www.pwc.com
Guide to Accounting for
Financing Transactions
What You Need To Know about Debt,
Equity and the Instruments in Between
2012
Black PANTONE 144 C
This publication has been prepared for general information on matters of interest
only, and does not constitute professional advice on facts and circumstances
specific to any person or entity. You should not act upon the information contained
in this publication without obtaining specific professional advice. No representation
or warranty (express or implied) is given as to the accuracy or completeness of
the information contained in this publication. The information contained in this
material was not intended or written to be used, and cannot be used, for purposes
of avoiding penalties or sanctions imposed by any government or other regulatory
body. PricewaterhouseCoopers LLP, its members, employees, and agents shall
not be responsible for any loss sustained by any person or entity who relies on this
publication.
The content of this publication is based on information available as of September
15, 2012. Accordingly, certain aspects of this publication may be superseded as new
guidance or interpretations emerge. Financial statement preparers and other users
of this publication are therefore cautioned to stay abreast of and carefully evaluate
subsequent authoritative and interpretative guidance that is issued.
“Portions of FASB Accounting Standards Codification®, copyrighted by the Financial
Accounting Foundation, 401 Merritt 7, Norwalk, CT 06856, are reproduced with
permission.”
Dear Clients and Friends:
PwC is pleased to offer this Guide to Accounting for Financing Transactions: What You Need to
Know about Debt, Equity and the Instruments in Between. This Guide compiles the accounting
guidance an issuer should consider when:
• Issuing debt, equity and hybrid securities (including determining whether the security should
be classified as debt or equity for accounting purposes),
• Creating a noncontrolling interest,
• Modifying debt or equity securities,
• Inducing an investor to convert, and
• Buying back debt or equity securities.
We have organized the Guide to first discuss the accounting literature and analyses applicable
to many financing transactions and then discuss the application of this guidance to specific
financing transactions. We hope you find this Guide to be a valuable tool for assessing the
accounting implications of financing transactions you are considering.
The accounting guidance for the issuance, modification, conversion and repurchase of debt and
equity securities has developed over many years into a complex set of rules. Before the FASB
codified accounting standards, the accounting guidance applicable to a single transaction was
contained in a number of separate FASB Standards, EITF Issues, interpretations, and speeches.
Although the guidance is now codified within the FASB’s Accounting Standards Codification, the
analysis continues to involve detailed and sequential consideration of the relevant provisions of
the guidance. This Guide provides a roadmap to the applicable accounting literature to help you
determine which steps are necessary for a particular transaction.
While this Guide can be a helpful tool, it cannot substitute for a thorough analysis of the relevant
accounting literature in light of the facts and circumstances of proposed transactions.
PwC professionals have years of experience advising clients on the transactions discussed in
this Guide. We have included a section entitled How PwC Can Help at the end of many chapters.
This section lists some of the many areas in which PwC can provide advice. If you would like to
discuss one of the topics covered in this Guide, please contact your PwC engagement partner
or one of the contacts included at the end of the Guide.
PricewaterhouseCoopers LLP
Table of Contents
Chapter 1:
Guidelines
1.1
Accounting for Financing Transactions .......................................................... 1-2
1.2
Organization of this Guide ............................................................................... 1-2
1.3
International Accounting Standards ............................................................... 1-2
1.4
Contracts to Enter into a Financing Transaction
(Forward Starting Transactions) ...................................................................... 1-3
1.5
Financing Transactions Reported at Fair Value ............................................. 1-3
1.6
How PwC Can Help........................................................................................... 1-3
Chapter 2:
Analysis of Equity-Linked Instruments
2.1
Analysis of Equity-Linked Instruments ........................................................... 2-2
2.2
Freestanding vs. Embedded ............................................................................ 2-2
Example 2-1 Tranched Preferred Stock .......................................................... 2-3
2.3
2.3.1
2.3.1.1
2.3.1.2
2.3.2
2.3.2.1
2.3.3
2.3.4
Analysis of Embedded Equity-Linked Components ...................................... 2-5
Clearly and Closely Related ............................................................................. 2-6
Preferred Stock ................................................................................................... 2-6
Debt Host ............................................................................................................ 2-6
Definition of a Derivative .................................................................................. 2-7
Readily Convertible to Cash ............................................................................... 2-8
Scope Exception for Certain Contracts Involving an Issuer’s
Own Equity ........................................................................................................ 2-9
Accounting for Separated Instruments .......................................................... 2-9
2.4
2.4.1
2.4.2
2.4.2.1
2.4.3
Analysis of Certain Freestanding Instruments (ASC 480) ............................. 2-10
Scope ................................................................................................................. 2-10
Recognition and Measurement ....................................................................... 2-11
Subsequent Measurement.................................................................................. 2-11
Non-Substantive Features ............................................................................... 2-12
Example 2-2 Impact of Declining Stock Price on Conversion Option ......... 2-13
2.5
2.5.1
2.5.1.1
2.5.1.2
2.5.1.3
Analysis of a Freestanding Equity-Linked Instrument .................................. 2-13
Indexed to a Company’s Own Stock—ASC 815-40-15
(previously EITF 07-5) ....................................................................................... 2-14
Step One—Exercise Contingencies.................................................................... 2-15
Step Two—Settlement Adjustments ................................................................... 2-15
Anti-dilution and Price Protection Provisions (including “down-round”
provisions) ........................................................................................................... 2-16
Example 2-3 Down-Round Provisions in a Security Received Upon
Exercise of a Warrant ....................................................................................... 2-16
Example 2-4 Valuation of a Warrant with a Down-Round Provision ............ 2-17
Table of Contents / i
2.5.1.4
Foreign Currency ................................................................................................ 2-18
Example 2-5 Foreign Currency Denominated Convertible Bond ................. 2-18
2.5.1.5
2.5.2
2.5.2.1
Indexed to Stock of Subsidiary, Affiliate, or Parent ............................................ 2-18
Requirements for Equity Classification—ASC 815-40-25
(previously EITF 00-19) ..................................................................................... 2-19
Additional Requirements for Equity Classification .............................................. 2-19
Example 2-6 Impact of Exchange Limits on Share Issuance ....................... 2-20
Example 2-7 Impact of Master Netting Agreements ..................................... 2-21
Example 2-8 Option to Pay Cash Penalty in the Event Timely Filings
with the SEC Are Not Made ............................................................................. 2-21
Example 2-9 Convertible Debt Indexed to Subsidiary’s Stock and
Settlable in Stock of Parent or Subsidiary ...................................................... 2-22
2.5.2.2
Application to Convertible Bonds ....................................................................... 2-23
Example 2-10 Application of Conventional Convertible Bond
Exception to Convertible Bonds with a Make-Whole Table .......................... 2-23
2.5.2.3
Reassessment .................................................................................................... 2-23
Chapter 3:
Analyzing Put and Call Options and Other Features and Arrangements
3.1
Put and Call Options Embedded in Debt Instruments .................................. 3-2
3.2
Analysis of Whether a Put or Call Is Clearly and Closely Related
to a Debt Host ................................................................................................... 3-2
Determine the Nature of the Settlement Amount Received Upon
Exercise of Put or Call Option ......................................................................... 3-4
Determine Whether the Put or Call Option Accelerates Repayment
of the Debt ......................................................................................................... 3-5
Determine if the Put or Call Option Is Contingently Exercisable ................. 3-5
Determine if the Debt Instrument Contains a Substantial Premium
or Discount ........................................................................................................ 3-6
Analysis of Embedded Interest Rate Derivatives ........................................... 3-7
Application of Test to Determine Whether the Investor Recovers
Substantially All of Its Investment ....................................................................... 3-8
Application of the Double-Double Test ............................................................... 3-8
3.2.1
3.2.2
3.2.3
3.2.4
3.2.5
3.2.5.1
3.2.5.2
Example 3-1 Debt Puttable Upon a Change in Interest Rates...................... 3-9
Example 3-2 Debt Issued at Par, Puttable Upon a Change in Control ......... 3-10
Example 3-3 Debt Issued at a Premium, Puttable Upon a
Change in Control ............................................................................................. 3-10
Example 3-4 Debt Issued at a Discount, Puttable Upon a
Change in Control ............................................................................................. 3-11
3.2.6
Fair Value Put and Call Options ....................................................................... 3-12
3.3
Put and Call Options Embedded in Equity Instruments ................................ 3-12
ii / Table of Contents
3.4
Warrants Issued in Connection with Debt and Equity Offerings .................. 3-12
Example 3-5 Warrants Classified as Equity Issued in Connection
with Debt............................................................................................................ 3-13
Example 3-6 Warrants Classified as Liabilities Issued in Connection
with Debt............................................................................................................ 3-14
3.5
3.5.1
Beneficial Conversion Feature ........................................................................ 3-14
Recognition and Measurement ....................................................................... 3-15
Example 3-7 Beneficial Conversion Feature (BCF) ........................................ 3-15
3.5.2
3.5.3
Commitment Date ............................................................................................. 3-16
Contingent BCF Measurement ........................................................................ 3-17
Example 3-8 Contingent BCF Recognition and Measurement ..................... 3-17
3.5.4
Amortization of BCF Discount ......................................................................... 3-18
3.6
Mezzanine (Temporary) Equity Classification ................................................ 3-18
Example 3-9 Classification of BCF .................................................................. 3-19
3.7
3.7.1
3.7.2
3.7.2.1
3.7.2.2
3.7.3
Issuance Costs.................................................................................................. 3-20
Equity Issuance Costs ...................................................................................... 3-20
Debt Issuance Costs ........................................................................................ 3-20
Convertible Debt with a Cash Conversion Feature............................................. 3-20
Units Structures .................................................................................................. 3-21
Amortization of Issuance Costs ...................................................................... 3-21
3.8
Registration Payment Arrangements.............................................................. 3-21
Example 3-10 Registration Payment Arrangement ....................................... 3-22
Chapter 4:
Earnings per Share
4.1
Basic and Diluted Earnings per Share ............................................................ 4-2
4.2
Anti-Dilution and Sequencing of Instruments ................................................ 4-2
4.3
4.3.1
If-Converted Method ........................................................................................ 4-2
Application to Convertible Debt ...................................................................... 4-3
Example 4-1 Application of the If-Converted Method ................................... 4-3
Example 4-2 Capitalized Interest .................................................................... 4-4
4.3.2
Application to Convertible Preferred Stock ................................................... 4-4
Example 4-3 Conversion During Reporting Period........................................ 4-5
4.4
Treasury Stock Method .................................................................................... 4-5
Example 4-4: Application of the Treasury Stock Method .............................. 4.6
4.5
Instruments Settlable in Cash or Shares ........................................................ 4-7
Table of Contents / iii
4.6
Convertible Debt with a Cash Conversion Feature ....................................... 4-8
4.7
Contingently Convertible Instruments ............................................................ 4-8
4.8
Participating Securities/Two-Class Method of Calculating Basic
and Diluted EPS ................................................................................................ 4-9
Example 4-5 Application of the Two-Class Method....................................... 4-9
Example 4-6 Participating Securities with a Conversion Feature ................ 4-11
4.8.1
4.8.1.1
4.8.1.2
4.8.1.3
Adjustments to Exercise or Conversion Prices ............................................. 4-11
Adjustments to Convertible Securities and Options ........................................... 4-11
Adjustments to Forward Contracts..................................................................... 4-11
Adjustments to Variable Share Forward Delivery Agreements ........................... 4-12
4.9
Share Lending Agreements.............................................................................. 4-13
Chapter 5:
Accounting for Modifications and Extinguishments
5.1
Restructuring and Extinguishment ................................................................. 5-2
5.2
Analyzing a Debt Restructuring ....................................................................... 5-2
Example 5-1 Repayment of Debt Instrument with Contemporaneous
Issuance of Debt ............................................................................................... 5-3
5.3
5.3.1
5.3.2
5.3.3
5.3.4
5.3.5
5.3.6
Troubled Debt Restructurings (TDRs) ............................................................. 5-3
Determining Whether the Borrower Is Experiencing Financial
Difficulties .......................................................................................................... 5-3
Determining Whether the Creditor Has Granted a Concession ................... 5-4
Full Settlement of the Debt .............................................................................. 5-5
Modification of Terms ....................................................................................... 5-5
TDR of a Variable-Rate Instrument ................................................................. 5-6
Restructuring of Debt by Existing Equity Holders ......................................... 5-6
Example 5-2 Troubled Debt Restructuring ..................................................... 5-7
5.4
5.4.1
5.4.1.1
5.4.1.2
5.4.1.3
5.4.1.4
5.4.1.5
5.4.1.6
5.4.1.7
5.4.1.8
5.4.1.9
Modification vs. Extinguishment—Non-Revolving Debt Security
or Term Loan ..................................................................................................... 5-8
Test to Determine Whether a Modification to Non-Revolving Debt
Is Substantial ..................................................................................................... 5-9
Loan Syndications and Participations ................................................................ 5-10
Third Party Intermediaries ................................................................................... 5-11
Consideration of Multiple Debt Instruments Held by One Lender ...................... 5-12
Prepayment Options ........................................................................................... 5-12
Non-cash Consideration ..................................................................................... 5-13
Restructured Debt Is the Hedged Item in a Fair Value Hedge of
Interest Rates ...................................................................................................... 5-14
Change in Currency of the Debt ......................................................................... 5-14
Change in Principal ............................................................................................. 5-14
Modification of Instruments Held by Multiple Lenders ....................................... 5-15
Example 5-3 Restructuring of Syndicated Term Loan Facility...................... 5-15
iv / Table of Contents
5.5
Modifications to and Payoffs of Line-of-Credit or
Revolving-Debt Arrangements ........................................................................ 5-19
Example 5-4 Accounting for Unamortized Costs and New Fees in
Revolving-Debt Arrangement .......................................................................... 5-20
5.6
5.6.1
5.6.2
Debt Extinguishment Accounting.................................................................... 5-20
Classification of Gain or Loss on Debt Extinguishments.............................. 5-21
Debt Extinguishment as a Subsequent Event ................................................ 5-21
5.7
5.7.1
Restructuring of Convertible Debt Instruments............................................. 5-22
Convertible Debt Modification Accounting .................................................... 5-23
5.8
5.8.1
5.8.2
5.8.2.1
Modification vs. Extinguishment—Preferred Stock....................................... 5-23
Preferred Stock Modifications ......................................................................... 5-23
Preferred Stock Extinguishment Accounting ................................................. 5-24
Extinguishment of Convertible Preferred Stock with a BCF ............................... 5-24
5.9
Modification of Warrants Classified as Equity ............................................... 5-25
5.10
How PwC Can Help........................................................................................... 5-25
Chapter 6:
Debt
6.1
Debt Instrument Overview ............................................................................... 6-2
6.2
Balance Sheet Classification—Current vs. Non-Current .............................. 6-2
Example 6-1 Long-Term Loan Payable Upon Demand ................................. 6-3
Example 6-2 Demand Provision vs. Subjective Acceleration Clause .......... 6-3
Example 6-3 Impact of an Approved Debt Repayment Plan ........................ 6-4
6.2.1
Short-Term Debt Refinanced on a Long-Term Basis After the
Balance Sheet Date .......................................................................................... 6-4
Example 6-4 Impact of Parent Guarantee ...................................................... 6-5
6.2.1.1
6.2.1.2
Subjective Acceleration Clauses ........................................................................ 6-5
Insufficient Refinancing and Fluctuating Balances ............................................. 6-6
Example 6-5 Refinancing Subject to Working Capital Requirement ........... 6-6
6.2.1.3
6.2.2
6.2.3
Refinancing with Successive Short-Term Borrowings ........................................ 6-6
Revolving-Debt Arrangements ........................................................................ 6-7
Commercial Paper ............................................................................................ 6-7
Example 6-6 Reclassification of Commercial Paper to Non-Current .......... 6-8
6.2.4
6.2.5
Liquidity Facility Arrangements for Variable Rate Demand Obligations ..... 6-8
Covenant Violations .......................................................................................... 6-9
Example 6-7 Violation of a Provision in the Debt Agreement ....................... 6-10
6.2.5.1
6.2.6
Payments Made to Effect a Change in Debt Covenants or a Waiver
of a Covenant Violation ....................................................................................... 6-11
Effect of Subjective Acceleration Clauses on the Classification
of Long-Term Debt ............................................................................................ 6-11
Table of Contents / v
6.2.6.1
Balance Sheet Classification of Borrowings Outstanding under Revolving
Credit Agreements That Include both a Subjective Acceleration Clause
and a Lock-Box Arrangement............................................................................. 6-12
6.3
Classification of Liabilities as “Trade Accounts Payable” or “Other
Liabilities/Bank Debt” in a Structured Payable Transaction ......................... 6-12
6.4
6.4.1
Payment in Kind ................................................................................................ 6-13
Classification of Accrued Interest Payable Settlable with
Paid-in-Kind (PIK) Notes .................................................................................. 6-14
Example 6-8 Accrued Interest Settlable in PIK Notes ................................... 6-14
6.5
Guarantees on Debt.......................................................................................... 6-15
6.6
Contingent Interest on Debt ............................................................................ 6-16
6.7
How PwC Can Help........................................................................................... 6-17
Chapter 7:
Convertible Debt
7.1
Analysis of Convertible Debt ........................................................................... 7-2
7.2
7.2.1
7.2.1.1
Embedded Conversion Options....................................................................... 7-4
Contingent Conversion Option ........................................................................ 7-6
Contingency Based on an Event or Index Other Than the Issuer’s
Stock Price ......................................................................................................... 7-6
Contingency Based on Issuer’s Stock Price ....................................................... 7-6
7.2.1.2
Example 7-1 Classification of Debt with a Contingent Conversion
Option ................................................................................................................ 7-7
7.2.2
7.2.3
Adjustment to Shares Delivered Upon Conversion in the Event
of a Fundamental Change (Make-Whole Table) ............................................. 7-8
Conversion Option Upon Trading Price Condition (Parity Provision)........... 7-9
7.3
Beneficial Conversion Feature (BCF) .............................................................. 7-9
7.4
7.4.1
7.4.1.1
Cash Conversion Feature (previously FSP APB 14-1) ................................... 7-10
Recognition and Measurement ....................................................................... 7-10
Determining the Expected Life ........................................................................... 7-11
Example 7-2 Impact of Change of Control Put on Expected Life................. 7-13
7.4.1.2
Determining the Nonconvertible Debt Rate ........................................................ 7-13
Example 7-3 Using a Purchased Call Option to Determine the
Nonconvertible Debt Rate ................................................................................ 7-14
7.4.1.3
7.4.2
Amortization of Debt Discount............................................................................ 7-14
Tax Accounting Considerations....................................................................... 7-15
Example 7-4 Application of ASC 470-20 to a Convertible Bond with
a Cash Conversion Feature.............................................................................. 7-15
Example 7-5 Change in the Expected Life of a Convertible Bond ............... 7-17
7.4.3
vi / Table of Contents
Mezzanine (Temporary) Equity Classification ................................................ 7-18
7.4.4
7.4.5
Earnings per Share ........................................................................................... 7-18
Derecognition (Conversion or Extinguishment) ............................................. 7-19
Example 7-6 Early Conversion of a Convertible Bond with a Cash
Conversion Feature .......................................................................................... 7-20
7.5
Conversion into Equity ..................................................................................... 7-21
Example 7-7 Conversion of Instrument Upon Issuer’s Exercise of
Call Option ......................................................................................................... 7-21
Example 7-8 Conversion of Bond with a Separated Conversion Option ..... 7-22
7.5.1
Conversion Prior to Full Accretion of BCF Discount ..................................... 7-22
7.6
Induced Conversion.......................................................................................... 7-22
Example 7-9 Offer to Convert Initiated by the Investor ................................. 7-23
Example 7-10 Reduction in Shares Issued Upon Conversion ...................... 7-23
7.6.1
Induced Conversion of Convertible Debt with a Cash
Conversion Feature .......................................................................................... 7-24
7.7
7.7.1
Convertible Debt Extinguishment Accounting ............................................... 7-24
Extinguishment Accounting—Bifurcated Conversion Option ...................... 7-24
7.8
7.8.1
7.8.2
Put and Call Options ......................................................................................... 7-25
Put Options ........................................................................................................ 7-25
Put Upon a Fundamental Change/Change in Control Put ............................ 7-26
Example 7-11 Fundamental Change Put at Higher of Par or
Conversion Value .............................................................................................. 7-26
7.8.3
Issuer Call Options ........................................................................................... 7-26
7.9
Contingent Interest ........................................................................................... 7-27
7.10
7.10.1
7.10.2
7.10.3
7.10.3.1
7.10.3.2
7.10.4
7.10.4.1
Instruments Executed in Conjunction with a Convertible Bond .................. 7-27
Detachable Warrants ........................................................................................ 7-27
Greenshoe (Overallotment Option) ................................................................. 7-28
Call Options Overlay (Call Spread, Capped Call) ........................................... 7-29
Earnings per Share ............................................................................................. 7-29
Tax Considerations ............................................................................................. 7-30
Share Lending Agreement ............................................................................... 7-30
Earnings per Share ............................................................................................. 7-30
7.11
How PwC Can Help........................................................................................... 7-31
Chapter 8:
Preferred Stock
8.1
Characteristics of Preferred Stock ................................................................. 8-2
8.2
Analysis of Preferred Stock ............................................................................. 8-3
8.3
8.3.1
Redemption Features in Preferred Stock ....................................................... 8-3
Mandatorily Redeemable Preferred Stock ..................................................... 8-4
Table of Contents / vii
Example 8-1 Preferred Stock Redeemable Upon Liquidation of an
Entity or Death/Termination of a Partner ........................................................ 8-5
Example 8-2 Redemption of Preferred Shares Funded by Insurance.......... 8-5
8.3.2
Contingently Redeemable Preferred Stock .................................................... 8-6
Example 8-3 Reassessment of Contingently Redeemable Instruments ..... 8-6
8.3.3
Perpetual Preferred Stock (No Redemption).................................................. 8-7
Example 8-4 Perpetual Preferred Stock with Liquidated Damages............. 8-7
Example 8-5 Increasing Rate Perpetual Preferred Stock ............................. 8-8
8.4
8.4.1
8.4.2
8.4.3
Conversion Features in Preferred Stock ........................................................ 8-8
Non-Redeemable Preferred Stock Convertible into a Fixed or
Variable Number of Shares .............................................................................. 8-9
Redeemable Convertible Preferred Stock ...................................................... 8-10
Analysis of the Conversion Option .................................................................. 8-11
8.5
Preferred Stock Exchangeable into Debt ....................................................... 8-12
8.6
Participation Rights .......................................................................................... 8-12
8.7
Calls and Puts ................................................................................................... 8-12
8.8
8.8.1
8.8.2
Tranched Preferred Stock ................................................................................ 8-13
Right to Issue Shares Is a Freestanding Instrument ..................................... 8-13
Right to Issue Shares Is an Embedded Feature ............................................. 8-14
8.9
8.9.1
8.9.2
Preferred Stock Measurement ........................................................................ 8-14
Initial Measurement .......................................................................................... 8-14
Subsequent Measurement ............................................................................... 8-14
8.10
Preferred Stock Dividends ............................................................................... 8-15
8.11
8.11.1
Conversion into Equity ..................................................................................... 8-16
Conversion Prior to Full Accretion of a Beneficial Conversion
Feature (BCF) Discount .................................................................................... 8-16
Example 8-6 Treatment of Unallocated BCF Upon Conversion ................... 8-16
8.11.2
Induced Conversion.......................................................................................... 8-17
8.12
8.12.1
Preferred Stock Extinguishment Accounting ................................................. 8-17
Extinguishment of Convertible Preferred Stock with a BCF......................... 8-17
8.13
How PwC Can Help........................................................................................... 8-17
Chapter 9:
Share Issuance Contracts
9.1
Summary of Share Issuance Contracts .......................................................... 9-2
9.2
Forward Sale Contract, Purchased Put Option, and Written Call
Option (Warrant) on a Company’s Own Stock................................................ 9-2
Instruments on Redeemable Shares ............................................................... 9-3
9.2.1
viii / Table of Contents
Example 9-1 Warrant on Puttable Shares ....................................................... 9-4
9.2.2
9.2.2.1
9.2.2.2
Prepaid Forward Sale of a Company’s Own Shares ...................................... 9-4
Fully Prepaid Forward Sale of a Company’s Own Shares .................................. 9-5
Partially Prepaid Forward Sale of a Company’s Own Shares ............................. 9-5
9.3
9.3.1
9.3.1.1
9.3.2
9.3.2.1
Units Structures ................................................................................................ 9-5
Debt Issued with Detachable Warrants .......................................................... 9-5
Repurchase of Debt with Detachable Warrants.................................................. 9-6
Mandatory Units................................................................................................ 9-6
Contract Payments Paid by the Issuer ............................................................... 9-8
Example 9-2 Accounting for Mandatory Units ............................................... 9-8
9.3.2.2
9.3.3
Repurchase of Mandatory Units ......................................................................... 9-10
EPS Considerations .......................................................................................... 9-11
9.4
How PwC Can Help........................................................................................... 9-11
Chapter 10: Derivative Share Repurchase Contracts
10.1
Summary of Share Repurchase Contracts ..................................................... 10-2
10.2
10.2.1
Forward Repurchase of a Company’s Own Stock ......................................... 10-3
Physically Settled Forward Repurchase ......................................................... 10-3
Example 10-1 Physically Settled Forward Repurchase ................................. 10-4
10.2.1.1
10.2.2
Earnings per Share Considerations .................................................................... 10-4
Net Cash or Net Share Settled Forward Repurchase .................................... 10-4
10.3
10.3.1
10.3.2
Written Put Option on Own Shares ................................................................. 10-5
Postpaid Written Put Option ............................................................................ 10-5
Prepaid Written Put Option .............................................................................. 10-6
10.4
10.4.1
10.4.1.1
10.4.1.2
Accelerated Share Repurchase (ASR) Programs........................................... 10-7
Recognition and Measurement ....................................................................... 10-9
Application of ASC 480....................................................................................... 10-10
Analysis of Freestanding Equity-Linked Instrument ........................................... 10-11
Example 10-2 Fixed Dollar Accelerated Share Repurchase Program ......... 10-11
10.4.2
10.4.2.1
10.4.2.2
Earnings per Share Considerations ................................................................ 10-12
Settlement in Cash or Shares ............................................................................. 10-12
Anti-Dilution ........................................................................................................ 10-12
10.5
How PwC Can Help........................................................................................... 10-13
Chapter 11: Noncontrolling Interest as a Source of Financing
11.1
Overview of Noncontrolling Interests ............................................................. 11-2
11.2
Analysis of Instruments Indexed to a Subsidiary’s Shares
Executed with NCI Holders .............................................................................. 11-2
Freestanding vs. Embedded ............................................................................ 11-3
11.2.1
Table of Contents / ix
11.2.1.1
11.2.1.2
Separately and Apart .......................................................................................... 11-4
Legally Detachable and Separately Exercisable ................................................. 11-4
Example 11-1 Analysis of Put Right ................................................................ 11-5
11.2.2
11.2.2.1
11.2.3
Accounting for a Freestanding Instrument Executed with
NCI Holders ....................................................................................................... 11-5
Combination of Written Put and Purchased Call Options .................................. 11-6
Accounting for an Instrument Embedded in a NCI ........................................ 11-7
11.3
11.3.1
11.3.2
Redeemable NCI ............................................................................................... 11-8
Initial Measurement .......................................................................................... 11-8
Subsequent Measurement ............................................................................... 11-8
Example 11-2 Adjustment to the Carrying Value of Redeemable
Equity Securities ............................................................................................... 11-9
11.4
How PwC Can Help........................................................................................... 11-10
Appendices
A
Technical References and Abbreviations ....................................................... A-1
B
Definition of Key Terms .................................................................................... B-1
x / Table of Contents
Table of Contents by Instrument
Accelerated Share Repurchase (ASR) Programs
2.1
2.4
2.5
4.1
4.2
4.4
4.5
4.8
10.1
10.4
Analysis of Equity-Linked Instruments ............................................................... 2-2
Analysis of Certain Freestanding Instruments (ASC 480) ................................... 2-10
Analysis of a Freestanding Equity-Linked Instrument ........................................ 2-13
Basic and Diluted Earnings per Share ................................................................ 4-2
Anti-Dilution and Sequencing of Instruments ..................................................... 4-2
Treasury Stock Method ....................................................................................... 4-5
Instruments Settlable in Cash or Shares ............................................................ 4-7
Participating Securities/Two-Class Method of Calculating Basic and
Diluted EPS ......................................................................................................... 4-9
Summary of Share Repurchase Contracts ......................................................... 10-2
Accelerated Share Repurchase (ASR) Programs ................................................ 10-7
Convertible Debt—Cash Conversion Feature
2.1
2.3
3.1
3.2
3.4
3.6
3.7
3.8
4.1
4.2
4.3
4.4
4.5
4.6
4.7
4.8
4.9
5.1
5.2
5.3
5.7
6.1
6.2
6.5
7.1
7.2
7.4
7.6
7.8
7.9
7.10
Analysis of Equity-Linked Instruments ............................................................... 2-2
Analysis of Embedded Equity-Linked Components ........................................... 2-5
Put and Call Options Embedded in Debt Instruments........................................ 3-2
Analysis of Whether a Put or Call Is Clearly and Closely Related
to a Debt Host..................................................................................................... 3-2
Warrants Issued in Connection with Debt and Equity Offerings......................... 3-12
Mezzanine (Temporary) Equity Classification ..................................................... 3-18
Issuance Costs ................................................................................................... 3-20
Registration Payment Arrangements .................................................................. 3-21
Basic and Diluted Earnings per Share ................................................................ 4-2
Anti-Dilution and Sequencing of Instruments ..................................................... 4-2
If-Converted Method .......................................................................................... 4-2
Treasury Stock Method ....................................................................................... 4-5
Instruments Settlable in Cash or Shares ............................................................ 4-7
Convertible Debt with a Cash Conversion Feature............................................. 4-8
Contingently Convertible Instruments ................................................................ 4-8
Participating Securities/Two-Class Method of Calculating Basic and
Diluted EPS ......................................................................................................... 4-9
Share Lending Agreements ................................................................................ 4-13
Restructuring and Extinguishment...................................................................... 5-2
Analyzing a Debt Restructuring .......................................................................... 5-2
Troubled Debt Restructurings (TDRs) ................................................................. 5-3
Restructuring of Convertible Debt Instruments .................................................. 5-22
Debt Instrument Overview .................................................................................. 6-2
Balance Sheet Classification—Current vs. Non-Current .................................... 6-2
Guarantees on Debt............................................................................................ 6-15
Analysis of Convertible Debt............................................................................... 7-2
Embedded Conversion Options ......................................................................... 7-4
Cash Conversion Feature (previously FSP APB 14-1) ........................................ 7-10
Induced Conversion ............................................................................................ 7-22
Put and Call Options ........................................................................................... 7-25
Contingent Interest ............................................................................................. 7-27
Instruments Executed in Conjunction with a Convertible Bond ......................... 7-27
Table of Contents / xi
Convertible Debt—Share Settled
2.1
2.3
3.1
3.2
3.4
3.5
3.6
3.7
3.8
4.1
4.2
4.3
4.7
4.8
4.9
5.1
5.2
5.3
5.7
6.1
6.2
6.5
7.1
7.2
7.3
7.5
7.6
7.7
7.8
7.9
7.10
Analysis of Equity-Linked Instruments ............................................................... 2-2
Analysis of Embedded Equity-Linked Components ........................................... 2-5
Put and Call Options Embedded in Debt Instruments........................................ 3-2
Analysis of Whether a Put or Call Is Clearly and Closely Related
to a Debt Host..................................................................................................... 3-2
Warrants Issued in Connection with Debt and Equity Offerings......................... 3-12
Beneficial Conversion Feature ........................................................................... 3-14
Mezzanine (Temporary) Equity Classification ..................................................... 3-18
Issuance Costs ................................................................................................... 3-20
Registration Payment Arrangements .................................................................. 3-21
Basic and Diluted Earnings per Share ................................................................ 4-2
Anti-Dilution and Sequencing of Instruments ..................................................... 4-2
If-Converted Method .......................................................................................... 4-2
Contingently Convertible Instruments ................................................................ 4-8
Participating Securities/Two-Class Method of Calculating Basic and
Diluted EPS ......................................................................................................... 4-9
Share Lending Agreements ................................................................................ 4-13
Restructuring and Extinguishment...................................................................... 5-2
Analyzing a Debt Restructuring .......................................................................... 5-2
Troubled Debt Restructurings (TDRs) ................................................................. 5-3
Restructuring of Convertible Debt Instruments .................................................. 5-22
Debt Instrument Overview .................................................................................. 6-2
Balance Sheet Classification—Current vs. Non-Current .................................... 6-2
Guarantees on Debt............................................................................................ 6-15
Analysis of Convertible Debt............................................................................... 7-2
Embedded Conversion Options ......................................................................... 7-4
Beneficial Conversion Feature (BCF) .................................................................. 7-9
Conversion into Equity ........................................................................................ 7-21
Induced Conversion ............................................................................................ 7-22
Convertible Debt Extinguishment Accounting .................................................... 7-24
Put and Call Options ........................................................................................... 7-25
Contingent Interest ............................................................................................. 7-27
Instruments Executed in Conjunction with a Convertible Bond ......................... 7-27
Convertible Preferred Stock
2.1
2.3
3.3
3.4
3.5
3.6
3.7
3.8
4.1
4.2
4.3
4.7
4.8
5.8
8.1
8.2
xii / Table of Contents
Analysis of Equity-Linked Instruments ............................................................... 2-2
Analysis of Embedded Equity-Linked Components ........................................... 2-5
Put and Call Options Embedded in Equity Instruments ..................................... 3-12
Warrants Issued in Connection with Debt and Equity Offerings......................... 3-12
Beneficial Conversion Feature ........................................................................... 3-14
Mezzanine (Temporary) Equity Classification ..................................................... 3-18
Issuance Costs ................................................................................................... 3-20
Registration Payment Arrangements .................................................................. 3-21
Basic and Diluted Earnings per Share ................................................................ 4-2
Anti-Dilution and Sequencing of Instruments ..................................................... 4-2
If-Converted Method .......................................................................................... 4-2
Contingently Convertible Instruments ................................................................ 4-8
Participating Securities/Two-Class Method of Calculating Basic and
Diluted EPS ......................................................................................................... 4-9
Modification vs. Extinguishment—Preferred Stock ............................................ 5-23
Characteristics of Preferred Stock ...................................................................... 8-2
Analysis of Preferred Stock................................................................................. 8-3
8.3
8.4
8.5
8.6
8.7
8.8
8.9
8.10
8.11
8.12
Redemption Features in Preferred Stock............................................................ 8-3
Conversion Features in Preferred Stock ............................................................. 8-8
Preferred Stock Exchangeable into Debt ........................................................... 8-12
Participation Rights............................................................................................. 8-12
Calls and Puts ..................................................................................................... 8-12
Tranched Preferred Stock ................................................................................... 8-13
Preferred Stock Measurement ............................................................................ 8-14
Preferred Stock Dividends .................................................................................. 8-15
Conversion into Equity ........................................................................................ 8-16
Preferred Stock Extinguishment Accounting ...................................................... 8-17
Debt with Detachable Warrants (accounted for as freestanding instruments)
2.1
2.2
2.4
2.5
3.1
3.2
3.4
3.6
3.7
3.8
4.1
4.2
4.4
4.5
4.8
5.1
5.2
5.3
5.4
5.9
6.1
6.2
6.5
6.6
9.1
9.2
9.3
Analysis of Equity-Linked Instruments ............................................................... 2-2
Freestanding vs. Embedded ............................................................................... 2-2
Analysis of Certain Freestanding Instruments (ASC 480) ................................... 2-10
Analysis of a Freestanding Equity-Linked Instrument ........................................ 2-13
Put and Call Options Embedded in Debt Instruments........................................ 3-2
Analysis of Whether a Put or Call Is Clearly and Closely Related
to a Debt Host..................................................................................................... 3-2
Warrants Issued in Connection with Debt and Equity Offerings......................... 3-12
Mezzanine (Temporary) Equity Classification ..................................................... 3-18
Issuance Costs ................................................................................................... 3-20
Registration Payment Arrangements .................................................................. 3-21
Basic and Diluted Earnings per Share ................................................................ 4-2
Anti-Dilution and Sequencing of Instruments ..................................................... 4-2
Treasury Stock Method ....................................................................................... 4-5
Instruments Settlable in Cash or Shares ............................................................ 4-7
Participating Securities/Two-Class Method of Calculating Basic and
Diluted EPS ......................................................................................................... 4-9
Restructuring and Extinguishment...................................................................... 5-2
Analyzing a Debt Restructuring .......................................................................... 5-2
Troubled Debt Restructurings (TDRs) ................................................................. 5-3
Modification vs. Extinguishment—Non-Revolving Debt Security or
Term Loan ........................................................................................................... 5-8
Modification of Warrants Classified as Equity .................................................... 5-25
Debt Instrument Overview .................................................................................. 6-2
Balance Sheet Classification—Current vs. Non-current ..................................... 6-2
Guarantees on Debt............................................................................................ 6-15
Contingent Interest on Debt ............................................................................... 6-16
Summary of Share Issuance Contracts .............................................................. 9-2
Forward Sale Contract, Purchased Put Option, and Written Call Option
(Warrant) on a Company’s Own Stock................................................................ 9-2
Units Structures .................................................................................................. 9-5
Forward Repurchase of Equity
2.1
2.4
2.5
4.1
4.2
4.4
4.5
Analysis of Equity-Linked Instruments ............................................................... 2-2
Analysis of Certain Freestanding Instruments (ASC 480) ................................... 2-10
Analysis of a Freestanding Equity-Linked Instrument ........................................ 2-13
Basic and Diluted Earnings per Share ................................................................ 4-2
Anti-Dilution and Sequencing of Instruments ..................................................... 4-2
Treasury Stock Method ....................................................................................... 4-5
Instruments Settlable in Cash or Shares ............................................................ 4-7
Table of Contents / xiii
4.8
10.1
10.2
Participating Securities/Two-Class Method of Calculating Basic and
Diluted EPS ......................................................................................................... 4-9
Summary of Share Repurchase Contracts ......................................................... 10-2
Forward Repurchase of a Company’s Own Stock.............................................. 10-3
Forward Sale of Equity
2.1
2.4
2.5
4.1
4.2
4.4
4.5
4.8
9.1
9.2
Analysis of Equity-Linked Instruments ............................................................... 2-2
Analysis of Certain Freestanding Instruments (ASC 480) ................................... 2-10
Analysis of a Freestanding Equity-Linked Instrument ........................................ 2-13
Basic and Diluted Earnings per Share ................................................................ 4-2
Anti-Dilution and Sequencing of Instruments ..................................................... 4-2
Treasury Stock Method ....................................................................................... 4-5
Instruments Settlable in Cash or Shares ............................................................ 4-7
Participating Securities/Two-Class Method of Calculating Basic and
Diluted EPS ......................................................................................................... 4-9
Summary of Share Issuance Contracts .............................................................. 9-2
Forward Sale Contract, Purchased Put Option, and Written Call Option
(Warrant) on a Company’s Own Stock................................................................ 9-2
Line-of-Credit or Revolving-Debt Arrangement
3.1
3.2
3.4
3.7
3.8
4.1
5.1
5.2
5.3
5.5
5.6
6.1
6.2
6.5
6.6
Put and Call Options Embedded in Debt Instruments........................................ 3-2
Analysis of Whether a Put or Call Is Clearly and Closely Related
to a Debt Host..................................................................................................... 3-2
Warrants Issued in Connection with Debt and Equity Offerings......................... 3-12
Issuance Costs ................................................................................................... 3-20
Registration Payment Arrangements .................................................................. 3-21
Basic and Diluted Earnings per Share ................................................................ 4-2
Restructuring and Extinguishment...................................................................... 5-2
Analyzing a Debt Restructuring .......................................................................... 5-2
Troubled Debt Restructurings (TDRs) ................................................................. 5-3
Modifications to and Payoffs of Line-of-Credit or Revolving-Debt
Arrangements ..................................................................................................... 5-19
Debt Extinguishment Accounting ....................................................................... 5-20
Debt Instrument Overview .................................................................................. 6-2
Balance Sheet Classification—Current vs. Non-Current .................................... 6-2
Guarantees on Debt............................................................................................ 6-15
Contingent Interest on Debt ............................................................................... 6-16
Mandatory Units (accounted for as freestanding instruments)
2.1
2.2
2.4
2.5
3.1
3.2
3.6
3.7
3.8
4.1
4.2
4.4
xiv / Table of Contents
Analysis of Equity-Linked Instruments ............................................................... 2-2
Freestanding vs. Embedded ............................................................................... 2-2
Analysis of Certain Freestanding Instruments (ASC 480) ................................... 2-10
Analysis of a Freestanding Equity-Linked Instrument ........................................ 2-13
Put and Call Options Embedded in Debt Instruments........................................ 3-2
Analysis of Whether a Put or Call Is Clearly and Closely Related
to a Debt Host..................................................................................................... 3-2
Mezzanine (Temporary) Equity Classification ..................................................... 3-18
Issuance Costs ................................................................................................... 3-20
Registration Payment Arrangements .................................................................. 3-21
Basic and Diluted Earnings per Share ................................................................ 4-2
Anti-Dilution and Sequencing of Instruments ..................................................... 4-2
Treasury Stock Method ....................................................................................... 4-5
4.5
4.8
5.1
5.2
5.3
5.4
6.5
6.6
9.1
9.2
9.3
Instruments Settlable in Cash or Shares ............................................................ 4-7
Participating Securities/Two-Class Method of Calculating Basic and
Diluted EPS ......................................................................................................... 4-9
Restructuring and Extinguishment...................................................................... 5-2
Analyzing a Debt Restructuring .......................................................................... 5-2
Troubled Debt Restructurings (TDRs) ................................................................. 5-3
Modification vs. Extinguishment—Non-Revolving Debt Security
or Term Loan ....................................................................................................... 5-8
Guarantees on Debt............................................................................................ 6-15
Contingent Interest on Debt ............................................................................... 6-16
Summary of Share Issuance Contracts .............................................................. 9-2
Forward Sale Contract, Purchased Put Option, and Written Call Option
(Warrant) on a Company’s Own Stock................................................................ 9-2
Units Structures .................................................................................................. 9-5
Preferred Stock
3.3
3.4
3.6
3.7
3.8
4.1
4.8
5.8
8.1
8.2
8.3
8.5
8.6
8.7
8.8
8.9
8.10
8.11
8.12
Put and Call Options Embedded in Equity Instruments ..................................... 3-12
Warrants Issued in Connection with Debt and Equity Offerings......................... 3-12
Mezzanine (Temporary) Equity Classification ..................................................... 3-18
Issuance Costs ................................................................................................... 3-20
Registration Payment Arrangements .................................................................. 3-21
Basic and Diluted Earnings per Share ................................................................ 4-2
Participating Securities/Two-Class Method of Calculating Basic and
Diluted EPS ......................................................................................................... 4-9
Modification vs. Extinguishment—Preferred Stock ............................................ 5-23
Characteristics of Preferred Stock ...................................................................... 8-2
Analysis of Preferred Stock................................................................................. 8-3
Redemption Features in Preferred Stock............................................................ 8-3
Preferred Stock Exchangeable into Debt ........................................................... 8-12
Participation Rights............................................................................................. 8-12
Calls and Puts ..................................................................................................... 8-12
Tranched Preferred Stock ................................................................................... 8-13
Preferred Stock Measurement ............................................................................ 8-14
Preferred Stock Dividends .................................................................................. 8-15
Conversion into Equity ........................................................................................ 8-16
Preferred Stock Extinguishment Accounting ...................................................... 8-17
Term Debt
3.1
3.2
3.4
3.7
3.8
4.1
5.1
5.2
5.3
5.4
5.6
6.1
6.2
Put and Call Options Embedded in Debt Instruments........................................ 3-2
Analysis of Whether a Put or Call Is Clearly and Closely Related
to a Debt Host..................................................................................................... 3-2
Warrants Issued in Connection with Debt and Equity Offerings......................... 3-12
Issuance Costs ................................................................................................... 3-20
Registration Payment Arrangements .................................................................. 3-21
Basic and Diluted Earnings per Share ................................................................ 4-2
Restructuring and Extinguishment...................................................................... 5-2
Analyzing a Debt Restructuring .......................................................................... 5-2
Troubled Debt Restructurings (TDRs) ................................................................. 5-3
Modification vs. Extinguishment—Non-Revolving Debt Security
or Term Loan ....................................................................................................... 5-8
Debt Extinguishment Accounting ....................................................................... 5-20
Debt Instrument Overview .................................................................................. 6-2
Balance Sheet Classification—Current vs. Non-Current .................................... 6-2
Table of Contents / xv
6.4
6.5
6.6
Payment in Kind .................................................................................................. 6-13
Guarantees on Debt............................................................................................ 6-15
Contingent Interest on Debt ............................................................................... 6-16
Warrants
2.1
2.4
2.5
3.4
3.6
3.7
3.8
4.1
4.2
4.4
4.5
4.8
5.9
9.1
9.2
Analysis of Equity-Linked Instruments ............................................................... 2-2
Analysis of Certain Freestanding Instruments (ASC 480) ................................... 2-10
Analysis of a Freestanding Equity-Linked Instrument ........................................ 2-13
Warrants Issued in Connection with Debt and Equity Offerings......................... 3-12
Mezzanine (Temporary) Equity Classification ..................................................... 3-18
Issuance Costs ................................................................................................... 3-20
Registration Payment Arrangements .................................................................. 3-21
Basic and Diluted Earnings per Share ................................................................ 4-2
Anti-Dilution and Sequencing of Instruments ..................................................... 4-2
Treasury Stock Method ....................................................................................... 4-5
Instruments Settlable in Cash or Shares ............................................................ 4-7
Participating Securities/Two-Class Method of Calculating Basic and
Diluted EPS ......................................................................................................... 4-9
Modification of Warrants Classified as Equity .................................................... 5-25
Summary of Share Issuance Contracts .............................................................. 9-2
Forward Sale Contract, Purchased Put Option, and Written Call Option
(Warrant) on a Company’s Own Stock................................................................ 9-2
Written Put Option or Prepaid Written Put Option
2.1
2.2
2.4
2.5
4.1
4.2
4.8
10.1
10.3
xvi / Table of Contents
Analysis of Equity-Linked Instruments ............................................................... 2-2
Freestanding vs. Embedded ............................................................................... 2-2
Analysis of Certain Freestanding Instruments (ASC 480) ................................... 2-10
Analysis of a Freestanding Equity-Linked Instrument ........................................ 2-13
Basic and Diluted Earnings per Share ................................................................ 4-2
Anti-Dilution and Sequencing of Instruments ..................................................... 4-2
Participating Securities/Two-Class Method of Calculating Basic and
Diluted EPS ......................................................................................................... 4-9
Summary of Share Repurchase Contracts ......................................................... 10-2
Written Put Option on Own Shares..................................................................... 10-5
Chapter 1:
Guidelines
Guidelines / 1 - 1
1.1
Accounting for Financing Transactions
Determining the appropriate accounting treatment for the issuance, modification,
conversion and repurchase of debt and equity securities under US GAAP can be
challenging. To do so, an issuer must understand all of the terms of a transaction,
including provisions that may be included in side agreements or not explicitly stated
but result from laws or regulations.
