, accruing

interest cost using the rate implicit at inception.

b. If either the amount to be paid or the settlement date varies based on specified conditions, those

instruments shall be measured subsequently at the amount of cash that would be paid under the

conditions specified in the contract if settlement occurred at the reporting date, recognizing the

resulting change in that amount from the previous reporting date as interest cost.

480-10-35-4

Cash (as that term is used in the preceding paragraph) includes foreign currency, so physically settled

forward purchase contracts in exchange for foreign currency shall be measured as provided in the

preceding paragraph then remeasured under Topic 830.

All Other Financial Instruments

480-10-35-5

All other financial instruments recognized under the guidance in Section 480-10-25 shall be measured

subsequently at fair value with changes in fair value recognized in earnings, unless either this Subtopic

or another Subtopic specifies another measurement attribute.

Implementation Guidance and Illustrations

Freestanding Warrants and Other Similar Instruments on Shares that Are Redeemable