The applicable accounting literature can be prescriptive, is dispersed among
various sections of the FASB’s Accounting Standards Codification (ASC), and is
generally tailored for specific types of instruments. To determine the appropriate
accounting treatment of a financing transaction, an issuer may need to consider the
relevant provisions of several sections of the ASC, and do so in a logical sequence.
Additionally, in some cases the accounting literature may not be clear or may permit
acceptable alternatives.
We believe good financial reporting reflects the economic substance of a transaction.
However, at times, accounting standards require the reporting to reflect the form of
the transaction. If the required accounting for a transaction and the economics of
that transaction appear to diverge because the form must be followed, we believe
the issuer should consider including disclosure in the financial statements to provide
users with an understanding of the economic substance of the transaction.
1.2
Organization of this Guide
This Guide provides a roadmap through the applicable accounting literature to help
you determine which steps are necessary for a particular transaction.
• In Chapters 2–5 we discuss the accounting literature and analyses applicable to
many financing transactions.
• In Chapters 6–11 we discuss the application of the accounting literature to specific
financing transactions, such as debt, convertible debt, and preferred stock.
We have included two tables of contents in the front of the Guide. The first lists the
contents of the Guide in the order they are presented. The second lists the applicable
sections of the Guide by financing transaction type. We have included this second
table of contents to help readers understand the accounting literature that may apply
to a particular transaction type.
All literature references in the Guide are defined in Appendix A. In Appendix B we
have included definitions of key terms used in the Guide. In addition, in this Guide
the terms the “company” and the “issuer” are used interchangeably, as are the terms
“security” and “instrument.”
1.3
International Accounting Standards
This Guide covers the accounting for financing transactions under US GAAP only.
The accounting for financing transactions under IFRS is very different than under US
GAAP. IFRS has a single comprehensive standard dealing with classification, IAS
32, which addresses the classification of financial instruments as a financial liability
or equity from a company’s perspective. The measurement guidance for financial
liabilities is provided in IAS 39.
1 - 2 / Guidelines
1.4
Contracts to Enter into a Financing Transaction (Forward Starting
Transactions)
This Guide does not explicitly address situations involving forward starting
transactions. A company may enter into a contract in which it commits to enter into a
financing transaction in the future. For example, a company may:
• Agree to issue debt to an investor upon the occurrence of a specified event, or
• Enter into a contract to buy back its stock after it releases earnings in 3 weeks
time.
These contracts (or agreements) may have accounting implications if the terms of the
underlying financing transaction have been set. For example, if a company agrees
to issue 5-year debt that pays a coupon of 3.00% to an investor in 3 months, the
company should record changes in the fair value of the obligation to issue that debt
in earnings. On the other hand, if a company agrees to issue debt with market terms
to an investor in 3 months, that contract is likely to have a fair value of zero, and thus
would not have an accounting impact.
1.5
Financing Transactions Reported at Fair Value
In the past several years, the FASB has issued standards that provide issuers with
the option of reporting certain financial statement items at fair value. These standards
allow issuers to elect a fair value option for certain qualifying financing transactions.
A majority of the accounting analyses discussed in this Guide does not apply to
financing transactions that are accounted for at fair value.
There are certain financing transactions that issuers are prohibited from reporting
at fair value. Convertible debt instruments that are bifurcated into a debt and an
equity component based on the guidance in ASC 470, such as debt with (1) a cash
conversion feature (as defined in FG section 7.4) or (2) a beneficial conversion feature
(as described in FG section 7.3), are not eligible for the fair value option under ASC
825 based on the guidance in ASC 825-10-15-5(f).
1.6
How PwC Can Help
PwC professionals have years of experience advising clients on the transactions
discussed in this Guide. At the end of each chapter in which we discuss the
application of guidance to specific financing transactions we have included a section
entitled How PwC Can Help. This section lists some of the many areas in which PwC
can provide advice. If you would like to discuss one of the topics covered in this
Guide, please contact your PwC engagement partner or one of the contacts included
at the end of the Guide.
Guidelines / 1 - 3
Chapter 2:
Analysis of Equity-Linked Instruments
Analysis of Equity-Linked Instruments / 2 - 1
2.1
Analysis of Equity-Linked Instruments
The analysis to determine the appropriate accounting for equity-linked instruments is
best performed using a multi-step approach. In this chapter we discuss each of the
steps and important points to consider when determining whether an equity-linked
instrument should be accounted for in its entirety as equity or a liability (or asset), or
separated into components. The overall model is illustrated below.
Analysis of Equity-Linked Instruments
Is the equity-linked instrument
(or embedded component)
freestanding or embedded in a
host instrument?
Embedded
Freestanding
Is the instrument within the
scope of ASC 480?
(FG section 2.4.1)
Embedded component is not within
the scope of ASC 480. Hybrid instrument
in its entirety must be analyzed under
ASC 480. Perform analysis of embedded
equity-linked component.
(FG section 2.3)
No
Yes
2.2
Apply the recognition
and measurement
guidance in ASC 480.
Perform analysis
of a freestanding equitylinked instrument.
(FG section 2.4.2)
(FG section 2.5)
Freestanding vs. Embedded
An equity-linked component can be embedded in a host instrument, such as a debt
instrument (convertible debt) or preferred stock (convertible preferred stock) that
has economic value attributable to factors other than the equity-linked component.
Alternatively, an instrument can comprise only the equity-linked component, as is
the case with a freestanding warrant. Thus, the first step in accounting for an equitylinked instrument is to determine whether the instrument is freestanding or whether
the equity-linked component is embedded in a host instrument, such as a debt
instrument or preferred stock.
The ASC Master Glossary defines a freestanding financial instrument as:
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.
2 - 2 / Analysis of Equity-Linked Instruments
The concept of “freestanding” refers to a single financial instrument or contract.
However, a single contract may contain more than one economic component, such
as an option or forward. For example, (1) a variable share forward delivery agreement
consists of a written put option and a purchased call option and (2) a capped
call option consists of a purchased call option and a written call option. In both
examples, neither component would be separated from the other.
In determining whether a component is a freestanding financial instrument or
embedded in a host instrument, issuers must consider all substantive terms.
Significant judgment may be needed in considering and weighing a number of
different contractual terms and indicators such as:
• Whether the components were issued (1) contemporaneously and in
contemplation of each other or (2) separately and at different points in time,
• Whether the components (1) may be legally transferred separately or (2) must be
transferred with the instrument with which they were issued or associated, and
• Whether (1) a right in a component may be exercised separately from other
components that remain outstanding or (2) if once a right in a component is
exercised, the other components are no longer outstanding.
Determining whether a component is freestanding or embedded is important
because the criterion used to determine the accounting recognition and
measurement for a freestanding instrument differs from that for an embedded
component. For example, ASC 480 does not apply to equity-linked components that
are embedded in host instruments. In addition, the guidance in ASC 815 is applied
differently to freestanding instruments than to embedded components.
The analyses described in this chapter are applicable to freestanding instruments
and embedded components in host instruments that an issuer has not elected (or
cannot elect) to carry at fair value.
Example 2-1: Tranched Preferred Stock
Background/Facts:
• Company Z issues Series A preferred shares to investors.
• Company Z also grants investors in the Series A preferred shares a warrant to buy
Series B preferred shares, if issued, at a fixed price (Series B warrant). The Series
B shares will only be issued (and the warrant is only exercisable) upon the receipt
of a patent for a specified technology being developed by Company Z.
• The investors can transfer the Series B warrant separately from the Series A
shares (i.e., they can sell the Series B warrant and retain the Series A shares).
• If the Series B warrant is exercised, the Series A shares are unaffected and remain
outstanding.
(continued)
Analysis of Equity-Linked Instruments / 2 - 3
Question:
Is the Series B warrant a freestanding instrument or a component embedded in the
Series A shares?
Analysis/Conclusion:
In making this determination, Company Z must apply judgment and consider all of
the contractual terms and indicators. For example:
• Were the Series A shares and Series B warrant issued (1) separately and
subsequent to an initial transaction or (2) contemporaneously and in
contemplation of each other?
The Series A shares and Series B warrant were issued contemporaneously and in
contemplation of each other. This indicates that the Series B warrant may be an
embedded component.
• Can the Series B warrant be transferred separately from the Series A shares or
must it be transferred with the Series A shares?
The Series B warrant can be separately transferred; the investor does not have
to transfer the Series B warrant with the Series A shares. This indicates that the
Series B warrant may be a freestanding instrument.
• Can the Series B warrant be exercised separately from the Series A shares such
that the Series A shares remain outstanding? Or do the Series A shares liquidate if
the Series B warrant is exercised?
The Series B warrant can be separately exercised; the Series A shares remain
outstanding if the Series B warrant is exercised. This indicates that the Series B
warrant may be a freestanding instrument.
Based on this preliminary analysis, the Series B warrant is a freestanding instrument.
See FG section 8.8 for a discussion of tranched preferred stock.
2 - 4 / Analysis of Equity-Linked Instruments
2.3
Analysis of Embedded Equity-Linked Components
Is the hybrid instrument
accounted for at fair value
and remeasured at fair value
through earnings?
Do not separate embedded
component from the hybrid
instrument.
Yes
No
Determine whether the host instrument
is a debt or equity host.
Yes
Is the embedded equity-linked
component clearly and closely related
to its host instrument?
(FG section 2.3.1)
No
Does the embedded equity-linked
component meet the definition
of a derivative?
No
(FG section 2.3.2)
Yes
Does the embedded derivative
qualify for the scope exception
for certain contracts involving
an issuer’s own equity?
(FG section 2.3.3)
No
Separately account for the
embedded derivative, initially
record at fair value
with changes in fair value
recorded in earnings.
Yes
ASC 815-15-25-1 calls for embedded components to be accounted for separately as
derivatives if all of the following criteria 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 measured at fair value with changes in fair value
recorded in earnings.
c. A separate instrument with the same terms as the embedded derivative would
be a derivative instrument pursuant to the requirements of ASC 815.
Analysis of Equity-Linked Instruments / 2 - 5
2.3.1
Clearly and Closely Related
Determine whether the host
instrument is a debt or equity host.
Is the embedded equity-linked
component clearly and closely
related to its host instrument?
Yes
Do not separate embedded
component from the hybrid
instrument.
(FG section 2.3.1)
No
Does the embedded equity-linked
component meet the definition
of a derivative?
(FG section 2.3.2)
An embedded component that meets the definition of a derivative does not have to
be separated from its host instrument and accounted for as a derivative if it is clearly
and closely related to its host. When considering whether an embedded equity-linked
component is clearly and closely related to its host instrument, an issuer must first
determine whether the host is an equity host or a debt host. An embedded equitylinked component will generally be clearly and closely related to an equity host,
whereas it would not be considered clearly and closely related to a debt host.
2.3.1.1
Preferred Stock
When determining whether a conversion option embedded within preferred stock
is clearly and closely related to the preferred stock host contract, an issuer must
first define the nature of the host contract by determining whether the convertible
preferred stock (ignoring the impact of the conversion option) is more akin to a
debt instrument or equity instrument. ASC 815-15-25-17 indicates that “a typical
cumulative fixed-rate preferred stock that has a mandatory redemption feature is
more akin to debt, whereas cumulative participating perpetual preferred stock is
more akin to an equity instrument.” However, depending on the contractual terms
of the preferred stock, judgment may need to be applied and other factors, such as
the existence of creditor or voting rights and the treatment of interest payments or
dividends for tax purposes, may need to be considered in defining the nature of the
host instrument as debt or equity.
2.3.1.2
Debt Host
When analyzing a conversion option embedded within a debt host contract, it is
important to note that the changes in fair value of an equity component and the
credit risk and interest rates on a debt instrument are not clearly and closely related.
ASC 815-15-25-51 further explains that for a debt security that is convertible into
a specified number of shares of the debtor’s common stock or another entity’s
common stock, the conversion option must be separately accounted for as a
derivative instrument if:
• It is not clearly and closely related to the debt host instrument,
• It meets the definition of a derivative (FG section 2.3.2),
2 - 6 / Analysis of Equity-Linked Instruments
• The hybrid instrument is not recorded at fair value in its entirety, and
• The embedded derivative does not otherwise meet the scope exception for
certain contracts involving an issuer’s own equity in ASC 815-10-15-74(a)
(FG section 2.3.3).
2.3.2
Definition of a Derivative
Does the embedded equity-linked
component meet the definition
of a derivative?
No
Do not separate the
embedded component
from the hybrid instrument.
(FG section 2.3.2)
Yes
Does the embedded derivative
qualify for the scope exception
for certain contracts involving
an issuer’s own equity?
(FG section 2.3.3)
ASC 815-10-15-83 defines a derivative instrument as a financial instrument or other
contract with all of the following characteristics:
a. One or more underlyings and one or more notional amounts or payment
provisions, or both,
b. 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, and
c. Net settlement provisions
A contract may be considered net settled when its settlement meets one of the
following criteria in ASC 815-10-15-99:
a. Net settlement under contract terms.
b. Net settlement through a market mechanism.
c. Net settlement by delivery of a derivative instrument or an asset readily
convertible to cash.
An embedded component can be net settled if the issuer (or counterparty investor) is
permitted, by the terms of the contract, to settle the embedded component in cash.
For example, if upon conversion a convertible debt instrument allows the issuer to
deliver cash equal to the conversion value (par amount of the debt plus conversion
option value), the embedded component (the conversion option) can be net settled
under the contract terms.
Generally, embedded components cannot be net settled through a market
mechanism. Net settlement through a market mechanism requires that an issuer (or
counterparty) have the ability to transfer the derivative instrument to another party
for a price approximately equal to fair value. This would be the case for certain
Analysis of Equity-Linked Instruments / 2 - 7
instruments, such as a freestanding exchange traded stock option. However, when
a component is embedded in a host instrument, it generally cannot be transferred
without transferring the entire instrument.
Chapter 2 of PwC’s Guide to Accounting for Derivative Instruments and Hedging
Activities 2012 edition provides additional guidance on how to determine whether a
contract meets the definition of a derivative.
2.3.2.1
Readily Convertible to Cash
A contract that requires delivery of the underlying asset in an amount equal to the
notional amount of the contract is considered to contain a net settlement provision if
the asset is readily convertible to cash. Such a contract puts the receiving party in a
position that is equivalent to a net settlement. When a contract is net settled, neither
party accepts the risks and costs customarily associated with owning and delivering
the asset associated with the underlying (e.g., storage, maintenance, and resale
costs). However, if the asset to be delivered is readily convertible to cash, those risks
are minimal, and therefore the parties should be indifferent as to whether there is a
gross physical exchange of the asset or a net settlement in cash.
An example of a contract with this form of net settlement is a forward contract that
requires delivery of a liquid exchange-traded equity security. A liquid exchangetraded security is readily convertible to cash.
ASC 815 defines the phrase readily convertible to cash in the Glossary. This
definition refers to the following characteristics as support that an asset is readily
convertible to cash:
1. Interchangeable (fungible) units, and
2. Quoted prices that are available in an active market, which can rapidly absorb the
quantity held by an entity without significantly affecting the price.
Based on this definition, a security traded in a deep and active market is an asset
that is readily convertible to cash provided the minimum number of shares to be
exchanged is relatively small when compared to the daily trading volume. Conversely,
securities that are not actively traded, as well as an unusually large block of thinly
traded securities, would not be considered readily convertible to cash in most
circumstances, even though the owner might be able to use such securities as
collateral in a borrowing arrangement. In addition, securities that are restricted from
sale for a period of at least 32 days upon receipt may not be considered readily
convertible to cash, as discussed in ASC 815-10-15-131 through 15-138.
An asset is considered to be readily convertible to cash only if the net amount of
cash received from its sale is equal to or not significantly less than the amount an
entity would typically have received under a net settlement provision.
An issuer must assess the estimated costs that would be incurred to immediately
convert the asset to cash. If those costs are significant, then the asset is not
considered readily convertible to cash and would not meet the definition of net
settlement. For purposes of assessing significance of such costs, an entity shall
consider those estimated conversion costs to be significant only if they are
10 percent or more of the gross sales proceeds (based on the spot price at the
inception of the contract) that would be received from the sale of those assets in the
closest or most economical active market (ASC 815-10-15-126).
2 - 8 / Analysis of Equity-Linked Instruments
2.3.3
Scope Exception for Certain Contracts Involving an Issuer’s Own Equity
An embedded equity-linked component that meets the definition of a derivative does
not have to be separated from its host instrument if the component qualifies for the
scope exception for certain contracts involving an issuer’s own equity in
ASC 815-10-15-74(a).
ASC 815-10-15-74 states:
Notwithstanding the conditions of paragraphs 815-10-15-13 through 15-139,
the reporting entity shall not consider the following contracts to be derivative
instruments for purposes of this Subtopic:
a. Contracts issued or held by that reporting entity that are both:
1. Indexed to its own stock
2. Classified in stockholders’ equity in its statement of financial position.
An embedded component is considered indexed to a company’s own stock if it
meets certain specified requirements in ASC 815-40-15. See FG section 2.5.1 for
discussion of these requirements.
An embedded component would be classified in stockholders’ equity if it meets the
requirements for equity classification in ASC 815-40-25. See FG section 2.5.2 for
discussion of these requirements.
2.3.4
Accounting for Separated Instruments
When an issuer does not elect to account for an entire hybrid instrument at fair
value, and an embedded derivative must be separated from the hybrid instrument
and accounted for separately, the accounting for the host contract should be based
on the accounting guidance that is applicable to similar host contracts of that type.
ASC 815-15-30-2 provides guidance on allocating the carrying amount of the hybrid
instrument between the host contract and the derivative. The guidance requires
the derivative to be recorded at fair value and the carrying value assigned to the
host contract to represent the difference between the previous carrying amount of
the hybrid instrument and the fair value of the derivative. Therefore, there will be no
immediate gain or loss from the initial recognition and measurement of an embedded
derivative that is accounted for separately from its host contract.
If the embedded derivative is an option, ASC 815-15-30-6 provides that the
embedded option-based contract can have a fair value other than zero at the
inception of the contract. The contractual terms of the embedded option, including
its strike or conversion price, should not be adjusted to result in the option being
at-the-money at the inception of the hybrid contract. As such, the intrinsic value
of the embedded option may be other than zero at issuance of the contract. This
intrinsic value would be included in the fair value of the embedded derivative at the
time it is initially recognized. For a debt host contract, this would require additional
debt discount or premium to be recorded that is equal to the initial fair value of the
option. If the embedded derivative is not an option (e.g., it is a forward component),
the terms of the 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.
Analysis of Equity-Linked Instruments / 2 - 9
2.4
Analysis of Certain Freestanding Instruments (ASC 480)
Is the instrument within the
scope of ASC 480?
(FG section 2.4.1)
Yes
2.4.1
No
Apply the recognition
and measurement
guidance in ASC 480.
Perform analysis
of a freestanding equitylinked instrument.
(FG section 2.4.2)
(FG section 2.5)
Scope
The guidance in ASC 480 applies to freestanding equity-linked financial instruments
and requires that issuers classify the following freestanding financial instruments as
liabilities (or in some cases as assets):
• Mandatorily redeemable financial instruments issued in the form of shares,
• Obligations that require or may require repurchase of the issuer’s equity
shares by transferring assets (e.g., Written put options and forward purchase
contracts), and
• Certain obligations to issue a variable number of shares where at inception the
monetary value of the obligation is based solely or predominantly on:
— A fixed monetary amount known at inception, for example, a payable settlable
with a variable number of the issuer’s equity shares,
— Variations in something other than the fair value of the issuer’s equity shares,
for example, a financial instrument indexed to the S&P 500 and settlable with a
variable number of the issuer’s equity shares, or
— Variations inversely related to changes in the fair value of the issuer’s equity
shares, for example, a written put option that could be net share settled.
Note that a purchased option, such as a purchased call option, does not create
an obligation to repurchase shares under ASC 480 because a purchased option
provides the issuer with a right but not an obligation. Further, ASC 480 does not
apply to contracts that will always be classified as an asset by the issuer as a
purchased option would be.
Whether a transaction is within the scope of ASC 480 may be dictated by the legal
form of the transaction. ASC 480 specifies that, generally, two or more freestanding
financial instruments (e.g., a written put option, a purchased call option, and a
share of common stock) should not be considered in combination; rather they
should be evaluated separately on a contract-by-contract basis. However, ASC 480
does require instruments that must be combined pursuant to the provisions of
2 - 10 / Analysis of Equity-Linked Instruments
ASC 815-10-15-8 and 15-9 to be combined for purposes of determining the
applicability of ASC 480.1
2.4.2
Recognition and Measurement
Financial instruments, other than physically settled forward repurchase contracts,
that fall within the scope of ASC 480 should be initially measured at fair value.
This includes mandatorily redeemable instruments. Financial instruments that,
subsequent to issuance, fall into the scope of ASC 480 (e.g., the instrument was
conditionally redeemable, and thus not in the scope, and the condition is later met
such that it become mandatorily redeemable) should be reclassified as a liability and
also measured at fair value. No gain or loss should be recorded as a result of the
reclassification.
Physically settled forward repurchase contracts, in which an issuer will repurchase a
fixed number of its shares in exchange for cash, should initially be measured at the
fair value of the shares at the contract’s inception (the spot price of the shares at that
date), adjusted for any unstated rights or privileges. At the inception of a physically
settled forward repurchase contract, the issuer should reduce equity and recognize a
liability for the fair value of the shares. Essentially these contracts are accounted for
as financed purchases of treasury stock.
2.4.2.1
Subsequent Measurement
Most financial instruments that fall within the scope of ASC 480 should be
subsequently measured at fair value, with changes in fair value recorded in earnings,
typically as other income or expense.
An exception to the fair value measurement principal in ASC 480 is provided for
(1) mandatorily redeemable instruments and (2) physically settled forward repurchase
contracts (FG section 2.4.2). These contracts should be measured in one of two
ways:
• If both (a) the amount to be paid and (b) the settlement date are fixed, the
instrument should be accreted to the amount to be paid on the settlement date (or
stated value). Interest cost should accrue based on the rate implicit at inception
of the instrument (for a forward repurchase contract this is generally the difference
between the spot price at inception of the contract and the contractually agreed
upon forward price). The stated dividend rate on mandatorily redeemable
instruments should generally be accrued even if it is not declared.
• If either (a) the amount to be paid or (b) the settlement date varies based upon
specified conditions, subsequent measurement of the instrument should be based
on the amount of cash that would have been paid under the conditions specified
in the contract if a settlement had occurred on the reporting date.
— If the amount to be paid to settle the liability varies, the amortization amount
should be adjusted such that the liability will reach the amount to be paid on
the settlement date.
1
ASC 815-10-15-9 generally requires contracts with the following characteristics to be combined:
•
•
•
•
The instruments were entered into contemporaneously and in contemplation of one another,
The instruments have the same counterparty,
The instruments relate to the same risk,
There is no substantive business purpose for executing two instruments rather than combining them
into a single instrument.
Analysis of Equity-Linked Instruments / 2 - 11
— If the settlement date varies, the amortization amount and period should be
adjusted to reflect that change.
Changes in the value of the instrument since the previous reporting date should be
recognized as interest expense.
ASC 480-10-55-14 through 55-17 includes an example of how a physically settled
forward purchase contract should be measured initially and accounted for in
subsequent periods.
2.4.3
Non-Substantive Features
As noted in FG section 2.4.1, ASC 480 applies only to certain freestanding
financial instruments. To avoid attempts to circumvent the application of ASC 480
by embedding a minimal or non-substantive feature in a freestanding financial
instrument, the guidance specifies that non-substantive features should be
disregarded when determining whether ASC 480 applies. The following examples
from ASC 480-10-55-12 and 55-41 illustrate features that may be considered
non-substantive:
• If a mandatorily redeemable preferred stock contains a conversion feature, it
would not be classified as a liability based on the inclusion of the conversion
feature (FG section 8.4). However, if the conversion price at inception is extremely
high relative to the current share price (so that the likelihood of the stock price
ever reaching the conversion price is remote), it would be disregarded as provided
in ASC 480-10-25-1. This would result in the preferred stock being considered
mandatorily redeemable and classified as a liability. The issuer would not be
permitted to reassess that classification on the basis of the conversion option
becoming substantive (the likelihood of the stock price reaching the conversion
price increases) after issuance.
• As discussed in FG section 2.4.1, a written put option is classified as a liability
under ASC 480 because it obligates the company to deliver assets (cash) to
repurchase shares. A company that embeds a written put option into a nonsubstantive host instrument would disregard that host instrument and account
for the written put option as a liability. For example, a company issues one share
of preferred stock (with a par value of $100), paying a small dividend, with an
embedded option that allows the holder to put the preferred share along with
100,000 shares of the issuer’s common stock (currently trading at $50) for a fixed
price of $45 per share in cash. The preferred stock host is judged at inception to
be minimal and would be disregarded under ASC 480-10-25-1. Therefore, the
entire instrument would be analyzed as a written put option, classified as a liability,
and measured at fair value.
The assessment of whether a feature is minimal or non-substantive is performed
only at inception of a financial instrument; no further assessment is required. This
assessment requires significant judgment and must consider not only the legal terms
of an instrument, but also other relevant facts and circumstances.
Although a feature may be non-substantive for purposes of applying ASC 480, that
feature should not necessarily be ignored for other accounting purposes.
2 - 12 / Analysis of Equity-Linked Instruments
Example 2-2: Impact of Declining Stock Price on Conversion Option
Background/Facts:
• On January 1, 2012 Company A issued preferred shares convertible into
Company A common shares. The preferred shares are redeemable five years
after issuance if they are not converted by the investor prior to the redemption
date. The embedded conversion option is struck at a 20% premium to Company
A’s common stock price on January 1, 2012 and is deemed to be a substantive
conversion option.
• Since the preferred shares are conditionally redeemable (redeemable only if
investors do not exercise their conversion option prior to the redemption date) the
shares are classified as equity.
• On December 31, 2012, the conversion option is at a 200% premium to Company
A’s common stock price on that date due to a decline in Company A’s stock price.
Question:
Does the decline in stock price cause the embedded conversion option to be
deemed non-substantive as of December 31, 2012 such that the preferred shares
become mandatorily redeemable and subject to liability classification?
Analysis/Conclusion:
No. Although the embedded conversion option would likely be deemed nonsubstantive if the instrument had been issued and evaluated on December 31, 2012,
the evaluation of whether a feature is minimal or non-substantive is performed only
at issuance of the instrument. A conversion option that is deemed substantive upon
issuance of an instrument does not subsequently become non-substantive as a
result of a substantial decline in common stock price.
2.5
Analysis of a Freestanding Equity-Linked Instrument
Is the freestanding instrument
considered indexed
to the company’s own stock?
No
(FG section 2.5.1)
Classify as asset or liability,
initially record at fair value
with changes in fair value
recorded in earnings.
Yes
Does the freestanding
instrument meet the requirements
for equity classification?
No
(FG section 2.5.2)
Yes
Classify as equity, initially
record at fair value,
no subsequent remeasurement.
Analysis of Equity-Linked Instruments / 2 - 13
Once an issuer has determined that a freestanding financial instrument should not be
accounted for in accordance with ASC 480, the next step is to determine whether the
instrument should be accounted for as (1) an equity instrument or (2) a liability (or in
some cases an asset) in accordance with the guidance in ASC 815.
As illustrated in the flowchart above, the steps used to analyze a freestanding equitylinked instrument differ from the analysis of an embedded equity-linked component.
The key difference between the analyses is:
• An embedded equity-linked component must meet the definition of a derivative
in ASC 815-10-15-83 to be subject to the guidance in ASC 815-40, which may
require separation and classification of the embedded derivative as a liability
measured at fair value.
• A freestanding instrument does not need to meet the definition of a derivative to
be subject to the guidance in ASC 815-40, which may require classification of the
instrument as a liability measured at fair value.
Contracts that are indexed to an issuer’s own equity must be analyzed as described
in the flowchart even if the freestanding instrument does not meet the definition of
a derivative in ASC 815-10-15-83. For example, a freestanding warrant on private
company shares may not meet the definition of a derivative because it cannot be net
settled and the underlying equity is not readily convertible to cash, however it must
still be analyzed to determine whether it should be classified as a liability pursuant to
the guidance in ASC 815-40.
2.5.1
Indexed to a Company’s Own Stock—ASC 815-40-15 (previously EITF 07-5)
Is the freestanding instrument
considered indexed to the
company’s own stock?
(FG section 2.5.1)
No
Classify as asset or liability,
initially record at fair value
with changes in fair value
recorded in earnings.
Yes
Does the freestanding instrument
meet the requirements
for equity classification?
(FG section 2.5.2)
ASC 815-40-15, addresses when an instrument or embedded component that meets
the definition of a derivative is considered indexed to the company’s own stock for
purposes of applying the scope exception in ASC 815-10-15-74(a). The guidance
requires an issuer to apply a two-step approach—it requires the evaluation of an
instrument’s or embedded component’s contingent exercise provisions and then the
instrument’s or embedded component’s settlement provisions.
2 - 14 / Analysis of Equity-Linked Instruments
2.5.1.1
Step One—Exercise Contingencies
Any contingent provision that affects the holder’s ability to exercise the instrument
or embedded component must be evaluated. For example, holders may have a
contingent exercise right or may have their right to exercise accelerated, extended,
or eliminated upon satisfaction of a contingency.
• If an exercise contingency is based on the occurrence of an event, such as
an IPO, the contingency does not impact the conclusion that the freestanding
instrument or embedded component is indexed to a company’s own stock.
• If an exercise contingency is based on an observable index, then the presence
of the exercise contingency precludes a freestanding instrument or embedded
component from being considered indexed to a company’s own stock with
two exceptions. A contingency based on the following would not preclude the
instrument or embedded component from being considered indexed to the
company’s own stock.
— The company’s stock price, or
— One measured solely by reference to the issuer’s own operations (e.g., sales
revenue, EBITDA).
For example, if a warrant becomes exercisable only if the S&P 500 increases by 10%
or the price of oil decreases by 10%, the contingency would fail this step and the
warrant would not be considered indexed to the issuer’s own stock. In contrast, if the
warrant became exercisable only if the issuer’s stock price increased 10%, this step
of the guidance would be met and the analysis would proceed to Step 2.
2.5.1.2
Step Two—Settlement Adjustments
If the settlement amount equals the difference between the fair value of a fixed
number of the issuer’s equity shares and a fixed monetary amount, then the
instrument or embedded component would be considered indexed to the company’s
own stock. The same is true if the settlement amount equals the difference between
the fair value of a fixed number of the issuer’s equity shares and a fixed principal
amount of debt issued by the issuer. The strike price or the number of shares used
to calculate the settlement amount cannot be considered fixed if the terms of the
instrument or embedded component allow for any potential adjustment (except as
discussed below), regardless of the probability of the adjustment being made or
whether the issuer can control the adjustment.
The exception to the “fixed-for-fixed” rule relates to certain adjustments made to
the strike price or number of shares used to calculate the settlement amount. Those
terms may be adjusted provided the inputs to the adjustment are variables that
are standard inputs to the value of a “fixed-for-fixed” forward or option on equity
shares. These variables include items such as the term of the instrument, expected
dividends, stock borrow costs, interest rates, stock price volatility, and the ability
to maintain a standard hedge position. Including other variables, or incorporating a
leverage factor that increases the instrument’s exposure to those variables, would
preclude the instrument from being considered indexed to the company’s own stock.
Analysis of Equity-Linked Instruments / 2 - 15
2.5.1.3
Anti-dilution and Price Protection Provisions (including “down-round”
provisions)
Settlement adjustments designed to protect a holder’s position from being diluted
by a transaction initiated by the issuer will generally not prevent a freestanding
instrument or embedded component from being considered indexed to the
company’s own stock provided the adjustments are limited to the effect that the
dilutive event has on the shares underlying the instrument. Common examples of
acceptable adjustments include the occurrence of a stock split, rights offering, stock
dividend, or a spin-off. Similarly, settlement adjustments due to issuances of shares
for an amount below current fair value, or repurchases of shares for an amount that
exceeds the current fair value of those shares would also be acceptable.
Not all “anti-dilution” settlement adjustments will meet the criteria for being
considered indexed to a company’s own stock in ASC 815-40-15. Some equitylinked financial instruments may contain price protection provisions requiring a
reduction in an instrument’s strike price as a result of a subsequent at-market
issuance of shares below the instrument’s original strike price, or as a result of the
subsequent issuance of another equity-linked instrument with a lower strike price.
This is typically referred to as a “down-round” provision. The issuance of shares
for an amount equal to the current market price of those shares is not dilutive.
Further, the possibility of a market price transaction occurring at a price below an
instrument’s strike price is not an input to the valuation of a standard fixed-for-fixed
instrument and thus it would not qualify for the exception discussed in FG section
2.5.1.2. Therefore any settlement adjustments related to such events would preclude
the issuer from considering the instrument or embedded component as indexed to
its own stock.
The term “down-round protection” is not defined by GAAP and can be applied to
provisions with varying terms. As such, an issuer must evaluate the specific provision
to determine whether it impacts the issuer’s ability to consider an instrument to be
indexed to its own stock in ASC 815-40-15.
Example 2-3: Down-Round Provisions in a Security Received Upon Exercise
of a Warrant
Background/Facts:
• Company A issues warrants that permit the investor to buy 100 shares of its
Series B preferred stock for $100 per share. The warrants have 3-year terms and
are exercisable at any time.
• The warrants for Series B preferred stock contain permitted anti-dilution
provisions, but do not contain a down-round provision that compensates the
investor for the sale of Series B preferred shares at a price less than $100.
• The Series B preferred stock is (1) perpetual and (2) convertible into 5 shares of
Company’s A common stock at any time, which equates to a $20 conversion
price.
• In addition to containing standard anti-dilution provisions, the Series B preferred
stock contains a down-round provision that compensates the investor for the sale
of Company A’s common stock at a price below $20.
(continued)
2 - 16 / Analysis of Equity-Linked Instruments
Question:
Does the inclusion of a down-round provision in the Series B convertible preferred
shares prevent the warrant to purchase the Series B preferred shares from being
indexed to the company’s own stock?
Analysis/Conclusion:
No, provided the warrant is a substantive instrument. If (1) the Series B shares
will be classified as equity and (2) the warrants meet the requirements for equity
classification, the warrants should be accounted for as an equity instrument.
Generally, there is no requirement to “look through” a substantive instrument to
evaluate the terms of the underlying equity.
In this case, the Series B preferred shares should be classified as equity since the
shares are perpetual and the conversion option would be considered clearly and
closely related to the equity host.
If, on the other hand, the conversion option embedded in the Series B preferred
shares should be separated and accounted for as a derivative liability, the warrant
should also be accounted for as a liability. This could be the case if the Series
B preferred shares were a debt-like host (FG section 2.3.1.1). In that case, the
embedded conversion option may have to be separated based on the guidance in
ASC 815-15-25-1 (FG section 2.3) as (1) the conversion option is not clearly and
closely related to the Series B preferred because the preferred is a debt-like host
(FG section 2.3.1), (2) the conversion would meet the definition of a derivative if
the underlying equity is readily convertible to cash (FG section 2.3.2), and (3) the
conversion option would not qualify for the scope exception for certain contracts
involving an issuer’s own equity in ASC 815-10-15-74(a) as the down-round provision
would cause the embedded conversion option not to be indexed to the company’s
own stock.
Example 2-4: Valuation of a Warrant with a Down-Round Provision
Background/Facts:
Company B issues warrants that permit the investor to buy 100 shares of its common
stock for $50 per share. The warrants have 5-year terms and are exercisable at any
time. The warrants contain a down-round provision that compensates the investor
for the sale of Company B’s common stock at a price below $50. The inclusion of
the down-round provision causes the warrant to not be considered indexed to the
company’s own stock. As such, the warrant is classified as a liability and carried at
fair value with changes in fair value recorded in earnings.
Question:
Can Company B use the Black-Scholes-Merton model (Black-Scholes) to value the
warrant?
Analysis/Conclusion:
No, the Black-Scholes model has inherent limitations and should only be used when
the inputs to the model are static throughout the life of the warrant. In the case of a
warrant with a down-round provision, the strike price can be adjusted downward.
Black-Scholes can be used to calculate the minimum value of a warrant with a downround provision. However, in order to calculate the fair value of the warrant, an issuer
(or investor) must consider the impact of the down-round provision using a binomial
or lattice model.
Analysis of Equity-Linked Instruments / 2 - 17
2.5.1.4
Foreign Currency
If an instrument’s strike price is denominated in a currency other than the issuer’s
functional currency, the issuer is exposed to changes in foreign currency exchange
rates. ASC 815-40-15-7I specifically precludes an instrument from being considered
indexed to an issuer’s own stock if it creates an exposure to changes in a foreign
currency. Whether the shares issuable under the instrument are traded in a market in
which transactions are denominated in the same foreign currency is irrelevant to the
analysis.
Example 2-5: Foreign Currency Denominated Convertible Bond
Background/Facts:
Company C, whose functional currency is the Chinese Renminbi (RMB), issues debt
denominated in US dollars (USD). The debt is convertible into 100 shares of its USD
denominated American Depository Receipts (ADR). An ADR is a negotiable security
that represents ownership of the underlying securities of a non-US company and can
be traded in the US financial markets. Since the RMB is a non-deliverable currency,
Company C cannot issue an RMB denominated bond, in a price-efficient manner, to
foreign investors.
Question:
Can the embedded conversion option meet the requirements for the scope exception
for certain contracts involving an issuer’s own stock in ASC 815-10-15-74(a)?
Analysis/Conclusion:
No. An instrument is precluded from being considered indexed to a company’s own
stock if it creates an exposure to changes in currency exchange rates. ASC 815-4015-7I states “an equity-linked financial instrument (or embedded component) shall
not be considered indexed to the entity’s own stock if the strike price is denominated
in a currency other than the issuer’s functional currency (including a conversion
option embedded in a convertible debt instrument that is denominated in a currency
other than the issuer’s functional currency).”
2.5.1.5
Indexed to Stock of Subsidiary, Affiliate, or Parent
An instrument issued by a parent indexed to the stock of a consolidated subsidiary
should be considered indexed to its own stock based on the guidance in ASC
815-40-15-5C. That guidance applies to freestanding financial instruments and
embedded components for which payoff to the counterparty is based, in whole or
in part, on the stock of a consolidated subsidiary, whether those instruments were
entered into by the parent or the subsidiary.
The same is not true for instruments indexed to the stock of an affiliate that is not a
consolidated subsidiary or stock of an equity method investee; the stock of such an
affiliate or equity method investee is not considered the company’s own stock.
Instruments issued by a subsidiary indexed to the stock of a parent would not
be considered indexed to the company’s own stock in the stand-alone financial
statements of the subsidiary. However, in the consolidated financial statements, the
instruments would be considered indexed to the company’s own stock.
2 - 18 / Analysis of Equity-Linked Instruments
2.5.2
Requirements for Equity Classification—ASC 815-40-25 (previously
EITF 00-19)
Does the freestanding instrument
meet the requirements
for equity classification?
Classify as asset or liability,
initially record at fair value
with changes in fair value
recorded in earnings.
No
(FG section 2.5.2)
Yes
Classify as equity, initially record
at fair value, no subsequent
remeasurement.
Application of the guidance in ASC 815-40-25 is premised on obtaining a detailed
understanding of the settlement and other terms of the contract.
• Contracts that are settled by gross physical delivery of shares or net share
settlement may qualify to be equity instruments (FG section 2.5.2.1).
• Contracts that require or permit the investor to require an issuer to net cash settle
are accounted for as assets or liabilities at fair value with changes in fair value
recorded in earnings.
• Contracts that an issuer could be required to settle in cash should be accounted
for as an asset or liability at fair value regardless of whether net cash settlement
would only occur under a remote scenario.
2.5.2.1
Additional Requirements for Equity Classification
It is important to note that not all share settled contracts qualify for equity
classification. In order for a share settled contract to be classified as equity, each of
the additional specific conditions in ASC 815-40-25-10 must be met to ensure that
the issuer has the ability to settle the contract in shares.
25-10 Because any contract provision that could require net cash settlement
precludes accounting for a contract as equity of the entity … all of the
following conditions must be met for a contract to be classified as equity:
a. Settlement permitted in unregistered shares. The contract permits the entity to
settle in unregistered shares.
b. Entity has sufficient authorized and unissued shares. The entity has
sufficient authorized and unissued shares available to settle the contract
after considering all other commitments that may require the issuance of
stock during the maximum period the derivative instrument could remain
outstanding.
c. Contract contains an explicit share limit. The contract contains an explicit limit
on the number of shares to be delivered in a share settlement.
Analysis of Equity-Linked Instruments / 2 - 19
d. No required cash payment if entity fails to timely file. There are no required
cash payments to the counterparty in the event the entity fails to make timely
filings with the Securities and Exchanges Commission (SEC).
e. No cash-settled top-off or make-whole provisions. There are no cash settled
top-off or make-whole provisions.
f.
No counterparty rights rank higher than shareholder rights. There are no
provisions in the contract that indicate that the counterparty has rights that
rank higher than those of a shareholder of the stock underlying the contract.
g. No collateral required. There is no requirement in the contract to post
collateral at any point or for any reason.
These conditions are intended to identify situations in which net cash settlement
could be forced upon the issuer by investors or in any other circumstance, regardless
of likelihood, except for (1) liquidation of the company or (2) a change in control in
which the company’s shareholders also receive cash.
An issuer is required to perform the analysis to determine whether the requirements
for equity classification have been met. Liability classification is not a default
classification; thus, an issuer cannot forgo the analysis and assume liability
classification. In some cases the evaluation of various contractual terms may be
complicated. In such cases, assistance from legal counsel may be required.
ASC 815-40-25-11 through 25-38 provide further guidance on the requirements for
equity classification.
Example 2-6: Impact of Exchange Limits on Share Issuance
Background/Facts:
Several stock exchanges in the US (e.g., NYSE and NASDAQ) have rules applicable
to companies listed on the exchange that limit the number of shares issuable in
an unregistered offering without shareholder approval. The rules generally apply to
the issuance of common shares (or an instrument that could be settled in common
shares) in excess of 20% of the outstanding common shares of the company.
Company A is registered on the NYSE and has 750,000 authorized shares and
500,000 shares issued and outstanding (and therefore 250,000 shares authorized
and unissued). Company A issues an unregistered convertible bond to multiple
investors that, upon conversion, will result in the issuance of 125,000 shares (25%
of outstanding shares). Company A concludes that the embedded conversion option
meets the definition of a derivative and must be evaluated to determine whether
the scope exception in ASC 815-10-15-74(a) can be applied. Company A has not
obtained shareholder approval to issue the shares upon conversion of the bond.
Question:
Can the conversion option embedded in Company A’s convertible bond meet the
requirements for the scope exception in ASC 815-10-15-74(a)?
Analysis/Conclusion:
No, because the requirements for equity classification are not met. If Company A’s
shareholders do not vote to approve the issuance of shares upon conversion of the
bond, Company A will be prohibited by the NYSE from issuing shares in excess of
(continued)
2 - 20 / Analysis of Equity-Linked Instruments
20% of its outstanding shares. In that case, upon conversion, investors would likely
receive cash equal to the fair value of the share shortfall. Since shareholder approval
is not within the control of Company A, the possibility of this outcome, however
remote, would preclude equity classification.
Example 2-7: Impact of Master Netting Agreements
Background/Facts:
• Company A issues a convertible bond that, upon conversion, will result in cash
settlement of the conversion option.
• Company A also enters into two contracts with Bank B:
— A convertible bond hedge (purchased call option) that mirrors the terms of the
embedded conversion option in Company A’s convertible bond and requires
Bank B to pay cash to Company A equal to the value of the conversion option
upon exercise, and
— A warrant with a strike price at a 20% premium to the embedded conversion
option price that requires Company A to deliver net shares to Bank B, if the
warrant is in the money when the conversion option is exercised.
• Since the convertible bond hedge requires cash settlement, the requirements for
equity classification are not met; therefore it is accounted for as a liability at fair
value with changes in fair value recorded in earnings.
• Company A and Bank B enter into a Master Netting Agreement that allows the
convertible bond hedge and warrant to be netted in determining the amount due
in the case of Company A’s bankruptcy.
Question:
Can the warrant meet the requirements for equity classification?
Analysis/Conclusion:
No, because upon bankruptcy, the warrant can be netted with a contract that does
not meet the requirements for equity classification (the convertible bond hedge). An
arrangement that provides for the netting of contracts that meet the requirements
for equity classification with those that do not meet the requirements provides the
counterparty (Bank B) with rights that rank higher than those of other shareholders.
However, a contract that otherwise would meet the requirements for equity
classification, can be included in a netting arrangement with other contracts that
(1) are indexed to the same class of shares (i.e., common shares) and (2) meet the
requirements for equity classification without tainting the ability to qualify for equity
classification.
Example 2-8: Option to Pay Cash Penalty in the Event Timely Filings
with the SEC Are Not Made
Background/Facts:
Company B issues a convertible bond with contractual terms that allow Company B
to make cash payments to investors in the event it does not make timely filings with
the SEC. If Company B chooses not to make the payments, investors can trigger an
(continued)
Analysis of Equity-Linked Instruments / 2 - 21
event of default, upon which investors would be unable to force Company B to issue
cash to settle any value of the conversion option embedded in the bond.
Question:
Can the conversion option embedded in Company B’s convertible bond meet the
scope exception in ASC 815-10-15-74(a)?
Analysis/Conclusion:
Yes, an optional cash payment to prevent an event of default would not preclude
equity classification. If, however, the terms of the bond required Company B to make
cash payments to investors in the event it does not make timely filings with the SEC,
the requirements for equity classification would not be met.
Example 2-9: Convertible Debt Indexed to Subsidiary’s Stock and Settlable
in Stock of Parent or Subsidiary
Background/Facts:
• Company P, a public company, has a subsidiary, Company S, which is also a
public company.
• Company P has issued convertible debt, which upon conversion can be settled in
either Company P or Company S shares at the discretion of Company P. The value
that investors will receive (i.e., the conversion value) is indexed solely to the stock
price of Company S; the ability to satisfy the conversion value in Company P’s
shares is merely a settlement mechanism and does not affect the value transfer.
Question:
Can the conversion option embedded in Company P’s convertible bond meet the
requirements for the scope exception in ASC 815-10-15-74(a)?
Analysis/Conclusion:
Probably. 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.” Since Company S is a
substantive entity, Company P must determine whether the embedded conversion
option meets the requirements to apply the ASC 815-10-15-74(a) scope exception
(FG section 2.3.3).
The value of the conversion option embedded in Company P’s bond is indexed to
Company S’s shares. Accordingly, it would be considered indexed to Company P’s
own stock based on the guidance in ASC 815-40-15-5C. The settlement mechanism
that allows settlement in shares of either Company P or Company S does not affect
this conclusion.
If Company P were required to settle the conversion option in shares of Company
P, then the contract should be evaluated to determine whether it contains an explicit
limit on the number of shares to be delivered in a share settlement. If Company S’s
share price rises, while Company P’s share price falls, then the number of Company
P shares required for delivery could be extremely high, possibly indeterminate.
Without a maximum cap on the number of Company P shares that Company P could
be required to deliver, classification of the conversion feature in stockholders’ equity
would not be permitted if this was the only settlement alternative.
2 - 22 / Analysis of Equity-Linked Instruments
2.5.2.2
Application to Convertible Bonds
To apply the requirements for equity classification to a conversion option embedded
in a convertible bond, the issuer must first determine whether the convertible bond is
considered “conventional.” ASC 815-40-25-39 defines conventional convertible debt as
debt whereby the holder will, at the issuer’s option, receive a fixed amount of shares or the
equivalent amount of cash as proceeds when the holder exercises the conversion option.
If the convertible bond is considered “conventional,” the issuer only needs to consider the
settlement alternatives (i.e., who controls the settlement and whether the settlement will
be in shares or cash) to determine whether the embedded conversion option meets the
requirements for equity classification; the additional requirements for equity classification
in ASC 815-40-25-10 are not applicable. If the convertible debt is not “conventional,” the
issuer must consider all of the requirements for equity classification in ASC 815, including
the additional requirements for equity classification in ASC 815-40-25-10.
A bond with a cash conversion feature that is within the scope of ASC 470-20
(FG section 7.4) is not considered conventional. Similarly, a convertible bond that
contains a make-whole provision upon a fundamental change (FG section 7.2.2), a
very common feature among publicly issued bonds, is not considered conventional.
ASC 815-40-25-39 through 25-42 provide further guidance on convertible debt and
other hybrids.
Example 2-10: Application of Conventional Convertible Bond Exception
to Convertible Bonds with a Make-Whole Table
Background/Facts:
An issuer does not need to consider the additional requirements for equity classification
in ASC 815-40-25-10 when determining whether the embedded conversion option in
a “conventional” convertible bond meets the requirements for the scope exception for
certain contracts involving an issuer’s own equity in ASC 815-10-15-74(a).
Question:
Is a convertible bond that provides for an adjustment to the number of shares
deliverable upon conversion via a “make-whole” table (FG section 7.2.2), as is market
standard practice, considered a “conventional” convertible bond?
Analysis/Conclusion:
No. Typically an adjustment to the conversion option for anything other than standard
anti-dilution provisions (e.g., adjustments for stock split, rights offering, dividend,
or spin-off) would cause the convertible bond to be considered not “conventional.”
Whether an adjustment is market standard is not relevant in determining whether the
convertible bond is “conventional” as defined in ASC 815-40-25-39.
2.5.2.3
Reassessment
ASC 815-40-35-8 requires that the classification or accounting treatment of a
contract be reassessed at each balance sheet date. If the previously determined
classification or accounting treatment changes, for example, due to a change in the
number of authorized and unissued shares available to settle the contract due to the
issuance or retirement of other securities, the contract should be reclassified from
equity or accounted for separately as a derivative instrument as of the date of the
event that resulted in this adjustment.
Analysis of Equity-Linked Instruments / 2 - 23
Chapter 3:
Analyzing Put and Call Options and Other Features
and Arrangements
Analyzing Put and Call Options and Other Features and Arrangements / 3 - 1
3.1
Put and Call Options Embedded in Debt Instruments
Many debt instruments include embedded put and call options. A put option
allows the investor (lender) to demand repayment, and a call option allows an
issuer (borrower) to extinguish debt on demand. Put and call options embedded
in debt instruments should be evaluated to determine whether they need to be
accounted for separately at fair value with changes in fair value recorded in earnings
under the guidance in ASC 815.
A put or call option should be accounted for separately if all of the following general
criteria in ASC 815-15-25-1 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 through earnings with
changes in fair value recorded in earnings.
c. A separate instrument with the same terms as the embedded put or call option
would be accounted for as a derivative under the guidance in ASC 815.
Provided the host debt instrument is not accounted for at fair value with changes in
fair value recorded in earnings, the first step in assessing whether an embedded put
or call should be separately accounted for is to determine whether the embedded
option would be accounted for as a derivative under the guidance in ASC 815 if it
were a freestanding instrument. To do this, an issuer should assess whether the
embedded put or call option (1) meets the definition of a derivative or (2) qualifies for
a scope exception to derivative accounting in ASC 815. See FG section 2.3.2 and
Chapter 2 of PwC’s Guide to Accounting for Derivative Instruments and Hedging
Activities—2012 for a discussion of the definition of a derivative and a discussion of
scope exceptions to ASC 815.
• An embedded put or call option that (1) does not meet the definition of a derivative
or (2) qualifies for a scope exception to derivative accounting in ASC 815 would
not be accounted for separately.
• An embedded put or call option that (1) does meet the definition of a derivative
and (2) does not qualify for a scope exception to derivative accounting in ASC
815 may need to be accounted for separately. These puts and calls should be
evaluated to determine whether they are clearly and closely related to their host
debt instrument.
3.2
Analysis of Whether a Put or Call Is Clearly and Closely Related
to a Debt Host
Generally, put and call options are considered clearly and closely related to their debt
hosts unless they are leveraged (i.e., create more interest rate and credit risk than is
inherent in the host instrument). For example, debt issued at par value that is puttable
at two times the par value upon the occurrence of a specified event may have an
embedded component that is not clearly and closely related to its debt host.
3 - 2 / Analyzing Put and Call Options and Other Features and Arrangements
The analysis to determine whether a put or call option is clearly and closely related to
a debt host instrument is best performed using a multi-step approach as illustrated
below.
Analysis of Whether a Put or Call Option Is Clearly and
Closely Related to a Debt Host
Is the amount paid upon exercise
of the put or call option
based on changes in an index?
Is the amount paid upon exercise
of the put or call option
based on an index other
than interest rates or credit?
Yes
(FG section 3.2.1)
(FG section 3.2.1)
No
No
Yes
Does the put or call option
accelerate repayment of
the debt?
No
(FG section 3.2.2)
Yes
No
Is the put or call option
contingently exercisable?
(FG section 3.2.3)
Yes
Does the debt involve a
substantial premium
or discount?1
(FG section 3.2.4)
No
Perform analysis to
determine whether there is
an interest rate derivative
that should be accounted
for separately.2
(FG section 3.2.5)
The put or call option is clearly
and closely related to its debt host.
It should not be accounted
for separately.
If the only exercise contingency is
based on interest rates, perform
analysis to determine whether there
is an interest rate derivative that
should be accounted for separately.
Yes
The put or call option is
not clearly and closely
related to its debt host.
It should be separated from
the debt host and recorded
at fair value with changes
in fair value recorded
in earnings.
(FG section 3.2.5)
1
As discussed in FG section 3.2.4, a put or call option that requires the debt to be repaid at accreted
value does not typically involve a substantial premium or discount.
2
This analysis is performed when the only underlying (or indexation) is an interest rate index. If there is
another underlying, for example, credit, this analysis is not required.
Analyzing Put and Call Options and Other Features and Arrangements / 3 - 3
3.2.1
Determine the Nature of the Settlement Amount Received Upon Exercise
of Put or Call Option
Is the amount paid upon exercise
of the put or call option
based on changes in an index?
(FG section 3.2.1)
Yes
Is the amount paid upon exercise
of the put or call option
based on an index other
than interest rates or credit?
(FG section 3.2.1)
No
No
Yes
Does the put or call option
accelerate repayment of
the debt?
No
(FG section 3.2.2)
The put or call option is
not clearly and closely
related to its debt host.
It should be separated from
the debt host and recorded
at fair value with changes
in fair value recorded
in earnings.
First, the issuer must determine if the amount paid upon exercise of a put or call
option is based on changes in an index rather than simply being the repayment of
principal at par or a premium. For example, a put option that entitles the holder to
receive an amount determined by the change in the S&P 500 index (i.e., par value
of the debt multiplied by the change in the S&P 500 index over the period the debt
was outstanding) is based on changes in an equity index. On the other hand, debt
callable at a fixed price of 101 is not based on changes in an index. Debt callable at a
price of 108 at the end of year 1, 106 at the end of year 2, and 104 at the end of year
3 is also not based on changes in an index because the premium changes simply
due to the passage of time.
If the amount paid upon exercise of a put or call option is based on changes in an
index, then the issuer should determine whether the index is an interest rate index or
credit index. If the index is not an interest rate or credit index, the put or call option is
not clearly and closely related to the debt host instrument and should be accounted
for separately at fair value with changes in fair value recorded in earnings under the
guidance in ASC 815.
If the amount paid upon exercise of the put or call option is (1) not based on
changes in an index or (2) based on changes in an interest rate or credit index,
further analysis is required to determine whether the put or call is clearly and closely
related (FG section 3.2.2).
3 - 4 / Analyzing Put and Call Options and Other Features and Arrangements
3.2.2
Determine Whether the Put or Call Option Accelerates Repayment
of the Debt
Does the put or call option
accelerate repayment of
the debt?
No
(FG section 3.2.2)
Yes
The put or call option is
not clearly and closely
related to its debt host.
It should be separated from
the debt host and recorded
at fair value with changes
in fair value recorded
in earnings.
Is the put or call option
contingently exercisable?
(FG section 3.2.3)
Next, the issuer should determine whether exercise of the put or call option
accelerates the repayment of the debt. As discussed in ASC 815-15-25-41, put and
call options that do not accelerate the repayment of the debt but instead require a
cash settlement that is equal to the price of the option at the date of exercise would
not be considered to be clearly and closely related to its debt host instrument.
If exercise of the put or call accelerates the repayment of the debt, further analysis is
required to determine whether the put or call is clearly and closely related to the debt
host (FG section 3.2.3).
3.2.3
Determine if the Put or Call Option Is Contingently Exercisable
No
Is the put or call option
contingently exercisable?
(FG section 3.2.3)
Yes
Perform analysis to
determine whether there is
an interest rate derivative
that must be accounted
for separately.
Does the debt involve a
substantial premium or
discount?
(FG section 3.2.4)
(FG section 3.2.5)
The issuer should then determine whether (1) the put or call option is contingently
exercisable and (2) the contingency is based solely on interest rates.
• If the put or call option is not contingently exercisable, the next step is for the
issuer to perform the analysis to determine whether there is an interest rate
derivative that should be accounted for separately (FG section 3.2.5).
Analyzing Put and Call Options and Other Features and Arrangements / 3 - 5
• If the put or call option is contingently exercisable and the contingency is based
solely on interest rates, the issuer should first determine whether the debt
instrument involves a substantial premium or discount (FG section 3.2.4) and if it
does not, then determine whether there is an interest rate derivative that should
be accounted for separately (FG section 3.2.5).
• If the put or call option is contingently exercisable and the contingency is
not based solely on interest rates, the next step is for the issuer to determine
whether the debt instrument involves a substantial premium or discount
(FG section 3.2.4).
3.2.4
Determine if the Debt Instrument Contains a Substantial Premium
or Discount
Does the debt involve a
substantial premium or
discount?
(FG section 3.2.4)
No
The put or call option
is clearly and closely
related to its debt host.
It should not be accounted
for separately.
Yes
The put or call option is
not clearly and closely
related to its debt host.
It should be separated from
the debt host and recorded
at fair value with changes
in fair value recorded
in earnings.
Practice generally considers a premium or discount equal to or greater than ten
percent of the par value of the host debt instrument to be substantial. Similarly,
a spread between the debt’s issuance price and the price at which the put or call
option can be exercised that is equal to or greater than ten percent is also generally
considered substantial. However, a ten percent premium or discount is not a brightline; all relevant facts and circumstances should be considered to determine whether
the premium or discount is substantial. A put or call option that requires the debt to
be repaid at its accreted value is generally not considered to involve a substantial
premium or discount.
If a put or call option analyzed per the flowchart in FG section 3.2 (1) accelerates
repayment of the debt, (2) is contingently exercisable, and (3) involves a substantial
premium or discount, the put or call option is not clearly and closely related to the
host debt instrument and should be separately accounted for at fair value with
changes in fair value recorded in earnings.
If a put or call option analyzed per the flowchart in FG section 3.2 (1) accelerates
repayment of the debt, (2) is contingently exercisable and (3) does not contain
a substantial premium or discount, the put or call option is clearly and closely
3 - 6 / Analyzing Put and Call Options and Other Features and Arrangements
related to its host debt instrument. However, if the put or call option is contingently
exercisable and the contingency is based solely on interest rates, the issuer should
also consider whether there is an interest rate derivative that should be accounted for
separately (FG section 3.2.5).
3.2.5
Analysis of Embedded Interest Rate Derivatives
The guidance in ASC 815-15-25-26 should be applied if a put or call option
embedded in a debt instrument is:
• Contingently exercisable and the only contingency is based on interest rates, or
• Not contingently exercisable and the only underlying is interest rates.
The guidance in ASC 815-15-25-26 states that the embedded interest rate
component is considered clearly and closely related (and does not need to be
accounted for separately) unless either of the following is true.
a. The hybrid instrument (the debt host and embedded put or call) can contractually
be settled (non-payment due to default should not be considered) such that the
investor would not recover substantially all of its initial recorded investment, or
b. The embedded put or call meets both of the following conditions. These
conditions together are referred to as the “double-double” test.
1. There is a possible future interest rate scenario (even though it may be
remote) under which exercise of the put or call option would at least double
the investor’s initial rate of return on the host contract, and
2. For any possible interest rate scenario in which the investor’s initial rate of
return would be doubled, exercise of the put or call option would also result
in a rate of return that is at least double what otherwise would be the thencurrent market return for the same host contract without the embedded
component.
ASC 815-15-25-29 clarifies that in the case of a put option that permits, but does not
require, the investor to settle the debt instrument in a manner that causes it not to
recover substantially all of its initial recorded investment, the guidance in paragraph
(a) above is not applicable.
ASC 815-15-25-37 and 25-38 clarify that in the case of a call option that permits, but
does not require, the issuer to accelerate the repayment of the debt, the guidance in
paragraph (b) above is not applicable.
The following flowchart combines all of this guidance. We have also assumed that
a put option is only exercisable by the investor (thus does not have to be analyzed
under paragraph (a) above based on the guidance in ASC 815-15-25-29) and a call
option is only exercisable by the issuer (thus does not have to be analyzed under
paragraph (b) above based on the guidance in ASC 815-15-25-37 and 25-38). In
evaluating a put or call option that is not truly an option, but rather is automatically
settled once the condition for exercise is met, both paragraphs (a) and (b) above
would have to be considered.
Analyzing Put and Call Options and Other Features and Arrangements / 3 - 7
Analysis of Embedded Interest Rate Derivatives1
Is the embedded component a
call or a put option?
Call
Put
Can the debt instrument be settled
such that the investor receives less
than substantially all of its
investment upon the issuer’s
exercise of the call option?
Is there any possible interest rate
scenario under which the investor
would both (a) double its initial rate
of return and (b) double the then
current market rate of return for the
host instrument?
(FG section 3.2.5.1)
(FG section 3.2.5.2)
Yes
No
Yes
There is an interest rate derivative
to be accounted for separately at
fair value with changes in fair value
recorded in earnings.
1
3.2.5.1
No
The put or call option does not create
an interest rate derivative to be
accounted for separately.
As discussed above, this flowchart applies to put options that are only exercisable by the investor and
call options that are only exercisable by the issuer.
Application of Test to Determine Whether the Investor Recovers
Substantially All of Its Investment
We believe “substantially all” means approximately 90 percent of the investment.
Therefore, if the exercise of a call option embedded in a debt instrument could result
in the investor receiving less than 90 percent of its initial recorded investment, it
likely creates an embedded interest rate derivative that should be accounted for
separately. This analysis should be performed without regard to the probability of the
event occurring as long as it is possible.
3.2.5.2
Application of the Double-Double Test
We believe the initial rate of return that should be used in the double-double test is
that of the host debt instrument without the embedded put option, not the combined
hybrid instrument (debt instrument with the embedded put option). The initial rate
of return on the host debt instrument may differ from the initial rate of return on the
hybrid instrument, as the yield on the hybrid may be impacted by the embedded put
option. The analysis should be performed without regard to the probability of the
event occurring as long as it is possible.
When considering transactions with multiple elements, such as debt issued with
warrants, the double-double test should be performed after proceeds have been
allocated to the individual transactions as discussed in FG section 3.4. However, the
terms of the combined transaction should be considered when performing the test.
For example, if upon the exercise of a call option embedded in a debt instrument
3 - 8 / Analyzing Put and Call Options and Other Features and Arrangements
issued with warrants, the investor will receive par value for the combination of the
debt and warrants, it is less likely to meet the double-double test than if the investor
would receive par value for the debt and the warrants remain outstanding.
For convertible debt with a cash conversion feature, the double-double test
should be performed before the bond is bifurcated as described in FG section 7.4.
Therefore, when evaluating whether an embedded put or call option should be
accounted for separately, the discount created by separating the conversion option
would not be considered.
Example 3-1: Debt Puttable Upon a Change in Interest Rates
Background/Facts:
Company A issues 5-year fixed-rate debt at par value that contains a put option,
exercisable by the investor when there is an increase in the 6-month LIBOR rate of
150 basis points. The put option requires the issuer to settle the debt at 105% of the
par value upon exercise.
Question:
Is the embedded put option clearly and closely related to the debt host? Does the
embedded put option create an embedded interest rate derivative that should be
accounted for separately?
Analysis/Conclusion:
Is the amount paid upon exercise of the put option based on changes in an index?
No, upon exercise of the put option the investor will receive 105% of the par value of
the bond.
Does exercise of the put option accelerate the repayment of the debt?
Yes, the put option requires the issuer to repay the debt instrument at 105% of the
par value upon exercise of the put option.
Is the put option contingently exercisable?
Yes, the put option can only be exercised by the investor when there is an increase in
the 6-month LIBOR rate of 150 basis points.
Does the debt involve a substantial premium or discount?
No, the debt was issued at par value and the premium received upon exercise of the
put option (5%) is less than 10% of the par value of the bond.
Perform the analysis to determine whether there is an interest rate derivative that
should be accounted for separately.
Since this is a put option, the guidance in ASC 815-15-25-26 (b) should be
considered. Due to the fact that the 5-year interest rate inherent in the host debt
instrument could change in a manner different than the 6-month LIBOR rate on which
the exercise of the put option is based, it is possible for the investor, through exercise
of its put option, to double its initial rate of return and double the then-current market
rate of return for the host debt instrument. Therefore, there is an embedded interest
rate derivative to be accounted for separately.
Analyzing Put and Call Options and Other Features and Arrangements / 3 - 9
Example 3-2: Debt Issued at Par, Puttable Upon a Change in Control
Background/Facts:
Company A issues 5-year fixed-rate debt at par value that contains a put option,
exercisable by the investor upon a change in control. The put option requires the
issuer to settle the debt at 105% of the par value upon exercise.
Question:
Is the embedded put option clearly and closely related to the debt host? Does the
embedded put option create an embedded interest rate derivative that should be
accounted for separately?
Analysis/Conclusion:
Is the amount paid upon exercise of the put option based on changes in an index?
No, upon exercise of the put option the investor will receive 105% of the par value of
the bond.
Does exercise of the put option accelerate the repayment of the debt?
Yes, the put option requires the issuer to repay the debt instrument at 105% of the
par value upon exercise of the put option.
Is the put option contingently exercisable?
Yes, the put option can only be exercised by the investor when there is a change in
control.
Does the debt involve a substantial premium or discount?
No, the debt was issued at par value and the premium received upon exercise of the
put option (5%) is less than 10% of the par value of the bond.
Perform the analysis to determine whether there is an interest rate derivative that
should be accounted for separately.
The put option is contingently exercisable based on a change in control, therefore is
based on a contingency other than interest rates. As such, the put option would not
be analyzed under the guidance in ASC 815-15-25-26.
Example 3-3: Debt Issued at a Premium, Puttable Upon a Change in Control
Background/Facts:
Company A issues fixed-rate debt at 102% of par value that contains a put option,
exercisable by the investor upon a change in control. Upon exercise of the put option
the issuer must settle the debt at par value.
Question:
Is the embedded put option clearly and closely related to the debt host? Does the
embedded put option create an embedded interest rate derivative that should be
accounted for separately?
(continued)
3 - 10 / Analyzing Put and Call Options and Other Features and Arrangements
Analysis/Conclusion:
Is the amount paid upon exercise of the put option based on changes in an index?
No, upon exercise of the put option the investor will receive the par value of the bond.
Does exercise of the put option accelerate the repayment of the debt?
Yes, the put option requires the issuer to repay the debt instrument at par value upon
exercise of the put option.
Is the put option contingently exercisable?
Yes, the put option can only be exercised by the investor when there is a change in
control.
Does the debt involve a substantial premium or discount?
No, the debt was issued at 102% of par value, thus the premium is less than 10%
of the par value of the bond. There is no premium received upon exercise of the put
option.
Perform the analysis to determine whether there is an interest rate derivative that
must be accounted for separately.
The put option is contingently exercisable based on a change in control, therefore is
based on a contingency other than interest rates. As such, the put option would not
be analyzed under the guidance in ASC 815-15-25-26.
Example 3-4: Debt Issued at a Discount, Puttable Upon a Change in Control
Background/Facts:
Company A issues fixed-rate debt at 80% of par value that contains a put option,
exercisable by the investor upon a change in control. The put option requires the
issuer to settle the debt at par value upon exercise.
Question:
Is the embedded put option clearly and closely related to the debt host? Does the
embedded put option create an embedded interest rate derivative that should be
accounted for separately?
Analysis/Conclusion:
Is the amount paid upon exercise of the put option based on changes in an index?
No, upon exercise of the put option the investor will receive the par value of the bond.
Does the put option accelerate repayment of debt?
Yes, the put option requires the issuer to repay the debt instrument at par value upon
exercise of the put option.
Is the put option contingently exercisable?
Yes, the put option can only be exercised by the investor when there is a change in
control.
(continued)
Analyzing Put and Call Options and Other Features and Arrangements / 3 - 11
Does the debt involve a substantial premium or discount?
Yes, the debt was issued at 80% of par value, thus the discount is greater than 10%
of the par value of the bond. Therefore, the put option is not clearly and closely
related to its debt host instrument and should be accounted for separately.
Since the put option is accounted for separately it should not be analyzed to
determine if it creates an embedded interest rate derivative under the guidance in
ASC 815-15-25-26.
3.2.6
Fair Value Put and Call Options
An embedded put or call option that allows the investor or issuer to receive the fair
value of the debt at the date the option is exercised provides liquidity to the option
holder. The option doesn’t otherwise have value and therefore its value should be
immaterial. In that case, no analysis is necessary. This is consistent with other areas
in accounting literature in which options at fair value are not considered, such as in
ASC 815-20-25-114, in which an option to prepay a contract at its then fair value
would not cause the contract to be considered prepayable because the option has
no value and only provides liquidity to the holder.
3.3
Put and Call Options Embedded in Equity Instruments
Put options allow an equity investor to require the issuer to reacquire an equity
instrument for cash or other assets, and call options allow the issuer to reacquire
an equity instrument. As discussed in ASC 815-15-25-20, put and call options are
typically not considered clearly and closely related to equity hosts. Whether these
options should be separated from their host instruments is determined based on
whether a separate instrument with the same terms as the embedded put or call
option would be accounted for as a derivative instrument under the guidance in ASC
815. If a put or call option embedded in an instrument classified as equity qualifies
for a scope exception for certain contracts involving an issuer’s own equity in ASC
815-10-15-74(a) (FG section 2.3.3) separate accounting for the put or call option is
not required.
3.4
Warrants Issued in Connection with Debt and Equity Offerings
Warrants issued in a bundled transaction with debt and equity offerings are typically
accounted for on a separate basis. When instruments are issued in a bundled
transaction, the allocation of the sales proceeds to the base instrument and to the
warrants depends on the accounting classification of the separate warrant as equity
or liability. See FG section 2.1 for the analysis of equity-linked instruments.
• If the warrants are classified as equity, then the allocation is made based upon the
relative fair values of the base instrument and the warrants following the guidance
in ASC 470-20-25-2.
• If the warrants are classified as a liability, then the sales proceeds are first
allocated to the warrant based on the warrant’s full fair value (not relative fair
value) and the residual amount of the sales proceeds is allocated to the base
instrument.
3 - 12 / Analyzing Put and Call Options and Other Features and Arrangements
The allocation of proceeds to the warrant, using either method, will create a discount
in the associated debt or equity security, which should be recognized as interest
expense or a dividend. However, when the interest or dividend is recognized
depends on the terms of the debt or equity security.
• A puttable debt instrument recorded at a discount should be accreted to par value
over the period from issuance to the first put date using the interest method.
• A non-puttable debt instrument recorded at a discount should be accreted to par
value over the life of the instrument using the interest method.
• An equity security recorded at a discount should be accreted to its redemption
value if the redemption is not solely at the issuer’s option. Accretion of preferred
stock is recorded as a deemed dividend, which reduces retained earnings and
earnings available to common shareholders in calculating basic and diluted EPS.
— If the security has a stated redemption date, the preferred stock should be
accreted over the period from issuance to the redemption date.
— In the case of preferred stock that is puttable by the investor, the instrument
should be recorded at redemption value at each put date. Any discount from
the redemption value would be recognized over the period from issuance to the
first put date.
— If the preferred stock is redeemable only at the option of the issuer, the
discount from the redemption value is not accreted. The difference between
issuance and redemption value is recognized as a one-time dividend upon
redemption of the instrument.
Example 3-5: Warrants Classified as Equity Issued in Connection with Debt
Background/Facts:
• Company A issues $1,000,000 of debt and 100,000 detachable warrants to
purchase its common stock in exchange for $1,000,000 in cash.
• The warrants are considered indexed to Company A’s stock and meet the
requirements for equity classification, thus Company A will classify the warrants
as equity (FG section 2.5).
• Since the warrants are classified as equity, the allocation of the proceeds from
the issuance of the debt and warrants is performed using the relative fair value
method.
• The fair values of the debt securities and warrants are determined as follows:
Instrument
Fair Value
% of Total
Allocated Amount
Debt
Warrants
Total
$ 910,000
$ 390,000
$1,300,000
70%
30%
100%
$ 700,000
$ 300,000
$1,000,000
Question:
What is the journal entry Company A would record to reflect the issuance of the debt
and warrants?
(continued)
Analyzing Put and Call Options and Other Features and Arrangements / 3 - 13
Analysis/Conclusion:
Company A would record the following journal entry:
Dr Cash
Dr Discount on Debt
Cr Debt
Cr Additional paid in capital (warrants)
$1,000,000
300,000
$1,000,000
300,000
Example 3-6: Warrants Classified as Liabilities Issued in Connection with Debt
Background/Facts:
• Company B issues $1,000,000 of debt and 100,000 detachable warrants to
purchase its common stock in exchange for $1,000,000 in cash.
• The warrant contract includes a down-round provision that requires a reduction in
the strike price if there are additional warrants issued with a lower strike price.
• The warrants are classified as liabilities under ASC 815-40-15 as the settlement
adjustment from the down-round does not allow for the strike price to be
considered fixed (FG section 2.5.1).
• The fair value of the warrants is $400,000.
• Since the warrants are liabilities, they must be recorded at their full fair value of
$400,000.
Question:
What is the journal entry the Company would record to reflect the issuance of the
debt and warrants?
Analysis/Conclusion:
Dr Cash
Dr Discount on Debt
Cr Debt
Cr Warrant Liability
3.5
$1,000,000
400,000
$1,000,000
400,000
Beneficial Conversion Feature
The Beneficial Conversion Feature (BCF) rules apply to convertible instruments other
than the following:
• Convertible debt and convertible preferred stock for which the embedded
conversion option is required to be accounted for separately as a derivative under
the guidance in ASC 815.
• Convertible debt with a cash conversion option (FG section 7.4) that must be
bifurcated into debt and equity components.
A convertible financial instrument includes a BCF if its conversion price is lower
than the issuer’s stock price (it’s in the money) at the commitment date. Similarly, a
contingent BCF arises when the conversion price could be adjusted at some future
date to an amount that is less than the issuer’s stock price at the commitment date.
3 - 14 / Analyzing Put and Call Options and Other Features and Arrangements
3.5.1
Recognition and Measurement
To determine whether a BCF should be recognized, an issuer should assess the
relationship between the accounting conversion price and the issuer’s stock price at
the commitment date (FG section 3.5.2). The accounting conversion price used to
compute the BCF may not equal the stated conversion price when other securities,
such as warrants, are issued with a convertible financial instrument. As discussed
in FG section 3.4, in a bundled transaction the sales proceeds should be allocated
between the convertible instruments and the warrants. The portion of the sales
proceeds allocated to the convertible instrument is divided by the contractual
number of conversion shares to determine the accounting conversion price per
common share (also called the effective conversion price), which is used to measure
the BCF. Costs of issuing convertible instruments do not affect the calculation of the
BCF.
In general, if the issuer’s stock price is greater than the accounting conversion price,
the conversion option is in the money at issuance and the conversion feature is
considered “beneficial” to the holder. The intrinsic value of the conversion option (or
the in-the-money amount) is recorded in equity with a corresponding reduction in
the carrying value of the convertible instrument. As noted in ASC 470-20-30-8, if the
intrinsic value of the BCF is greater than the proceeds allocated to the convertible
instrument, the amount of the discount assigned to the BCF is limited to the amount
of the proceeds allocated to the convertible instrument.
See the discussion of mezzanine (temporary) equity classification in FG section 3.6
for a discussion of the application of ASC 480-10-S99 to BCFs.
Example 3-7: Beneficial Conversion Feature (BCF)
Background/Facts:
• Company A issues $1,000,000 of convertible debt and 100,000 detachable
warrants to purchase its common stock in exchange for $1,000,000 in cash.
• The warrants are classified as equity and the sales proceeds have been allocated
based upon the relative fair values of the instruments (refer to Example 3-5).
• The sales proceeds allocated to the convertible debt are $700,000 and the
amount allocated to the warrants is $300,000.
• The convertible debt has a stated conversion price of $20 per share and the
issuer’s stock price at the commitment date is $18 per share.
Questions:
How would Company A calculate a BCF, if any?
What is the journal entry Company A would record to reflect issuance of the
convertible debt and warrants and the granting of a BCF in the convertible debt, if
applicable?
(continued)
Analyzing Put and Call Options and Other Features and Arrangements / 3 - 15
Analysis/Conclusion:
Step 1: Calculate the accounting conversion price
The accounting conversion price is equal to (a) the proceeds allocated to the
convertible debt divided by (b) the contractual number of shares underlying the
conversion option
$700,000/50,000 = $14
(50,000 shares = $1,000,000 principal/$20 conversion price)
Step 2: Determine if there is a BCF
Compare the issuer’s stock price at the commitment date to the accounting
conversion price; if the issuer’s stock price is greater than the accounting conversion
price, a BCF exists
$18 > $14, BCF exists
Step 3: Calculate value of BCF
BCF is equal to:
(issuer’s stock price – accounting conversion price) x contractual number of shares
($18 – $14) x 50,000 = $200,000
Step 4: Record journal entry
Dr Cash
Dr Discount on convertible debt
Cr Convertible debt
Cr Additional paid in capital (warrants)
Cr Additional paid in capital (BCF)
3.5.2
$1,000,000
500,000
$1,000,000
300,000
200,000
Commitment Date
The commitment date is the date when an agreement has been reached with an
unrelated party that is binding on both parties, usually legally enforceable, and has
the following characteristics:
• The agreement specifies all significant terms, including the quantity to be
exchanged, the fixed price, and the timing of the transaction. The fixed price
may be expressed as a specified amount of an entity’s functional currency or of a
foreign currency. It may also be expressed as a specified interest rate or specified
effective yield.
• The agreement includes a disincentive for nonperformance that is sufficiently
large to make performance probable. In the legal jurisdiction that governs the
agreement, the existence of statutory rights to pursue remedies for default
equivalent to the damages suffered by the nondefaulting party, in and of
itself, represents a sufficiently large disincentive for nonperformance to make
performance probable.
In practice there is rarely a commitment date prior to the issuance date (the date the
cash and securities have been exchanged). This is because if there are subjective
3 - 16 / Analyzing Put and Call Options and Other Features and Arrangements
provisions that permit either party to rescind the transaction, the commitment date
does not occur until the earlier of the expiration of the provisions or the date the
convertible financial instrument is issued. Examples of subjective provisions that
permit either party to rescind its commitment are:
• A material adverse change clause (included in most purchase agreements).
• A provision allowing for customary due diligence or shareholder approval.
3.5.3
Contingent BCF Measurement
As noted in ASC 470-20-25-6 a contingent BCF should be measured using the
commitment date stock price and recognized in earnings when the contingency is
resolved. However, the point at which the BCF is measured can differ.
• Contingent BCFs that can be measured at the commitment date (for example, a
conversion option whose conversion price is reset to a specified price below the
commitment date price if an IPO occurs) should be measured at the commitment
date.
• Contingent BCFs that involve changes to conversion terms triggered by future
events not controlled by the issuer should be measured when the triggering event
occurs.
Example 3-8: Contingent BCF Recognition and Measurement
Background/Facts:
Company A issues Series Z convertible preferred stock, which includes a provision
that adjusts the conversion price for common stock dividends to protect the value of
the Series Z conversion right. More specifically, the conversion price of outstanding
Series Z shares will adjust from the initial stated conversion price to a lower
conversion price, resulting in the Series Z shares converting into a greater number of
common shares.
Five years after the issuance of the Series Z shares, Company A issues a special
dividend. As a result of the special dividend, the conversion price of the outstanding
Series Z shares is adjusted to a level that creates a BCF.
Question:
When and how should Company A measure and recognize the contingent BCF on
the Series Z shares triggered by issuance of the special dividend?
Analysis/Conclusion:
The Series Z shares contain a contingent BCF that was triggered upon declaration of
the special dividend. Since the contingent BCF on the Series Z shares could not be
measured at the commitment date, ASC 470-20-35-1 requires the company to wait
until the contingent event occurs. The contingent BCF is measured when Company
A declares the special dividend by calculating the in-the-money amount. This is the
difference between (1) the price of Company’s A shares at the commitment date and
(2) the accounting conversion price of the Series Z shares after the conversion price
is adjusted for the special dividend.
When the special dividend is declared, the contingency is resolved and the
contingent BCF should be recognized.
Analyzing Put and Call Options and Other Features and Arrangements / 3 - 17
3.5.4
Amortization of BCF Discount
For convertible preferred securities and convertible debt, a discount to the par value
arises from the allocation of a portion of the proceeds to additional paid in capital
(APIC) for the intrinsic value of the BCF.
For nonredeemable convertible instruments, such as perpetual convertible preferred
stock, the discount created by the BCF is amortized through the date of earliest
conversion. For instruments that are immediately convertible, a deemed dividend
(and corresponding EPS effect) is recognized immediately.
For redeemable instruments, the BCF discount is amortized as a deemed dividend
on preferred stock or deemed interest on debt, with a corresponding increase to the
carrying value of the convertible security. ASC 470-20-35-7 requires amortization of
the BCF discount over the period from the date of issuance to the stated redemption
date of the convertible instrument, regardless of when the earliest conversion date
occurs.
3.6
Mezzanine (Temporary) Equity Classification
For SEC registrants, ASC 480-10-S99 addresses the financial statement
classification and measurement of preferred stock that is redeemable or may become
redeemable at a fixed or determinable price on a fixed or determinable date, at the
option of the holder, or upon the occurrence of an event that is not solely within the
control of the issuer. Although the rule specifically discusses preferred securities, the
SEC staff has long maintained that this guidance should be applied to other equity
instruments. This guidance may apply to:
• Certain convertible and redeemable preferred stock instruments that are classified
as equity rather than as debt instruments.
• Redeemable noncontrolling interests.
• The equity-classified component of convertible debt with a cash conversion
feature (FG section 7.4).
• BCFs allocated to equity (FG section 3.5).
The guidance in ASC 480-10-S99 is based on Rule 5-02.28 of Regulation S-X. It
requires equity classified instruments redeemable for cash or other assets to be
classified outside of permanent equity if their redemption is:
• At a fixed or determinable price on a fixed or determinable date,
• At the option of the holder, or
• Based upon the occurrence of an event that is not solely within the control of the
issuer.
The existence of a contractual redemption provision gives rise to mezzanine equity
classification even if the redemption is contingent upon the occurrence of a future event
that is outside of the issuer’s control. A probability assessment of whether a redemption
event’s occurrence is remote is not permitted; that is, mezzanine equity classification is
required even though the likelihood of redemption is considered remote.
Examples of contingent/conditional redemption provisions that may require
mezzanine equity classification of the related instrument are as follows:
• The company is delisted from trading on any stock exchange on which it is listed.
3 - 18 / Analyzing Put and Call Options and Other Features and Arrangements
• The company fails to file a registration statement by a certain date or make timely
SEC filings.
• Change in control of the company due to merger, consolidation, or otherwise.
• The company fails to effect an IPO.
• A registration statement is not declared effective by a stated date.
• The company has a debt covenant violation.
• The failure to achieve specified earnings targets.
There are many other conditions or events provided for in the terms of securities that
are outside the control of the company and trigger redemption at the option of the
holder and therefore require classification as mezzanine equity.
Securities in the scope of this guidance are required to be classified outside of
permanent equity in mezzanine equity, whether they are currently redeemable or
not. However, an exception to this general rule is provided for the equity-classified
component of convertible debt with a cash conversion feature as defined in FG
section 7.4 or a BCF classified as equity. Under the exception, all or a portion of the
equity-classified component must be classified in mezzanine equity only in periods
in which the convertible instrument is currently redeemable or convertible for cash
or other assets. See FG section 7.4.3 for a discussion of mezzanine classification of
the equity-classified component of convertible debt with a cash conversion feature.
The exception also requires the unamortized portion of the BCF to be classified as
mezzanine equity only in periods the convertible instrument is currently redeemable.
The requirement to classify the BCF as mezzanine equity does not change the
measurement of the BCF or the period over which it is amortized. It is merely a
balance sheet presentation requirement.
Although the SEC’s guidance is aimed at public entities, we believe that the
mezzanine equity presentation is preferable for a non-public entity’s instruments that
meet these criteria.
Example 3-9: Classification of BCF
Background/Facts:
• Company A issued Series Z convertible preferred stock that is puttable in years
3–5 but not before then. If the Series Z shares are not put after year 5, they are
automatically converted into common shares.
• The Series Z shares contain a BCF.
• Based upon the guidance in ASC 480-10-S99-3A the classification of the Series Z
shares is determined to be mezzanine equity.
Question:
How should Company A classify the BCF?
Analysis/Conclusion:
The BCF should be recorded in equity in the period the instrument is not puttable
(years 1 and 2). When the instrument becomes puttable (in years 3 through 5) the
remaining BCF should be reclassified into mezzanine equity.
Analyzing Put and Call Options and Other Features and Arrangements / 3 - 19
3.7
Issuance Costs
Issuance costs are specific incremental costs directly attributable to an offering of
equity or debt securities. Costs that qualify as issuance costs include printing bonds
and other documents, commissions, investment banker fees, due diligence costs,
legal and accounting costs, underwriter fees, registration and listing fees, and other
external, incremental expenses paid to advisors that are directly attributable to the
instrument issued. Costs that do not qualify as issuance costs include cash bonuses
to employees, employee performance stock options wherein the milestone is raising
capital through the issuance of equity shares, and premiums for Directors and
Officers’ insurance policies (even if mandated by the underwriters).
3.7.1
Equity Issuance Costs
Costs of obtaining new capital by issuing common or preferred stock that is
classified as permanent equity are considered a reduction of the related proceeds,
and the net amount should be recorded in permanent equity (i.e., as a reduction
of the carrying value of the related equity capital). If the shares are classified as
permanent equity, it is preferable that issue costs be charged directly to additional
paid in capital. However, retained earnings may be charged when applicable
regulations prohibit charging stock issue costs to paid in capital accounts.
Issuance costs related to preferred stock that is classified in the mezzanine section
of the balance sheet should be recorded in the mezzanine section as a reduction of
the related proceeds from such securities (i.e., the securities would be reported at
the net carrying amount). Subsequent accretion, if required, is based on increasing
this net recorded amount to the redemption amount.
The accounting for issuance costs related to common or preferred shares that are
classified as a liability and not remeasured at fair value should generally be treated in
the same manner as debt issuance costs.
3.7.2
Debt Issuance Costs
Debt issuance costs should be reported on the balance sheet as deferred charges.
Deferred debt issuance costs are subsequently amortized using the interest method to
interest expense, generally over the contractual life of the debt. If the fair value option
is elected for a debt instrument, issuance costs should be expensed immediately.
3.7.2.1
Convertible Debt with a Cash Conversion Feature
The issuer of a convertible debt instrument with a cash conversion feature should
bifurcate the convertible debt into a debt and an equity component, as described in
FG section 7.4. Costs associated with the issuance of a convertible debt instrument
with a cash conversion feature should be allocated between the debt and equity
components in proportion to the allocation of the proceeds.
The portion of the debt issuance costs allocated to the debt component should be
amortized using the interest method. In applying the interest method to instruments
with a cash conversion feature the debt issuance costs should be amortized over
the expected life of a similar liability without an associated equity component
(considering the effects of any embedded features other than the conversion option,
such as prepayment options). It should also be noted that if an issuer uses an income
valuation approach, or a valuation technique that is consistent with that approach, to
measure the fair value of the debt component at initial recognition, the issuer should
3 - 20 / Analyzing Put and Call Options and Other Features and Arrangements
consider the periods of cash flows used to measure fair value when identifying the
appropriate discount amortization period. The expected life is not reassessed in
subsequent reporting periods unless the instrument is modified.
3.7.2.2
Units Structures
Issuance costs associated with the issuance of units structures (FG section 9.3),
such as debt with detachable warrants or mandatory units (FG section 9.3.2) should
generally be allocated between the components in a rational manner. Some issuers
allocate issuance costs based on the relative fair values of the base instrument and
of the share issuance contract. Another method used by issuers is the with-andwithout method.
3.7.3
Amortization of Issuance Costs
When the fair value option is not elected, the issuance costs for instruments
classified as liabilities should be amortized over the contractual life of the instrument
using the interest method. Other methods of amortization may be used if the results
obtained are not materially different from those that would result from use of the
interest method. The contractual life of the instrument should be used to amortize
the issuance costs unless embedded features in the instrument support a shorter
life over which to amortize the issuance costs. For example, if a debt instrument is
puttable we believe it is preferable to fully amortize the debt issuance costs by the
first put date, not over the instrument’s contractual life.
3.8
Registration Payment Arrangements
Registration rights may be provided to investors in the form of a separate agreement,
such as a registration rights agreement, or included as part of an investment
agreement, such as an investment purchase agreement, warrant agreement, debt
indenture, or preferred stock indenture. The guidance in ASC 825-20 applies to
the issuer of a registration payment arrangement whether it is issued as a separate
agreement or included as part of another agreement. A registration payment
arrangement is an arrangement with both of the following characteristics:
• It specifies that the issuer will endeavor to (1) file a registration statement for the
resale of specified financial instruments (or for the resale of equity shares that are
issuable upon exercise or conversion of specified financial instruments) that is
declared effective by the SEC or other applicable securities regulators and/or
(2) maintain the effectiveness of the registration statement for a specified period of
time or in perpetuity, and
• It requires the issuer to transfer consideration to the counterparty (investor) if the
registration statement for the resale of the financial instrument or instruments
subject to the arrangement is not declared effective or if effectiveness of the
registration statement is not maintained.
ASC 825-20 does not apply to the following arrangements:
• Those that require registration or listing of convertible debt instruments or
convertible preferred stock if the form of consideration that would be transferred
to the investor is an adjustment to the conversion ratio.
• Those in which the amount of consideration transferred is determined by reference
to (a) an observable market, other than the market for the issuer’s stock, or (b) an
observable index.
Analyzing Put and Call Options and Other Features and Arrangements / 3 - 21
• Those in which the financial instrument or instruments subject to the arrangement
are settled when the consideration is transferred. An example is a common stock
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 time period.
There is no recognition of a registration payment arrangement unless transfer of
consideration under such an arrangement is probable and the payment amount
or a range of payment amounts can be reasonably estimated. In that case, the
contingent liability under the registration payment arrangement should be included
in the allocation of proceeds from the related financing transaction. The remaining
proceeds should be allocated to the financial instruments issued in conjunction with
the arrangement based on the provisions of other GAAP. For example, if debt and
equity classified warrants are issued with a registration payment arrangement, the
registration payment proceeds are first recognized and measured under ASC 450.
The remaining proceeds are allocated on a relative fair value basis between the debt
and the warrants.
Example 3-10: Registration Payment Arrangement
Background/Facts:
• Company A issues $50 million of notes in a private placement. In connection
with the offering Company A enters into a registration payment arrangement that
requires Company A to 1) file a registration statement with the SEC within 90 days
of the offering’s closing date and 2) once the registration statement is effective, to
maintain effectiveness for three years.
• If the registration statement is not declared effective or if it ceases to be effective
during the 3 year period, investors are entitled to an increase of 40 basis points of
interest per year.
• At closing Company A files a registration statement with the SEC within 90 days.
However, after one year Company A determines that the effectiveness of the
registration statement will not be maintained for some portion of the remaining
two years. Company A determines that the registration statement will not be
effective for a period between 1 and 1.5 years.
Question:
How should Company A estimate the range of loss and account for the obligation to
investors?
Analysis/Conclusion:
Company A should record a contingent liability under ASC 450 when it is probable
that the company will be required to remit payments and the range of loss can be
reasonably estimated.
The range of loss would be between $200,000 ($50 million x 0.4% x 1 year) and
$300,000 ($50 million x 0.4% x 1.5 years). Company A would then determine if an
amount within the range is a better estimate than any other amount and accrue
that amount. In the event no amount within the range is a better estimate, then the
minimum amount should be accrued.
3 - 22 / Analyzing Put and Call Options and Other Features and Arrangements
Chapter 4:
Earnings per Share
Earnings per Share / 4 - 1
4.1
Basic and Diluted Earnings per Share
ASC 260-10 requires public companies to report both basic and diluted earnings per
share (EPS) as of each reporting period.
• Basic EPS is calculated by dividing earnings available to common shareholders
by the number of weighted average common shares outstanding. It is impacted
by interest expense, preferred stock dividends, and the issuance of shares in
connection with financing transactions.
• Diluted EPS is calculated by dividing earnings available to common shareholders
by the number of weighted average common shares outstanding plus potentially
issuable shares, such as those that result from the conversion of a convertible
instrument or exercise of a warrant. Diluted EPS can be impacted by equity-linked
financing transactions in complex, and sometimes unexpected, ways.
In this chapter we explain several methodologies used in calculating EPS and
highlight some of the key considerations in determining which method should be
used to include a particular instrument in EPS.
4.2
Anti-Dilution and Sequencing of Instruments
Instruments that, if included in diluted EPS, would increase diluted EPS as compared
to basic EPS (or decrease a loss per share amount) are considered anti-dilutive
and should generally not be included in the calculation of diluted EPS. Examples of
anti-dilutive instruments include purchased call options on a company’s own stock
as well as many prepaid share repurchase contracts, such as accelerated stock
repurchase contracts and prepaid written put options; however, market conditions
impacting each contract must be evaluated to determine whether it is dilutive or antidilutive in any given reporting period. An instrument that is anti-dilutive and excluded
from diluted EPS in one reporting period (for example, due to a company’s current
stock price being lower than the exercise price of a warrant) may be dilutive, and
thus should be included in diluted EPS, in another period.
In determining whether potential common shares are dilutive, each instrument
should be considered separately, rather than in the aggregate. Instruments should be
considered in sequence from the most dilutive to the least dilutive. That is, dilutive
potential common shares with the lowest “earnings add-back per incremental share”
shall be included in diluted EPS before those with a higher “earnings add-back per
incremental share.” Each instrument should be sequentially included in the diluted
EPS calculation until the next instrument is incrementally anti-dilutive.
4.3
If-Converted Method
Share settled convertible debt and convertible preferred stock are generally
included in diluted EPS using the if-converted method. Convertible debt with a cash
conversion feature (as discussed in FG section 7.4), on the other hand, is typically
included in diluted EPS using a method similar to the treasury stock method (see
discussion in FG section 4.6).
Whether a convertible instrument is dilutive under the if-converted method is
determined by the adjustments to the numerator (i.e., interest expense on a
convertible debt instrument) and the denominator (shares to be delivered upon
conversion) of the diluted EPS calculation as compared to basic EPS. The required
adjustments are not affected by the issuer’s current stock price in relation to the
conversion price. That is, a convertible security has the same effect on diluted EPS
4 - 2 / Earnings per Share
when the conversion option is very out of the money (i.e., the security has little
chance of being converted) as it does when it’s deep in the money (i.e., the security
has a high likelihood of being converted). The adjustments to the diluted EPS
numerator and denominator required under the if-converted method are discussed in
FG sections 4.3.1 and 4.3.2.
Convertible securities that have a dilutive effect on EPS should be included in the
weighted average shares outstanding for purposes of calculating diluted EPS from
the beginning of the period or from the time of issuance, if later. Dilutive convertible
securities that are extinguished or redeemed should be included in weighted average
shares outstanding for the period that they were outstanding as should securities in
which the conversion options lapse. Also, dilutive convertible securities converted
during the period are included in the weighted average number of shares outstanding
for purposes of calculating diluted EPS for the period prior to their conversion.
Thereafter, the shares issued are included in the weighted average calculation of
shares outstanding used for both basic and diluted EPS.
4.3.1
Application to Convertible Debt
Under the if-converted method, income available to common shareholders would be
adjusted as follows for a convertible debt instrument:
• Interest expense related to the convertible debt, including deemed interest
expense from amortization of a beneficial conversion feature or other discount, is
added back.
• Nondiscretionary adjustments based on income made during the period that
would have been computed differently had the interest on convertible debt not
been recognized are eliminated.
• The income tax effect of both the interest expense and nondiscretionary
adjustments would also be reflected in the adjustment.
The diluted EPS denominator should be increased by the number of shares issuable
upon conversion of the convertible debt as though the instrument were converted at
the beginning of the reporting period, or as of the issuance date, if later.
If the number of shares to be issued upon conversion varies based on (1) the stock
price at the conversion date, (2) an average of stock prices around the conversion
date, or (3) a formula based on stock prices, the number of shares included in the
diluted EPS denominator should be determined by applying the conversion formula
to the stock prices at the end of the reporting period.
Example 4-1: Application of the If-Converted Method
Background/Facts:
On January 1, 2011, Company A issued $10 million of convertible bonds (10,000
bonds) in $1,000 increments, at par, to investors. On the issuance date, Company A’s
common stock price was $100 per share. The terms of the bonds include:
• A coupon rate of 2.00% paid semi-annually, which results in after-tax interest
expense of $30,000 per quarter ($10 million x 2% x 1/4 = $50,000 less income tax
of $20,000 (40% tax rate x $50,000)).
(continued)
Earnings per Share / 4 - 3
• A requirement that Company A deliver 8 shares per bond to investors upon
conversion (which equates to a conversion price of $125), or 80,000 shares
(10,000 bonds x 8 shares per bond) in total.
Company A has 10,000,000 weighted average common shares outstanding and net
income for the quarter ended March 31, 2011 is $50,000,000.
Question:
How should Company A include the convertible bonds in the diluted EPS calculation
for the period ended March 31, 2011?
Analysis/Conclusion:
Company A should include the convertible bond in diluted EPS using the if-converted
method, if it is dilutive.
Earnings
Weighted average common
shares and common share
equivalents
EPS
Basic EPS
Adjustments
Diluted EPS
$50,000,000
$30,000
$50,030,000
10,000,000
5.00
80,000
$
$
10,080,000
4.96
Example 4-2: Capitalized Interest
Background/Facts:
• Company A issued $10,000,000 of convertible notes in January. The notes have a
10-year term and bear interest at 5% per year.
• Company A capitalized $50,000 of interest on these notes under the provisions of
ASC 835-20 during the year ended December 31, 2011.
Question:
Should the capitalized interest be added back to earnings available to common
shareholders when calculating diluted EPS?
Analysis/Conclusion:
No. Capitalized interest is not a current period expense. If interest associated with
the convertible debt is capitalized, assumed conversion of the debt at the beginning
of the current period would likely not have affected earnings available to common
shareholders. The issuer should, however, consider whether assumed conversion at
the beginning of the period would have ultimately impacted earnings. To do this, the
issuer should perform a “with conversion” and “without conversion” calculation of
capitalized interest to determine if assumed conversion at the beginning of the period
would have affected earnings in the current period.
4.3.2
Application to Convertible Preferred Stock
In the case of convertible preferred stock, income available to common shareholders
would be adjusted as follows:
• Preferred dividends, declared or cumulative (even if undeclared), related to the
convertible preferred stock are added back.
4 - 4 / Earnings per Share
• Deemed dividends in the period from amortization of a beneficial conversion
feature or inducement charge are added back.
• Any adjustments charged or credited to equity in the period to accrete preferred
stock to its cash redemption price are added back/deducted.
The diluted EPS denominator should be increased by the number of shares issuable
upon conversion of the convertible preferred stock as though the instrument was
converted at the beginning of the reporting period, or as of the issuance date, if later.
If the number of shares to be issued upon conversion varies based on (1) the stock
price at the conversion date, (2) an average of stock prices around the conversion
date, or (3) a formula based on stock prices, the number of shares included in the
diluted EPS denominator should be determined by applying the conversion formula
to the stock prices at the end of the reporting period.
Example 4-3: Conversion During Reporting Period
Background/Facts:
• Company A had $50,000,000 of convertible preferred stock outstanding for the
period January 1 to June 30 of the current year.
• On June 30 the holders of the preferred stock exercised their conversion option
and converted the preferred stock into common shares.
Question:
Should the convertible securities be included in diluted EPS for the annual reporting
period ended December 31 even though they are no longer outstanding at the end of
the reporting period?
Analysis/Conclusion:
Yes, dilutive convertible securities converted (or extinguished) during a period should
be included in diluted EPS for the period of time they were outstanding prior to their
conversion (or extinguishment) using the if-converted method.
The if-converted method assumes that the instrument is converted as of the
beginning of the reporting period. If convertible preferred shares were converted at
the beginning of the reporting period, there would be no dividends during the period.
Therefore, any dividends reflected prior to the conversion or extinguishment date,
and any charge/credit on conversion or extinguishment, should be added back to
earnings available to common shareholders.
The number of shares deliverable upon conversion should be included in weighted
average shares outstanding for diluted EPS for the period prior to conversion or
extinguishment. If common shares are issued upon conversion, those shares are
included in the weighted average number of shares outstanding (used to calculate
both basic and diluted EPS) for the period from their date of issuance through
period-end.
4.4
Treasury Stock Method
The treasury stock method is generally used to include forward sale contracts,
options, and warrants on an issuer’s stock in diluted EPS. To apply the treasury stock
method:
Earnings per Share / 4 - 5
• Exercise or settlement of the instrument is assumed at the beginning of the period
(or at the time of issuance, if later) and common shares are assumed to have been
issued.
• The proceeds from exercise or settlement are assumed to have been used to
repurchase the company’s common shares at their average market price during
the period.
• The incremental shares (shares assumed to be issued less shares assumed
to have been repurchased) are included in the denominator of the diluted EPS
calculation.
If the settlement terms or number of shares to be issued upon settlement vary based
on (1) the stock price at the settlement date, (2) an average of stock prices around
the settlement date, or (3) a formula based on stock prices, the number of shares
included in the diluted EPS denominator should be determined by applying the
settlement terms to the stock prices at the end of the reporting period.
Dilutive instruments that are (1) issued, (2) expire unexercised or (3) are cancelled
during the period should be included in the weighted average number of shares
outstanding for purposes of calculating diluted EPS for the period that they were
outstanding. Additionally, dilutive instruments exercised during the period should
be included in the weighted average number of shares outstanding for purposes of
calculating diluted EPS for the period prior to exercise. Thereafter, the shares issued
will be included in the weighted average calculation of shares outstanding used for
both basic and diluted EPS.
Example 4-4: Application of the Treasury Stock Method
Background/Facts:
• Company A has outstanding warrants to issue 500,000 shares of its common
stock.
• The warrants have a strike price of $10 per share.
• The average market price of the common stock during the period is $20.
Question:
How should Company A include the warrants in the diluted EPS calculation for the
period?
Analysis/Conclusion:
Company A should include the incremental shares calculated using the treasury
stock method in the denominator of the diluted EPS calculation.
The incremental shares are calculated assuming the warrants are exercised at the
beginning of the periods, as follows:
Step 1: Calculate the assumed proceeds
Assumed proceeds = Number of warrants x strike price
$5,000,000 = 500,000 x $10
(continued)
4 - 6 / Earnings per Share
Step 2: Calculate the shares to be repurchased
Shares = Assumed proceeds / average market price
250,000 = $5,000,000 / $20
Step 3: Calculate the incremental shares assumed to be issued
Incremental shares = Common shares issued upon exercise of warrants – shares to
be repurchased
250,000 = 500,000 – 250,000
4.5
Instruments Settlable in Cash or Shares
Certain instruments may allow the issuer, at its election, to settle in cash or shares.
Under ASC 260-10-55-32 through 55-36A, when the entity has the choice of, and
controls the settlement method, share settlement should be presumed for EPS
purposes. However, this presumption may be overcome, and cash settlement may
be assumed, when there is a past practice or substantive stated policy that provides
a reasonable basis to believe that the contract will be paid partially or wholly in cash.
The SEC staff looks to a number of factors in evaluating whether a company’s stated
policy to cash settle a portion of its convertible debt instruments is substantive,
including:
• Settlement alternatives as a selling point—the extent to which the ability to share
settle factored into senior management’s decision to approve the issuance of the
instrument rather than an instrument that only allowed for cash settlement.
• Intent and ability to cash settle—the extent to which the company has the positive
intent and ability to cash settle the face value and interest components of the
instrument upon conversion. Both current and projected liquidity should be
considered in determining whether positive intent and ability exists. Management’s
representation attesting to the company’s positive intent and ability to cash settle
is also a factor.
• Disclosure commensurate with the company’s intention—the extent to which
the disclosures included in current period financial statements, as well as those
included in the instrument’s offering documents, acknowledge and support the
company’s positive intent and ability to adhere to its stated policy.
• Past practice—whether the company has previously share-settled contracts that
provided a choice of settlement alternatives.
If the instrument provides the counterparty (or investor) with the choice of settlement
method, the more dilutive outcome should be utilized each period.
For contracts accounted for as equity that are treated as cash settled for EPS, an
adjustment should be made to income available to common shareholders when
computing diluted EPS to reflect the income or loss on the contract that would
have resulted during the period if the contract had been reported as an asset or
liability. Similarly, in computing the more dilutive effect of cash or share settlement
for a contract that provides the holder a choice of settlement method (and is being
accounted for as a liability with changes in fair value recorded in earnings), the
calculation of assumed share settlement would include an adjustment of the diluted
Earnings per Share / 4 - 7
EPS numerator to eliminate the effects of the contract that have been recorded in
net income and an adjustment of the denominator to include the impact of the share
settled contract.
4.6
Convertible Debt with a Cash Conversion Feature
Most convertible debt with a cash conversion feature (FG section 7.4) is included
in diluted EPS using a method similar to the treasury stock method, which is
illustrated in ASC 260-10-55-84 through 55-84B. Under this method:
• There is no adjustment for the cash-settled portion of the instrument; interest
expense (including the accretion of the discount created by separating the equity
component at issuance) remains in income available to common shareholders
(i.e., the numerator of the diluted EPS calculation).
• The number of shares included in the denominator of the diluted EPS calculation
is determined by dividing the “conversion spread value” by the average share
price during the reporting period. The “conversion spread value” is the value that
would be delivered to investors in shares based on the terms of the bond, upon an
assumed conversion.
However, the issuer of a debt instrument that may settle in any combination of cash
or stock at the issuer’s option (known in practice as an Instrument X bond) must
consider the guidance on instruments settlable in cash or shares (FG section 4.5).
• If the issuer has a stated policy or past practice of settling the principal amount
of the debt instrument in cash and the conversion spread value in shares, diluted
EPS should be calculated using the method described above.
• If the issuer cannot assert a stated policy to settle the principal amount of the
debt instrument in cash, or has a past practice of settling similar debt instruments
entirely in shares, the issuer may need to include the debt instruments in diluted
EPS using the if-converted method (FG section 4.3.1).
4.7
Contingently Convertible Instruments
Some conversion options can only be exercised by the investor upon satisfaction of
a contingency. There are two broad categories of conversion option contingencies:
• Contingencies tied to an event or index other than the issuer’s stock price—for
example, the investor can only exercise the conversion option upon the issuer’s
successful completion of an IPO.
• Contingencies tied to the issuer’s stock price—for example, the investor cannot
exercise the conversion option until the issuer’s stock price reaches a level of
120% of the conversion price.
If the instrument’s conversion is based on achieving a substantive contingency based
on an event or index other than the issuer’s stock price, the instrument would not be
included in diluted EPS until the non-market based contingency has been met or is
being met based on circumstances at the end of the reporting period.
On the other hand, contingently convertible instruments that are tied to the issuer’s
stock price must be treated in the same manner as other convertible securities and
included in diluted EPS, if the effect is dilutive, regardless of whether the stock price
trigger has been met.
4 - 8 / Earnings per Share
Depending on the terms of the security, it could be included in diluted EPS using
either the if-converted method (FG section 4.3) or a method that approximates
the treasury stock method in the case of a convertible bond with a cash conversion
feature (FG section 4.6).
4.8
Participating Securities/Two-Class Method of Calculating Basic and
Diluted EPS
The two-class method is an earnings allocation method that treats a participating
security as having rights to earnings that otherwise would have been available to
common shareholders. Under the two-class method, the current period earnings
(after reduction for contractual preferred stock dividends) are allocated between
the common shareholders and the participating security holders based on their
respective rights to receive dividends as if all undistributed earnings for the period
were distributed. The allocation of earnings is based on reported income and the
terms of the participating security, without regard to the practical or legal limitations
of the issuer paying dividends.
As discussed in ASC 260-10-20, a participating security is any security that
may participate in undistributed earnings with common shareholders. The form
of the participation does not have to be a dividend. Any form of participation in
undistributed earnings constitutes participation by that security, regardless of
whether the payment is referred to as a dividend unless participation is contingent
upon a future event, such as the subsequent exercise of an option (FG section 4.8.1).
The key to applying the two-class method is identifying the instruments that, in their
current form (i.e., prior to exercise, settlement, conversion, or vesting), are entitled to
receive dividends if and when declared on common stock.
The two-class method does not require the presentation of basic and diluted EPS for
securities other than common stock; however, it is not precluded.
Example 4-5: Application of the Two-Class Method
Background/Facts:
• Company A has 10,000,000 shares of common stock and 2,000,000 shares of
convertible preferred stock (issued at $10 par value per share) outstanding.
• Company A’s net income is $50,000,000.
• Each share of preferred stock is convertible into 3 shares of common stock.
• The preferred stock participates on a 1:1 basis in any common dividends that
would have been payable had the preferred stock been converted immediately
prior to the record date of any dividend declared on the common stock (i.e., as
converted basis).
• At year-end dividends of $2 per share were paid to the common stockholders.
Preferred shareholders were paid $6 per share since each preferred share
converts into 3 common shares.
Question:
What would basic EPS be under the two-class method?
(continued)
Earnings per Share / 4 - 9
Analysis/Conclusion:
Step 1: Calculate the undistributed earnings
Net income
Less dividends declared:
Common stock1
Participating preferred stock dividend2
Undistributed earnings
$50,000,000
$20,000,000
12,000,000
32,000,000
$18,000,000
1
Common stock dividend
$20,000,000 = 10,000,000 shares x $2 dividend
2
Participating preferred stock dividend
$12,000,000 = 6,000,000 “as converted” shares of common stock (2,000,000 preferred shares x 3
shares of common stock per share of preferred) x $2 per share dividend paid on common stock.
Step 2: Allocate undistributed earnings to the two classes
To common:
[(Common shares outstanding) / (common shares outstanding + “as converted”
shares of preferred)] x undistributed earnings
[(10,000,000) / (10,000,000 + 6,000,000)] x 18,000,000 = $11,250,000
Per share amount:
$11,250,000 / 10,000,000 = $1.13 per share
To preferred:
[(“As converted” common shares) / (common shares outstanding + “as converted”
shares of preferred)] x undistributed earnings
[(6,000,000) / (10,000,000 + 6,000,000)] x 18,000,000 = $6,750,000
Per share amount:
$6,750,000 / 2,000,000 = $3.38
Step 3: Allocate the total amount between distributed and undistributed
earnings
Distributed earnings
Undistributed earnings
Total
Common Stock
Preferred Stock
Total
$20,000,000
11,250,000
$31,250,000
$12,000,000
6,750,000
$18,750,000
$32,000,000
18,000,000
$50,000,000
Step 4: Calculate basic earnings per share amounts
Note that the presentation of EPS is only required for each class of common stock
and not for preferred stock or other participating securities. However, companies are
not precluded from showing EPS for other participating securities.
Distributed earnings
Undistributed earnings
Total
4 - 10 / Earnings per Share
Common Stock
Preferred Stock
$2.00
1.13
$3.13
$6.00
3.38
$9.38
Example 4-6: Participating Securities with a Conversion Feature
Background/Facts:
• Company A issued Series B convertible preferred stock.
• The provisions of the stock agreement allow the holder of the instrument to
receive dividends paid and distributed to the holders of the common stock.
• Based upon the provisions set forth in the stock agreement, Company A
determines that the Series B convertible preferred shares are participating
securities.
Question:
What method should Company A use to calculate basic EPS, the if-converted
method or the two-class method?
Analysis/Conclusion:
ASC 260-10-45-60A confirms that convertible participating securities must be
included in basic EPS using the two-class method. The if-converted method should
only be used for purposes of calculating diluted EPS if the effect is dilutive.
4.8.1
Adjustments to Exercise or Conversion Prices
Participation may not always involve the right to receive dividends in cash. For many
equity-linked securities, dividends do not get paid to investors when declared on
common stock. Instead, the conversion or exercise price of the security may be
adjusted for dividends above a specified threshold to keep the investor whole. In
some cases, those adjustments may constitute participation rights.
4.8.1.1
Adjustments to Convertible Securities and Options
As stated in ASC 260-10-45-62, dividends transferred to an investor holding a
convertible security in the form of a reduction of the conversion price or an increase
in the conversion ratio of the security do not represent a participation right. This
conclusion also applies to other optional securities on an issuer’s stock (e.g., options
or warrants) if those securities provide for an adjustment to the exercise price that
is tied to the declaration of dividends by the issuer. An adjustment to the conversion
or strike price of an optional security represents a contingent transfer of value; the
investor will only benefit from the adjustment if it converts or exercises the security
and receives shares. The investor will not participate in dividends with common
shareholders if the optional instrument expires without being converted or exercised.
4.8.1.2
Adjustments to Forward Contracts
Conversely, a provision that reduces the price paid in a forward sale contract on
an issuer’s stock upon the declaration of a dividend does represent a participation
right because it is a non-contingent transfer of value to the investor. In this case,
the investor has a right to participate in the undistributed earnings of the issuer
because a dividend declaration results in a transfer of value to the investor through
a reduction in the forward purchase price per share. Because a forward contract
must be settled and, therefore, the value transfer is not contingent—as opposed
to a similar reduction in the exercise price of an option or warrant, which could
expire unexercised—a forward contract with this type of provision is a participating
Earnings per Share / 4 - 11
security, regardless of whether a dividend is declared during the period the contract
is outstanding.
4.8.1.3
Adjustments to Variable Share Forward Delivery Agreements
Variable share forward delivery agreements are typically components in mandatory
units securities, such as ACES, PRIDES and DECS (FG section 9.3.2). In a variable
share forward delivery agreement, the issuer sells its shares at a stated price, for
example, for $50 per share in 3 years, with the number of shares to be issued
dependent on the then current market price of the common stock. Typically, the
investor is required to pay the stated price to the issuer at the settlement date.
Economically, a variable share forward delivery agreement is a combination of a
written call option and a purchased put option, each with different strike prices. For
purposes of illustration, if after 3 years the stock price is:
• Less than $50, the company will issue 1 share;
• Between $50 and $62.50, the company will issue a pro rata number of shares
between 1 share and 0.8 share equal to a fixed dollar amount of $50;
• Greater than $62.50, the company will issue 0.8 shares.
The range between $50 and $62.50 is commonly referred to as the “dead zone.” If
the issuer’s stock price at settlement falls within the dead zone, there is no transfer
of value; the investor delivers $50 and the issuer delivers shares with a value equal to
$50 based on the then current stock price.
Most variable share forward delivery agreements include an adjustment for dividends
declared while the contract is outstanding as follows:
• The end points of the dead zone are adjusted downward.
• The number of shares delivered when the stock price at settlement is outside of
the dead zone is also adjusted downward.
• There is no adjustment to the number of shares delivered when the stock price at
settlement is within the dead zone.
As discussed above, an adjustment to an optional security, such as convertible
debt or a warrant, is typically not considered a participation right whereas an
adjustment to a forward sale contract where the holder will always receive the benefit
of dividends if declared (i.e., there is always a transfer of value) is considered a
participation right. The issuer of a variable share forward delivery agreement must
determine whether any adjustment provisions included in its contract convey a
contingent or a non-contingent transfer of value. Generally, a variable share forward
delivery agreement is not considered a participating security provided:
• The agreement does not entitle the investor to participate in dividends if the final
settlement is within the dead zone, and
• At issuance, it is at least reasonably possible that the final settlement of the
contract will be at a price within the dead zone.
To determine whether it is reasonably possible for a particular variable share forward
delivery agreement to settle at a price within the dead zone, an issuer may need to
perform a quantitative evaluation that incorporates:
4 - 12 / Earnings per Share
• The contractual terms of the agreement, including the method of adjusting for
dividends and the maturity date,
• Volatility of the issuer’s stock,
• Historical and expected dividends, and
• How wide the dead zone is and whether the issuer’s stock price is inside or
outside the dead zone at issuance.
This assessment must only be performed at issuance of the instrument; no
subsequent evaluation need be performed.
4.9
Share Lending Agreements
A convertible bond issuer may enter into a share lending agreement with an
investment bank. A share lending agreement is intended to facilitate the ability of
investors, primarily hedge funds, to borrow shares to hedge the conversion option
in the convertible debt. Typically, they are executed in situations where the issuer’s
stock is difficult or expensive to borrow in the conventional stock loan market.
The terms of a share lending arrangement typically require the issuer to issue shares
to the investment bank in exchange for a small fee, generally equal to the par value
of the common stock. Upon conversion or maturity of the convertible debt, the
investment bank is required to return the loaned shares to the issuer. The shares
issued are legally outstanding, entitled to vote and entitled to dividends, though
under the terms of the arrangement the investment bank may agree to reimburse the
issuer for dividends received and may agree to not vote on any matters submitted to
a vote of the company’s shareholders.
See FG section 7.10.4 for a discussion of the recognition and measurement
considerations of a share lending arrangement.
ASC 470-20-45-2A states that loaned shares are excluded from basic and diluted
earnings per share unless default of the share lending arrangement occurs, at
which time the loaned shares would be included in the basic and diluted EPS
calculations. If dividends on the loaned shares are not reimbursed to the entity, any
amounts, including contractual (accumulated) dividends and participation rights
in undistributed earnings, attributable to the loaned shares would be deducted in
computing income available to common shareholders, in a manner consistent with
the two-class method (FG section 4.8).
Earnings per Share / 4 - 13
Chapter 5:
Accounting for Modifications and Extinguishments
Accounting for Modifications and Extinguishments / 5 - 1
5.1
Restructuring and Extinguishment
For a variety of reasons an issuer may modify the terms of an outstanding debt or
equity security.
• A debt modification may be accounted for as (1) the extinguishment of the existing
debt and the issuance of new debt or (2) a modification of the existing debt,
depending on the extent of the changes.
• The accounting for the modification of an equity-classified instrument is typically
dictated by the legal form of the transaction.
Alternatively, an issuer may decide to extinguish an instrument prior to its maturity.
This may be done because of changes in interest rates or credit rating, changes
in capital needs, or to mitigate the dilutive impact of the instrument, among other
reasons. If a debt instrument is convertible, the issuer may instead decide to induce
the investor to convert into equity by offering a cash or share “sweetener” for doing
so, rather than extinguishing the instrument through the repayment of cash.
5.2
Analyzing a Debt Restructuring
A debt restructuring can be achieved in the following ways.
• Amending the terms or cash flows of an existing security.
• Exchanging existing debt for new debt with the same creditor.
• Repaying an existing debt obligation and contemporaneously issuing new debt
with the same creditor. Although this is a legal extinguishment, the transaction
must be analyzed under the relevant debt restructuring accounting guidance. See
example 5-1.
The steps to determine the appropriate accounting treatment for a debt restructuring
are illustrated in the following flowchart.
Analyzing a Debt Restructuring
Troubled Debt Restructuring? (FG section 5.3)
No
Debt Security/Term Loan or Line of Credit?
Debt Security or
Term Loan
Line of Credit
Extinguishment or Modification?
(FG section 5.4)
Assess borrowing capacity
(FG section 5.5)
5 - 2 / Accounting for Modifications and Extinguishments
Example 5-1: Repayment of Debt Instrument with Contemporaneous Issuance
of Debt
Background/Facts:
• Company A has an outstanding loan (Loan 1) with Bank B with an unpaid balance
of $5 million.
• Company A pays Loan 1 in full.
• At the same time, Company A enters into a new loan agreement (Loan 2) with
Bank B with a principal balance of $7.5 million.
Question:
Should Company A assess the borrowing under Loan 2 as a restructuring of Loan 1?
Analysis/Conclusion:
Yes, even though Loan 1 was legally extinguished, the transactions should be analyzed
as a restructuring. Depending on several factors, this could result in accounting for
the transaction as either (1) a troubled debt restructuring, (2) a modification of Loan 1,
or (3) an extinguishment of Loan 1 and consummation of Loan 2.
5.3
Troubled Debt Restructurings (TDRs)
The first step in determining the appropriate accounting treatment for a debt
restructuring is to assess whether it is a troubled debt restructuring (“TDR’’). A
restructuring is a TDR if:
• The borrower is experiencing financial difficulties, and
• The lender grants a concession.
Both criteria are required to be met in order to have a TDR. ASC 470-60 requires
both a qualitative and a quantitative analysis to determine whether the TDR criteria
have been met.
A borrower that is experiencing financial difficulties should assess whether the lender
has granted a concession in a debt restructuring, even if the restructuring results in
the debt being fully satisfied with cash, other assets, or equity. See FG section 5.3.3.
In a restructuring in which the borrower grants an equity interest to the lender, the
borrower should assess whether the equity grant triggers a change in control that
requires push-down accounting to the reporting entity. For example, if a troubled
debtor that is an SEC registrant settles its debt by giving a lender a 95 percent equity
interest in the debtor, this could result in the new basis of the lender being pushed
down to the debtor/reporting entity. This would result in a new basis of accounting for
the reporting entity and business combination accounting guidance would be applied.
In that case, the TDR may be recorded differently than described in this section.
5.3.1
Determining Whether the Borrower Is Experiencing Financial Difficulties
The first consideration in determining whether a borrower is experiencing financial
difficulties is whether its creditworthiness has deteriorated since the debt was
originally issued. As discussed in ASC 470-60-55-7, changes in an investment-grade
credit rating are not considered a deterioration in creditworthiness for purposes
Accounting for Modifications and Extinguishments / 5 - 3
of this guidance. Conversely, a decline in credit rating from investment grade to
noninvestment grade is considered a deterioration in the borrower’s creditworthiness.
If the creditworthiness of the borrower has deteriorated since the debt was originally
issued, then the indicators of financial difficulty described in ASC 470-60-55-8 should
be assessed. These indicators serve as examples of financial difficulty but are not allinclusive; all aspects of the borrower’s current financial situation should be evaluated.
• The borrower is currently in default on its debt.
• The borrower has declared or is in the process of declaring bankruptcy.
• There is significant doubt as to whether the borrower will continue to be a going
concern.
• The borrower’s securities have been, are in the process of, or are under threat of
being delisted.
• Based on estimates and projections that only encompass the current business
capabilities, the borrower 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 borrower could not 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 borrower.
Notwithstanding the above, the following factors, if both are present, provide
determinative evidence that the borrower is not experiencing financial difficulties.
• The borrower is servicing its existing debt and can obtain funds to repay that
debt from sources other than the existing creditors (without regard to the current
restructuring) at an effective interest rate equal to the current market interest rate
for a non-troubled borrower.
• The creditors agree to restructure the existing debt solely to reflect a decrease
in current market interest rates for the borrower or positive changes in the
creditworthiness of the borrower since the debt was originally issued.
5.3.2
Determining Whether the Creditor Has Granted a Concession
A concession is deemed to be granted if the effective borrowing rate on the
restructured debt is less than the effective borrowing rate on the original debt.
See Example 5-2 for a concession calculation. When performing a concession
calculation, the following points should be considered:
• The carrying value of the original debt includes unamortized premium, discount,
and issuance costs, and does not include hedging effects.
• If the debt has recently been restructured, the carrying value and effective interest
rate of the debt immediately before the earlier restructuring should be used.
• If any sweeteners (e.g., preferred stock, warrants) are issued, their fair values
should be included in day-one cash flows. If a previously issued sweetener is
restructured, the change in fair value should be included in day-one cash flows.
• If the debt is settled through the transfer of assets or issuance of equity securities,
the fair value of these instruments should be compared to the current carrying
value of the debt.
5 - 4 / Accounting for Modifications and Extinguishments
5.3.3
Full Settlement of the Debt
A restructuring that results in the full settlement of the debt obligation should be
accounted for in the same manner as a debt extinguishment (FG section 5.6).
However, a borrower must determine whether the restructuring is a TDR even if it
results in no remaining debt outstanding (i.e., the debt is fully satisfied with cash,
other assets, or equity) as the borrower is required to disclose the fact that the debt
was extinguished as the result of a TDR.
5.3.4
Modification of Terms
The recognition and measurement guidance for a modification of terms in a TDR
varies based on whether the future undiscounted cash flows specified by the new
terms are greater than or less than the carrying value of the debt. In calculating the
future undiscounted cash flows specified by the new terms:
• All payments under the new terms should be included.
• Any contingent payments should be included without regard to the probability of
those payments being made.
• If the number of future payment periods may vary because the debt is payable on
demand, the estimate of future cash payments should be based on the maximum
number of periods that could be required under the terms of the revised debt
agreement.
Summary of Modification of Terms Accounting
If Future
Undiscounted
Cash Flows
(Including All
Contingent
Payments) Are:
Gain Recognition and
Interest Expense Impact
New Fees
Paid to
Creditor
New Fees
Paid to Third
Parties
Less than the net
carrying value of
the original debt
• A gain is recorded for the
difference.
• The carrying value of the
debt is adjusted to the future
undiscounted cash flow amount.
• No interest expense is recorded
going forward. Instead, each time
a payment is made, the carrying
value is reduced.
Reduce the
recorded gain
Expense
Greater than the
net carrying value
of the original
debt
• No gain is recorded.
• A new effective interest rate
is established based on the
carrying value of the debt and
the revised cash flows.
Capitalize and
amortize
Expense
If a TDR involves a combination of actions, such as a partial settlement of the debt
and a modification of terms:
• The debtor should first reduce the carrying value of the debt by the fair value of
the assets or equity interests transferred,
• Then apply the modification of terms guidance to determine the appropriate
accounting.
Accounting for Modifications and Extinguishments / 5 - 5
5.3.5
TDR of a Variable-Rate Instrument
When a restructured debt instrument has a variable interest rate, the guidance in
ASC 470-60-35-11 indicates that the cash interest payments to be included in the
TDR calculation should be based on the interest rate that was in effect at the time
of the restructuring. If the cash flows from the principal repayments and interest
payments determined based on the spot variable rate (e.g., LIBOR) at the date
of restructuring are less than the carrying value of the debt, then a gain would be
recorded on the date of the restructuring. Subsequently, all future principal and
interest payments would be charged against the carrying value of the debt with no
amounts being charged to interest expense.
However, subsequent to the restructuring, interest rates will change, resulting in
cash flows differing from those used in the initial TDR calculation. The accounting
treatment for changes in cash flows due to changes in interest rates depends on
whether there is an increase or decrease from the spot interest rate used in the initial
TDR accounting (the “threshold interest rate”).
We believe that upon an increase in interest rates, the borrower should record
additional interest expense in the period that the expense was incurred. The additional
interest expense is calculated by multiplying the difference between the current rate
and the threshold rate by the current carrying value of the debt. ASC 470-60-35-11
indicates that the additional interest expense should be accounted for using a loss
contingency model, which requires the borrower to record amounts that are probable
and reasonably estimable. The amount of additional interest expense is both probable
and reasonably estimable in the period in which an increase in interest rates occurs.
Accordingly, the additional interest expense is recorded in that period.
A decrease in interest rates could result in an additional restructuring gain due to
lower forecasted payments than those used to calculate the originally recorded
liability. Based on the guidance in ASC 470-60-35-11
• Fluctuations in the effective interest rate after the TDR from changes in interest
rates or other causes should be accounted for as changes in estimates in the
periods the changes occur.
• However, the accounting for those fluctuations should not result in recognizing
a gain on restructuring that may be offset by future cash payments. Rather, the
carrying value of the restructured debt should remain unchanged, and future cash
payments should reduce the debt balance until the point that any gain recognized
cannot be offset by future cash payments.
In the case of a variable rate instrument, there is always a potential for future cash
payments to offset the unrecorded gain generated by an interest rate decrease (the
variable rate could increase in the future). Therefore, no gain is recognized until the
entire debt balance is paid off and there are no future interest payments.
5.3.6
Restructuring of Debt by Existing Equity Holders
Parties that hold equity securities of the borrower (in addition to the restructured
debt instrument) prior to a restructuring are considered related parties. If the
borrower restructures its debt with these related parties, gain recognition may not
be appropriate under ASC 470-50-40-2. Such a restructuring may be in essence
a capital transaction. If the lender/equity holder is restructuring its debt to protect
its equity investment, then it is generally appropriate to account for the “gain” on
restructuring as a capital contribution. This may be the case when the lender holds
5 - 6 / Accounting for Modifications and Extinguishments
a significant amount of the borrower’s equity securities. In contrast, if the lender only
holds a small amount of the borrower’s equity securities, gain recognition could be
appropriate.
Example 5-2: Troubled Debt Restructuring
Background/Facts:
• Company A has a term loan outstanding with one lender.
• Company A has (a) experienced a significant decline in sales, (b) defaulted on its
interest payments, and (c) recently been delisted. The Company projects that it
will not be able to make its future upcoming interest payments.
• On January 1, 2012 Company A negotiated a restructuring with its lender.
• Following is a summary of the terms of Company A’s original debt instrument and
the terms added or modified during the restructuring. There are no contingent
payments in the restructured debt obligation.
Terms of the Original Debt
Outstanding Balance
Years
Maturity Date
Effective Interest Rate
Unamortized Discount
Net Carrying Value
Coupon
Interest Payments
Principal Payment
$1,000,000
4 years, 6 months
6/30/2016
6.00%
$19,200
$980,800
5.50%
Annually in June
Balloon payment at maturity
Modifications
Lender Forgave
Coupon Decreased To
Fair Value of Equity Granted to the Lender
$250,000
3.00%
$ 50,000
Question:
Is the restructuring of Company A’s debt considered a TDR?
Analysis/Conclusion:
To determine whether the restructuring meets the qualifications for a TDR there are
two questions to be answered:
1. Is Company A experiencing financial difficulties?
Yes, Company A is experiencing financial difficulties because it is in default on its
debt, has had a significant decline in sales, and has been delisted.
2. Was Company A granted a concession by its lender?
To determine whether it was granted a concession, Company A must compare
the effective interest rate of the restructured debt with the effective interest rate of
the original debt. The effective interest rate of the restructured debt is calculated
based on the guidance in ASC 470-60-55-10 through 55-14 as follows:
(continued)
Accounting for Modifications and Extinguishments / 5 - 7
1/1/2012 6/30/2012 6/30/2013 6/30/2014 6/30/2015 6/30/2016
Interest
Payments
Principal
Payment
Equity Grant
Total Payments
$11,250
$22,500
$22,500
$22,500
$ 22,500 $101,250
750,000
$50,000
$50,000
Effective Interest Rate
$11,250
$22,500
$22,500
$22,500
Total
750,000
$772,500 $851,250
–1.50%1
Effective Interest Rate of Original Debt 6.00%
1
The effective interest rate is determined by calculating the internal rate of return that is needed to equate
the total payments on the modified debt to the original net carrying value of $980,800. Since the effective
interest rate of the restructured debt (–1.50%) is lower than the effective interest rate on the original debt
(6.00%) the lender has granted a concession.
Based on the above, Company A is subject to the TDR model. This restructuring is
a combination of types since it involves an equity issuance and a modification of
terms. As such the TDR calculation is as follows:
Carrying value of the debt
Less: fair value of the equity granted
Adjusted carrying value
Less: future undiscounted cash flows
Gain
$980,800
(50,000)
930,800
(851,250)
$ 79,550
By reducing the debt balance by the fair value of the equity granted ($50,000),
and recording the TDR gain ($79,550), the carrying value of the debt is adjusted to
$851,250 (sum of the future undiscounted cash flows). Going forward, no interest
expense is recognized and each time a payment is made the carrying value of the
debt is reduced.
5.4
Modification vs. Extinguishment—Non-Revolving Debt Security or
Term Loan
If a debt restructuring of non-convertible, non-revolving debt is not a TDR, the
guidance in ASC 470-50-40 should be followed to determine if the restructuring is
a modification or extinguishment. A debt modification can be achieved either by
amending the terms of an existing security or by exchanging existing debt for
new debt with the same creditor. The legal form of the transaction, whether a legal
exchange or a legal amendment, is irrelevant for the purpose of determining whether
an accounting extinguishment or modification has occurred (FG section 5.8 for
discussion of modification of preferred stock). What is relevant is (1) whether
the creditor remains the same and (2) whether the change in the debt terms is
considered substantial.
Transactions involving the issuance of a new debt obligation to one creditor and the
concurrent satisfaction of an existing debt obligation to another unrelated creditor
(i.e., when the debtor and creditor are not the same in both agreements) are always
accounted for as an extinguishment of the existing debt and issuance of new debt.
The table below summarizes the accounting for a debt modification and
extinguishment. More detailed guidance on the accounting for extinguishments is
included in FG section 5.6.
5 - 8 / Accounting for Modifications and Extinguishments
Modification vs. Extinguishment
5.4.1
New Fees
Paid to Third
Parties
Gain/Loss
Recognition and
Interest Expense Impact
New Fees
Paid to
Creditor
Modification
• No gain or loss is recorded.
• A new effective interest rate is
established based on the carrying
value of the debt and the revised
cash flows.
Capitalize and
amortize
Expense
Extinguishment
• A gain or loss is recorded for
the difference between the net
carrying value of the original debt
and the fair value of the new debt.
• Interest expense is recorded
based on the effective interest
rate of the new debt.
• See FG section 5.3.6 for a
discussion of gain/loss treatment
when the debt holders also hold
equity securities of the borrower.
Expense
Capitalize and
amortize
Type of
Transaction
Test to Determine Whether a Modification to Non-Revolving Debt Is
Substantial
ASC 470-50-40-6 through 40-12 provide a test for determining whether cash
flows have “substantially different terms” such that a debt instrument has been
extinguished (rather than modified) for accounting purposes.
The terms of the new (or amended) debt instrument are substantially different from
the original debt instrument if the present value of the cash flows under the amended
or new debt is at least 10 percent different from the present value of the remaining
cash flows under the original debt. To conduct this test, the issuer must compare:
• The present value of the cash flows of the original debt discounted at the effective
interest rate of the original debt, with
• The present value of the cash flows of the new debt also discounted at the
effective interest rate of the original debt.
The effective interest rate of the original debt includes the coupon and any premium
or discount at issuance. It does not include debt issuance costs.
If the present value of the two cash flow streams differs by 10 percent or more (in either
direction), the debt instruments have substantially different terms and the original debt
is considered extinguished. This is commonly referred to as the “10 percent test.”
Cash flows can be affected by changes in principal amounts, interest rates, or
maturity. They can also be affected by fees exchanged between the debtor and
creditor to effect changes in:
• Recourse or non-recourse features
• Priority of the obligation
• Collateralization features (including changes in collateral)
• Debt covenants and/or waiver terms
Accounting for Modifications and Extinguishments / 5 - 9
• The guarantor (or elimination of the guarantor)
• Option features
ASC 470-50-40-12 provides specific guidance on performing the 10 percent test.
Below are a few key takeaways from this guidance:
• When performing the 10 percent test, the cash flows of the new debt instrument
should include all amounts paid by the debtor to the creditor (i.e., any fees paid
to the lender in conjunction with the restructuring should be included in the cash
flows of the new debt instrument) as a day-one cash flow.
• Third party fees should not be included in the cash flow analysis.
• If there is a variable interest rate in any of the debt instruments, the rate in effect at
the time of the restructuring should be used.
• If any of the debt instruments are callable or puttable, then separate cash flow
analyses should be performed assuming exercise and non-exercise of the put and
call. The scenario that generates the smallest change should be used. See FG
section 5.4.1.4 for further discussion of prepayment options.
• For debt that has been amended more than once in a one-year period, ASC
470-50-40-12(f) specifies that the debt terms that existed prior to the previous
modification(s) should be used to apply the 10 percent test, if the modification(s)
were deemed not to be substantially different. In other words, this is a “cumulative
impact” assessment—when comparing the principal, interest, and creditor fee
cash flows immediately before and after the current amendment, the terms that
existed prior to the previous modification(s) should be used as opposed to the
terms that existed immediately before the current amendment.
When applying the 10 percent test to a public debt issuance, the debt instrument is
the individual security held by an investor and the creditor is the security holder. In an
exchange or modification offer made to all investors, the 10 percent test is applied to
those investors who agree to the exchange or modification; debt instruments held by
investors who do not agree would not be affected.
ASC 470-50-40 does not apply when the debt instruments are sold directly from one
investor to another investor in a market transaction, as the company has not engaged
in an extinguishment or modification transaction (i.e., the ability of the investors to
purchase and sell a public debt instrument does not impact the issuer’s accounting).
See FG section 5.7 for a discussion of restructuring of convertible debt instruments.
5.4.1.1
Loan Syndications and Participations
Many financing arrangements involve multiple lenders who are members of a loan
syndicate or loan participation. The accounting for a loan syndication differs from
that of a loan participation.
• In a loan syndication, each creditor is viewed as having its own loan with the
borrower that is separate and distinct from the other creditors in the syndicate.
• In a loan participation, the debt instrument is a contract between the debtor and
the lead creditor. Participating creditors are not direct creditors but rather, have an
interest represented by a certificate of participation.
5 - 10 / Accounting for Modifications and Extinguishments
Accordingly, the analysis of whether a restructuring of a loan syndication is a
modification or extinguishment differs from the analysis a borrower would perform for
a loan participation.
• In analyzing the restructuring of a loan syndication, the borrower must perform the
10 percent test separately with respect to each individual creditor participating in
the syndication. We believe this approach should also apply to line-of-credit and
revolving debt arrangements that are syndicated and are evaluated under ASC
470-50-40-21 (see FG section 5.5 for discussion relating to modifications to lines
of credit).
• In analyzing the restructuring of a loan participation, the borrower must perform
the 10 percent test with respect to the lead creditor. Similarly, for a line-of-credit
and revolving debt arrangement structured as a participation the debtor would
be required to apply the guidance in ASC 470-50-40-21 only to the lead creditor
to determine if there has been a change in the borrowing capacity from the lead
creditor (see FG section 5.5 for discussion relating to modifications to lines of
credit).
The conclusions reached under the 10 percent test for each creditor in the term loan
syndicate can be different (i.e., one creditor loan may be considered to be modified,
while another may be considered extinguished). Similarly, under ASC 470-50-40-21,
issuance costs may be written off for one member of the line-of-credit syndicate but
not another.
If an exchange or modification offer is made to all members of the syndicate and
only some of the creditors agree to the exchange or modification, the 10 percent
test would be applied to debt instruments held by those creditors who agree to the
exchange or modification. Debt instruments held by those creditors who do not
agree to the exchange or modification would not be affected, unless their interests
are paid off, in which case they would be accounted for as extinguishments.
If a new creditor enters the lending syndicate and provides a new term loan or
access to a new line of credit, costs paid to creditors and third parties are treated as
they would be for a new loan or line of credit from a new creditor; that is, deferred as
debt issuance costs and amortized over the life of the new term loan or line of credit.
5.4.1.2
Third Party Intermediaries
A third party intermediary (e.g., an investment bank) may arrange a debt restructuring
or exchange offer. For example:
• Company A has multiple bonds of a single bond offering outstanding. The bonds
are held by a number of third-party investors.
• Bank B buys the bonds from the third-party investors.
• Bank B and Company A negotiate a restructuring (or exchange offer) of the bonds.
• Bank B sells the new bonds to third-party investors (who may, or may not, be the
same as the investors in the original bonds).
To determine the appropriate accounting treatment for a restructuring transaction
arranged by a third-party intermediary, the company must first determine whether
the intermediary is a principal to the transaction (i.e., arranging the debt restructuring
on its own behalf) or the company’s agent (i.e., arranging the debt restructuring on
behalf of the company or investors).
Accounting for Modifications and Extinguishments / 5 - 11
If the third-party intermediary is an agent, the company would look through the
intermediary to determine whether the restructuring should be accounted for as an
extinguishment or a modification.
• The company must first determine whether the investors after the restructuring
are the same as the investors prior to the restructuring. If they are not, then the
restructuring is accounted for as an extinguishment because the transaction does
not involve the same creditor.
• If an investor holds the debt before and after the restructuring, the company
should perform the 10 percent test based on the cash flows of the debt
instruments held by those investors before and after the restructuring. The thirdparty intermediary is ignored for purposes of performing the 10 percent test.
If the third-party intermediary is considered a principal to the transaction, it is the
investor. In this case, the company would perform the 10 percent test based on
the cash flows of the debt held by the third-party intermediary before and after the
restructuring.
Generally, if the intermediary is putting its own funds at risk and is subject to loss in
the transaction, it is acting more like a principal. If it seeks to find other purchasers
for the company’s debt and is compensated by a fee arrangement, it is acting more
like an agent.
5.4.1.3
Consideration of Multiple Debt Instruments Held by One Lender
Oftentimes, a borrower may have several debt instruments outstanding with one
lender. When performing the 10 percent test, we believe all of a lender’s debt
instruments should be included in the 10 percent test. For example,
• A borrower has two debt instruments outstanding with one lender, Tranche A and
Tranche B.
• The borrower (1) increases the principal balance of Tranche A and (2) pays off
Tranche B.
Although there was a legal extinguishment of Tranche B, the borrower must perform
the 10 percent test by (1) combining the cash flows of the original Tranche A and
Tranche B debt instruments and (2) comparing those combined cash flows to the
new cash flows of the restructured Tranche A. When discounting the cash flows of
the restructured Tranche A, we believe a blended effective rate based on the original
Tranche A and Tranche B should be used.
See FG section 5.4.1.9 for discussion of the concurrent modification of non-revolving
(i.e., term debt) and revolving debt arrangements.
5.4.1.4
Prepayment Options
Oftentimes, debt agreements allow a borrower to prepay the debt prior to maturity,
especially in variable rate debt instruments. A prepayment option is a call option
that gives the borrower the right to call the debt from the lender and pay the amount
owed.
ASC 470-50-40-12(c) specifies that if either the new debt instrument or the original
debt instrument is callable (by the issuer) or puttable (by the holder):
5 - 12 / Accounting for Modifications and Extinguishments
• The issuer should do separate cash flow analyses assuming exercise and nonexercise of the call or put at its earliest available date and for the stated call/put
price (which may be par value or another amount).
• The cash flow test that generates the smaller change (exercise or non-exercise)
should be used as the basis for determining whether the 10 percent threshold has
been met.
• If a modification conclusion (e.g., change in cash flows is less than 10 percent)
is reached in any scenario, then the analysis is complete and the restructuring is
considered a modification.
If the prepayment option (or any put or call feature) is exercisable at any time, a
borrower should assume it is exercised immediately on the date of amendment. This will
usually result in the smallest change in cash flows. When including prepayment options
in the 10 percent test, it is not necessary to assess the ability of the borrower to prepay
the debt. The 10 percent test considers all non-contingent contractual scenarios.
When applying the 10 percent test, it may also be appropriate to consider contingent
prepayment options, such as a put option exercisable upon a change in control
or upon completion of qualified financing. Determining whether a contingent
prepayment option should be considered requires judgment based on the facts and
circumstances at the modification date.
5.4.1.5
Non-cash Consideration
A debt restructuring may involve an issuance of non-cash consideration, such as
warrants or preferred stock, to the lender. As stated in ASC 470-50-40-12, the cash
flows of the new debt instrument include:
• All cash flows specified by the terms of the new debt instrument, plus
• Any amounts paid by the debtor to the creditor as part of the exchange or
modification, less
• Any amounts received by the debtor from the creditor as part of the exchange or
modification.
When the consideration to the creditor includes additional financial instruments, such
as warrants or preferred stock, we believe the fair value of the instruments issued
should be included as a day-one cash flow for purposes of the 10 percent test.
If the restructuring is considered a modification based on the 10 percent test, then
any non-cash consideration should be capitalized similar to a cash fee paid to the
lender. The capitalized amount, along with any existing unamortized debt discount
or premium, should be amortized as an adjustment to interest expense over the
remaining term of the modified debt instrument using the effective interest method.
If the restructuring is to be accounted for as a debt extinguishment, then the
fair value of any non-cash consideration (e.g., fees paid to the creditor) is to be
associated with the extinguishment of the original debt instrument (i.e., treated
as an amount paid to extinguish the debt) and included in determining the debt
extinguishment gain or loss to be recognized.
If warrants or preferred stock are issued to third-party advisors rather than the lender,
we believe the fair value of the warrants or preferred stock should be accounted for
following the guidance in ASC 470-50-40-18 for third-party costs. The accounting for
Accounting for Modifications and Extinguishments / 5 - 13
third-party costs depends upon whether there is an extinguishment or a modification
(FG section 5.4).
5.4.1.6
Restructured Debt Is the Hedged Item in a Fair Value Hedge of
Interest Rates
When performing the 10 percent test, the impact of the required amortization of basis
adjustments due to the application of fair value hedge accounting should be ignored
for the purposes of calculating the effective interest rate of the original debt instrument.
The goal of the 10 percent test is to determine whether the terms of the relationship
between the debtor and creditor pre- and post-exchange are substantially different.
The fact that the debtor designated the debt as the hedged item in a fair value hedging
relationship does not impact the relationship between the debtor and creditor.
If the exchange is considered a modification based on the 10 percent test, a new
effective yield is to be determined based on the carrying value of the original debt
instrument and the revised cash flows. ASC 815-25-35-8 states that the adjustment
of the carrying value of a hedged asset or liability required by ASC 815-25-35-1(b)
shall be accounted for in the same manner as other components of the carrying value
of that asset or liability. Therefore, the basis adjustment becomes a part of the new
effective yield computation that considers all of the cash flows over the remaining life
of the new debt (i.e., the basis adjustment is amortized over the modified loan term).
If the exchange is an extinguishment, the debt is removed from the books, and a new
debt instrument is recorded at fair value. As such, the existing hedging relationship is
de-designated. If the interest rate swap is not terminated, the issuer could either
(1) re-designate the swap in a hedging relationship of the new debt, if the
requirements for hedge accounting are met or (2) record any future changes in the
fair value of the swap in earnings.
5.4.1.7
Change in Currency of the Debt
If a debt instrument is modified such that the currency in which the debt is
denominated changes, the change in currency should be included in the cash flows
as part of the 10 percent test. To convert the cash flows on the new debt into the
currency of the original debt, we believe there are two acceptable methods:
• Use the spot rate in effect at the debt exchange date.
• Use the forward rates corresponding to each cash flow (interest payment and
principal) payment date.
5.4.1.8
Change in Principal
Application of the 10 percent test is a bit more complicated when there is a change
in principal balance as a result of the restructuring. There are various methods of
reflecting a change in principal in the 10 percent test. We believe the net method
(described below) is the preferable method. Under the net method:
• The cash flows related to the lowest common principal balance (i.e., rollover
money) between the original debt instrument and the new debt instrument are
compared for purposes of the 10 percent test.
• Any principal in excess of the rollover money is treated as a new, separate debt
issuance.
• Any decrease in principal is treated as a partial extinguishment of debt.
5 - 14 / Accounting for Modifications and Extinguishments
Under the net method, unamortized debt issuance costs and new fees associated
with the restructuring are generally accounted for as follows.
Money Classification
Unamortized
Debt Issue Costs
New
Creditor Fees
New Third
Party Fees
Principal increase with an
existing lender
N/A
Capitalize
allocated portion
Capitalize
allocated portion
Partial principal pay-down made
to existing lender
Expense
allocated portion
Expense
allocated portion
Expense
allocated portion
Rollover Money—Modification
Continue to
amortize
Capitalize
Expense
Rollover Money—Extinguishment
Expense
Expense
Capitalize
Another acceptable method of reflecting a change in principal in the 10 percent test
is the gross method. Under the gross method:
• The cash flows of the original debt instrument are compared to the cash flows
based on the repayment schedule of the new debt instrument.
• An increase in principal is treated as a day-one cash inflow in the cash flows of
the new debt instrument.
• A decrease in principal is treated as a day-one cash outflow in the cash flows of
the new debt instrument.
5.4.1.9
Modification of Instruments Held by Multiple Lenders
In practice, debtors may have both non-revolving (i.e., term debt) and revolvingdebt arrangements that are concurrently modified. When legal exchanges and
amendments of debt affect non-revolving and revolving debt simultaneously,
companies should allocate the new fees paid to the creditor and new third-party
costs to the individual instruments using a reasonable, rational, and supportable
approach. New costs paid to creditors and third parties in connection with a
legal exchange or amendment should also be allocated to the new instruments
and then further allocated to each creditor. Once these various costs have been
allocated to the creditor level, the analysis of each creditor may be completed and
a determination made as to (1) whether the exchange or amendment of the nonrevolving debt is considered a modification or extinguishment under ASC 47050-40 and (2) the appropriate accounting for the revolving instrument under ASC
470-50-40-21.
Example 5-3: Restructuring of Syndicated Term Loan Facility
Background/Facts:
• Company A has a syndicated term loan facility.
• Given the decline in interest rates and the Company’s improved credit rating, the
Company wishes to take advantage of the opportunity to lower its borrowing
costs so it enters into an agreement to restructure the syndicated facility.
• The restructuring transaction (1) increases the total amount of money borrowed,
(2) extends the term of the facility, and (3) lowers the interest rate on the facility.
(continued)
Accounting for Modifications and Extinguishments / 5 - 15
• All fees paid during the restructuring were paid to secure the new debt instrument;
there were no fees incurred to exit the original pre-payable debt instrument.
The following table summarizes the terms of the original syndicated facility and the
new syndicated facility at the restructuring date.
Principal Balance
Coupon (paid annually)
Effective Interest Rate
Original Term
Remaining Term
Unamortized Debt Issuance Costs
New Creditor Fees
New Third-Party Fees
Original Syndicated
Facility
New Syndicated
Facility
$52,000,000
5.5%
6.0%
10 years
3 years
$ 695,000
—
—
$100,000,000
5.0%
5.9%
5 years
5 years
—
$ 4,000,000
$ 1,000,000
Analysis/Conclusion:
Step 1: Compare lender balances
All lenders in both the original and new debt agreements must be compared to
determine common lenders to both agreements. Then, the classification of the
principal balances for common lenders must be determined. The principal balances
could be classified as (1) rollover money, (2) new money, or (3) partial extinguishment.
Summary of Loan Balances
Bank
Balance
of Original
Syndication
Balance of New
Syndication
Change
Classification
A
B
C
D
$ 5,000,000
$20,000,000
—
$12,000,000
$ 5,000,000
$ 30,000,000
$ 60,000,000
$ 5,000,000
—
$ 10,000,000
$ 60,000,000
$ (7,000,000)
E
Total
$15,000,000
$52,000,000
—
$100,000,000
$(15,000,000)
Rollover money
Rollover and new money
New money
Rollover and partial
extinguishment
Extinguishment
Step 2: Allocate costs
Unamortized debt issuance costs relating to the original syndicated facility are
allocated to each bank on a pro-rata basis. Unamortized debt issuance costs allocated
to rollover loan amounts should continue to be amortized; those costs allocated to
debt that was paid down should be expensed.
One method that may be used to allocate the costs based on the percentage of the
loan balance that was (1) rolled over to the new facility and (2) paid down (if applicable)
is illustrated below.
(continued)
5 - 16 / Accounting for Modifications and Extinguishments
Allocation of Unamortized Issuance Costs
Bank
A
B
C
D
E
Balance
of Original
Syndication
Percentage
of Original
Syndication
Allocation of
Unamortized
Issuance Costs
Rollover
Paydown
$ 5,000,000
$ 20,000,000
—
$ 12,000,000
$ 5,000,000
$ 52,000,000
9.6%
38.5%
—
23.1%
28.8%
100%
$ 67,000
$268,000
—
$160,000
$200,000
$695,000
$ 67,000
$268,000
—
$ 67,000
—
$402,000
—
—
—
$ 93,000
$200,000
$293,000
Allocated to
New fees paid to creditors and to third parties are allocated to each bank in the new
syndicated facility on a pro-rata basis. Since all of the fees paid are associated with the
issuance of the new instrument, no amounts are allocated to the pay-off amounts.
Allocation of New Creditor Fees
Bank
A
B
C
D
E
Balance of New
Syndication
Percentage
of New
Syndication
Allocation
of New
Creditor Fees
Rollover
New Money
$ 5,000,000
$ 30,000,000
$ 60,000,000
$ 5,000,000
—
$100,000,000
5.0%
30.0%
60.0%
5.0%
—
100%
$ 200,000
$1,200,000
$2,400,000
$ 200,000
—
$4,000,000
$ 200,000
$ 800,000
—
$ 200,000
—
$1,200,000
—
$ 400,000
$2,400,000
—
—
$2,800,000
Allocated to
Allocation of New Third-Party Fees
Bank
A
B
C
D
E
Balance of New
Syndication
Percentage
of New
Syndication
Allocation
of New
Third-Party Fees
Rollover
New Money
$ 5,000,000
$ 30,000,000
$ 60,000,000
$ 5,000,000
—
$100,000,000
5.0%
30.0%
60.0%
5.0%
—
100%
$ 50,000
$ 300,000
$ 600,000
$ 50,000
—
$1,000,000
$ 50,000
$ 200,000
—
$ 50,000
—
$ 300,000
—
$ 100,000
$ 600,000
—
—
$ 700,000
Allocated to
Step 3: Perform the 10 percent test:
• The 10 percent test is performed for those creditors who were in the facility before
and after the debt restructuring.
• Calculate the present value of the future cash flows of the original facility (e.g., the
contractual principal and interest payments) using the effective interest rate of the
original facility at the date of the modification.
• Calculate the present value of the new facility (e.g., contractual principal and
interest payments, as well as the fees allocated to the creditor) using the effective
interest rate in effect for the original facility on the date of the modification.
• Calculate the difference between the present values.
• The results using the net method are summarized in the table below.
(continued)
Accounting for Modifications and Extinguishments / 5 - 17
Summary of 10 Percent Test
Bank
Present Value of the Lowest
Common Principal Amount
of Original Debt1
Present Value of Rollover
Money2 (Including
Creditor Fees)
Difference in
Present Value of
Rollover Money
A
B
D
$ 4,933,000
$19,733,000
$ 4,933,000
$ 5,067,000
$20,265,000
$ 5,067,000
2.70%
2.70%
2.70%
1
This amount is calculated by scheduling out the cash flows of the original instrument and discounting at the
effective interest rate of 6%.
2
This amount is calculated by scheduling out the cash flows of the new instrument based on its new coupon
and term and discounting at the original effective interest rate of 6%. The creditor fees allocated to the
rollover money are also included as a day one cash flow.
Step 4: Determine if modification or extinguishment and account for the fees:
• Determine whether the new term loan syndicated facility is a modification or an
extinguishment for each bank.
• Determine the appropriate accounting treatment and dollar amounts of
(1) unamortized debt issuance costs, (2) new fees paid to creditors, and (3) new
fees paid to third parties.
Summary of Fee Accounting3
Bank
A
Modification
B
New Money and
Modification
C
D
E
3
Modification or
Extinguishment?
New Money
Modification and
Partial Pay Down
Extinguishment
Treatment
Expense
Capitalize
Continue
to Amortize
Expense
Capitalize
Continue
to Amortize
Expense
Capitalize
Continue
to Amortize
Expense
Capitalize
Continue
to Amortize
Expense
Capitalize
Continue
to Amortize
Unamortized
Debt Issuance
New
Costs
Creditor Fees
New ThirdParty Fees
—
—
—
$ 200,000
$
$ 67,000
—
—
—
—
—
$1,200,000
$ 200,000
$ 100,000
$268,000
—
—
—
—
$2,400,000
—
—
$ 600,000
—
—
—
$ 93,000
—
—
$ 200,000
$ 67,000
$200,000
—
—
—
—
—
—
—
—
$695,000
—
$4,000,000
—
$1,000,000
$
50,000
—
50,000
—
See FG sections 5.4 and 5.4.1.8 for a discussion of the accounting for unamortized debt issuance costs,
creditor fees and third-party fees.
5 - 18 / Accounting for Modifications and Extinguishments
5.5
Modifications to and Payoffs of Line-of-Credit or Revolving-Debt
Arrangements
A line-of-credit or revolving-debt arrangement is an agreement that provides the
borrower with the ability to:
• Borrow money at different points in time, up to a specified maximum amount,
• Repay portions of previous borrowings, and
• Reborrow under the same contract.
Line-of-credit and revolving-debt arrangements may include both amounts drawn by
the borrower (a debt instrument) and a commitment by the lender to make additional
amounts available to the borrower under predefined terms (a loan commitment). In
most situations, the borrower incurs costs to establish a line-of-credit or revolvingdebt arrangement, and some or all of the costs are deferred and amortized over the
term of the arrangement.
If a restructuring of a line-of-credit or revolving-debt arrangement is not a troubled
debt restructuring, the guidance in ASC 470-50-40-21 provides a framework for
determining how to account for unamortized debt issue costs and new fees.
The debtor should compare the borrowing capacity under the original arrangement
(the product of the remaining term and the maximum available credit under the
arrangement) to the borrowing capacity of the new or modified arrangement (rather
than the outstanding principal amount as is done for non-revolving debt) with the
same creditor. In other words, on a lender by lender basis, perform the following
analysis:
• If the borrowing capacity of the new arrangement is greater than or equal to the
borrowing capacity of the original arrangement, then any unamortized debt issue
costs, any new fees paid to the creditor, and any new third-party costs incurred
should be associated with the new arrangement (that is, deferred and amortized
over the term of the new arrangement).
• If the borrowing capacity of the new arrangement is less than the borrowing
capacity of the original arrangement, then any new fees paid to the creditor
and any new third-party costs incurred should be associated with the new
arrangement (that is, deferred and amortized over the term of the new
arrangement). However, any unamortized debt issue costs relating to the original
arrangement at the time of the change should be immediately written off in
proportion to the decrease in borrowing capacity of the original arrangement. The
unamortized debt issue costs relating to the original arrangement that remain
after the proportional write off should be amortized over the term of the new
arrangement.
If a lender exits the line of credit completely, then all unamortized costs should be
written off.
Accounting for Modifications and Extinguishments / 5 - 19
Example 5-4: Accounting for Unamortized Costs and New Fees in
Revolving-Debt Arrangement
Background/Facts:
Terms of original revolving arrangement:
• Five year term (three years remaining)
• $10 million commitment amount
• Unamortized debt issuance costs at the restructuring date: $200,000
Terms of new revolving arrangement:
• Four year term
• $5 million commitment amount
• New third party fees: $10,000
• New creditor fees: $20,000
Questions/Conclusions:
1. What is the borrowing capacity of both the original and the new arrangements?
Original borrowing capacity: $30 million ($10 million commitment amount x 3-year
remaining term)
New borrowing capacity: $20 million ($5 million commitment amount x 4-year
remaining term)
2. Is there an adjustment required to the unamortized costs? If so, what is the
adjustment?
Yes. The borrowing capacity decreased by $10 million or 33% percent ($10
million/$30 million). Therefore, 33% ($66,000) of the unamortized costs should be
expensed in the current period. The remaining unamortized debt issuance costs
should be amortized over the term of the new arrangement.
3. How should the new fees be recorded?
Both the creditor fees and third-party fees should be capitalized and amortized
over four years, which is the term of the new arrangement.
5.6
Debt Extinguishment Accounting
Debt extinguishment accounting is required when a company:
• Restructures a debt instrument in a manner that causes it to trigger extinguishment
accounting based on the 10 percent test, or
• Reacquires its debt for cash, other assets, or equity.
When debt extinguishment accounting is required, the company will generally record
a gain or loss on extinguishment in earnings. ASC 470-50-40-2 addresses how a
gain or loss on debt extinguishment should be measured. It requires that the issuer
recognize currently in income the difference between the reacquisition price and the
net carrying amount of the original debt.
Reacquisition price is defined in the ASC Master Glossary to include the amount paid
on extinguishment, including a call premium, miscellaneous costs of reacquisition,
5 - 20 / Accounting for Modifications and Extinguishments
and the fair value of any assets transferred or equity securities issued. Accordingly,
reacquisition price would include fees (which may include non-cash fees) paid by the
debtor to the creditor in connection with the extinguishment.
Net carrying amount is defined in the ASC Master Glossary to include unamortized
debt issuance costs and any unamortized debt discount or premium related to the
extinguished debt including:
• Unamortized discounts from a derivative that required separation,
• An unamortized beneficial conversion feature (BCF), and
• A discount from allocation of a portion of the investment proceeds to warrants
sold with the debt (FG section 3.4).
Thus, the difference between (1) the net carrying value of the debt plus any separated
derivative and (2) the reacquisition price is recorded as an extinguishment gain
or loss. If there is a BCF in the debt, the BCF must be recognized as part of the
extinguishment accounting.
See FG section 5.3.6 for a discussion of debt extinguishment gain/loss treatment
when the debt holders are also equity holders of the debtor’s company.
In a restructuring accounted for as an extinguishment, the new debt instrument
would be recorded at fair value.
5.6.1
Classification of Gain or Loss on Debt Extinguishments
ASC 470-50-45-1 indicates that gains and losses from extinguishment of debt that
are unusual in nature are not precluded from being classified as extraordinary items.
Nevertheless, the FASB has observed that debt extinguishment transactions “would
seldom, if ever, result in extraordinary classification of the resulting gains and losses.”
Accordingly, gains and losses on debt extinguishment, including troubled debt
restructurings, are rarely classified as extraordinary items.
There is no specific SEC guidance regarding the classification of a debt extinguishment gain or loss. ASC 470-50-40-2 requires an extinguishment gain or loss to be
identified as a separate item.
• One method of accounting for the extinguishment gain or loss is to present the
amount as a separate line item on the income statement, typically within nonoperating income.
• Another acceptable method is to report the extinguishment gain or loss in interest
expense with disclosure of the components of the gain or loss in the footnotes to
the financial statements. If this approach is taken the company should also disclose
this treatment in the accounting policies footnote to provide full transparency and
clarity in the financial statements.
5.6.2
Debt Extinguishment as a Subsequent Event
An extinguishment occurring subsequent to the end of the fiscal year but prior to the
issuance of the financial statements should be accounted for as a non-recognized
subsequent event, which is not recorded in the financial statements. The SEC
staff has indicated that it will object to recognition of a gain or loss from a debt
extinguishment in a period other than the period in which the debt is considered
extinguished. This includes circumstances in which extinguishment of a debt
Accounting for Modifications and Extinguishments / 5 - 21
obligation occurs subsequent to a period end, but prior to issuance of the financial
statements, or in which a registrant announces prior to the end of a period its
intention to call debt for redemption in a subsequent period.
If the gain or loss from a planned extinguishment would be material, disclosure
regarding a planned extinguishment and its likely effects is required in notes to the
financial statements and in MD&A. For periods preceding the actual extinguishment,
interest expense and other carrying costs, as well as debt issuance costs and debt
discount or premium should continue to be accounted for pursuant to the terms of
the debt instrument and the life assumed when the obligation was initially recorded.
5.7
Restructuring of Convertible Debt Instruments
For convertible debt, the test to determine whether the cash flows are substantially
different for the purpose of determining whether a debt modification or
extinguishment has occurred is more complicated. ASC 470-50-40-12(g) prescribes
a two-step approach for determining whether a convertible debt restructuring should
be accounted for as a modification or extinguishment.
ASC 470-50-40-10 does not address legal modifications or exchanges of debt
instruments in which the embedded conversion option is separated and accounted
for as a derivative under ASC 815 prior to modification, subsequent to modification,
or both. The accounting for these transactions depends on the specific facts and
circumstances.
Step 1:
Change in cash flows: Perform the 10 percent test discussed in FG section 5.4.
The 10 percent test should not include any changes in fair value of the embedded
conversion option.
If there is an extinguishment under Step 1, there is no need to conduct the additional
tests in Step 2. However, if under Step 1 there is not an extinguishment, proceed to
the tests in Step 2 to determine if extinguishment accounting is required.
Step 2:
Change in fair value of the embedded conversion option: If the change in the fair
value of the embedded conversion option is greater than 10 percent of the carrying
value of the original debt instrument immediately before the restructuring, account for
the restructuring as an extinguishment. The fair value of the embedded conversion
option is generally calculated using an option pricing model, such as the BlackScholes-Merton model, based on the terms of the embedded conversion option and
inputs such as market interest rates, the company’s stock price, the volatility of the
company’s stock price, and the expected dividend yield on the company’s stock.
Addition or removal of an embedded conversion option: If the restructuring added
or removed a substantive conversion option from the original debt instrument, the
restructuring would automatically be accounted for as an extinguishment.
If the test in either Step 1 or Step 2 is met, the restructuring of the debt instrument
should be accounted for as an extinguishment.
As noted in Step 1, the change in the fair value of an embedded conversion option
resulting from a convertible debt restructuring should not be included in the 10
percent test. Further, Step 2 must be performed if the 10 percent test in Step 1
5 - 22 / Accounting for Modifications and Extinguishments
does not result in a conclusion that extinguishment accounting is required. Thus,
if a convertible debt restructuring produces a change in cash flows that is less
than 10 percent under Step 1 and the change in the fair value of an embedded
conversion option is less than 10 percent under Step 2, then even if in the aggregate
the changes exceed 10 percent of the original carrying value of the convertible
debt instrument, extinguishment accounting is not required (assuming the second
condition in Step 2 is not met).
See FG section 7.7 for a discussion of convertible debt extinguishment accounting.
5.7.1
Convertible Debt Modification Accounting
When a convertible debt instrument is modified in a transaction that is not accounted
for as an extinguishment, an increase in the fair value of the embedded, unseparated
conversion option (calculated as the difference between the fair value of the embedded
conversion option immediately before and after the modification or exchange) should
reduce the carrying value of the debt instrument (increasing debt discount or reducing
debt premium) with a corresponding increase in additional paid-in capital. This
additional discount would be amortized over the remaining term of the debt. However,
a decrease in the fair value of an embedded conversion option resulting from a
restructuring should not be recognized.
An issuer should not recognize a BCF or reassess an existing BCF upon a
restructuring that is not accounted for as an extinguishment.
5.8
Modification vs. Extinguishment—Preferred Stock
When preferred stock has been modified through a legal amendment, questions
may arise about the appropriate accounting for the modification. When, if ever, is a
preferred stock modification in substance an extinguishment such that the guidance
in ASC 260-10-S99-2 and ASC 470-50 (for debt) should be applied? In addition, if
the modification is not in substance an extinguishment, how should the modification
be accounted for?
These questions arise because the guidance in ASC 470-50 only addresses the
accounting for debt modifications that involve a change in cash flows. There is no
comparable guidance for evaluating and accounting for preferred stock modifications.
In addition, many preferred stock modifications do not involve changes in cash
flows, but may result in a significant change to the fair value of the security, such
as a change in the liquidation preference order/priority, voting rights, or conversion
ratio. As such, the accounting for preferred stock modifications depends on the facts
and circumstances of each transaction, including the nature of, and reasons for, the
modification.
5.8.1
Preferred Stock Modifications
Some legal modifications of preferred stock only involve the holders of different
classes of preferred stock and do not impact common shareholders. For example,
when a modification to outstanding preferred stock is made concurrent with the sale
of new preferred stock, the existing preferred stockholders may make concessions
regarding their rights in order to attract the new capital. The new preferred stockholders may insist on such concessions as a condition of their investment to avoid
immediate dilution of their investment upon closing. Based on an evaluation of fair
value of the securities before and after the modification, such concessions by the
Accounting for Modifications and Extinguishments / 5 - 23
existing preferred stockholders may represent a transfer of value from the existing
preferred stockholders to the new preferred stockholders.
Transfers of value between different classes of preferred stockholders are generally
not recorded by the company. However, these transactions are often very complex
and should be carefully considered to determine the appropriate accounting. In
some cases, additional consideration may be conveyed to the original preferred
stockholders for agreeing to consent to the transaction (consent fee), which may
need to be recognized as a charge to retained earnings and earnings per share (EPS).
Other preferred stock modifications may involve a transfer of value between preferred
stockholders and common stockholders. In such cases, we believe it is generally
appropriate to account for the modification based on the guidance in ASC 71820-35-3 for modifications to stock compensation arrangements classified as
equity. Accordingly, for these modifications, any change in value resulting from the
modification (computed as the difference between the fair value of the security with
the new terms and the fair value of the security with the original terms, measured
on the modification date) should be included in earnings available to common
shareholders (used to calculate basic and diluted EPS) as an effective dividend to
(from) preferred stockholders. This is similar to the EPS treatment for extinguishment
gains (losses) on preferred stock in ASC 260-10-S99-2.
5.8.2
Preferred Stock Extinguishment Accounting
When preferred stock is legally extinguished (e.g., by exchanging Series A preferred
stock for Series B preferred stock), the guidance in ASC 260-10-S99-2 applies
(i.e., extinguishment accounting applies). Accordingly, in a legal extinguishment of
preferred stock, companies should calculate the difference between (1) the fair value
of the consideration transferred (Series B) to the holders of the Series A preferred
stock and (2) the carrying value of the securities surrendered (Series A).
• If the fair value of the consideration transferred is greater than the carrying value
of the securities surrendered (1) retained earnings should be reduced by the
difference (in the absence of retained earnings, additional paid-in capital should
be reduced) and (2) earnings available to common shareholders (used to calculate
basic and diluted EPS) should be reduced by the difference.
• If the fair value of the consideration transferred is less than the carrying value of
the securities surrendered, the difference should be credited to retained earnings
and added to earnings available to common shareholders.
The accounting for extinguishments and modifications of preferred stock classified
as liabilities under the guidance in ASC 480 is the same as that for other debt
instruments. See the debt extinguishment discussion in FG section 5.6.
5.8.2.1
Extinguishment of Convertible Preferred Stock with a BCF
If an entity redeems a convertible preferred security with a beneficial conversion
feature (BCF), the excess of (a) the fair value of the consideration transferred to
the holders of the convertible preferred security over (b) the carrying value of the
convertible preferred security on the issuer’s balance sheet plus (c) the amount
previously recognized for the BCF, should be subtracted from net earnings to arrive
at earnings available to common shareholders (used to calculate basic and diluted
EPS). Similarly, if (a) the fair value of the consideration transferred to the holders is
less than the sum of (b) the carrying value of the convertible preferred security on
5 - 24 / Accounting for Modifications and Extinguishments
the issuer’s balance sheet, and (c) the amount previously recognized for the BCF, the
difference should be added to earnings available to common shareholders.
5.9
Modification of Warrants Classified as Equity
Warrants to acquire common stock or preferred stock may be modified through
an amendment. The reasons for a modification vary. Some modifications involve
the reduction of the warrant exercise price to induce exercise and thus raise new
capital. Other warrant modifications may be made in connection with modifications
to preferred stock as discussed in FG section 5.8.1. Depending on the nature of, and
reason for, the modification, there may be a need for a charge to earnings or retained
earnings and EPS.
5.10
How PwC Can Help
Our debt restructuring consultants and Assurance professionals frequently advise
companies regarding the interpretation and application of the accounting rules for
debt restructurings, including:
• Whether a debt restructuring should be accounted for as a modification, an
extinguishment, or a troubled debt restructuring.
• Identification of restructuring costs and whether those costs should be capitalized
or expensed.
• Appropriate classification of restructured debt.
• Appropriate disclosures.
If you have questions regarding the accounting for debt restructurings or would like
help in assessing the impact a debt restructuring has on your company’s financial
statements, please contact your PwC engagement partner or one of the subject
matter experts listed in the contacts section at the end of this Guide.
Accounting for Modifications and Extinguishments / 5 - 25
Chapter 6:
Debt
Debt / 6 - 1
6.1
Debt Instrument Overview
Entities issue debt for a number of reasons, including obtaining funding for:
• Day-to-day operations,
• Acquisitions and capital investments,
• Satisfying maturing debt,
• Share buybacks, and
• Pension plan contributions.
There are many types of debt instruments and agreements, each of which may
contain features that require consideration in determining the appropriate accounting
treatment. This chapter discusses a number of these features and discusses the
potential accounting implications of each. See FG section 3.1 for a discussion of
puts and calls embedded in debt instruments.
6.2
Balance Sheet Classification—Current vs. Non-Current
The ASC Master 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 (emphasis added).
The principal guidance for determining the balance sheet classification of liabilities is
contained in ASC 210-10-45-5 through 45-12. Under that guidance, current liabilities
include:
• Short-term debt expected to be liquidated within one year (or operating cycle, if
longer).
• Current maturities of long-term obligations.
• Obligations that, by their terms, are due on demand or will be due on demand
within one year (or the operating cycle, if longer) from the balance sheet date,
even if liquidation is not expected within that period.
• Long-term obligations that are (or will be) puttable by the creditor either because
(a) the debtor’s violation of a provision of the debt agreement at the balance
sheet date makes the obligation puttable or (b) the violation, if not cured within
a specified grace period, will make the obligation puttable. When (1) cure of the
violation is not expected within the grace period, resulting in the debt becoming
puttable, (2) no waiver of the puttable debt will be granted, and (3) the company
does not meet the conditions under ASC 470-10-45-13 through 45-20 for
refinancing the short-term debt on a long-term basis (FG section 6.2.1).
• Contingently convertible debt with a cash conversion feature (FG section 7.4)
for which (1) the issuer is required to or has asserted that it will settle the par or
accreted value of the bond in cash upon conversion and (2) the contingency has
been met at the reporting date.
6 - 2 / Debt
Example 6-1: Long-Term Loan Payable Upon Demand
Background/Facts:
Company A has entered into a long-term loan agreement with Bank B that includes a
provision allowing Bank B to demand full payment of the loan at any time.
Question:
Should the loan be classified as non-current in the financial statements of Company
A?
Analysis/Conclusion:
No. Based on the guidance in ASC 470-10-45-9 and 45-10, loan amounts that have
long-term maturities but enable the lender to demand payment at any time should
be classified as current liabilities. Demand (or puttable) obligations are considered
current liabilities as the timing of payment is controlled by the lender.
Example 6-2: Demand Provision vs. Subjective Acceleration Clause
Background/Facts:
• As of December 31, 2012, Company A has two outstanding loans, Loan X and
Loan Y. Both loans have a stated maturity date beyond December 31, 2013 (one
year from the balance sheet date).
• Loan X contains a demand provision that allows the lender to put the debt to
Company A at any time.
• Loan Y contains a subjective acceleration clause (SAC) that would allow the
lender to put the debt to Company A if Company A fails to maintain satisfactory
operations or if a material adverse change in Company A’s financial condition
occurs.
• The lender historically has not accelerated due dates of loans containing similar
clauses and the financial condition of Company A is strong.
Question:
How should Company A classify Loan X and Loan Y on its balance sheet as of
December 31, 2012?
Analysis/Conclusion:
Loan X, which contains a demand provision, should be classified as current.
Loan Y, which contains a SAC, should be classified as non-current.
A demand provision differs from a SAC in a long-term debt agreement, as discussed
in ASC 470-10-45-2. A demand provision requires current liability classification even
if liquidation is not expected within the period. A SAC does not require classification
of the debt as current if the likelihood of acceleration of the due date (the lender’s
exercise of the SAC) is remote.
Debt / 6 - 3
Example 6-3: Impact of an Approved Debt Repayment Plan
Background/Facts:
• On December 31, 2011, Company A had an outstanding debt instrument with a
maturity date of March 31, 2016, which the company classified as non-current.
• Prior to December 31, 2011, Company A announced a debt repayment plan,
which was approved by its Board of Directors.
• Under the debt repayment plan, redemption is scheduled to occur in Q1 2012,
subsequent to the release of the 2011 annual report on Form 10-K. The debt
would not otherwise require repayment until its scheduled maturity date in 2016.
Question:
How should Company A classify this debt instrument as of December 31, 2011?
Analysis/Conclusions:
The redemption plan is not an irrevocable commitment to redeem the debt as of
year-end and Company A’s announcement of the plan prior to the balance sheet
date does not create a legally binding obligation to redeem the debt. Company A
should continue to classify the debt in accordance with the original terms of the debt
agreement, which would result in a non-current classification at December 31, 2011.
6.2.1
Short-Term Debt Refinanced on a Long-Term Basis After the Balance
Sheet Date
ASC 470-10-45-14 allows short-term obligations to be reclassified as non-current
at the balance sheet date if the borrower has the intent to refinance the shortterm obligation on a long-term basis and its intent is supported by an ability to
consummate the refinancing demonstrated in one of the following two ways:
1. Before that balance sheet is issued a long-term obligation or equity securities are
issued that replace the short-term debt.
2. Before the balance sheet is issued, the borrower has entered into a financing
agreement to refinance the short-term obligation on a long-term basis on terms
that are readily determinable and all the following conditions are met:
a. The new financing agreement does not expire within one year from the
balance-sheet date.
b. The debt that will be issued is not cancelable by the lender (and obligations
incurred under the agreement are not puttable during that period) except for
violation of a provision with which compliance is objectively determinable or
measurable.
c. No violation of any provision of the financing agreement exists at the balancesheet date and no available information indicates that a violation has occurred
thereafter but prior to the issuance of the balance sheet.
d. If a violation of the financing agreement exists, a waiver has been obtained.
e. The lender or the prospective lender or investor is expected to be financially
capable of honoring the financing agreement.
6 - 4 / Debt
If the financing agreement discussed in (2) has a subjective termination clause rather
than an objective termination clause, the short-term debt will not be considered
refinanced on a long-term basis. See FG section 6.2.1.1 for discussion of subjective
acceleration clauses.
Example 6-4: Impact of Parent Guarantee
Background/Facts:
• Company A has a short-term obligation to an unaffiliated third party that the
company intends to refinance on a long-term basis with a guarantee provided by
its parent.
• The parent owns 100% of the company’s voting stock.
Question:
Can Company A classify the short-term obligation as non-current since it has
the intent to refinance the debt and a parent guarantee to support its ability to
consummate the refinancing?
Analysis/Conclusion:
No. Company A may classify a short-term obligation as non-current only if the
conditions in ASC 470-10-45-14 (FG section 6.2.1) are met. One requirement,
discussed in ASC 470-10-45-14(b)(1), is:
The agreement does not expire within one year from the date of the entity’s
balance sheet and during that period the agreement is not cancelable by the
lender or the prospective lender or investor (and obligations incurred under
the agreement are not callable during that period) except for violation of a
provision with which compliance is objectively determinable or measurable.
Although, Company A has demonstrated its intent to refinance the short-term
obligation on a long-term basis by acquiring the long-term guarantee from its parent,
the parent owns 100% of the company and thus, controls both the parties to the
agreement and can cancel the guarantee at any time. Since there is no deterrent to
prevent the parent from cancelling the guarantee, it is discretionary. As a result, the
guarantee fails the provisions of ASC 470-10-45-14(b)(1).
6.2.1.1
Subjective Acceleration Clauses
Many long-term financing agreements contain clauses that allow the lender to refuse
to lend if the borrower experiences an adverse change. These are often referred to as
Subjective Acceleration Clauses (SAC), Material Adverse Change (MAC), or Material
Adverse Effect (MAE) clauses.
A long-term financing arrangement that contains these clauses can be called at the
discretion of the lender. Thus, such clauses prevent the reclassification of short-term
obligations from current to non-current. This prohibition is due to the subjective
nature of these clauses, which may be interpreted differently by the parties to the
financing agreement. The fact that the lender can refuse to allow the company to
refinance its short-term obligations undermines the company’s assertion that it has
the ability to refinance the current obligation into long-term, non-current debt.
Debt / 6 - 5
6.2.1.2
Insufficient Refinancing and Fluctuating Balances
To meet the requirements for non-current classification based on refinancing, the
amount of the short-term obligation to be refinanced cannot exceed the estimated
minimum amount expected to be available under the long-term financing agreement.
For financing agreements that specify objective criteria (e.g., inventory levels) that
the borrower must maintain or achieve to ensure adequate borrowing capacity, the
company should evaluate whether it will continue to meet the provisions set forth in
the financing agreement.
When the provisions of the financing agreement call for the attainment of specified
operating results, levels of financial position, or another measurement that exceeds
those previously attained, classification as non-current is permissible only if it is
reasonable to expect that the specified requirements can be achieved such that longterm borrowings (or successive short-term borrowings for an uninterrupted period
under a financing agreement, as described in FG section 6.2.1.3) will be available to
refinance the short-term debt outstanding at the balance sheet date on a long-term
basis. Meeting this test requires a high degree of assurance.
Example 6-5: Refinancing Subject to Working Capital Requirement
Background/Facts:
In January 2012, Lender A agrees to extend Company B’s loan, which is due on June
30, 2012, by one year. The extension requires that Company B maintain a specified
level of working capital during the six months ending June 30, 2012.
Question:
How should the loan be classified in the December 31, 2011 financial statements of
Company B?
Analysis/Conclusion:
It would be appropriate to reclassify the short-term debt as non-current at December
31, 2011, if the specified working capital level had been reached at December 31,
2011, and it is reasonable to expect that the working capital level will be maintained
through June 30, 2012.
6.2.1.3
Refinancing with Successive Short-Term Borrowings
A short-term obligation that will be refinanced with successive short-term obligations
may be classified as non-current as long as the cumulative period covered by the
financing agreement is uninterrupted and extends beyond one year. This would
include short-term borrowings under revolving credit agreements that permit either
continuous replacement with successive short-term borrowings for more than a year
or conversion to term loans extending beyond a year at the company’s option. These
should be classified as non-current if the borrower intends to utilize those provisions
and meets the criteria for refinancing the short-term debt on a long-term basis.
The rollover provisions must be included in the terms of the debt obligation;
classification as non-current cannot be based solely on management’s intent. For
example, short-term debt in the form of commercial paper must be supported by a
contractually long-term financing arrangement, such as a revolving credit agreement
with sufficient unused borrowing capacity to support the ability to refinance the
6 - 6 / Debt
commercial paper. Any SACs, MACs or MAEs in the refinancing agreements would
cause the company to fail to meet the requirements to assert its ability to refinance
its short-term debt on a long-term basis.
6.2.2
Revolving-Debt Arrangements
Revolving-debt arrangements with a contractual term beyond one year may require
the execution of a note for each borrowing under the arrangement. While the credit
arrangement may permit long-term borrowings, the underlying notes may be for
a shorter term, possibly less than one year. When individual notes are issued, the
debt should be classified based upon the term of each individual note, not based
on the expiration date of the credit agreement, unless the conditions for non-current
classification based on a refinancing are met (FG section 6.2.1).
Other revolving-debt arrangements may have a feature that gives the debtor the
option to select between two different types of borrowings, each with potentially
different terms. For example, a borrower may be able to choose between:
• A long-term, dollar-denominated loan having a maturity date consistent with the
expiration date of the revolving debt arrangement and carries a rate of LIBOR, or
• A dollar-denominated loan with a maximum maturity of ninety days that carries a
rate based on Euribor.
In such cases, the Euribor debt would require current classification unless (1) the
conditions are met for refinancing the short-term debt on a long-term basis (FG
section 6.2.1) or (2) the Euribor debt automatically converts at its maturity date,
without any further actions, into the LIBOR debt with a long-term maturity date.
6.2.3
Commercial Paper
When the interest rate payable by a company on commercial paper is lower than the
rate on long-term borrowings, a company may borrow funds by issuing commercial
paper (which has maturities of 30, 60, or 90 days) and use the proceeds to repay
borrowings under long-term revolving-debt arrangements. When the interest
rate on the commercial paper exceeds the rate under the long-term revolvingdebt arrangements, the company will borrow under the long-term revolving-debt
arrangements and pay off the short-term commercial paper. Companies can
reclassify their commercial paper as non-current, provided the requirements for
refinancing the short-term commercial paper debt on a long-term basis (FG section
6.2.1) are met and appropriate disclosures are made in the notes to the financial
statements.
Repayments of commercial paper using working capital after the balance sheet date
followed by a borrowing under a long-term revolving-debt arrangement to replenish
the working capital prior to the financial statement issuance date do not meet the
intent requirement for refinancing a short-term borrowing on a long-term basis
(FG section 6.2.1). The commercial paper should be classified as current.
Subject to meeting the conditions for refinancing a short-term borrowing on a longterm basis, the amount of the commercial paper to be presented as non-current at
the balance sheet date should not exceed the estimated minimum amount expected
to be available under the revolving-debt arrangement.
Debt / 6 - 7
Example 6-6: Reclassification of Commercial Paper to Non-Current
Background/Facts:
• Company A has $100 million outstanding in commercial paper at the reporting
date.
• Company A has a long-term revolving-debt arrangement that will allow it to
borrow up to $80 million. Company A projects that the full $80 million under the
long-term revolving-debt arrangement will be available during the next year.
• The long-term revolving-debt arrangement contains no SAC, MAC, or MAE
clauses with respect to future borrowings.
• The company has represented its intent to use the long-term revolving-debt
arrangement to repay $50 million of the commercial paper at maturity in 30 days.
Question:
Would it be appropriate for Company A to reclassify $50 million of the $100 million of
commercial paper to non-current as of the balance sheet date?
Analysis/Conclusion:
Yes, because the company will use long-term funding to achieve this outcome. If
the company used its working capital to pay the $50 million of commercial paper at
maturity and subsequently borrowed $50 million under the long-term revolving-debt
arrangement, reclassification of the $50 million of commercial paper at the balance
sheet date to non-current would be inappropriate as it used its working capital for
repayment.
6.2.4
Liquidity Facility Arrangements for Variable Rate Demand Obligations
A Variable Rate Demand Obligation (VRDO) is a debt instrument, typically a bond,
that the investor can put (or demand repayment). This feature gives the investor
the ability to redeem the investment on short notice (usually 7 days) by putting the
debt to the issuer’s remarketing agent. Upon an investor’s exercise of a put, the
remarketing agent will resell the debt to another investor to obtain the funds to honor
the put (i.e., to repay the investor). If the remarketing agent fails to sell the debt
(referred to as a “failed remarketing”), the funds to pay the investor who exercised the
put will often be obtained through a liquidity facility issued by a financial institution.
Liquidity facilities typically take the form of a standby or direct-pay letter of credit,
line of credit, or standby bond purchase agreement.
ASC 470-10-55-7 through 55-9 addresses these instruments and states that the
presence of a “best-efforts” remarketing agreement (typical for VRDO issuances)
should not be considered when evaluating whether the VRDO should be classified as
current or non-current. A company must assume that a put will occur and unless the
VRDO issuer has the ability and intent to refinance the debt on a long-term basis
(FG section 6.2.1), VRDOs should be classified as a current liability. If a liquidity
facility provides the issuer with the ability to refinance, issuers should evaluate the
terms of their liquidity agreements in light of the requirements for refinancing a
short-term borrowing on a long-term basis (FG section 6.2.1) for attributes that might
impact balance sheet classification of the debt, including:
• Expiration date of the commitment. A liquidity facility for the VRDOs must be
effective for at least one year past the balance sheet date. VRDOs supported by
liquidity agreements that expire within one year of the balance sheet must be
classified as current.
6 - 8 / Debt
• Covenant violations. Violations of covenants set forth in the liquidity agreements
could cause termination of the agreement or demand for immediate repayment
of any draws. There should be no violation of any provision in the financing
agreement at the balance sheet date and no available information that indicates
that a violation occurred after the balance sheet date but prior to the issuance
of the financial statements. A covenant violation occurring prior to or after the
balance sheet date requires a waiver to be obtained to achieve non-current
classification. The form and content of the waiver needs to ensure that the waiver
is in force for at least 12 months and is not subject to termination beyond those
conditions set forth in the original agreement. See FG section 6.2.5 for further
discussion of covenant violations.
• SAC, MAC, or similar clauses. The existence of subjective clauses that provide
the lender with the ability to demand repayment based on subjective (rather than
objective) criteria will typically preclude classification of the VRDOs as non-current.
• Repayment terms. The repayment terms of the liquidity facility will impact the
determination of amounts due within one year of the balance sheet date (and
thus the amount of the VRDOs that must be classified as a current liability). Some
liquidity facilities have repayment terms that are installment-based and others
require a balloon payment at the facility’s expiration date.
• Ability to cancel. The lender should not have the ability to cancel the credit
facility within one year from the balance sheet date except for violations of
the terms of the agreement (including failure to meet a condition, or breach or
violation of a provision, such as a restrictive covenant, representation, or warranty)
that can be objectively measured.
The demand for and cost of liquidity facilities has increased significantly over the
past few years, in response to the financial crisis and economic conditions. As a
result, organizations are evaluating alternative liquidity facilities to provide backup funding in the event that VRDOs are put. These liquidity facilities require an
organization to ensure that it has sufficient cash or funds available in the event puts
occur. The absence of a third-party liquidity provider to refinance the debt on a longterm basis generally will result in classification of the VRDOs as a current liability.
6.2.5
Covenant Violations
Many debt agreements contain covenants that the borrower must adhere to
throughout the life of the agreement. The terms of the covenants are negotiated
between the borrower and the lender and may vary from agreement to agreement.
Financial ratio covenants, which require the borrower to maintain various financial
ratios, are included in nearly every debt agreement.
A breach of a covenant triggers an event of default. An event of default may lead to
an increase in the interest rate and a potential demand for repayment (i.e., the debt
becomes due).
Long-term obligations that are, or will be, puttable by the lender are required to be
classified as current liabilities. A long-term obligation could be puttable by the lender
because:
• The borrower has violated a covenant in the debt agreement, which makes the
obligation puttable by the lender.
• The violation, if not cured within a specified grace period, will make the obligation
puttable by the lender.
Debt / 6 - 9
Under ASC 470-10-45-11, these puttable1 obligations must be classified as current
unless:
• The creditor has waived the right to demand repayment for more than a year
(or an operating cycle, if longer) from the balance sheet date. If the obligation is
puttable because of violations of certain provisions of the debt agreement, the
creditor needs to waive its right with regard only to those violations.
• The creditor has subsequently lost the right to demand repayment for more than
a year (or an operating cycle, if longer) from the balance sheet date. For example,
the debtor has cured the violation after the balance sheet date and the obligation
is not puttable at the time the financial statements are issued.
• For obligations containing a grace period within which the debtor may cure the
violation, it is probable that the violation will be cured within that period, thus
preventing the obligation from becoming puttable.
ASC 470-10-55-2 through 55-6 specifies additional guidance when there has been a
covenant violation at the balance sheet date that has been subsequently waived (for
a period greater than one year) and there are the same or more restrictive covenants
at subsequent compliance measurement dates within the next year. Classification of
such an obligation as a current liability at the balance sheet date is not required if:
• The debtor has cured the violation after the balance sheet date within the specified
grace period such that the debt is not puttable at the financial statement issuance
date.
• The obligation is not puttable at the time the financial statements are issued due
to receipt of a waiver from the creditor in which the creditor has given up its right
(arising from the covenant violation) to demand repayment for more than one
year from the balance sheet date and the borrower has determined that it is not
probable that violation of the same or more restrictive covenants will occur at
subsequent compliance measurement dates within the next year that will make
the debt puttable.
• The short-term obligation meets the requirements for refinancing on a long-term
basis (FG section 6.2.1).
Example 6-7: Violation of a Provision in the Debt Agreement
Background/Facts:
• Company A is a publicly-traded enterprise, with its stock traded on the NASDAQ
Stock Exchange (the “Stock Exchange”).
• At December 31, 2011, Company A has an outstanding bond with a maturity
date of December 31, 2014. The bond indenture contains a feature that allows
investors to put the bonds to Company A upon the occurrence of a “fundamental
change.” One of the events defined as a fundamental change is the Company
losing approval for trading on the Stock Exchange (referred to as delisting).
(continued)
1
6 - 10 / Debt
ASC 470-45-11 refers to debt that is callable by the lender. We have referred to these instruments as
puttable because debt that is callable by the lender is the same as puttable debt (i.e., the lender may
require the issuer to repay the debt prior to its contractual maturity date).
• On December 15, 2011, Company A failed to meet the requirements of a NASDAQ
Rule that requires a minimum market value of securities. The Stock Exchange
notified the Company that its stock would be delisted within forty-five business
days (i.e., in February 2012) unless the Company obtained a waiver of the violation
from the Stock Exchange.
• It is not probable that the Company will be able to cure the violation during the
period between the notification date and the delisting date.
Question:
How should Company A account for the bond in the December 31, 2011 financial
statements?
Analysis/Conclusion:
The Company should classify the bond as a current liability on the balance sheet
reporting date.
The condition prompting the delisting was present as of the balance sheet date and
therefore is considered a violation as of December 31, 2011.
6.2.5.1
Payments Made to Effect a Change in Debt Covenants or a Waiver
of a Covenant Violation
A payment (of cash or other instruments) made to a lender to effect a waiver of a
covenant violation is considered a modification of the terms of the debt instrument.
When such a payment is made, the issuer should analyze the modification using the
debt restructuring guidance discussed in FG section 5.4.1.
6.2.6
Effect of Subjective Acceleration Clauses on the Classification of
Long-Term Debt
A long-term obligation that contains a subjective acceleration clause (SAC) is not
required to be classified as a current liability so long as acceleration of the due
date is judged as remote. However, if the company’s circumstances are such that
acceleration of the due date is probable (for example, there are recurring losses or
liquidity problems), long-term debt subject to a SAC should be classified as a current
liability. If acceleration of the due date is judged reasonably possible, disclosure of
the existence of a SAC clause is generally sufficient.
This guidance differs from the requirement to reclassify short-term obligations at
the balance sheet date to non-current and the prohibition of replacement long-term
borrowing and financing agreements from being cancellable by the lender based
upon a subjective acceleration clause. The requirement to reclassify short-term
obligations at the balance sheet date to non-current represents a higher standard
for a financing agreement than is required for long-term debt obligations that have a
SAC. As noted in ASC 470-10-55-1, this different standard reflects the fact that in the
case of long-term debt, the lender has already loaned money on a long-term basis
and the continuation of non-current classification requires a judgment about the
likelihood of acceleration of the due date caused by an exercise of the SAC by the
lender.
Debt / 6 - 11
6.2.6.1
Balance Sheet Classification of Borrowings Outstanding under Revolving
Credit Agreements That Include both a Subjective Acceleration Clause
and a Lock-Box Arrangement
Borrowings that are legally long-term under a revolving credit agreement must be
classified as current if they include:
• A Subjective Acceleration Clause (SAC), Material Adverse Change clause (MAC),
or Material Adverse Effect clause (MAE), and
• A requirement to maintain a lock-box arrangement (or a sweep feature or other
creditor arrangements), whereby remittances from the borrower’s customers must
reduce the revolving debt outstanding
Such lock-box arrangements require that working capital be used to reduce the debt
outstanding and thus current classification of the debt is required even though the
revolving credit agreement may have a long-term contractual maturity. However,
as discussed in FG section 6.2.1.3, short-term borrowings under revolving credit
agreements that permit either continuous replacement with successive short-term
borrowings for more than a year or conversion to term loans extending beyond a year
at the company’s option should be classified as non-current if the borrower intends
to utilize those provisions and meets the criteria for refinancing the short-term debt
on a long-term basis (FG section 6.2.1). Consequently, the removal of a SAC, MAC,
or MAE would permit a revolving line of credit with a lock-box arrangement to be
classified as non-current provided it meets the requirements for refinancing with
successive short-term borrowings discussed in FG section 6.2.1.3. The lock-box
arrangement does not in and of itself require current classification of the debt.
Borrowings outstanding under a revolving credit agreement that includes both a SAC
and a requirement to maintain a “springing” lock-box, whereby remittances from the
borrower’s customers are not forwarded to the lender to reduce the debt outstanding
until and unless an event of default occurs, are non-current obligations, because the
remittances do not automatically reduce the debt outstanding without another event
occurring. In this circumstance, the effect of the SAC on classification of this longterm debt should be determined based on the guidance described in FG section
6.2.6.
6.3
Classification of Liabilities as “Trade Accounts Payable” or “Other
Liabilities/Bank Debt” in a Structured Payable Transaction
For a variety of reasons, a company may establish a payment program with a
financial institution (e.g., a bank) whereby the bank will make payments to vendors
on behalf of the company. This could be done as part of a cash management service
offering of a bank, to take advantage of discounts offered by vendors as incentives
for making early payments, or to provide vendors the opportunity to sell their
receivables to a financial institution (which typically results in better payment terms
for the company).
For example, such an arrangement may involve:
• Company A and Bank B approach certain of the Company’s vendors regarding
entering into a new payment program.
• Under the payment program, the Bank pays the vendors directly.
• Company A is then obligated to pay the Bank an agreed upon amount.
6 - 12 / Debt
• Once a vendor’s receivable has been selected for the program, further
adjustments (e.g., product returns) are not permitted. As such, any future
adjustments would be negotiated between the Company and the vendor.
The balance sheet classification of the resulting payable depends on the economic
substance of the arrangement. If the arrangement is similar to a factoring
arrangement and the legal classification of the payable remains that of a trade
payable, it would be classified as such. If the arrangement is substantively a
refinancing of the trade payables with the bank, it should be classified as debt or
other liabilities. If the arrangement results in balance sheet classification as debt or
other liabilities, it would impact the classification of the payments in the company’s
statement of cash flows as they would now be considered a financing activity used
to pay off a vendor payable (an operating activity).
Guidance relevant to making this determination is limited. Some arrangements
may appear to be structured transactions to avoid classifying the arrangement as
a borrowing. The SEC Staff2 has stated that an entity must thoroughly analyze all
the facts and circumstances specific to the individual transaction to ensure that the
accounting for the transaction reflects the substance of the transaction. The following
are among the factors that an entity should consider in this analysis:
• The roles and responsibilities of each party (a tri-party agreement may indicate a
refinancing of the payable),
• Whether the program is offered to a wide range of vendors and whether vendor
participation in the program is voluntary,
• Impact of the transaction on other contractual arrangements,
• Whether default on payment to the bank under such an arrangement would trigger
a cross default (other than a general debt obligation cross-default),
• Whether there would be an automatic drawdown on the company’s line of credit
with the bank upon a failure to pay on a payable,
• Any fees, interest, commissions, rebates or discounts,
• Any extended deadlines for paying third parties,
• Whether the terms of the payable to the bank are those typical of a trade payable,
and
• Whether the payable continues to meet the UCC definition of a trade payable.
6.4
Payment in Kind
Some debt agreements provide that interest accrued must be paid in kind (PIK) with
the same instruments as those in the original issuance. With PIK debt, cash interest
is deferred, generally at the issuer’s option, until some later date. Unlike zero-coupon
bonds, which simply accrete interest from a discounted amount up to par, the
interest rate on PIK debt is paid out over time with issuances of the same security.
Some agreements allow for interest to be paid in another series of preferred stock
or debt. Other agreements provide that accumulated undeclared dividends or
unpaid interest can be paid in additional shares of common stock upon the holder’s
conversion of the preferred stock or debt. Some provide both a PIK feature and a
conversion feature for the accumulated dividends or unpaid interest.
2
Discussed in speech at 2004 AICPA National Conference in Current SEC and PCAOB Developments.
Debt / 6 - 13
PIK notes are separate loan commitments from the original debt issuance because
each time the interest payment comes due and the issuer elects to pay with PIK
notes, the lender is issuing the company a separate debt instrument. These types of
loan commitments (for the interest) may meet the definition of a derivative.
A scope exception from derivative accounting exists for borrower loan commitments
per ASC 815-10-15-13(i). Specifically, the guidance states that a potential borrower’s
ability to borrow is not subject to the requirements of ASC 815, and there is no
requirement for the borrower to separately account for these commitments.
6.4.1
Classification of Accrued Interest Payable Settlable with Paid-in-Kind
(PIK) Notes
The terms of debt instruments may permit the issuer to satisfy accrued interest on
the debt with additional PIK notes having identical terms (maturity date, interest rate,
etc.) as the original debt. In such cases, the original debt is referred to as PIK notes.
Typically, the interest may be paid either in cash or additional (PIK) notes, at the
issuer’s discretion. If the issuer intends on paying the interest with additional notes,
the balance sheet classification of the accrued interest payable should be based on
the maturity date of the additional notes expected to be issued.
Example 6-8: Accrued Interest Settlable in PIK Notes
Background/Facts:
• In October 2012, Company A issued floating-rate senior PIK notes that are due on
September 30, 2017.
• The notes have semi-annual interest payments payable in the form of cash or
additional PIK notes at Company A’s option.
• Company A intends on paying the interest in the form of additional PIK notes.
The maturity date of the PIK notes delivered to settle the interest payments is the
same as the original note.
Question:
How should Company A classify the accrued interest on the notes as of December
31, 2012?
Analysis/Conclusion:
At December 31, 2012 Company A should classify the accrued interest as noncurrent liabilities since it has both the intent and ability to refinance the short-term
liability (accrued interest) on a long-term basis.
The issuance of the original PIK notes demonstrates Company A’s ability to
consummate a refinancing of the interest on a long-term basis, with terms that are
readily determinable and meet all of the following conditions:
1. Does not expire within one year from the Company’s balance sheet.
2. The agreement (i.e., the right to satisfy interest with long-term PIK notes) is not
cancellable by the lender.
3. The PIK notes issued under the agreement are not puttable, except for violations
for which compliance is objectively measurable.
(continued)
6 - 14 / Debt
4. No violation of any provision in the financing agreement exists at the balance
sheet date.
5. There is no available information that indicates that a violation has occurred after
the balance sheet date and prior to the issuance of the financial statements, which
would prevent the issuer from having the right to satisfy the interest with long-term
PIK notes; for example, there is no covenant violation of the original PIK notes that
would:
— Accelerate their due date and the due date of any additional PIK notes that
might be used to satisfy the interest, or
— Prevent the issuer from electing to pay the interest in PIK notes while there is a
covenant violation of the original PIK notes.
6. The lender entered into the financing agreement permitting interest to be
refinanced with PIK notes.
7. The company is expected to be financially capable of honoring the agreement.
6.5
Guarantees on Debt
Under ASC 460, guarantees of a third-party’s indebtedness and indirect guarantees
of the indebtedness of others (when the creditor has only an indirect claim against
the guarantor) are to be recorded by the guarantor as a liability at fair value. The
following guarantees are excluded from the initial recognition and measurement
provisions of ASC 460-10-25-4:
• A guarantee between a parent and its subsidiaries.
• Guarantees between corporations under common control.
• A parent’s guarantee of its subsidiary’s debt to a third party.
• A subsidiary’s guarantee of the debt owed to a third party by either its parent or
another subsidiary of that parent.
See ASC 460-10-25-1 for additional arrangements that are excluded from its initial
recognition and measurement requirements.
ASC 460-10-50 requires disclosures by guarantors, including guarantees that are
excluded from the initial recognition and measurement provisions of ASC 460.
Disclosures related to intercompany guarantees are only required in the separate
financial statements of the issuer of the guarantees. See ASC 460-10-15-7 for
additional arrangements that are excluded from all of its requirements (i.e., initial
recognition, measurement, and disclosure).
Although not within the scope of ASC 460, a company should consider disclosing
guarantees of its indebtedness by principal shareholders or other related parties to
inform the reader that the company may not be able to obtain financing without the
guarantees of others.
Per ASC 825-10-25-13, the issuer of a liability with an inseparable third-party credit
enhancement shall not include the effect of (benefit of) the credit enhancement in
the fair value measurement of the liability. In determining the fair value of debt with a
third-party guarantee, the issuer would consider its own credit standing and not that
of the third-party guarantor.
Debt / 6 - 15
Certain guarantee contracts may meet the definition of a derivative in ASC 815-1015-83, which would require the guarantee contracts to be reported at fair value with
changes in fair value recorded in earnings.
ASC 815-10-15-58 provides a scope exception from derivative accounting treatment
for certain financial guarantee contracts that meet all of the following conditions:
a. The guarantee provides for payments to be made solely to reimburse the
guaranteed party for failure of the debtor to satisfy its required payment
obligations under a non-derivative contract, at:
1. Prespecified payment dates,
2. Accelerated payment dates as a result of the occurrence of an event of
default (as defined in the financial obligation covered by the guarantee
contract), or
3. An accelerated payment date due to a notice of acceleration made to the
debtor by the creditor.
b. Payment under the financial guarantee contract is made only if the debtor’s
obligation to make payments as a result of conditions as described in (a) is past
due.
c. The guaranteed party is exposed to the risk of nonpayment both at inception
of the financial guarantee contract and throughout its term through direct legal
ownership of the guaranteed obligation or through a back-to-back arrangement
with another party that is required by the back-to-back arrangement to maintain
direct ownership of the guaranteed obligation.
Financial guarantee contracts are subject to ASC 815 if they do not meet all three of
the above conditions. For example, some contracts require payments to be made
in response to changes in another underlying, such as a decrease in a specified
debtor’s creditworthiness.
6.6
Contingent Interest on Debt
Some debt securities pay additional interest only when certain conditions exist.
For example, the amount of interest to be paid may be based on company stock
price, company credit rating, or the amount of dividends declared on the company’s
common stock.
In other scenarios, the payment of additional interest may be contingent on the
occurrence of certain events. For example, additional interest could be paid to
investors upon a change in tax law (e.g., withholding or deduction) that increases the
tax obligation of certain investors. In such cases, the issuer will often pay additional
amounts so that the payments received by the investors after such withholding or
deduction will equal the amounts they would have received in the absence of such
withholding or deduction.
Generally, interest is considered clearly and closely related to a debt host contract
when it is solely indexed to interest rates or the issuer’s own credit risk. Many of
the contingent interest features in debt instruments would not be considered clearly
and closely related to the debt host contract. Contingent interest features that
are not clearly and closely related to the debt host contract should be separated
from the debt and evaluated separately in accordance with ASC 815. Although the
contingent interest might not be material to a company’s financial statements initially
6 - 16 / Debt
(e.g., due to a low probability of the condition or event occurring that would require
such additional payments), the company should monitor and periodically assess its
materiality.
Certain contingent obligations to pay additional interest may meet the definition of a
registration payment arrangement within the scope of ASC 825-20. The scope of the
guidance includes arrangements requiring payment of an increased interest rate on
debt instruments as a consequence of not obtaining a listing on a stock exchange.
In these circumstances, the contingent obligation to pay additional interest should
be recognized and measured separately in accordance with ASC 450-20-25 (and
not ASC 815). See FG section 3.8 for further discussion of registration payment
arrangements.
The determination of the likelihood of payment of contingent interest should generally
be consistent for book and tax purposes. When an issuer determines that the value
of the contingent interest is not material because the likelihood of payment is remote,
a similar assertion should generally be used when determining the interest deduction
for tax purposes.
6.7
How PwC Can Help
Our capital market transaction consultants and Assurance professionals frequently
advise companies regarding the interpretation and application of the accounting
literature to debt instruments, including:
• Classification of debt instruments as current or non-current.
• Classification (i.e., trade account payable or other bank debt) of a structured
vendor payable transaction.
• Whether embedded components such as put and call options (discussed in
Chapter 3) should be separated and recorded at fair value with changes in fair
value recorded in earnings.
• Guarantees on debt.
• Appropriate disclosure items.
If you have questions regarding the accounting for a debt instrument or would
like help in assessing the impact a debt issuance would have on your company’s
financial statements, please contact your PwC engagement partner or one of the
subject matter experts listed in the contacts section at the end of this Guide.
Debt / 6 - 17
Chapter 7:
Convertible Debt
Convertible Debt / 7 - 1
7.1
Analysis of Convertible Debt
Convertible debt is a debt instrument (typically a bond) that the investor can either:
• Hold until maturity and redeem for par value, or
• Exercise the conversion option and receive an amount equal to (1) a fixed number
of shares multiplied by (2) the issuer’s stock price at the date of conversion.
If the conversion option is in the money, the investor would exercise the option and
take the shares, which are worth more than the par value of the debt. However, the
investor should only exercise the conversion option when it’s in the money at (or
close to) the bond’s maturity date. Exercising the conversion option at an earlier date
causes the investor to forfeit the time value of the conversion option. Rather than
early exercising a conversion option, investors looking to exit a bond typically sell the
bond to another investor who will pay for both the intrinsic (in the money) and time
values.
If the issuer’s stock price does not reach a level where the conversion option is in
the money, the investor would not exercise its option, the debt will mature, and the
investor will receive the par value.
One of the key benefits to issuers of convertible debt is the relatively low cash
coupon (due to the value of the conversion option) when compared to similar
non-convertible debt. The interest deducted for tax purposes, however, may be
significantly higher through the use of a contingent interest feature (FG section 7.9)
or a call option overlay (FG section 7.10.3). In deciding whether to issue convertible
debt, a company must weigh these benefits with the risk of diluting shareholders’
equity through the issuance of equity at the specified conversion price.
Many convertible debt instruments contain a number of complicated provisions—
such as puts and calls, contingent conversion options, and contingent interest
provisions—that must be analyzed to determine whether the features need to be
accounted for separately.
One of the first decisions an issuer of convertible debt makes in determining the
structure of the debt it will issue is the settlement method upon conversion. There
are two primary methods of settling a debt upon conversion (1) entirely in shares or
(2) in some combination of cash and shares. An issuer must weigh cash
management, dilution, and earnings per share considerations, among others, when
deciding on a settlement feature. See FG section 7.4 for a discussion of convertible
debt with cash conversion features.
The following flowchart lays out a framework for navigating the many standards that
must be applied to determine the appropriate accounting treatment by the issuer of a
convertible debt instrument.
See FG section 4.3.1 for a discussion of the EPS treatment of share-settled
convertible debt. See FG section 4.6 for a discussion of the EPS considerations for
convertible debt with a cash conversion feature.
7 - 2 / Convertible Debt
Analysis of Convertible Debt
Should the embedded conversion
option be separately accounted for
pursuant to the guidance in ASC 815?1
Does the instrument contain a
cash conversion feature (as
defined in FG section 7.4)?
No
(FG section 7.2)
(FG section 7.4)
Yes
No
Yes
Does the instrument contain a
beneficial conversion feature
(BCF)?
Account for conversion option
separately, initially record at fair
value with changes in fair value
recorded in earnings.
(FG section 7.3)
No
Account for the instrument as a
liability in its entirety.
Yes
Separate the instrument into debt
and equity components following the
respective allocation guidance for a
BCF or cash conversion feature.
(FG sections 7.3 and 7.4)
Evaluate other embedded components—such as put options, call options, contingent interest—
to determine whether they require separate accounting as derivatives (see Chapter 3—Guide to
Accounting for Derivative Instruments and Hedging Activities—2012 edition)
1
Note that the analysis used to determine whether to separate an embedded conversion option differs
for “conventional” convertible debt versus “non conventional” convertible debt.
Convertible Debt / 7 - 3
Methods of Separating Convertible Debt
Method
7.2
When Applied
Description of Methodology
Result
Derivative
Separation
If the embedded
• Determine the fair value of
conversion option
the embedded conversion
must be separated and
option
accounted for under the • Record the conversion
guidance in ASC 815
option at fair value and
reduce the debt liability by
an equivalent amount
• Carry the conversion
option as a liability at fair
value with changes in fair
value recorded in earnings
• Amortize the discount on
the debt liability to interest
expense over the life of
the bond
• Debt liability
carried at
accreted value
• Separate
derivative liability
recorded at
fair value with
changes in fair
value recorded in
earnings
Cash
Conversion
Option
Separation
If the bond must be
separated into debt
and equity components
under the guidance in
ASC 470-20
• Determine the fair value
of the debt liability by
determining the fair value
of an equivalent debt
instrument without a
conversion option
• Record the debt liability
at fair value as calculated
above
• The difference between
the proceeds received
and the debt liability is
recorded in additional
paid-in capital
• No subsequent
remeasurement of the
amount recorded in equity
• Amortize the discount
on the debt liability to
interest expense over the
expected life of the bond
• Debt liability
carried at
accreted value
• Equity is not
subsequently
remeasured
BCF
Separation
If a BCF must be
separated under the
guidance in ASC
470-20
• Determine the BCF
amount based on the
in-the-money amount of
the conversion option
• Record the BCF in
additional paid-in capital
and record a discount
on the debt liability by a
corresponding amount
• No subsequent
remeasurement of the
amount recorded in equity
• Amortize the discount on
the debt liability to interest
expense over the life of
the bond
• Debt liability
carried at
accreted value
• Equity is not
subsequently
remeasured
Embedded Conversion Options
The first step in determining the appropriate accounting for a convertible debt
instrument is to determine whether the embedded conversion option must be
7 - 4 / Convertible Debt
separated and accounted for as a derivative. ASC 815-15-25-1 requires embedded
derivatives to be accounted for separately if all of the following criteria 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.
A conversion option embedded in a debt instrument allows the investor to
convert the debt into an equity classified security (common or preferred stock)
of the issuer. Such an equity-linked feature would not be considered clearly and
closely related to a debt host instrument. See FG section 2.3.1.2.
b. The hybrid instrument is not measured at fair value with changes in fair
value reported in earnings.
Convertible debt instruments that are bifurcated into a debt and an equity
component based on the guidance in ASC 470-20, such as debt with (1) a cash
conversion feature (FG section 7.4) or (2) a beneficial conversion feature (FG
section 7.3), are not eligible for the fair value option under ASC 825 based on the
guidance in ASC 825-10-15-5(f). All other convertible debt instruments may be
carried at fair value by the issuer, although this is typically not the case.
If an issuer carries a convertible debt instrument at fair value with changes in fair
value recorded in earnings, evaluation of the embedded conversion option and
other embedded features to determine whether they require separation is not
required.
c. A separate instrument with the same terms as the embedded derivative
would be a derivative instrument subject to the requirements of ASC 815.
As discussed in FG section 2.3, to determine whether a conversion option would
be accounted for as a derivative under the guidance in ASC 815, an issuer
should consider the following:
• Does the conversion option meet the definition of a derivative?
— If the equity securities underlying the embedded conversion option are
readily convertible to cash, such as publicly traded common shares, the
embedded conversion option meets the definition of a derivative.
— If the equity securities underlying the conversion option are not readily
convertible to cash, the embedded conversion option may not meet the
definition of a derivative. See FG section 2.3.2.
• Does the conversion option qualify for the scope exception for certain
contracts involving an issuer’s own equity in ASC 815-10-15-74?
See FG section 2.3.3 for a discussion of the scope exception for certain
contracts involving an issuer’s own equity. See FG section 2.5.2.2 for a
discussion of the application of the requirements for equity classification to
convertible debt instruments.
Many convertible debt instruments have several embedded conversion options that
are interrelated. If after performing the accounting analysis of one conversion option,
it is determined that it must be separated because it does not qualify for the scope
exception for certain contracts involving an issuer’s own equity in ASC 815-10-1574 (FG section 2.3.3), then all of the conversion options should be separated and
accounted for as a single derivative at fair value with changes in fair value recorded
in earnings.
Convertible Debt / 7 - 5
7.2.1
Contingent Conversion Option
A conversion option contingency may determine whether the investor has the right
to convert the debt instrument into equity (e.g., if the company has a successful IPO,
the investor may convert; if the company does not have a successful IPO, the bond
is not convertible). More commonly, a conversion option contingency merely impacts
when an investor can exercise its conversion option.
Without a conversion contingency, we would expect that a bond with a cash
conversion feature (FG section 7.4) would be classified as a current liability (because
it can be converted at any time); with a conversion contingency a bond with a
cash conversion feature should be classified as a non-current liability provided the
contingency has not been resolved and there is sufficient time to maturity. Once the
contingency has been resolved or the time to maturity would require current liability
classification, the bond should be classified as a current liability.
There are two broad categories of conversion option contingencies:
• Contingencies tied to an event or index other than the issuer’s stock price, and
• Contingencies tied to the issuer’s stock price.
7.2.1.1
Contingency Based on an Event or Index Other Than the Issuer’s
Stock Price
There may be many reasons for an issuer to include a contingency tied to something
other than its stock price in a conversion option. For example, a bond may be
convertible only upon the successful completion of an IPO because the issuer does
not want to issue equity unless the IPO occurs.
In evaluating whether a contingent conversion option should be separated and
accounted for as a derivative, careful consideration should be given to the impact of
the contingency on the determination of whether the option is considered indexed
to the company’s own stock. To qualify for the scope exception for certain contracts
involving an issuer’s own equity in ASC 815-10-15-74, the conversion option must
(1) be indexed to the company’s own stock and (2) meet the requirements for
equity classification. Contingent conversion options that require the satisfaction
of a contingency based on something other than the issuer’s stock price would be
considered indexed to the company’s own stock only if the contingency is based
on something other than an observable market or index. See FG section 2.3.3 for
a discussion of the scope exception for certain contracts involving an issuer’s own
equity. See FG section 2.5.1 for a discussion of the requirements to be considered
indexed to a company’s own stock.
If the instrument’s conversion is based on achieving a substantive contingency based
on an event or index other than the issuer’s stock price, the instrument would not
be included in diluted EPS until the non-market based contingency has been met,
provided the instrument is not convertible unless the contingency occurs.
7.2.1.2
Contingency Based on Issuer’s Stock Price
Contingent conversion options are the norm in debt instruments that contain a
cash conversion feature (FG section 7.4). Contingent conversion options tied to the
issuer’s stock price typically allow the investor to exercise its conversion option only
once the price of the common stock has met or exceeded a predetermined threshold
for a certain period of time. They are included to provide the issuer some protection
7 - 6 / Convertible Debt
against an unanticipated use of cash upon an early conversion by prohibiting
conversion unless the specified stock price has been achieved. Most stock price
contingencies only impact the timing of when the investor can exercise its conversion
option, as they generally expire shortly before the maturity date of the bond. At that
time, the investor is allowed to exercise its conversion option prior to maturity even if
the stock price contingency has not been satisfied.
If the only conversion option contingency is related to the issuer’s stock price, the
option would generally be considered indexed to the company’s own stock (FG
section 2.5.1). Provided the requirements for equity classification in ASC 815-40-25
(FG section 2.5.2) are met, such a contingent conversion option would typically
meet the requirements for the scope exception for certain contracts involving an
issuer’s own equity in ASC 815-10-15-74 and would not have to be separated and
accounted for as a derivative. See FG section 2.3 for a discussion on the analysis
of an embedded equity-linked feature. See FG section 2.3.3 for a discussion of the
scope exception for certain contracts involving an issuer’s own equity.
ASC 260-10-45-44 requires contingently convertible instruments that are tied to the
issuer’s stock price to be treated in the same manner as other convertible securities
and included in diluted EPS, if the effect is dilutive, regardless of whether the stock
price contingency has been met. Depending on the terms of the security, it could
be included in diluted EPS using either the if-converted method (FG section 4.3) or
a method that approximates the treasury stock method in the case of a convertible
bond with a cash conversion feature (FG section 4.6).
Example 7-1: Classification of Debt with a Contingent Conversion Option
Background/Facts:
• On January 1, 2011 Company A issued a convertible bond with a conversion price
of $120. Upon conversion the bond will be settled in (1) cash up to the par value of
the bond and (2) net shares for any additional value resulting from the conversion
option. Company A concluded that the bond must be bifurcated into its debt and
equity components pursuant to the guidance in ASC 470-20 (FG section 7.4).
• The bond has a maturity date of December 31, 2015 and is convertible by the
investor:
— Prior to September 30, 2015 only if Company A’s share price trades at or above
a price of $130 for 45 days of the preceding quarter.
— After September 30, 2015 at any time.
• During Q2 2012 Company A’s stock price traded above a price of $130 for more
than 45 days, which allowed investors to exercise their conversion option in Q3
2012.
• In Q3 2012 Company A’s stock price traded below a price of $130 for the entire
quarter such that the stock price contingency was no longer met and, beginning in
Q4 2012, investors could no longer exercise their conversion option.
Question:
Should the convertible bond be classified as a current or non-current liability in
Company A’s financial statements as of (a) June 30, 2012 and (b) September 30, 2012?
(continued)
Convertible Debt / 7 - 7
Analysis/Conclusion:
Upon conversion, Company A will deliver cash (and shares) to settle the convertible
bond. Therefore, Company A should classify the convertible bond as a current liability
in any period in which investors could exercise their conversion option within the 12
months following the reporting period.
Company A should classify the convertible bond as follows:
June 30, 2012
Current liability. In Q2 2012 Company A’s stock price traded
at a level that allowed investors to exercise their conversion
option for the period July 1–September 30, 2012.
September 30, 2012 Non-current liability. In Q3 Company A’s stock price traded
at a level that would not allow investors to exercise their
conversion option for the period October 1–December 31,
2012. It is unknown whether the stock price contingency will
be met, allowing investors to convert, at a future date.
Furthermore, in periods that Company A could be required to deliver cash to settle
the bond, it should reclassify an amount from permanent equity to mezzanine
(temporary) equity equal to the difference between:
• The amount of cash deliverable upon conversion (typically par value of the bond),
and
• The carrying value of the bond liability.
See FG section 7.4.3 for a discussion of mezzanine equity classification of the equity
component of a convertible bond with a cash conversion feature.
7.2.2
Adjustment to Shares Delivered Upon Conversion in the Event of a
Fundamental Change (Make-Whole Table)
Many convertible debt instruments provide for an adjustment to the number of shares
deliverable upon conversion in the event of a fundamental change. This provision
is included to compensate the investor for the lost option time value and forgone
interest payments upon an unanticipated fundamental change, such as a change in
control or significant change in the Board of Directors’ membership. Typically, the
adjustment to the number of shares is included in a matrix of issuer stock price and
time to maturity. The number of shares to be received upon conversion decreases
as (1) stock price increases and (2) time to maturity decreases. However, because
option time value is not linear, neither is the adjustment.
To determine whether a conversion option subject to adjustment in the event of
a fundamental change should be separated and accounted for as a derivative,
the issuer should consider whether it qualifies for the scope exception for certain
contracts involving an issuer’s own equity in ASC 815-10-15-74. To qualify for this
scope exception the conversion option must (1) be indexed to the company’s own
stock and (2) meet the requirements for equity classification. See FG section 2.3 for
a discussion on the analysis of an embedded equity-linked feature. See FG section
2.3.3 for a discussion of the scope exception for certain contracts involving an
issuer’s own equity.
As discussed in FG section 2.5.1.2, to be considered indexed to the company’s own
stock any adjustments to the settlement amount should be based on variables that
are standard inputs to the value of a “fixed-for-fixed” forward or option on equity
7 - 8 / Convertible Debt
shares. These variables include items such as the term of the instrument, expected
dividends, stock borrow costs, interest rates, stock price volatility, and the ability to
maintain a standard hedge position. Generally, a make-whole table used to calculate
the adjustment of the number of shares delivered upon conversion in the event
of a fundamental change has two inputs: (1) stock price and (2) time to maturity.
As discussed in the example in ASC 815-40-55-45 and 55-46, these inputs are
standard inputs to the value of a “fixed-for-fixed” forward or option on equity shares.
Therefore, such an adjustment to the number of shares deliverable upon conversion
in the event of a fundamental change would not impact the conclusion that the
feature is considered indexed to the company’s own stock.
In addition, make-whole tables typically include a cap on the number of shares the
issuer could be required to deliver upon conversion, which addresses one of the
requirements for equity classification in ASC 815-40-25. Provided the remaining
requirements for equity classification in ASC 815-40-25 are met, a provision that
adjusts the number of shares delivered upon conversion in the event of a fundamental
change typically would not cause the conversion option to be separated and
accounted for as a derivative.
7.2.3
Conversion Option Upon Trading Price Condition (Parity Provision)
Many convertible debt instruments with a contingent conversion option contain a
provision that permits the investor to exercise the conversion option if the bond
is trading at a specified percentage, for example 98% of the parity value of the
underlying shares (referred to as a “parity provision”). This provision is typically
included to provide protection to the investor by allowing conversion in a scenario
when they may want to convert, but would be unable to do so under a contingent
conversion option.
Theoretically, a convertible bond should always be worth more than the underlying
shares because a convertible bond provides a floor on the value to be received
(absent an issuer credit event, the investor will receive at least the par value of the
bond at maturity) as well as coupon payments over the life of the bond. A parity
provision is likely to only be triggered in periods of extreme market disruption or
in issuer specific situations, such as a significant change in the availability of the
issuer’s shares in the stock loan market.
To determine whether a conversion option with a parity provision should be separated
and accounted for as a derivative, the issuer should consider whether it qualifies for
the scope exception for certain contracts involving an issuer’s own equity in ASC
815-10-15-74. To qualify for the own equity scope exception, the conversion option
must (1) be indexed to the company’s own stock and (2) meet the requirements
for equity classification. The example in ASC 815-40-55-45 and 55-46 concludes
that a parity provision is considered indexed to the company’s own stock. Thus,
provided the requirements for equity classification in ASC 815-40-25 are met, a parity
provision typically would not cause the conversion option to have to be separated
and accounted for as a derivative. See FG section 2.3 for a discussion on the
analysis of an embedded equity-linked feature. See FG section 2.3.3 for a discussion
of the scope exception for certain contracts involving an issuer’s own equity.
7.3
Beneficial Conversion Feature (BCF)
The Beneficial Conversion Feature (BCF) rules apply only to convertible instruments
(1) whose embedded conversion option is not required to be separated under
Convertible Debt / 7 - 9
ASC 815 (FG section 7.2) and (2) that do not contain a cash conversion feature that
must be separately reported under ASC 470-20 (FG section 7.4).
A BCF exists if the conversion option is in the money at the commitment date (i.e.,
when the conversion price of the convertible debt instrument is less than the fair
value of the instrument into which it is convertible). The BCF is determined using a
conversion ratio based on the book value allocated to the convertible instrument
(e.g., considering allocations to detachable warrants). Similarly, a contingent BCF
may occur if at some date in the future, the conversion option is adjusted to a price
that is less than the issuer’s stock price at the commitment date.
Convertible debt instruments with a beneficial conversion feature that are bifurcated
into a debt and equity component subject to the guidance in ASC 470-20 are not
eligible for the fair value option under ASC 825 based on the guidance in ASC
825-10-15-5(f).
See FG section 3.5 for a further discussion of BCFs.
7.4
Cash Conversion Feature (previously FSP APB 14-1)
In traditional, share settled convertible debt, no cash is received upon conversion.
If the investor exercises its conversion option, the full number of shares underlying
the bond is received. In contrast, a convertible bond with a cash conversion feature
allows the issuer to settle its obligation upon conversion, in whole or in part, in a
combination of cash or stock either mandatorily or at the issuer’s option.
Generally, a convertible debt instrument with a cash conversion feature takes one of
three forms:
• The issuer may at its option satisfy the entire obligation in either cash or stock
(Instrument B).
• The issuer must settle the par (or accreted) value of the obligation in cash and the
conversion spread in either cash or stock (Instrument C).
• The issuer may settle the entire obligation in any combination of cash or stock
(Instrument X).
ASC 470-20 requires special accounting for convertible debt instruments with a
cash conversion feature, unless the embedded conversion option must be separated
and accounted for as a derivative (FG section 7.2). The guidance in ASC 470-20
also applies to convertible preferred shares that are classified as liabilities for
financial reporting purposes. For example, convertible preferred stock with a stated
redemption date that requires settlement of the par amount of the instrument in cash
is within the scope of ASC 470-20.
7.4.1
Recognition and Measurement
If convertible debt with a cash conversion feature contains an embedded derivative
other than the embedded conversion option (e.g., a change in control put option),
that embedded derivative should be evaluated under the guidance in ASC 815 to
determine whether it should be accounted for separately before the guidance in ASC
470-20 (discussed in this section) is applied. Therefore, when evaluating whether
an embedded put or call option should be accounted for separately from the host
debt instrument, the discount created by separating the conversion option under
the guidance in ASC 470-20 would not be considered. See FG section 7.8 for a
7 - 10 / Convertible Debt
discussion of embedded put and call options and FG section 7.9 for a discussion of
contingent interest.
Provided the embedded conversion option does not have to be separated and
accounted for as a derivative (FG section 7.2), convertible debt instruments within
the scope of ASC 470-20 should be bifurcated into a liability component and the
embedded conversion option (i.e., the equity component) in a manner that reflects
the interest cost at the rate of similar nonconvertible debt. This is done by:
• Determining the carrying amount of the liability component based on the fair value
of a similar debt instrument excluding the embedded conversion option. Typically,
an income valuation approach, or a present value calculation, is used to calculate
the fair value of the debt liability. To perform this calculation the issuer should
determine (1) the expected life of the liability (FG section 7.4.1.1) and (2) the
borrowing rate of a nonconvertible debt instrument (FG section 7.4.1.2).
• Recognizing the embedded conversion option in equity by ascribing the difference
between the proceeds and the fair value of the debt liability to additional paid in
capital (APIC).
• Reporting the difference between the principal amount of the debt and the amount
of the proceeds allocated to the liability component as a debt discount, which is
subsequently amortized to interest expense over the instrument’s expected life
using the interest method (FG section 7.4.1.3).
Convertible debt instruments with a cash conversion feature that are bifurcated
into a debt and equity component subject to the guidance in ASC 470-20 are not
eligible for the fair value option under ASC 825, based on the guidance in ASC
825-10-15-5(f).
The equity component should not be remeasured, provided that the conversion
option continues to meet the requirements for equity classification in ASC 81540. If the conversion option subsequently fails to meet the requirements for equity
classification and is reclassified as a liability, the difference between the amount
recognized in equity and the fair value of the embedded conversion option at the
reclassification date should be accounted for as an adjustment to equity.
Periodic reported interest expense for convertible debt with a cash conversion
feature includes (1) the instrument’s coupon and (2) the current period’s amortization
of the debt discount. Therefore, the accounting interest expense will be higher than
the cash coupon on the convertible debt. See FG section 7.4.1.3 for a discussion of
amortization of the debt discount.
See FG section 7.4.4 for a discussion of earnings per share.
7.4.1.1
Determining the Expected Life
In determining the expected life of the debt liability for purposes of the fair
value measurement described in FG section 7.4.1, only substantive embedded
features, other than the embedded conversion option, should be considered. The
determination of whether an embedded feature is nonsubstantive should be based
on the probability, at the instrument’s issuance date, of the feature being exercised.
This should be considered in the context of the instrument in its entirety, including
the embedded conversion option.
Convertible Debt / 7 - 11
An issuer should consider the impact of any prepayment features, such as puts and
calls, on the expected life of the debt liability. One way to do this is to use a valuation
approach that considers all of the features of the convertible debt liability, including
the conversion option. Although this method is likely to reflect the commercial
substance and economics of the debt instrument, it may not be consistent with the
requirements in ASC 470-20. The method of determining the expected life of a debt
liability with puts and calls described in ASC 470-20 is to consider whether it would
be rational to exercise a call (or for the investor to exercise a put) if it were embedded
in a nonconvertible debt with the same terms as the convertible debt being
evaluated. The hypothetical nonconvertible debt instrument is an instrument that (1)
pays the same coupon rate as the convertible debt instrument and (2) was issued at
a discount to par value, to compensate for the low coupon rate when compared to
nonconvertible debt rates.
When considering puts and calls embedded in debt instruments:
• An issuer would generally not call a nonconvertible debt instrument with a low
coupon rate. Therefore, a bond with an issuer call option would generally have an
expected life equal to its contractual life.
• Conversely, an investor would generally put a nonconvertible debt instrument with
a low coupon as soon as possible. Therefore, generally for such an instrument it is
probable that an investor put option will be exercised. In this case, the bond has
an expected life from the period from issuance to the first put date.
• A bond that has an issuer call and an investor put option at the same date
generally has an expected life equal to the period from issuance to the
simultaneous put/call date.
Summary of Likely Impact of Puts and Calls on Estimated Life
Description
Likely
Estimated Life
Matures in 10 years
Issuer call in 5 years
Investor put in 5 years
5 years
Matures in 10 years
Issuer call in 5 years
Investor put in 7 years
7 years
Matures in 10 years
Issuer call in 7 years
Investor put in 5 years
5 years
Matures in 10 years
No issuer call
Investor put in 5 years
5 years
Matures in 10 years
Issuer call in 5 years
No investor put
10 years
The expected life is not reassessed in subsequent reporting periods unless the
instrument is modified.
7 - 12 / Convertible Debt
Example 7-2: Impact of Change of Control Put on Expected Life
Background/Facts:
• Company A issues a convertible bond that may be settled upon conversion in
any combination of cash or shares at the Company’s option and concludes that
the bond must be bifurcated into a debt and equity component pursuant to the
guidance in ASC 470-20.
• The bond contains a feature that allows the investors to put the bond to Company
A at the bond’s par value upon a fundamental change, in this case a change in
control. This feature is frequently referred to as a “change-in-control” put. See FG
section 7.8.2
• Company A determines that the investor’s put option should not be separated and
accounted for as a derivative (FG section 7.8).
Question:
Should the inclusion of the put option exercisable upon a fundamental change
be taken into account in determining the expected life of the convertible bond for
purposes of determining the fair value of the debt liability?
Analysis/Conclusion:
Company A must assess whether the change in control put is a substantive feature
at the bond’s issuance date. If, at issuance of the bond, it is probable that an event
that would trigger the change in control put will not occur, the change in control put
would likely be deemed nonsubstantive and disregarded for purposes of determining
the expected life.
7.4.1.2
Determining the Nonconvertible Debt Rate
In determining the nonconvertible debt rate for purposes of the fair value
measurement described in FG section 7.4.1, an issuer should consider:
• The interest rate on its own nonconvertible debt. If that debt is similar to the
convertible debt being evaluated, in terms of issuance date and seniority, it may
be appropriate to use the interest rate on its own nonconvertible debt without
making any adjustments to it. If there are differences in seniority, issuance
date, or tenor, an issuer should consider these differences in determining the
nonconvertible debt rate.
• Market rates for nonconvertible debt instruments with terms similar to the
convertible debt being evaluated that have been issued by companies with similar
credit quality.
• The use of a valuation specialist. This is especially true for high-yield issuers who
may not have sufficient market data regarding nonconvertible debt rates available
due to low credit quality.
Convertible Debt / 7 - 13
Example 7-3: Using a Purchased Call Option to Determine the Nonconvertible
Debt Rate
Background/Facts:
• Company A issues a convertible bond that may be settled upon conversion in
any combination of cash or shares at the Company’s option and concludes that
the bond must be bifurcated into its debt and equity components pursuant to the
guidance in ASC 470-20.
• Concurrent with the issuance of the convertible bond, Company A enters into a
call options overlay transaction on its own stock with Bank Z (FG section 7.8.3)
in which the Company (1) purchases a call option on its own shares from Bank Z
that mirrors the strike price and terms of the conversion option embedded in the
convertible bond and (2) sells a call option on its own shares to Bank Z at a higher
strike price.
• Company A decides to determine the borrowing rate of a nonconvertible debt
instrument by determining the difference between (1) the proceeds received
upon issuance of the convertible bond and (2) the amount paid to Bank Z for the
purchased call option. The Company believes this is the most reliable method of
determining the nonconvertible debt rate because it would be based on input from
market-based transactions.
Question:
Is the methodology to be used by Company A acceptable to determine the
borrowing rate of a nonconvertible debt instrument?
Analysis/Conclusion:
Probably not. The call option purchased from Bank Z will not have the same value as
the call option embedded in Company A’s convertible debt due to:
• Inefficiencies in the convertible debt market, which cause a conversion option
embedded in a bond to generally be worth less than a similar freestanding option.
• Differences in counterparty credit risk.
Therefore, using the value of the purchased call option as a proxy for the value of the
embedded conversion option, without adjustment, is generally not appropriate.
7.4.1.3
Amortization of Debt Discount
The debt discount created by bifurcating a convertible bond within the scope of
ASC 470-20 into its debt and equity components should be amortized using the
interest method. The amortization period should be the expected life of a similar
nonconvertible liability (considering the effects of any embedded features other than
the conversion option, such as prepayment options). If an issuer uses an income
valuation approach, or a valuation technique that is consistent with that approach,
to measure the fair value of the liability component at initial recognition, the time
period used as the expected life should also be used to amortize the discount. The
amortization period is not reassessed in subsequent reporting periods unless the
instrument is modified.
7 - 14 / Convertible Debt
7.4.2
Tax Accounting Considerations
The application of the guidance in ASC 470-20 will result in a basis difference
associated with the liability component that represents a temporary difference under
ASC 740. The basis difference is the difference between:
• The carrying value of the debt liability under the provisions of ASC 470-20, and
• The convertible debt instrument’s tax basis (which would generally be its original
issue price adjusted for any original issue discount or premium).
The initial recognition of the deferred taxes associated with this basis difference
should be recorded as a deferred tax liability with an adjustment to additional paid
in capital. In subsequent periods, the deferred tax liability is reduced and a deferred
tax benefit will be recognized in earnings as the debt discount is amortized to pre-tax
income. Consequently, the total income tax benefit in subsequent periods would
include the current tax effect of deducting interest (to the extent permitted under the
tax law) and the deferred tax benefit from the reversal of a portion of the deferred tax
liability.
The taxable temporary difference associated with the debt discount on a bond with a
cash conversion feature may constitute a source of future taxable income under ASC
740-10-30-18. Depending on reversal patterns, this taxable temporary difference
should be considered in assessing the future realization of existing deferred tax
assets.
The guidance in ASC 470-20 applies to certain convertible preferred shares that
are mandatorily redeemable. For example, convertible preferred stock with a stated
redemption date that requires settlement of the par amount of the instrument in cash
is within the scope of ASC 470-20. For tax purposes, however, the instrument may
be considered equity. In that case, the instrument may not result in a tax liability
in the event it is redeemed for the book carrying amount, nor would it provide tax
deductions for accrued interest (which may constitute dividends for tax purposes).
Consequently, deferred taxes would not be recognized because the instrument’s
carrying value (or book basis) is expected to reverse without tax consequence.
Example 7-4: Application of ASC 470-20 to a Convertible Bond with a Cash
Conversion Feature
Background/Facts:
• Company A issues a convertible bond that will be settled upon conversion by
delivering (1) cash up to the principal amount of the bond and (2) net shares
equal to any value due to the conversion option being in the money. Company A
concludes that the bond must be bifurcated into its debt and equity components
pursuant to the guidance in ASC 470-20.
• Company A’s stock price is $85 at the date the bond is issued.
(continued)
Convertible Debt / 7 - 15
• The convertible bond has the following terms:
Principal Amount
$100 million issued in $1000 bonds
Coupon Rate
2.00%
Years to Maturity
7 years
Issuer Call Option
2 years and thereafter
Investor Put Option
5 years and thereafter
Conversion Price
$100
Conversion Terms
Investors can convert in any quarter following a
quarter in which Company A’s stock price traded
at or above $110 for at least 45 days
Conversion Settlement
Upon conversion, investors will receive per $1000
bond (1) $1000 in cash and (2) net shares equal to
any value due to the conversion option being in the
money
• Company A determines that a nonconvertible debt instrument with the same
terms would have an expected life of 5 years because its bond is puttable by
investors beginning in year 5.
• Based on its analysis of 5 year nonconvertible debt with similar terms issued by
companies with similar credit quality, Company A determines the coupon rate for
a nonconvertible debt instrument with the same terms to be 8.00%.
• Using a present value calculation, Company A determines the initial carrying value
of the debt to be $76 million. The embedded conversion option is $24 million; the
difference between the $100 million proceeds and $76 million debt liability.
• Company A calculates deferred taxes associated with bifurcating the bond into its
debt and equity components as the product of (1) the debt liability discount ($24
million) and (2) Company A’s effective tax rate of 40%, resulting a deferred tax
liability of $9.6 million.
• Company A develops the following schedule of balances and accretion using the
beginning debt liability balance calculated using an income valuation approach
and the interest method of amortization.
(In millions)
Year 1
Year 2
Year 3
Year 4
Year 5
Balance at Beginning of
Period
$76.0
$80.1
$84.5
$89.3
$ 94.4
Amortization of Discount
4.1
4.4
4.8
5.1
5.6
Balance at End of Period
$80.1
$84.5
$89.3
$94.4
$100.0
(continued)
7 - 16 / Convertible Debt
Question:
What are the journal entries recorded by Company A (1) upon issuance of its
convertible bond and (2) during Year 1?
Analysis/Conclusion:
At issuance of the convertible bond:
(Amounts in millions)
1. Dr Cash
Dr Debt discount
Dr Additional paid-in capital
Cr Debt
Cr Additional paid-in capital
Cr Deferred tax liability
$100.0
24.0
9.6
$100.0
24.0
9.6
To recognize (a) the receipt of cash, (b) bifurcation of the convertible bond into its
debt liability and residual equity components and (c) creation of the deferred tax
liability associated with that bifurcation.
During Year 1:
(Amounts in millions)
2. Dr Interest expense
Cr Cash
Cr Debt discount
$
6.1
$
2.0
4.1
To recognize (a) the payment of the 2.0% cash coupon and (b) amortization of the
debt discount using the interest method.
(Amounts in millions)
Dr Deferred tax liability
Cr Deferred tax benefit (P/L)
$
1.6
$
1.6
To recognize the reduction of the deferred tax liability as the debt liability discount is
amortized.
Example 7-5: Change in the Expected Life of a Convertible Bond
Background/Facts:
• This example is based on the same information and assumptions used in Example
7-4.
• Company A determined the expected life of the bond to be 5 years based on the
inclusion of an investor put option exercisable beginning in year 5. The Company
used that 5 year life to determine the borrowing rate of a nonconvertible debt
instrument and as the amortization period. At the end of 5 years the debt discount
has been fully amortized such that the convertible bond is recorded on Company
A’s books at its par value.
• At the end of 5 years, the bond is neither called by Company A nor converted or put
by investors.
(continued)
Convertible Debt / 7 - 17
Question:
How should Company A record interest expense on the convertible bond in Year 6
and beyond?
Analysis/Conclusion:
Once the debt discount recorded at issuance has been fully amortized, Company A
would record only the convertible coupon paid in cash (2.00%) as interest expense.
ASC 470-20 does not permit adjustments to the amortization period or expected life
of a convertible debt instrument after issuance.
7.4.3
Mezzanine (Temporary) Equity Classification
An embedded conversion option that is accounted for separately in equity under
the guidance in ASC 470-20 may be required to be classified as mezzanine equity in
periods in which the debt is currently convertible or redeemable.
• Debt is currently convertible if the investor is able to exercise its conversion
option. For contingently convertible debt, this would typically be the period after
the contingency has been met. For debt without a conversion contingency, the
debt may be convertible at any time.
• Debt is currently redeemable if (1) the investor holds a put option that is currently
exercisable or (2) the bond matures in the current period.
The amount required to be classified in mezzanine equity when a debt instrument
with a cash conversion feature is currently convertible depends on the terms of the
debt instrument (see FG section 7.4 for a description of each instrument).
• Instruments B and X—Mezzanine equity classification is not required because,
upon conversion, the issuer has the option to settle both the bond principal and
the conversion option value in shares.
• Instrument C—The difference between (1) the amount of cash deliverable upon
conversion (i.e., par value of the debt) and (2) the carrying value of the debt
component should be classified as mezzanine equity.
The amount required to be classified in mezzanine equity when a debt instrument
with a cash conversion feature is currently redeemable is equal to the difference
between (1) the redemption amount and (2) the carrying value of the debt
component.
See FG section 3.6 for a further discussion of mezzanine equity classification.
7.4.4
Earnings per Share
Most convertible bonds with a cash conversion feature are included in diluted EPS
using a method similar to the treasury stock method, which is illustrated in ASC 26010-55-84 through 55-84B. Under this method:
• There is no adjustment for the cash-settled portion of the instrument; interest
expense (including the accretion of the discount created by separating the equity
component at issuance) remains in income available to common shareholders, or
the numerator of diluted EPS.
7 - 18 / Convertible Debt
• The number of shares included in the denominator of diluted EPS is calculated
by dividing the conversion spread value by the average share price during the
reporting period. The conversion spread value is the value that would be delivered
to investors based on the terms of the bond, at the assumed conversion date.
However, the issuer of a debt instrument that may settle in any combination of cash
or stock at the issuer’s option (Instrument X bond) should consider the guidance on
instruments settlable in cash or shares (FG section 4.5).
• If the issuer has a stated policy to settle or a past practice of settling, upon
conversion, (1) the par (or accreted) value of the obligation in cash and (2) the
value of the conversion spread in shares, diluted EPS should be calculated using
the method described above.
• If the issuer does not have a stated policy to settle, upon conversion, the par (or
accreted) value of the obligation in cash, or has a past practice of settling similar
instruments entirely in shares, the issuer may need to include the debt instrument
in diluted EPS using the if-converted method (FG section 4.3).
7.4.5
Derecognition (Conversion or Extinguishment)
The accounting for the derecognition of a convertible bond with a cash conversion
feature is the same whether the bond is (1) extinguished/repurchased or
(2) converted. In either case, the issuer should allocate the fair value of the
consideration transferred (cash or shares) and any transaction costs incurred
between (1) the debt component—to reflect the extinguishment of the debt and
(2) the equity component—to reflect the reacquisition of the embedded conversion
option.
• The issuer should first calculate the fair value of the debt immediately prior to
it’s derecognition. This is generally done by re-calculating the carrying value of
the bond using an updated remaining expected life of the debt instrument and
updated nonconvertible debt rate assumption. This is the amount used to account
for the extinguishment of the debt.
— A gain or loss on extinguishment equal to the difference between the
consideration allocated to the liability component and the carrying value of
the liability component, including any unamortized debt discount or issuance
costs, is recorded in earnings.
• The remainder of the consideration is allocated to the reacquisition of the
embedded conversion option (equity component).
• If any other stated or unstated rights and privileges exist, a portion of the
consideration should be allocated to those rights and privileges and accounted for
according to other applicable accounting guidance.
Transaction costs incurred with third parties (other than the investors) that
directly relate to the settlement of the instrument should be allocated to the debt
component by calculating the ratio of the fair value of the debt to the total fair value
of consideration delivered and multiplying it by the total transaction costs. The
remainder of the transaction costs are allocated to the reacquisition of the equity
component.
Convertible Debt / 7 - 19
Example 7-6: Early Conversion of a Convertible Bond with a Cash
Conversion Feature
Background/Facts:
• This example is based on the same information and assumptions used in Example
7-4.
• At the end of Year 3, Company A’s stock price is $150.
• Company A decides to exercise its call option. Once the bond is called by
Company A, investors have the ability to either (1) convert the bond and
receive cash and shares with a value equal to $1500, which reflects the value
of the conversion option, or (2) choose not to convert and receive $1000 upon
settlement of the call option. Investors decide to convert their bonds.
• Upon conversion, Company A settles the bonds by issuing $100 million in cash
and $50 million in common shares.
• The remaining original expected life of a nonconvertible debt instrument is 2 years.
• Based on its analysis of 5 year nonconvertible debt with 2 years left to maturity
with similar terms issued by companies with similar credit quality, Company A
determines the coupon rate for a nonconvertible debt instrument with the same
terms to be 6.00%.
• Using a present value calculation, Company A determines the fair value of the
debt to be $92.7 million.
• Company A allocates the $150.0 million consideration transferred to investors
as follows (1) $92.7 million to extinguish the debt and (2) $57.3 million to the
embedded conversion option.
• A loss on extinguishment of $3.4 million is determined by calculating the
difference between (1) the fair value of the bond prior to conversion—$92.7 million
and (2) the carrying value of the bond at the end of year 3—$89.3 million (see
table in Example 7-4).
• A deferred income tax benefit related to the loss on extinguishment of $1.4 million
($3.4 million x 40% tax rate) is also recorded.
• The remaining deferred tax liability at the end of year 3 is $4.3 million.
• The difference between the deferred tax liability and deferred income tax benefit
resulting from the loss on extinguishment is recognized in additional paid in capital.
Question:
How should Company A record the early conversion by investors?
Analysis/Conclusion:
(Amounts in millions)
Dr Debt
Dr Additional paid-in capital
Dr Loss on extinguishment
Dr Deferred tax liability
Cr Debt discount
Cr Cash
Cr Deferred income tax benefit
Cr Common stock
Cr Additional paid-in capital
7 - 20 / Convertible Debt
$100.0
57.3
3.4
4.3
$ 10.7
100.0
1.4
50.0
2.9
7.5
Conversion into Equity
The conversion into common or preferred stock is not an extinguishment if it
represents the exercise of a conversion right that was included in the original terms
of the instrument.
• In a conversion of a convertible bond pursuant to original conversion terms,
the debt is settled in exchange for equity and no gain or loss is recognized on
conversion.
• The exchange of common or preferred stock for debt that does not contain a
conversion right in its original terms is an extinguishment. Such an exchange may
also be considered a troubled debt restructuring. See discussion of Troubled Debt
Restructurings in FG section 5.3.
Example 7-7: Conversion of Instrument Upon Issuer’s Exercise of Call Option
Background/Facts:
• Company A issued a bond with an embedded conversion option that investors
can exercise in any quarter following a quarter in which Company A’s stock price
traded at or above $110 for at least 45 days.
• The bond also contains a call option that allows Company A to call the bond 2
years after issuance and anytime thereafter. Upon Company A’s exercise of its
call option, investors have the right to exercise their conversion option even if the
stock price contingency has not been met.
• Company A calls the bond at a time when the investors cannot otherwise exercise
their conversion option because the contingency has not been met.
Question:
Is the settlement of the bond considered a conversion or an extinguishment?
Analysis/Conclusion:
It depends on whether the conversion option was substantive at the date the bond
was issued. If the conversion option was considered substantive as of the date of
issuance, settlement of the bond would be accounted for as a conversion. If the
bond did not contain a substantive conversion option as of its issuance date, the
settlement should be accounted for as a debt extinguishment.
A substantive conversion option is one that is at least reasonably possible of being
exercisable in the future absent the issuer’s exercise of a call option. For purposes
of determining whether it is reasonably possible that the conversion option will be
exercised, an assessment of the holder’s intent is not necessary. The assessment
of whether the conversion feature is substantive should be based on assumptions,
considerations, and marketplace information available as of the issuance date.
An instrument that has no conversion option other than upon the issuer exercising
its call option does not have a substantive conversion option. ASC 470-20-40-9
contains a list (not intended to be all-inclusive) of additional factors that may be
helpful in assessing whether a conversion option is substantive (that is, whether it
is at least reasonably possible that the conversion option will be exercised in the
future).
Convertible Debt / 7 - 21
Example 7-8: Conversion of Bond with a Separated Conversion Option
Background/Facts:
• Company A issues a 5-year convertible bond that allows bondholders to exercise
a conversion option over a 3-year period beginning three months after issuance.
• The embedded conversion option was separated from the debt host upon
issuance pursuant to ASC 815. Accordingly, the proceeds from issuance were
allocated to the derivative and debt host, both of which are liabilities.
• In subsequent periods, the debt host is accreted using the interest method over
the term of the debt, and the derivative is remeasured at fair value with changes in
fair value recorded in earnings.
• Prior to the expiration of the conversion option, the bondholders exercise the
conversion option.
Question:
How should Company A account for the conversion?
Analysis/Conclusion:
It should be accounted for as an extinguishment (FG section 7.7.1). ASC 470-5040-5 and ASC 470-50-15-3(a) exclude the use of extinguishment accounting for
conversions that represent the exercise of the conversion right contained in the
terms of debt at issuance. This exclusion is based on the concept that the debt
and the conversion option are inseparable from each other. The exclusion does not
apply when the conversion option is separated at the time the debt is issued; thus
extinguishment accounting should be applied. See FG section 7.7.1 for a discussion
of extinguishment accounting for a convertible debt instrument with a separated
conversion option.
7.5.1
Conversion Prior to Full Accretion of BCF Discount
When an instrument with a beneficial conversion feature (BCF) (FG section 7.3) is
converted prior to the full accretion of the discount created by the BCF, ASC 470-2040-1 requires the unamortized BCF amount to be recorded as interest expense.
The amount of BCF amortized could exceed the amount the holder realizes upon
conversion. This could occur when a debt instrument incorporates a multiple-step
discount to the stock price at the commitment date, such as a 15% discount to the
commitment date stock price if the debt is converted after 6 months, and a 35%
discount to the commitment date stock price if the debt is converted after 1 year.
Based on the guidance in ASC 470-20-30-7, the issuer of such a debt instrument
would record a BCF based on the most beneficial terms to the investor (35%
discount to the commitment date stock price), provided there are no contingencies
other than the passage of time, and would amortize that BCF. If the investor converts
the debt instrument at a point in time when the less beneficial conversion price (15%
discount to the commitment date stock price) is in effect, the previously recognized
BCF amortization would not be reversed.
7.6
Induced Conversion
An induced conversion is a transaction in which the issuer induces conversion of
the debt by offering (or agreeing to issue) additional securities or other consideration
(“sweeteners”) to investors. Induced conversions are transactions that both:
7 - 22 / Convertible Debt
• Change the conversion privileges if the investor exercises during a limited period
of time, and
• Include all equity securities issuable pursuant to conversion privileges included in
the original terms, regardless of which party initiates the offer or whether the offer
relates to all holders.
ASC 470-20-40-13 through 40-17 require recognition of an expense (which
consequently impacts EPS) equal to the fair value of the securities or other
consideration issued to induce conversion in excess of the fair value of securities
issuable pursuant to the original conversion terms. The expense may not be
reported as an extraordinary item. Repurchases that are not induced conversions
are extinguishments (FG section 7.7). These two accounting methods can produce
significantly different results depending on the market value of the securities issued.
Example 7-9: Offer to Convert Initiated by the Investor
Background/Facts:
• Company A issues share-settled convertible debt to investors.
• One of the investors offers to surrender the debt in exchange for more shares of
stock than the investor is entitled to under the original conversion terms. The offer
is valid for a limited period of time.
• Company A agrees to the offer.
Question:
Should Company A account for the transaction as an induced conversion or as an
extinguishment of debt?
Analysis/Conclusion:
Company A should account for the transaction as an induced conversion. The SEC
staff has indicated a preference for inducement accounting in such circumstances,
noting that the party who makes the offer should not affect the accounting. Thus,
inducement accounting is not affected by which party makes the offer.
Example 7-10: Reduction in Shares Issued Upon Conversion
Background/Facts:
• Company A issues share-settled convertible debt to investors.
• Company A extends an offer to investors, for a limited period of time, to allow
investors to tender their debt instruments in exchange for cash and shares. The
total value of consideration that could be received would be greater than the value
of the shares that the investor is entitled to under the original conversion terms.
• The number of shares the investor would receive is less than the number of shares
that the investor is entitled to under the original conversion terms. This shortfall is
made up for with cash.
(continued)
Convertible Debt / 7 - 23
Question:
Should Company A account for the transaction as an induced conversion or as an
extinguishment of debt?
Analysis/Conclusion:
Company A should account for the transaction as an extinguishment. ASC 470-2040-13 (b) requires that all equity securities issuable pursuant to conversion privileges
included in the terms of the debt at issuance should be issued if the conversion is to
qualify for inducement accounting. If fewer shares are issued, this condition is not
met and extinguishment accounting is required.
7.6.1
Induced Conversion of Convertible Debt with a Cash Conversion Feature
The guidance for determining whether the issuer of convertible debt with a cash
conversion feature has induced conversion differs from the guidance for convertible
debt without a cash conversion feature and preferred stock. As discussed in
ASC 470-20-40-26, if convertible debt with a cash conversion option is amended
to induce early conversion, the issuer should apply the inducement accounting
described below. However, if the issuer merely offers investors additional
consideration if they exercise their conversion option during a specified period of
time (without amending the terms of the instrument), that would be accounted for
using the derecognition guidance discussed in FG section 7.4.5.
Upon an induced conversion of convertible debt with a cash conversion feature, the
issuer
• Recognizes an inducement charge equal to the difference between (1) the fair
value of the consideration delivered to the investor and (2) the fair value of the
consideration issuable under the original conversion terms.
• Allocates the fair value of the consideration issuable under the original conversion
terms to the debt and equity components as described in FG section 7.4.5.
7.7
Convertible Debt Extinguishment Accounting
The accounting for an extinguishment of share-settled convertible debt is similar to
the accounting for nonconvertible debt. A gain or loss on extinguishment equal to the
difference between (1) the reacquisition price and (2) the net carrying amount of the
original debt is recorded. See FG section 5.6 for a discussion of debt extinguishment
accounting.
Debt extinguishment accounting may also be applied if an issuer restructures sharesettled convertible debt in a manner that triggers extinguishment accounting. See FG
section 5.7 for a discussion of the restructuring of convertible debt instruments.
See FG section 7.4.5 for a discussion of extinguishment accounting for convertible
debt with a cash conversion feature.
7.7.1
Extinguishment Accounting—Bifurcated Conversion Option
When a conversion feature has been separated from a convertible debt host contract
and accounted for as a liability, there is no equity conversion feature remaining in
the debt for accounting purposes. Therefore, while there may be a legal conversion
of the debt, for accounting purposes we believe that both liabilities (i.e., the debt
host and the separated derivative liability) are subject to extinguishment accounting
7 - 24 / Convertible Debt
because they are being surrendered in exchange for common shares. As such, a
gain or loss upon extinguishment of the two liabilities equal to the difference between
the recorded value of the liabilities and the fair value of the common stock issued to
extinguish them should be recorded.
To account for the conversion of convertible debt securities when the conversion
option has been separated and accounted for as a liability, perform the following
steps:
• Update the valuation of the separated derivative to the date of legal conversion.
• Adjust the carrying value of the host debt instrument to reflect accretion of
any premium or discount on the host debt instrument up to the date of legal
conversion.
• Amortize debt issue costs to the date of legal conversion.
• Ensure that the book basis of the host debt instrument reflects all components of
book value, including the unamortized portion of any premiums or discounts on
the debt host recorded as an adjustment to the debt host and any unamortized
debt issue costs recorded as deferred charges. These items collectively represent
the net carrying amount of the debt host used to measure the extinguishment gain
or loss. See ASC 470-50-40-1 through 40-3.
• Calculate the difference between the reacquisition price and net carrying amount
of the debt by comparing the fair value of the shares issued upon conversion to
the updated net carrying values of the sum of the separated embedded derivative
liability and the debt host. Record any difference as an extinguishment gain or loss
in earnings.
7.8
Put and Call Options
An issuer should evaluate put and call options embedded in a convertible debt
instrument under the guidance in ASC 815-15-25-42 and ASC 815-15-25-26 to
determine whether they should be separated and accounted for as derivatives at
fair value. See FG section 3.1 for a discussion of puts and calls embedded in debt
instruments.
As discussed in FG section 7.4.1, if a convertible debt instrument with a cash
conversion feature contains a put or call option, it should be evaluated under the
guidance in ASC 815 to determine whether it should be accounted for separately
before the guidance in ASC 470-20, discussed in that section, is applied.
7.8.1
Put Options
Some convertible debt instruments, particularly long-dated instruments, contain a
put option that allows investors to redeem the bond, typically at par value, either
continuously or at discrete dates after a specified point in time.
An issuer should evaluate a put option embedded in a convertible debt instrument
under the guidance in ASC 815-15-25-42 and ASC 815-15-25-26 to determine
whether it should be separated and accounted for as a derivative at fair value. Even
a put at par value may be required to be separated if the debt instrument was not
issued at par value. See FG section 3.1 for a discussion of puts and calls embedded
in debt instruments.
Convertible Debt / 7 - 25
7.8.2
Put Upon a Fundamental Change/Change in Control Put
Many convertible debt instruments contain a contingently exercisable put option that
allows the investor to put the bond, typically at par, upon a fundamental change,
such as a change in control. A put upon a fundamental change is included as a form
of investor protection that allows the investor the ability to dispose of the instrument
in circumstances when they may not want to continue to hold it.
Example 7-11: Fundamental Change Put at Higher of Par or Conversion Value
Background/Facts:
Company A issues a convertible bond with a provision that allows the investor to
put the bond, at par value, upon a fundamental change. The terms of this provision
require Company A to deliver cash equal to the greater of the (1) par value of the
bond or (2) the converted value of the bond.
Question:
Should the option to put the bond upon a fundamental change be separated from the
convertible bond?
Analysis/Conclusion:
Possibly. The put option at par value needs to be evaluated to determine whether it
should be separated (FG section 3.2). Often it will not be separated.
However, the embedded conversion option should be separated. The term used
to describe an option or right in a bond is irrelevant; an issuer should look to the
economic substance of the right that has been conveyed. The put option upon
a fundamental change is really two options (1) a put option at par value and (2) a
contingently exercisable conversion option, which must be settled in cash.
A conversion option that must be settled in cash in circumstances beyond the
issuer’s control does not meet the requirements for equity classification in ASC 81540-25 and is not eligible for the scope exception for certain contracts involving an
issuer’s own stock in ASC 815-10-15-74. Although the cash settlement provision is
only included in the conversion option exercisable upon a fundamental change, all
of the conversion options, including the base conversion option that requires share
settlement, are interrelated. For that reason, they should be evaluated in combination
and if one fails to qualify for the ASC 815-10-15-74 scope exception, they should be
separated and valued as a group. Therefore, the entire conversion option should be
separated and carried at fair value with changes in fair value recorded in earnings.
7.8.3
Issuer Call Options
Many convertible debt instruments contain a call option that allows the issuer to
redeem the bond, typically at par value, either continuously or at discrete dates.
Typically, the investor will have the right to exercise its conversion option (even a
contingent conversion option for which the contingency has not been met) upon
the issuer’s exercise of its call option. An issuer typically will call a convertible bond
to force the investor to exercise its conversion option. For example, the issuer of a
convertible bond that is sufficiently in the money such that conversion at maturity is
relatively certain may decide to force the investor to exercise its conversion option to
stop the interest payments on the bond.
7 - 26 / Convertible Debt
An issuer should evaluate a call option embedded in a convertible debt instrument
under the guidance in ASC 815-15-25-42 and ASC 815-15-25-26 to determine
whether it should be separated and accounted for as a derivative at fair value. See
FG section 3.1 for a discussion of puts and calls embedded in debt instruments.
7.9
Contingent Interest
A contingent interest feature requires additional interest to be paid only when certain
conditions exist. Typically, contingent interest features are included for tax purposes
to allow the issuer to deduct interest expense in excess of the cash coupon paid,
although the extra deductions are subject to recapture. In addition, contingent
interest can deter investors from exercising their put or conversion option. Prior to
conversion (or extinguishment) the issuer would continue to deduct interest expense
in excess of the cash coupon paid.
A contingent interest provision in convertible debt typically requires the payment
of additional interest if the instrument’s average trading price is at a specified level
above or below par value. For example, contingent interest in the amount of 25bp
multiplied by the instrument’s trading price will be paid if the average trading price
is above $120. Many contingent interest features become effective only after a
simultaneous put/call date.
A contingent interest feature that meets the definition of a derivative would be
considered clearly and closely related to a debt host when indexed solely to interest
rates and credit risk. However, the trading price of a convertible debt instrument
is a function of more than just interest rates and credit risk due to the embedded
conversion option. As a result, contingent interest features in convertible debt
instruments that are indexed to the instrument’s trading price are generally not
considered clearly and closely related to the debt host and are separated and
accounted for as a derivative. The issuer should monitor the value of the contingent
interest feature and periodically assess its materiality. Many contingent interest
features are not material to the issuer’s financial statements initially. This is more
likely to be the case for a contingent interest feature in an instrument that is callable
and puttable before the contingent interest feature is effective. A contingent interest
feature in an instrument that is not puttable is more likely to have material value.
The determination of the likelihood of paying contingent interest must be consistent
for book and tax purposes. That is, if the issuer determines that the value of the
contingent interest is not material because the likelihood of payment is remote, then
the same assertion should be used when determining if the interest is deductible for
tax purposes. One should question any conclusion that payment of such feature is
remote for book purposes but reasonably possible or probable for tax purposes.
7.10
Instruments Executed in Conjunction with a Convertible Bond
An issuer may execute a number of agreements in connection with the issuance of a
convertible bond. In the following sections we describe some of the more common
agreements. There are several reasons an issuer may choose to enter into these
agreements, however the majority are executed to achieve better pricing for the
convertible bond.
7.10.1
Detachable Warrants
An issuer, typically a high-yield issuer, may bundle convertible debt with detachable
warrants and issue the combined instrument as a unit. When an instrument is issued
Convertible Debt / 7 - 27
in a bundled transaction with warrants, the sales proceeds should be allocated
between the base instrument and the warrants. The allocation of proceeds depends
on the accounting classification of the separate warrant as equity or liability:
• If the warrants are classified as equity, then such allocation is made based upon
the relative fair values of the base instrument and of the warrants following the
guidance in ASC 470-20-25-2.
• If the warrants are classified as a liability, then the sales proceeds are first
allocated to the warrant based on the warrant’s full fair value (not relative fair
value) and the residual amount of the sales proceeds is allocated to the base
security.
If the convertible bond is subject to the beneficial conversion feature (BCF) guidance
in ASC 470-20 the sales proceeds allocated to the convertible instrument is divided
by the contractual number of conversion shares to determine the accounting
conversion price per common share (also called the effective conversion price),
which is used to measure the BCF. See FG section 3.5 for a discussion of BCFs.
7.10.2
Greenshoe (Overallotment Option)
A greenshoe is a freestanding agreement between an issuer and an underwriter that
allows the underwriter to call additional convertible debt instruments to “upsize”
the amount of securities issued. For example, a 20% greenshoe on a $100 million
convertible debt offering allows the underwriter to require the issuer to issue an
additional $20 million of debt at par value. The term “greenshoe” comes from the
name of the company (Green Shoe Manufacturing, which later became Stride Rite
Corporation) that first used such an agreement with its underwriter.
Prior to the issuance of a convertible debt instrument, an underwriter will take
orders from investors. The underwriter will then allocate the base amount plus any
greenshoe amount to the investors. The amount allocated to investors in excess
of the base amount is called an overallotment. One way an underwriter may fill an
overallotment is by exercising the greenshoe. Another way is by buying the newly
issued convertible debt in the open market. An underwriter will rarely exercise its
option if the debt is trading below par value. Instead, the underwriter will buy the
debt in the open market, and in doing so create additional demand, which should
increase the price of the newly issued convertible debt.
There are several types of greenshoes, the most common being an overallotment
option. An overallotment option allows the underwriter to call additional debt from the
issuer only to fill overallotments. The underwriter cannot exercise an overallotment
option and hold or sell the convertible debt for its own account. Other types of
greenshoes allow the underwriter full discretion over the convertible debt received by
exercising their option.
A greenshoe on a publicly traded debt instrument generally will meet the definition
of a derivative. However, since it is an option to call a debt instrument (not the
underlying equity) it is not eligible for the scope exception for certain contracts
involving an issuer’s own equity in ASC 815-10-15-74. As a result, a greenshoe on
public debt is generally accounted for as a derivative at fair value. Greenshoes are
generally short-dated and, as such, may not have a value material to the issuer’s
financial statements; accordingly, the issuer should determine the value and assess
its materiality to determine how to proceed.
7 - 28 / Convertible Debt
A greenshoe on a privately placed debt instrument may not meet the definition of a
derivative if the debt is not readily convertible to cash (FG section 2.3.2.1). In that
case, the greenshoe on privately placed debt would not be separately accounted
for as a derivative. Rather, there would be no accounting until any additional debt
instruments are issued under the greenshoe.
7.10.3
Call Options Overlay (Call Spread, Capped Call)
A call option overlay (call spread, capped call) is a transaction executed between a
convertible bond issuer and an investment bank. They are more commonly executed
in connection with a convertible bond with a cash conversion option, but may also
be executed in connection with a share-settled bond. In a call option overlay, the
issuer buys a call option from the investment bank that mirrors the conversion option
embedded in the convertible bond, effectively “hedging” or canceling the embedded
conversion option. The issuer pays a premium to the investment bank to buy this
option. The issuer then sells a call option to the investment bank, almost always
at a higher strike price than the embedded conversion option and purchased call
option, effectively raising the strike price of the convertible bond transaction. If the
strike price of the sold call option is higher than the strike price of the purchased call
option, the issuer will receive a lower premium from the investment bank for selling
this option.
The primary reasons an issuer may execute a call option overlay transaction are
(1) to receive additional tax benefits and (2) to synthetically raise the strike price on
the convertible bond, which diminishes the likelihood the issuer will have to issue
shares, to a level that would not price efficiently in the convertible bond market. See
FG section 7.10.3.2 for a discussion of the tax considerations.
A call option overlay may be executed as two separate call option transactions—
this is referred to as a call spread—or it can be executed as a single integrated
transaction—this is referred to as a capped call. The issuer must weigh credit, tax,
and EPS considerations in determining whether to execute a call spread or a capped
call.
A call spread and a capped call are accounted for separately from the convertible
bond with which they are issued or associated with. A call spread is accounted for
as two transactions (1) a purchased call option on the company’s own stock and
(2) a written call option on the company’s own stock at a higher strike price, whereas
a capped call is accounted for as a single transaction. See FG section 2.5 for a
discussion of the analysis of freestanding equity-linked instruments. See FG section
7.10.3.1 for a discussion of the EPS treatment, which is different for a call spread and
a capped call.
7.10.3.1
Earnings per Share
A call option overlay is included in diluted EPS based on the form of the transaction.
A capped call generally is not include in diluted EPS because it is anti-dilutive. In a
call spread, however, the purchased call is not include in diluted EPS because it is
anti-dilutive, but the sold call is included in diluted EPS. This can create so called
“double dilution” from the convertible bond and the sold call, if the issuer’s stock
price increases to a level above the strike price on the sold call.
Convertible Debt / 7 - 29
7.10.3.2
Tax Considerations
An issuer can receive additional tax deductions for a call option overlay, if it meets
certain requirements and properly elects to integrate the call option overlay with
the convertible bond, pursuant to applicable Treasury regulations. The specific tax
requirements to achieve integration are quite detailed. Typically, issuers pursuing
this strategy will execute two separate call options in a call spread transaction, and
will only elect to integrate the purchased call, so that they can deduct the premium
paid over the term of the convertible bond. Under this approach, the premium
received for issuing the higher strike call option is not integrated—nor is it included
in taxable income. In order for this strategy to work, the two call options must be
truly separate for tax purposes, which typically requires certain conditions, including
staggered maturity dates, to be met. This aspect of the tax analysis can also be quite
detailed. (If the two options are not separate for tax purposes—e.g., a capped call is
executed—the issuer can only obtain a tax deduction for the net premium paid.)
A deferred tax asset equal to the additional tax deductions that will be taken over the
life of the transaction should be recorded with an offsetting entry to additional paid in
capital.
7.10.4
Share Lending Agreement
Less commonly, a convertible bond issuer may enter into a share lending agreement
with an investment bank. A share lending agreement is intended to facilitate the
ability of investors, primarily hedge funds, to borrow shares to hedge the conversion
option in the convertible bond. Typically they are executed in situations where the
issuer’s stock is difficult or expensive to borrow in the conventional stock borrow
market.
The terms of a share lending arrangement typically require the issuer to issue (loan)
shares to the investment bank in exchange for a small fee, generally equal to the par
value of the common stock. Upon conversion or maturity of the convertible debt,
the investment bank is required to return the loaned shares to the issuer. The shares
issued are legally outstanding, entitled to vote, and entitled to dividends, although
under the terms of the arrangement the investment bank may agree to reimburse the
issuer for dividends received and may agree to not vote on any matters submitted to
a vote of the company’s shareholders.
Under ASC 470-20-25-20A, the fair value of the share lending arrangement should
be recorded at inception as a debt issuance cost with the offset to equity. The debt
issuance cost should be amortized to interest expense over the life of the debt,
increasing the overall “implied” cost of the convertible debt arrangement.
7.10.4.1
Earnings per Share
ASC 470-20-45-2A states that loaned shares are excluded from basic and diluted
earnings per share unless default of the share-lending arrangement occurs, at
which time the loaned shares would be included in the basic and diluted EPS
calculations. If dividends on the loaned shares are not reimbursed to the entity, 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, in a manner consistent with
the two-class method in paragraph ASC 260-10-45-60B.
7 - 30 / Convertible Debt
7.11
How PwC Can Help
Our capital market transaction consultants and Assurance professionals frequently
advise companies regarding the interpretation and application of the accounting
literature to convertible debt, including:
• Whether the embedded conversion option, or other features embedded within the
convertible debt, should be separated and recorded at fair value with changes in
fair value recorded in earnings.
• Whether convertible debt should be bifurcated based on the guidance for
convertible debt with cash conversion options in ASC 470-20. When a convertible
debt instrument does need to be bifurcated, providing advice regarding
performing the calculation, and inputs to the calculation, of the amounts recorded
as debt and equity.
• The appropriate accounting treatment for greenshoes (or over-allotment options),
detachable warrants, call option overlays and other transactions executed in
connection with convertible debt.
• Earnings per share impacts.
• Appropriate disclosure items.
If you have questions regarding the accounting for convertible debt or would like help
in assessing the impact a convertible debt issuance would have on your company’s
financial statements, please contact your PwC engagement partner or one of the
subject matter experts listed in the contacts section at the end of this Guide.
Convertible Debt / 7 - 31
Chapter 8:
Preferred Stock
Preferred Stock / 8 - 1
8.1
Characteristics of Preferred Stock
Preferred stock (also called preferred shares or preference shares) is a class of
ownership in a company that is senior to common stock and subordinate to debt.
The following features are associated with preferred stock:
• In the event of liquidation, preferred stockholders have a priority claim on a
company’s assets over common stockholders, and a subordinate claim to
bondholders and other creditors.
• May be voting or non-voting; some preferred shares may have voting rights for
certain extraordinary events (e.g., take-over of the company, issuance of new
shares).
• Generally receives dividends before common stockholders. The dividend is
usually fixed and may be cumulative or non-cumulative. Dividends typically must
be declared by the board of directors to be distributable.
• May be entitled to receive additional dividends in conjunction with dividends paid
to common shareholders (“participating preferred stock”).
• May be perpetual, mandatorily redeemable on a certain redemption date, or
contingently redeemable either upon occurrence of a certain event or at a point in
time.
• Can be callable at the option of the issuer after a certain period (e.g., 5 years) or
upon extraordinary events (e.g., tax law change, rating agency or capital treatment
events).
• May contain other features, such as put options, exchange rights, increasing
dividends, and conversion options.
In practice, the terms of preferred stock issues can vary widely. A company may
issue several series of preferred stock with different features and different priorities
as to dividends or assets in case of liquidation. Depending on its terms, preferred
stock may be considered a hybrid instrument with characteristics of both equity and
debt.
From the issuer’s perspective, preferred stock is a more expensive form of financing
than debt. The incremental cost comes with some advantages. The issuer may
achieve better credit ratings than with “straight” debt, and the issuance of preferred
stock does not affect control held by the common shareholders (due to the absence
or limitation of voting rights). Dividends may be deferred without credit downgrade,
as opposed to interest on a debt instrument. Preferred stock may also be used to
prevent hostile takeovers by adding a conversion feature, or a feature calling for
forced redemption at a high liquidation value, upon a change in control. One of the
main disadvantages of preferred stock for issuers is that dividends are paid from
after-tax profits (i.e., they are not tax deductible).
From the investor’s perspective, dividends on preferred stock are generally higher
than the interest paid on debt with similar terms due to preferred stock’s lower
seniority claim on assets in case of liquidation. Preferred securities are generally
higher risk than debt securities due to their lower seniority claim in bankruptcy and,
in some cases the lack of a maturity date, which extends the potential term of the
investment. In addition, absent a conversion option, preferred securities have a
8 - 2 / Preferred Stock
lower potential for market price increases, which may make them less attractive
than common stock. The tax treatment to investors differs for an individual and
a corporation. Specifically, a corporate investor is taxed at a lower rate than an
individual.
8.2
Analysis of Preferred Stock
Based on an evaluation of the
redemption and conversion
features, is the instrument a
liability under ASC 480?
(FG sections 8.3 and 8.4)
No
Yes
Analyze if mezzanine equity
classification is required under
ASC 480-10-S99
(FG sections 8.3 and 8.4)
Yes
Classify as a liability
Classify as
mezzanine equity
No
Classify as
permanent equity
Evaluate conversion options (see FG section 8.4.3) and other embedded derivatives to
determine whether they should be accounted for separately. (see Chapter 3 –
Guide to Accounting for Derivative Instruments and Hedging Activities – 2012 edition)
8.3
Redemption Features in Preferred Stock
The first step in determining the accounting treatment of preferred stock is to
determine whether the preferred stock must be accounted for as a liability under ASC
480 (see FG section 2.4). If the preferred shares are not convertible, their redemption
features should be analyzed under ASC 480. Mandatorily redeemable preferred stock
that is not convertible is classified as a liability under ASC 480. Refer to FG section
8.4.2 for a discussion of mandatorily redeemable convertible preferred stock.
If the issuer concludes that the preferred stock should not be accounted for as a
liability under ASC 480, it should be accounted for as equity. The issuer should
then determine whether to present the preferred shares as permanent or mezzanine
equity.
Preferred Stock / 8 - 3
For SEC registrants, ASC 480-10-S99 requires preferred securities redeemable for
cash or other assets to be classified outside of permanent equity (in the “mezzanine”
equity or “temporary” equity section) if their redemption is:
• At a fixed or determinable price on a fixed or determinable date.1
• At the option of the holder.
• Based upon the occurrence of an event that is not solely within the control of the
issuer.
Although the SEC’s guidance is aimed at public entities, we believe that the
mezzanine equity presentation is preferable for a non-public entity’s preferred
securities that meet these criteria.
Various redemption features and their impact on the classification of preferred stock
as a liability, mezzanine, or permanent equity are summarized in the table below and
discussed in more detail in FG sections 8.3.1 through 8.3.3.
Preferred Stock Redemption Features
Type of Redemption Feature
8.3.1
Liability or Equity
Mezzanine or
Permanent Equity
Mandatory Redemption
Contingent Redemption
Liability
Equity
Not Applicable
Mezzanine
No Redemption
(i.e., perpetual preferred stock)
Equity
Permanent
Mandatorily Redeemable Preferred Stock
ASC 480 defines a mandatorily redeemable financial instrument as an instrument
that is issued in the form of shares and embodies an unconditional obligation for the
issuer to redeem the instrument on a specified or determinable date (or dates) or
upon an event that is certain to occur.
Common examples of mandatorily redeemable preferred stock include:
• Preferred stock (non-convertible, or convertible, if conversion option is not
substantive) that must be redeemed on a specified date.
• Preferred stock held by an employee that must be redeemed in the event of the
employee’s death or termination of employment.
• Preferred stock that is redeemable subject to an “adequate liquidity” clause or a
term-extension option. A liquidity provision may affect the timing of the unconditional
requirement for redemption but does not eliminate the redemption requirement.
Mandatorily redeemable preferred stock that is not convertible is classified as a
liability under ASC 480. Refer to FG section 8.4.2 for a discussion of mandatorily
redeemable convertible preferred stock.
The definition of “mandatorily redeemable” specifically excludes instruments that
are redeemable only upon the liquidation or termination of the reporting entity. For
example, if the reporting entity (such as a trust or partnership) has a finite life (e.g.,
25 years) and is to be liquidated at the end of its term, its equity securities are not
1
8 - 4 / Preferred Stock
Preferred stock with a redemption at a fixed or determinable date can be classified as equity if it has a
substantive conversion option (see FG section 8.4).
considered mandatorily redeemable simply because they are redeemed when the
entity is liquidated.
Example 8-1: Preferred Stock Redeemable Upon Liquidation of an Entity
or Death/Termination of a Partner
Background/Facts:
A partnership issues two series of preferred stock with the following redemption
provisions:
• Series A is redeemable upon liquidation of the partnership. The partnership has a
life of 25 years.
• Series B is redeemable upon the death or termination of the partner holding the
shares.
Question:
Are the Series A and Series B shares mandatorily redeemable, requiring liability
classification under ASC 480?
Analysis/Conclusion:
Series A: No, the definition of mandatorily redeemable specifically excludes
instruments that are redeemable only upon the liquidation or termination of the
reporting entity. Assuming Series A does not have any other features that would
require liability classification, it is classified as equity as it is only redeemable upon
liquidation of the partnership.
Series B: No, the partnership is a limited life partnership with a life of 25 years. The
redemption event (death or termination of the partner) is not certain to occur within the
life of the partnership. Assuming Series B does not have any other features that would
require liability classification, it is classified as equity as it is contingently redeemable.
If, however the life of the partnership were 100 years the partner’s equity interest
would be considered mandatorily redeemable as it is based on an event (death or
termination of the partner within 100 years) that is certain to occur.
Example 8-2: Redemption of Preferred Shares Funded by Insurance
Background/Facts:
A partnership with a life of 100 years issues Series B preferred shares which are
redeemable upon the death or termination of the partner holding the shares.
The partnership classifies the shares as a liability because (as discussed in Example
8-1) the shares are considered mandatorily redeemable as the redemption is based on
an event (death or termination of the partner within 100 years) that is certain to occur.
The partnership purchases life insurance policies to cover the cost of the redemption
of the Series B shares upon the death of the partner holding the shares.
Question:
Does the purchase of life insurance to cover the cost of redemption affect the
classification of the Series B preferred shares?
(continued)
Preferred Stock / 8 - 5
Analysis/Conclusion:
No. ASC 480-10-55-64 clarifies that an insurance contract that funds the redemption
of shares does not affect the shares’ classification as a liability.
ASC 480 and SEC guidance differ on this matter. The SEC Staff’s training manual
includes a provision that allows registrants to report as permanent equity instruments
that are mandatorily redeemable upon the death of the holder if the registrant has
purchased life insurance to fund the entire cost of the redemption. However, the
FASB believes that the shares are liabilities regardless of the issuer’s ability to fund
their redemption through insurance proceeds. Therefore, an issuer must classify
as a liability any preferred shares that are a liability within the scope of ASC 480,
regardless of the effects of the insurance policy. Issuers can only consider the effects
of an insurance policy for redeemable securities that are not liabilities within the
scope of ASC 480 (i.e., convertible, redeemable preferred shares).
8.3.2
Contingently Redeemable Preferred Stock
The classification of contingently redeemable preferred securities as equity or
a liability is based on an evaluation of their features. A contingently redeemable
security with substantive conditions for redemption is not considered mandatorily
redeemable. For example, the following instruments are not considered mandatorily
redeemable:
• Preferred stock where the holder has the option to redeem (e.g., preferred stock
with put options or “puttable” stock). In this case, the holder may or may not
exercise the option.
• Preferred stock that is redeemable only if there is a change in control or
successful initial public offering.
Contingently redeemable securities that contain redemption provisions that (1) are
not substantive or (2) affect the timing of the redemption, but do not remove the
redemption requirement, such as an adequate liquidity clause or term-extending
option, are considered mandatorily redeemable and classified as a liability under the
guidance in ASC 480.
The existence of a contractual redemption provision results in mezzanine equity
classification if the redemption is contingent upon the occurrence of a future event
that is outside of the issuer’s control. A probability assessment that a redemption
event’s occurrence is remote cannot overcome the requirement for mezzanine equity
classification.
The SEC Staff has indicated (in ASC 480-10-S99-3A) that it believes ordinary
liquidation events, which involve the redemption and liquidation of all equity
securities, should not result in a security being classified as mezzanine equity.
Example 8-3: Reassessment of Contingently Redeemable Instruments
Background/Facts:
Company A issues Series C perpetual preferred shares that are callable anytime after
year 5 and mandatorily redeemable only upon a change in control of Company A.
(continued)
8 - 6 / Preferred Stock
Question:
Must Company A continually reassess whether the Series C preferred shares are
contingently redeemable (i.e., classified as equity) or mandatorily redeemable (i.e.,
classified as a liability)?
Analysis/Conclusion:
Yes. ASC 480 requires an issuer to assess whether an instrument is mandatorily
redeemable at each reporting period. A contingently redeemable financial instrument
should be reclassified as a liability when the contingent event has occurred or
becomes certain to occur, thus making the instrument unconditionally redeemable.
The Series C preferred shares would initially be classified as equity because
redemption is not unconditional. The occurrence of a change in control event would
require the Series C shares to be reclassified as a liability.
The reclassification is recorded at the instrument’s fair value as a debit to equity and
a credit to liability without any impact on earnings. The difference between the fair
value of the redeemable preferred stock and the carrying value prior to becoming
unconditionally redeemable should be subtracted from (or added to) net income to
arrive at earnings available to common shareholders used in computing basic and
diluted EPS (ASC 260-10-S99).
8.3.3
Perpetual Preferred Stock (No Redemption)
Perpetual preferred stock, by its legal terms, has no contractual redemption
provisions. Absent any conversion or exchange provisions, perpetual preferred stock
would not be classified as a liability under ASC 480.
However, if the perpetual preferred stockholders control the board (or could control
the board as a result of events outside the company’s control, such as a debt default)
and the instrument contains a call option exercisable at the company’s discretion, the
shares would be considered to have a redemption feature. The SEC Staff believes
preferred stock with these attributes contains a substantive redemption feature
allowing the preferred stockholders to force the company to redeem their preferred
stock for cash. This would require mezzanine equity classification despite the
absence of a contractual redemption right.
Example 8-4: Perpetual Preferred Stock with Liquidated Damages
Background/Facts:
Company B issues perpetual preferred shares. The shares provide for liquidated
damages in the event Company B is not able to register the preferred shares within
90 days of issuance, an event that is outside the control of Company B.
Question:
Must the preferred shares be classified as mezzanine equity because Company B
can be required to pay liquidated damages on the preferred shares upon an event
outside its control?
Analysis/Conclusion:
No, a liquidated damage right is not a legal redemption right and payment of such
damages does not result in a legal redemption or settlement of the security. The
(continued)
Preferred Stock / 8 - 7
payment of liquidated damages also does not affect any other rights associated with
the security (e.g., voting rights, conversion rights, etc).
If a security is not otherwise required to be classified as mezzanine equity, the SEC
Staff has generally not required mezzanine equity classification solely as a result of a
liquidated damage clause.
Example 8-5: Increasing Rate Perpetual Preferred Stock
Background/Facts:
Company A issues perpetual preferred stock for which it received proceeds equal to
the par value of the security. The preferred stock pays an at-market dividend rate of
6% for the first 5 years and a dividend rate of 25% thereafter.
The preferred shares contain a call option that allows Company A to call the preferred
shares at par value at the end of year 5 before the dividend rate steps up.
Questions:
Are the preferred shares considered perpetual even though Company A would be
economically compelled to call the shares to avoid paying a very high, off-market
dividend rate?
How would Company A accrue the dividends on the increasing rate preferred stock?
Analysis/Conclusion:
Yes, the shares are perpetual. The shares are not redeemable even if Company
A may be economically compelled to redeem an increasing-rate preferred share.
Further, if a security is not otherwise required to be classified as mezzanine equity,
the SEC Staff has generally not required mezzanine equity classification solely as a
result of an increasing-rate dividend feature since the preferred stockholder cannot
force the company to redeem the security.
Dividends on increasing rate preferred stock are accrued based on the payment
schedule in the guidance in ASC 505-10-S99-7. Therefore, Company A would accrue
6% per share for the first 5 years and 25% therafter until it calls the preferred stock
and retires it.
If an increasing rate preferred stock has a variable dividend, computation of the
dividend should be based on the value of the applicable index at the date of issuance
and should not be affected by subsequent changes in the index until those changes
are effective.
8.4
Conversion Features in Preferred Stock
From the investor’s perspective, one of the main disadvantages of preferred stock
compared to common stock is its limited potential to benefit from increases in the
enterprise value of the issuer. While higher (or lower) earnings expectations lead to
increases (or decreases) in the fair value of common stock, the fair value of preferred
stock is largely unaffected by the company’s performance unless the preferred stock
has a conversion feature.
8 - 8 / Preferred Stock
A conversion feature that allows the holder to convert preferred stock into common
is a mechanism that may be used to eliminate this disadvantage of owning preferred
shares and generally reduces the stated dividend on preferred stock issuances.
When the accounting conversion price of a convertible preferred stock is less than
the market price for the equity into which the instrument is convertible, a beneficial
conversion feature (BCF) likely exists. See FG section 3.5 for discussion of BCFs.
Convertible preferred stock requires liability classification under ASC 480 if it results
in an obligation to issue a variable number of shares with a monetary value based
solely or predominantly on a fixed monetary amount known at inception.
The table below summarizes the impact of various conversion features on the
classification of preferred stock as a liability, mezzanine, or permanent equity. It is
important to note that after the analysis of the impact of the conversion features on
the classification of the preferred stock, the issuer must also assess the appropriate
accounting for the embedded conversion feature (see FG section 8.4.3).
Mezzanine or Permanent Equity
8.4.1
Mandatory Conversion
Redeemable or
Convertible at
the Option of
the Holder
Conversion Feature
Liability or Equity
Fixed number
of shares
Equity
Permanent
Mezzanine
Fixed or variable
number of shares
depending on the
common stock’s
market value
Fact dependent
Mezzanine if there
is no cap on the
number of shares
Mezzanine if
there is no cap
on the number
of shares
Variable number
of shares equal
to a fixed
monetary amount
Liability
N/A
N/A
Non-Redeemable Preferred Stock Convertible into a Fixed or Variable
Number of Shares
The guidance in ASC 480 requires issuers to classify preferred shares that, upon
conversion, will result in the delivery of a variable number of shares that have a value
solely or predominantly based on a fixed monetary amount. This determination is
made upon issuance of the shares and is not reassessed.
Consider the following examples of convertible preferred stock:
• Series A: automatically converts into a fixed number of common shares on a
specified date.
Series A is outside the scope of ASC 480. Although the issuer is obligated
to deliver shares, the share amount is fixed. Series A should be classified as
permanent equity as it is mandatorily convertible into common shares.
• Series B: automatically converts into a variable number of common shares with a
monetary value equal to the par amount (or stated value) of the preferred shares.
The number of shares that the company will issue is based on the par value of the
Preferred Stock / 8 - 9
preferred stock divided by the market price of the common stock on the specified
conversion date.
Series B is within the scope of ASC 480. The Series B shares convert into a
variable number of shares and the monetary value of the obligation is based
solely on a fixed monetary amount (par value of the Series B preferred) known
at inception. Series B should be classified as a liability.
• Series C: automatically converts on a specified date and the number of shares
to be issued depends on the then-current market price of the common stock as
follows:
— If the market price of the common stock is less than $50, the company will
issue 1 share.
— If the market price of the common stock is between $50 and $62.50, the
company will issue a pro rata number of shares between 1 share and 0.8 share.
— If the market price of the common stock is greater than $62.50, the company
will issue 0.8 shares.
Series C is more difficult to analyze under ASC 480. Under the terms
described above:
— The issuer is obligated to issue a fixed number of shares if the stock price is
below $50 (i.e., 1 share) or above $62.50 (i.e., 0.8 shares).
— If the stock price is between $50 and $62.50 the issuer is obligated to issue a
variable number of shares with a value of $50 (i.e., a pro rata number between
1 share and 0.8 shares). Thus, if the stock price is within the range of $50
and $62.50, the holder will receive a variable number of shares with a fixed
monetary value (i.e., $50).
The obligation to issue a variable number of shares for a fixed monetary
amount known at inception is only one of the three possible scenarios.
Therefore, the issuer must evaluate whether the obligation to issue a variable
number of shares is for a predominantly fixed amount known at inception.
The determination of predominance depends on the facts and circumstances
of each issuance, and should involve consideration of:
— The volatility of the company’s stock,
— The stock price at issuance, and
— The range of the stock price at which the company will issue a variable number
of shares for a fixed monetary amount.
If the company determines that the monetary value of the obligation is based
predominantly on a fixed monetary amount known at inception, ASC 480 requires
liability classification of the instrument.
8.4.2
Redeemable Convertible Preferred Stock
Mandatorily redeemable preferred stock, convertible at the option of the investor
into the issuer’s equity prior to its redemption date, is outside the scope of ASC
480 and should be classified as equity. In such cases, the redemption is not certain
to occur since the conversion option could be exercised prior to the redemption
8 - 10 / Preferred Stock
date. However, the instrument requires mezzanine classification as the conversion is
outside the issuer’s control. Consider the following example:
An issuer issues Series D preferred stock that is convertible into a fixed number of
shares and can be:
• Redeemed any time after the fifth anniversary, or
• Converted into common stock by the holder any time before the first redemption
date.
In this example, the Series D preferred stock should be classified as mezzanine
equity securities because the cash redemption feature is outside of the issuer’s
control (i.e., the preferred shareholders can force cash redemption).
8.4.3
Analysis of the Conversion Option
Upon determination of the instrument’s classification, the issuer should determine
whether the conversion option should be separated from the host and accounted for
at fair value.
The first step in the embedded derivative analysis is to determine whether the host
is more akin to debt or equity. For a hybrid instrument issued in the form of a share,
the SEC Staff clarified that the classification of preferred stock as mezzanine equity
is not in and of itself determinative of whether the nature of the host is debt or equity.
The evaluation of the nature of the host should take into consideration the economic
characteristics and risks, based on stated and implied features (ASC 815-10-S99-3).
In remarks at the 2006 AICPA National Conference on Current SEC and PCAOB
Developments, the SEC Staff noted that there are certain attributes that the Staff
believes should be analyzed to determine the nature of the host. These attributes
include (but should not be limited to):
• Redemption provisions in the instrument,
• The nature of the returns (stated rate or participating),
• Mandatory or discretionary returns,
• Voting rights,
• Collateral requirements,
• Whether the preferred stockholders participate in the residual,
• Whether they have a preference in liquidation, and
• Whether the preferred stockholders have creditor rights (i.e., the right to force
bankruptcy).
One of these factors standing alone would not be determinative of the nature of the
host, and therefore judgment is required in making the host determination.
If a hybrid instrument is determined to be akin to equity, the equity conversion option
is not separated because it is considered clearly and closely related to the preferred
stock. See FG section 7.1 for a discussion of convertible debt including convertible
preferred stock determined to be akin to debt.
Preferred Stock / 8 - 11
8.5
Preferred Stock Exchangeable into Debt
Some freestanding preferred stock contains a provision that requires a mandatory
exchange into debt on a stated date. This feature allows the issuer to “swap”
after-tax dividends for tax deductible interest payments. Such instruments are
classified as liabilities under ASC 480.
However, preferred stock with a mandatory exchange-into-debt feature that is
convertible into common shares at the option of the holder is outside the scope
of ASC 480. The investor could convert the preferred stock into common stock
prior to the mandatory exchange date. The instrument would require presentation
as mezzanine equity because it embodies an obligation to redeem for a fixed or
determinable amount that is outside of the issuer’s control.
8.6
Participation Rights
One of the main disadvantages of preferred stock compared to common stock is its
limited potential to benefit from increases in earnings. Participation rights entitle the
holder to receive additional income in conjunction with dividends paid to common
stockholders. Participation rights are a feature that may be used to reduce the
dividend on preferred stock issuances.
If a preferred share is determined to be more akin to equity than debt, a participation
right is considered clearly and closely related to the host equity instrument. If the
preferred stock is more akin to debt, the participation right should be analyzed to
determine if it represents an embedded derivative requiring separate accounting
at fair value under ASC 815 (see Chapter 3—Guide to Accounting for Derivative
Instruments and Hedging Activities—2012 edition). See FG section 8.4.3 for a
discussion of attributes that should be considered in determining whether preferred
stock is more akin to equity or debt.
In addition, participation rights generally require the issuer to include the instrument
in earnings per share using the two-class method of calculating EPS. See FG
section 4.8 for a discussion of participating securities and the two-class method of
calculating EPS.
8.7
Calls and Puts
Due to the higher cost of issuing preferred stock, these instruments are often callable
after a certain period (e.g., after five years). Put options provide investors liquidity
and protection upon the occurrence of specified events. For example, a put option
exercisable upon a fundamental change may be included to give investors the ability
to exit the investment in circumstances in which they may not want to continue to
hold it.
Call and put options may affect the mezzanine classification of the instrument.
For example, call options would trigger mezzanine classification if the preferred
shareholders control or could control the board. Put options would trigger mezzanine
classification if they give the holder the right to require redemption unconditionally, or
upon the occurrence of an event that is not solely within the control of the issuer.
The issuer should also consider whether any call or put options embedded in a
preferred stock host should be separated and accounted for under the guidance in
ASC 815. See FG section 3.3 for a discussion of calls and puts embedded in equity
instruments.
8 - 12 / Preferred Stock
8.8
Tranched Preferred Stock
Tranched preferred stock issuances have become increasingly popular, particularly
in the technology and biotechnology sectors and with start-up companies. A
tranched preferred stock issuance is one in which preferred stock is issued with a
simultaneous contractual commitment, which either (1) requires the company to
issue additional series at a future date or upon occurrence of a specified milestone
or (2) gives investors the option to require the company to issue additional series at a
future date or upon occurrence of a specified milestone.
From the investor’s perspective, tranched financing defers cash funding. Milestones
align the commitment of funds to the company’s performance. From the issuer’s
perspective, tranched preferred stock reduces fundraising efforts and funding risk if
the milestones are achieved.
The issuer must determine whether the right (or commitment) to issue preferred stock
in the future (collectively, the right to issue shares) is a freestanding instrument or a
component embedded in the initial issuance.
As discussed in FG section 2.2, ASC Master Glossary defines a freestanding financial
instrument as:
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.
Since the right to issue shares is typically entered into in connection with the
issuance of the first tranche of preferred stock an issuer typically considers the
provisions in (b) above.
• Are the first tranche of preferred stock and the right to issue shares legally
detachable?
• Are the first tranche of preferred stock and the right to issue shares separately
exercisable?
Freestanding
Indicators
Embedded
Indicators
Can the investor separate its originally issued
preferred shares from any newly issued shares?
Yes
No
Do the originally issued shares remain outstanding
when the right to issue shares is exercised?
Yes
No
Feature
8.8.1
Right to Issues Shares Is a Freestanding Instrument
If the right to issue shares is a freestanding instrument, the issuer must first
determine the appropriate classification of that freestanding right. The classification
affects the methodology for allocating the proceeds to the originally issued preferred
stock and the right to issue shares.
Preferred Stock / 8 - 13
The right to issue shares should first be evaluated under the analysis for certain
freestanding instruments (ASC 480) in FG section 2.4 and then using the model for
freestanding equity-linked instruments in FG section 2.5.
• If it is determined that the right to issue shares should be classified as equity,
the proceeds from the original issuance should be allocated to the originally
issued preferred stock and the right to issue shares using the relative fair value
method. There is no subsequent remeasurement of that right to issue shares if it is
classified as equity.
• If it is determined that the right to issue shares should be classified as an asset or
liability, the proceeds from the original issuance should be first allocated to that
right at fair value, with any remainder allocated to the originally issued preferred
shares. The right to issue shares would be subsequently recorded at fair value
with changes in fair value recorded in earnings.
The allocation of value to the right to issue shares will create a discount from the
par value of the originally issued preferred shares. Any discount may have to be
accreted. See subsequent measurement discussion in FG section 8.9.2.
8.8.2
Right to Issue Shares Is an Embedded Feature
If the right to issue shares is an embedded feature, it should be evaluated to
determine whether it should be separated and accounted for at fair value with
changes in fair value recorded in earnings using the model for embedded equitylinked components in FG section 2.3.
If an embedded right to issue shares must be separated, a discount from the par
value in the originally issued preferred shares will be created. Any discount may have
to be accreted. See subsequent measurement discussion in FG section 8.9.2.
8.9
8.9.1
Preferred Stock Measurement
Initial Measurement
Upon issuance, preferred shares are generally recorded at fair value. If the preferred
shares are issued in conjunction with other securities, such as warrants, and the
other securities that meet the requirements for equity classification, the sales
proceeds from the issuance should be allocated to each security based on their
relative fair values.
8.9.2
Subsequent Measurement
A discount may arise from a preferred stock issuance when it is issued:
• On a stand-alone basis with a fair value less than its redemption value.
• In a bundled transaction with warrants, in which the proceeds are allocated
between the preferred stock and the warrants.
Preferred stock recorded as equity at a value less than its redemption value should
be accreted to its redemption value if the redemption is not solely at the issuer’s
option. Accretion of preferred stock is recorded as a deemed dividend, which
reduces retained earnings and earnings available to common shareholders in
calculating basic and diluted EPS.
8 - 14 / Preferred Stock
• If the security has a stated redemption date, the preferred stock should be
accreted over the period from issuance to the redemption date.
• In the case of preferred stock that is puttable by the investor, the instrument
should be recorded at redemption value at each put date. Any discount from the
redemption value would be recognized over the period from issuance to the first
put date.
• If a preferred stock instrument is redeemable only at the option of the issuer,
the discount from the redemption value is not accreted. The difference between
issuance and redemption value is recognized as a one-time dividend upon
redemption of the instrument.
For mandatorily redeemable instruments classified as liabilities within the scope of
ASC 480, the subsequent measurement should be recognized in one of two ways:
• If both (a) the amount that is to be paid and (b) the settlement date are
fixed, the instrument should be subsequently measured at the present value of
the amount that is to be paid on the settlement date, with interest cost accruing
based on the rate implicit at the inception of the instrument.
Mandatorily redeemable instruments should be recorded at the redemption
amount at the redemption date. Therefore, the stated dividend rate on
mandatorily redeemable instruments with cumulative dividends should
generally be accrued even if the dividend is not declared, as the cumulative
dividends are generally included in the redemption amount. This accounting is
consistent with the guidance in ASC 480-10-S99-2, which requires accretion
or adjustment to the mandatory redemption amount over the period that
begins on the issuance date and ends on the redemption date.
• If either the amount that is to be paid or the settlement date varies as a result
of specified conditions, the subsequent measurement of the instrument should
be based on the amount of cash that would have been paid under the conditions
specified in the contract if a settlement had occurred on the reporting date.
• If the amount to be paid to settle the liability varies, the amortization amount
should be adjusted such that the liability will reach the amount to be paid on the
settlement date.
• If the settlement date varies, the amortization amount and period should be
adjusted to reflect that change.
Changes in the value of the instrument since the previous reporting date should be
recognized as interest expense.
Other instruments classified as liabilities under ASC 480 should be recorded at
fair value with changes in fair value recorded in earnings, unless ASC 480 or other
accounting guidance specifies another measurement method.
8.10
Preferred Stock Dividends
Dividends on preferred stock, whether cumulative or noncumulative, do not accrue to
the preferred shareholders until declared by the directors and should be recorded only
when declared. The terms of a preferred stock contract may require the payment of
periodic dividends and a declaration by the board of directors is not required. In that
case it is appropriate to record the dividend when payment is due as the company is
legally obligated regardless of whether there has been a declaration by the board.
Preferred Stock / 8 - 15
8.11
Conversion into Equity
The conversion of an instrument into common or preferred stock is not an
extinguishment if it represents the exercise of a conversion right that was included
in the original terms of the instrument. In a conversion of convertible preferred stock
pursuant to original conversion terms, the stock is extinguished in exchange for
equity with no impact on retained earnings or EPS.
However, the exchange of common or preferred stock for preferred stock that does
not contain a conversion right in its original terms is considered an extinguishment
(see FG section 8.12).
8.11.1
Conversion Prior to Full Accretion of a Beneficial Conversion Feature (BCF)
Discount
When an instrument with a BCF is converted prior to the full accretion of the
discount created by the BCF, ASC 470-20-40-1 requires a “catch up” charge for
any unamortized BCF amount at the date of conversion. In the case of preferred
stock conversions, such a “catch-up” charge is a deemed dividend charged to
retained earnings. The guidance also requires any other unamortized discounts at the
conversion date to be written off to expense.
In accordance with ASC 470-20-40-2, if the amount of BCF discount amortized
exceeds the amount the holder realized because conversion occurred at an earlier
date, no adjustment should be made to amounts previously amortized.
Example 8-6: Treatment of Unallocated BCF Upon Conversion
Background/Facts:
• On January 2, 2012, Company A sold 1,000 shares of Series A Convertible
Preferred Stock for $10,000. The Series A shares have a stated value of $10/share
and a five year stated life.
• The conversion price is initially $10, subject to adjustment upon the occurrence
of anti-dilution events. Company A concludes that the embedded conversion
features does not require separate accounting as a derivative under ASC 815.
• The market price of common stock at the commitment date (determined to be
January 2, 2012) was $13/share; therefore of the $10,000 of sales proceeds
received for the 1,000 shares of Series A Convertible Preferred Stock, $3,000 was
allocated to additional paid-in capital at issuance for the BCF embedded in the
preferred stock.
• The preferred stock was converted two years after its issuance. At the conversion
date, Company A had $1,800 of unamortized BCF recorded in additional paid-in
capital.
Question:
How is the unamortized discount on the preferred stock accounted for upon
conversion?
Analysis/Conclusion:
ASC 470 requires that unamortized BCF discounts be expensed at the conversion
date. Since the preferred stock was converted prior to the stated redemption date,
the remaining unamortized discount is required to be immediately expensed on the
conversion date.
8 - 16 / Preferred Stock
8.11.2
Induced Conversion
An induced conversion is a transaction in which the issuer induces conversion of
a convertible instrument by offering additional securities or other consideration
(“sweeteners”) to the convertible security holders. Induced conversions are
transactions that:
• Change the conversion privileges if the investor exercised during a limited period
of time, and
• Include all equity securities issuable pursuant to conversion privileges included in
the original terms, regardless of which party initiates the offer or whether the offer
relates to all holders.
ASC 260-10-S99-2 addresses the accounting for induced conversions of preferred
stock. Inducement accounting applies to conversions of convertible preferred
stock regardless of whether the “offer” for consideration in excess of the original
conversion terms is made by the preferred holder rather than the issuer.
For an induced conversion of preferred stock, the fair value of the inducement is a
charge to retained earnings with an offsetting credit to the inducement consideration
as appropriate (e.g., cash, common stock, etc.). The fair value of the inducement is
also reflected in earnings per share. In addition, if such preferred stock was reported
as mezzanine equity, the amount in mezzanine equity is transferred to permanent
equity (common stock) upon conversion.
8.12
Preferred Stock Extinguishment Accounting
When preferred stock is extinguished, the issuer records a preferred stock dividend
equal to the difference between (1) the fair value of the consideration transferred
to the holders of the preferred stock and (2) the carrying amount of the securities
surrendered. The preferred stock dividend could be either an increase to or a reduction
of earnings available to common shareholders, which is used to calculate both basic
and diluted EPS. See FG section 5.8.1 for a discussion of preferred stock modification.
The accounting for extinguishments and modifications of preferred stock classified
as liabilities under the guidance in ASC 480 is the same as that for other debt
instruments. See the debt extinguishment discussion in FG section 5.6.
8.12.1
Extinguishment of Convertible Preferred Stock with a BCF
When a convertible preferred stock is redeemed, the investor does not realize
the value of the BCF; a BCF arises only from a conversion. Therefore, upon the
redemption of preferred stock with a BCF, the BCF amount allocated to additional
paid-in capital at issuance is reversed (debit to equity) which impacts the amounts
recognized in equity and earnings available to common shareholders (i.e., the EPS
numerator). Upon the extinguishment of a convertible preferred stock with a BCF, the
issuer:
• Redeems the BCF through a debit to additional paid-in capital equal to the
amount originally allocated to additional paid-in capital for the BCF,
• Records a reduction in earnings available to common shareholders to the extent
(a) the fair value of the consideration transferred to the holders of the convertible
preferred security is greater than (b) the carrying amount of the convertible
preferred security in the issuer’s balance sheet plus (c) the amount previously
recognized for the beneficial conversion option, and
Preferred Stock / 8 - 17
• Records an increase in earnings available to common shareholders to the extent
(a) the fair value of the consideration transferred to the holders of the convertible
preferred security is less than (b) the carrying amount of the convertible preferred
security in the issuer’s balance sheet plus (c) the amount previously recognized for
the BCF.
8.13
How PwC Can Help
Our capital market transaction consultants and Assurance professionals frequently
advise companies regarding the interpretation and application of the accounting
literature to preferred stock, including:
• Classification (i.e., liability, mezzanine equity or permanent equity) of preferred
stock transactions, including advice regarding the analyses needed to determine
the appropriate classification (e.g., analysis of whether a transaction is
predominantly indexed to a fixed monetary amount).
• Whether embedded components should be separated and recorded at fair value
with changes in fair value recorded in earnings.
• Earnings per share impacts.
• Appropriate disclosure items.
If you have questions regarding the accounting for preferred stock or would like help
in assessing the impact a preferred stock issuance would have on your company’s
financial statements, please contact your PwC engagement partner or one of the
subject matter experts listed in the contacts section at the end of this Guide.
8 - 18 / Preferred Stock
Chapter 9:
Share Issuance Contracts
Share Issuance Contracts / 9 - 1
9.1
Summary of Share Issuance Contracts
In this chapter we describe contracts under which a company sells its own shares
for future delivery using a derivative instrument. These instruments include forward
contracts to sell a company’s own shares, purchased puts, written warrants
(call options), and variable share forward delivery agreements (components of a
mandatory units structure). Such contracts can either require the company to issue
the shares, or give the company or the investor the option to sell or buy the shares,
respectively. The following table summarizes the contracts discussed in this chapter.
Summary of Share Issuance Contracts
Summary of Terms
Issuer agrees to sell a fixed number
of shares to an investor on a specified
date in the future, typically at a
fixed price2
Purchased Put Option
Issuer can sell a fixed number of
shares to an investor on a specified
date or dates in the future or upon the
occurrence of an event, typically
at a fixed price2
Investor can buy a fixed number
of shares on a specified date or dates
in the future or upon the occurrence
of an event, typically at a fixed price2
Issuer’s Option
Issuer agrees to sell a variable number
of shares, based on the issuer’s stock
price or some other variable, to an
investor at a fixed price2 on a specified
date in the future
Mandatory
Warrant/Written Call Option
Variable Share Forward
Delivery Agreement
9.2
Mandatory or Optional
Settlement1
Mandatory
Contract
Forward Sale
Investor’s Option
1
Settlement may involve “gross physical settlement” where the full number of shares underlying the
contract and exercise prices are exchanged or “net settlement” where the unrealized gain or loss on the
contract is settled by the payment of cash or shares.
2
Fixed price agreements typically have provisions where the price may change upon the occurrence of
specific events.
Forward Sale Contract, Purchased Put Option, and Written Call Option
(Warrant) on a Company’s Own Stock
A forward sale contract on a company’s own stock is a derivative instrument
that obligates the holder to buy a specified number of the company’s shares at
a specified date and price. In contrast, purchased puts and written calls on a
company’s own stock are derivative instruments that provide the company (or
holder), with the right, not the obligation, to sell (or acquire), the company’s shares
by a certain date and at a specified price. The company receives a premium from the
holder when it writes a call option on its own stock, and pays a premium to purchase
a put on its own stock. Forward contracts effectively fix the price an investor will pay
for the company’s stock. A call option allows the investor to benefit from favorable
share price movements since whether and when to buy the stock is a choice the
investor makes based on the market price of the stock. These instruments can be
combined with other instruments and structured to include many different types of
features, such as contingencies, which could benefit the company or be used to
attract investors.
9 - 2 / Share Issuance Contracts
The first step in determining the appropriate accounting treatment for a freestanding
instrument involving an issuer’s own shares is to assess whether the instrument is
within the scope of ASC 480 (see FG section 2.4). A physically settled forward sale
contract whereby the issuer delivers a fixed number of its shares for a fixed amount
of cash would typically be excluded from the scope of ASC 480, and therefore would
not be recorded as a liability under that guidance. Similarly, a freestanding written call
option and a purchased put option on a company’s own shares would typically be
excluded from ASC 480. However, the terms of each instrument should be analyzed
carefully. The following instruments would be classified as a liability within the scope
of ASC 480:
• A forward contract to sell a variable number of the issuer’s own shares for a fixed
monetary amount (see FG section 9.3.2),
• A forward contract to sell redeemable preferred shares, since the instrument may
require settlement by the transfer of assets if the underlying preferred stock is
redeemed (see FG section 9.2.1), and
• Warrants (written call options) to sell redeemable shares, since the instrument
may obligate the issuer to transfer assets, albeit it is a conditional obligation (see
FG section 9.2.1).
If the instrument is not within the scope of ASC 480, the next step is to determine
whether it should be classified as (a) equity or (b) a liability (or asset) measured at fair
value with changes in value recorded in earnings. See FG section 2.5 for the analysis
of freestanding equity-linked instruments.
9.2.1
Instruments on Redeemable Shares
Under ASC 480, freestanding financial instruments that at inception embody an
obligation to repurchase the issuer’s equity shares and that require or may require
the issuer to settle by transferring assets are required to be classified as liabilities.
Examples include forward purchase contracts, written put options, and other similar
instruments (but not outstanding equity shares).
A mandatorily redeemable financial instrument is classified as a liability within the
scope of ASC 480. It is an instrument issued in the form of equity that requires the
issuer to redeem it by transferring assets at a specified or determinable date, or upon
an event that is certain to occur (other than liquidation or termination of the reporting
entity).
ASC 480-10-55-33 clarifies that all freestanding warrants (and other similar
instruments) to acquire shares are liabilities if the underlying shares are either
puttable by the holder or mandatorily redeemable. This is because they embody an
obligation by the issuer to repurchase its own shares, and may require a transfer of
assets. Liability classification is required regardless of the timing of the redemption or
the redemption price.
ASC 480-10-25-9 states that the obligation for the issuer to transfer assets includes
both conditional and unconditional obligations. Thus, even if the obligation (due
to the redemption feature embedded in the shares) is conditional, the presence of
any contingencies that may need to be met that would require the issuer to transfer
assets is irrelevant in determining the applicability of ASC 480. Probability is therefore
not a relevant consideration. See FG section 2.4.2 for guidance on the measurement
of these instruments.
Share Issuance Contracts / 9 - 3
Example 9-1: Warrant on Puttable Shares
Background/Facts:
On July 1, 2011, Company A issued warrants on puttable shares, whereby upon
exercise of the warrant, the holder receives shares of common stock that have an
embedded put right. The put right gives the holder the right to put the shares received
to Company A for cash. Each warrant is exercisable at a strike price of $50 per share
until July 1, 2013. Once the warrants are exercised, the shares may be put to the issuer
at their current market value for a two-year period from exercise of the warrant.
Question:
How should Company A classify the warrants upon issuance?
Analysis/Conclusion:
The warrants are within the scope of ASC 480 and should be classified as a liability.
They should be recorded at fair value with changes in fair value recorded in earnings.
The warrants contain a conditional obligation to transfer assets—if the holder
exercises the warrant, receives the shares, and exercises the put option embedded
in the shares, the issuer must pay cash. ASC 480-10-25-9 includes both conditional
and unconditional obligations in determining the appropriate classification of such
instruments. The conditions leading to the transfer of assets is irrelevant in the
analysis of whether the warrants are within the scope of ASC 480.
Moreover, the classification of the underlying shares (which ordinarily would be
temporary equity, once issued) is not considered in determining the classification of
the warrants. Instead, the existence of the put feature in the shares, which allows
the holder to compel the issuer to redeem the shares for cash, is the driver in
determining the classification of the warrants.
9.2.2
Prepaid Forward Sale of a Company’s Own Shares
A prepaid forward contract to sell a company’s own shares is an instrument in which
the company receives cash (or other assets) at inception of the contract to issue
either a fixed or variable number of its equity shares at a future date. A forward
sale contract can be fully prepaid (i.e., the investor delivers substantially all of the
consideration at inception of the contract) or partially prepaid (i.e., the investor
delivers some of the consideration at inception of the contract and the remainder of
the consideration during the life or at maturity of the contract).
In determining the appropriate accounting for a prepaid forward sale of a company’s
own shares, the issuer must first consider whether the contract is fully or partially
prepaid as the application of the accounting literature differs. Generally, a prepaid
forward contract would be considered
• Fully prepaid if the investor delivers consideration equal to or greater than 90% of
the forward purchase price at inception of the contract, and
• Partially prepaid if the investor delivers consideration less than 90% of the forward
purchase price at inception of the contract.
Forward contracts on a company’s own shares should be included in diluted EPS
using the treasury stock method (see FG section 4.4). For a fully prepaid forward sale
contract, there are no proceeds received upon exercise or settlement of the contract
9 - 4 / Share Issuance Contracts
(the proceeds are paid at inception). This results in incremental shares that are
included in diluted EPS equal to the full number of shares issuable under the forward
contract.
In addition, if the prepaid forward contract is to issue a fixed number of shares it is
generally appropriate to show the shares as outstanding for basic EPS purposes.
The number of shares to be issued is known and they are issuable for no additional
consideration.
9.2.2.1
Fully Prepaid Forward Sale of a Company’s Own Shares
A fully prepaid forward sale contract is a hybrid instrument comprising (1) a debt host
instrument and (2) an embedded forward sale contract. As discussed in FG section
2.1, embedded features are not within the scope of ASC 480. Therefore, the issuer
would apply the guidance in ASC 480 (see FG section 2.4) to determine whether the
contract as a whole meets the requirements for liability classification, but would not
separately analyze the embedded forward sale contract using the guidance in ASC
480. Generally, a fully prepaid forward sale of a company’s own shares would not be
a liability under the guidance in ASC 480.
If the prepaid forward sale contract is not within the scope of ASC 480, the guidance
in FG section 2.3 should be applied to determine whether the embedded forward
sale contract (1) meets the own equity scope exception in ASC 815-10-15-74, and
thus should not be separated or (2) should be separated and accounted for at fair
value with changes in fair value recorded in earnings.
9.2.2.2
Partially Prepaid Forward Sale of a Company’s Own Shares
A partially prepaid forward sale contract is a freestanding instrument that must
be evaluated to determine whether it is a liability within the scope of ASC 480.
Therefore, the issuer would analyze the contract using the guidance in ASC 480
(see FG section 2.4). Generally, a partially prepaid forward sale of a company’s own
shares would not be a liability under the guidance in ASC 480.
If the prepaid forward contract is not within the scope of ASC 480, the guidance in
FG section 2.5 should be applied to determine whether it should be classified as (a)
equity or (b) a liability measured at fair value with changes in fair value recorded in
earnings.
9.3
Units Structures
Units structures are bundled instruments that typically involve debt securities that
are issued along with a share issuance derivative contract, such as a detachable
written call option or a forward sale on a variable number of shares (see FG section
9.3.2). In units structures, companies issue separate instruments together in a single
transaction to meet its financing objectives, meet its investors’ objectives, or for tax
purposes. This section discusses two main types of units structures: (a) debt issued
with detachable warrant, and (b) mandatory units.
9.3.1
Debt Issued with Detachable Warrants
Debt is commonly issued with detachable warrants that allow the investor to
purchase shares of the company at a fixed price. Issuing warrants along with the
debt in a bundled transaction results in a lower interest rate on the debt, since
the investor is also receiving an option to participate in the economic rewards
Share Issuance Contracts / 9 - 5
(with limited downside risks) of being an equity holder. Because the warrants are
detachable and may be sold or exercised independently of holding the debt, they are
considered freestanding (see FG section 2.2).
The appropriate accounting treatment for the issued warrants is determined by
whether they are classified as (a) equity or (b) a liability (see FG section 2.5). If the
warrants are classified as equity, proceeds are allocated to the warrants on a relative
fair value basis and they are not remeasured subsequently; in contrast, if they are
accounted for as liabilities, they are recorded at fair value with changes in fair value
recorded in earnings.
Whether the warrant is accounted for as equity or a liability also impacts the initial
measurement of the issued debt. As discussed in FG section 3.4, if the warrants are
classified as a liability, the sales proceeds received from the issuance of the bundled
transaction are first allocated to the warrants based on their full fair value, and the
residual amount of the sales proceeds is allocated to the debt security. In contrast, if
the warrants are classified as equity, the allocation is made based on the relative fair
values of the debt security and the warrants. The determination of the initial carrying
amount of the debt security is important because it will determine the appropriate
discount to record on the debt, which is accreted through interest expense up to its
par amount using the effective interest method. The degree of the discount may also
impact the evaluation of other features of the debt such as embedded derivatives.
9.3.1.1
Repurchase of Debt with Detachable Warrants
When an issuer extinguishes debt with detachable warrants, such as through an
open market repurchase of the securities, it must allocate the repurchase price (cash
and fair value of the common stock) to the debt security and the warrants using a
relative fair value allocation.
• The portion of the repurchase price attributable to the debt security is used to
calculate any gain or loss on debt extinguishment. A gain on extinguishment
is recognized in earnings if the amount allocated to the debt is less than the
carrying value. See FG section 5.6 for further discussion of debt extinguishment
accounting.
• The portion of the repurchase price attributable to the warrant(s) is recorded
as a reduction of additional paid-in-capital. There is no loss recognized when
a common equity instrument is retired provided the issuer does not convey
additional rights and privileges that require recognition of income or expense.
9.3.2
Mandatory Units
Mandatory units are equity-linked financial products, often marketed under different
proprietary names by different financial institutions, (e.g., ACES, PRIDES, or DECS).
Typically, a mandatory unit consists of a bundled transaction comprising both (a)
term debt with a remarketing feature and (b) a detachable forward purchase contract
that obligates the holder to purchase shares of the company’s common stock at a
specified time and at a specified price before the maturity of the debt. The number of
shares to be received by the holder is based on the market price of the issuer’s stock
on the settlement date of the contract (“variable share forward delivery agreement”).
Typically the terms of the debt issued as part of a mandatory units structure include:
• The debt has a stated principal amount equal to the settlement price of the
variable share forward delivery agreement and is pledged to secure the holder’s
9 - 6 / Share Issuance Contracts
obligation to pay the settlement/exercise price of the variable share forward
delivery agreement.
• The debt has a fixed maturity (generally, five years) with a “remarketing”
(described below) that occurs in proximity to the maturity date of the variable
share forward delivery agreement (generally, three years).
• The interest rate is a fixed rate for the period from issuance to the remarketing
date.
• If the remarketing is successful, the debt is sold to new investors at the market
rate for debt with the remaining term to maturity (generally, two years). The
debt must be sold for an amount at least equal to the settlement price of the
variable share forward delivery agreement. If the remarketing does not result
in a successful sale of the term debt at the minimum required price (failed
remarketing), then the term debt would be delivered to the issuer. This deliverance
would be considered satisfaction of the settlement price under the variable share
forward delivery agreement. Generally, the interest rate an issuer will pay upon
remarketing is not capped, making a failed remarketing less likely to occur.
The number of shares issued under the variable share forward delivery agreement will
depend on the price of the underlying stock at the end of the contract. For example:
If the stock price is:
Less than $50
Between $50 and $62.50
Greater than $62.50
The company issues:
1 share
A pro rata number of shares between 1 share and 0.8
equal to a fixed dollar amount of $50
0.8 shares
The price paid by the investor is $50.
As such, the variable share forward delivery agreement is an instrument that
comprises three features:
• A purchased put on the company’s own shares (a put on one share with an
exercise price of $50),
• A written call option on the company’s own shares (a call on 0.8 shares with an
exercise price of $62.50), and
• An agreement to issue the company’s own shares at their prevailing fair values (if
the share price is between $50 and $62.50).
Because the variable share forward delivery agreement is entered into separately and
is legally detachable from the issued debt, it is considered a freestanding instrument
and accounted for separately from the debt. Refer to FG section 2.2 for additional
discussion on the analysis of whether an instrument is considered freestanding or
embedded.
The variable share forward delivery agreement must then be analyzed to determine
whether it should be classified as a liability per ASC 480-10-25-14(a). Under that
guidance, an instrument to deliver a variable number of shares is classified as a
liability if, at inception of the contract, the monetary value of the obligation is based
solely or predominantly on a fixed monetary amount known at inception. In this
example, the company only issues a variable number of shares for a fixed monetary
amount if the share price is between $50 and $62.50. An assessment therefore
Share Issuance Contracts / 9 - 7
must be made to determine whether the possibility of settling within that range is
“predominant.” Judgment may be required; factors to consider include the following:
• The volatility of the company’s stock,
• The stock price at issuance, and
• The range of the stock price at which the company will issue a variable number of
shares for a fixed monetary amount.
If the variable share forward delivery agreement is not within the scope of ASC 480,
the next step is to determine whether it should be classified as (a) equity or (b) a
liability (or asset) measured at fair value with changes in value recorded in earnings
(see FG section 2.5).
9.3.2.1
Contract Payments Paid by the Issuer
Typically, the investor in a mandatory units structure receives quarterly payments
comprising both (a) interest on the debt and (b) “contract payments” on the variable
share forward delivery agreement. The contract payments result from the fact that
the purchased put in the variable share forward delivery agreement has a greater
value than the written call, resulting in a net premium paid on a net purchased put on
the company’s own stock. Rather than paying the premium upfront to the investor,
the issuer pays the premium over time in the form of these contract payments.
Assuming the forward contract will be treated as an equity instrument, the issuer
should account for the obligation to make the contract payments as a liability
measured at the present value of the payments over the life of the variable share
forward delivery agreement. The liability is subsequently accreted using the effective
interest method over the life of the variable share forward delivery agreement.
Example 9-2: Accounting for Mandatory Units
Background/Facts:
Company A issues 10 mandatory units to investors. Each mandatory unit has a
stated par value of $1,000 and consists of the following:
• A five-year debt security of Company A with an initial rate of 4.5%, paid quarterly,
for the first thirty-three months. At the end of thirty-three months, the debt security
will be remarketed and the interest rate will reset to the market rate demanded by
investors for the remaining life of the debt.
• A three-year variable share forward delivery agreement under which at maturity,
each investor will pay Company A $1,000 and get a variable number of shares
depending on Company A’s stock price at the maturity date, as summarized
below:
If the stock price is:
Less than $50
Between $50 and $62.50
The company issues:
20 shares
A pro rata number of shares equal
to a fixed dollar amount of $1,000
Greater than $62.50
16 shares
(continued)
9 - 8 / Share Issuance Contracts
• Company A will pay a 1.00% per annum contract payment on the variable share
forward delivery agreement.
• Company A’s common stock has a $1.00 par value.
Company A determines that the debt and the variable share forward delivery
agreement should be accounted for separately. In addition, Company A concludes
that the variable share forward delivery agreement should be accounted for as an
equity instrument (see FG sections 2.4 and 2.5).
Upon remarketing, the interest rate on the debt resets to 3.8%. At settlement of the
variable share forward delivery agreement, Company’s A stock price is $65.00.
Question:
What are the journal entries to record (1) issuance of the mandatory units, (2) periodic
entries over the life of the instrument, (3) the debt remarketing, (4) maturity of the
variable share forward delivery agreement, and (5) maturity of the issued debt?
Analysis/Conclusion:
1. Issuance of the mandatory units. Record (a) cash proceeds from the issuance
of 10 mandatory units, (b) the issued debt, (c) the contract payments at their
present value based on the company’s three year financing rate, and (d) the fair
value of the variable share forward delivery agreement to equity.
Dr Cash
Dr Equity—APIC
Cr Debt (Note payable)
Cr Debt (Contract payments)
$10,000
$275
$10,000
$275
Note: Since the forward contract is deemed to be a freestanding instrument
and classified within equity, proceeds received ($10,000) are allocated to the
debt and equity instruments on a relative fair value basis. In this case, the fair
value of the forward contract is $0. However, a financing of $275 is imputed
based upon the present value of the contract payments discounted at the
company’s three year financing rate. These contract payments are treated as
a corresponding reduction of equity as premiums on purchased options on a
company’s own stock (classified as stockholder’s equity).
2. Periodic entries over the life of the instrument. Record (a) quarterly interest
expense of $112.50 ($10,000 x 4.5% x 1/4), and (b) cash paid under the contract
obligation along with interest expense using the effective interest method.
a. Dr Interest expense
Cr Cash
b. Dr Debt (Contract payment)
Dr Interest expense
Cr Cash
$112.50
$112.50
$23
$2
$25
3. Upon debt remarketing. Record quarterly interest expense of $95 ($10,000 x
3.8% x 1/4) upon remarketing for the remaining life of the instrument.
Dr Interest expense
Cr Cash
$95
$95
(continued)
Share Issuance Contracts / 9 - 9
4. Upon maturity of the variable share forward delivery agreement. Record (a)
the issuance of shares at par value (10 units x 16 shares per unit x $1.00 par value
= $160) and (b) proceeds received upon settlement of the variable share forward
delivery agreement.
a. Dr Cash
Cr Equity—Par Value
Cr Equity—APIC
$10,000
$160
$9,840
5. Upon maturity of the issued debt. Record cash paid upon redemption of the
notes.
a. Dr Debt (Note payable)
Cr Cash
9.3.2.2
$10,000
$10,000
Repurchase of Mandatory Units
When an issuer extinguishes mandatory units, such as through an open market
repurchase of the securities, the accounting treatment depends on whether the
variable share forward delivery agreement is economically an asset or liability to the
issuer. For example, using the terms in Example 9-2:
• If the issuer’s stock price were $40, it would be required to deliver 20 shares of
its stock with a fair value of $800 in exchange for $1,000 in cash; therefore the
variable share forward delivery agreement is economically an asset to the issuer.
• If the issuer’s stock price were $75, it would be required to deliver 16 shares of
its stock with a fair value of $1,200 in exchange for $1,000 in cash, therefore the
variable share forward delivery agreement would be a liability to the issuer.
The contract payment liability discussed in FG section 9.3.2.1 constitutes an
additional liability that should be included in the debt extinguishment analysis
discussed below.
If the variable share forward delivery agreement is economically a liability to the
issuer, the accounting for a repurchase of mandatory units is the same as the
accounting for debt with detachable warrants. The repurchase price (cash and fair
value of the common stock) is allocated to the debt security and components of the
variable share forward delivery agreement using a relative fair value methodology.
• A gain or loss on extinguishment equal to the difference between (1) the amount
allocated to the debt and (2) the carrying value is recognized in earnings. See FG
section 5.6 for further discussion of debt extinguishment accounting.
• The portion of the repurchase price attributable to the variable share forward
delivery agreement is recorded as a reduction of additional paid-in capital. There
is no loss recognized when a common equity instrument is retired provided the
issuer does not convey additional rights and privileges that require recognition of
income or expense.
If, however, the variable share forward delivery agreement is economically an asset
to the issuer, we believe the issuer should take into consideration the fact that the
investors are relieving themselves of a liability. One method of doing this is to record:
• A gain or loss on extinguishment equal to the difference between (1) the
consideration paid plus the fair value of the variable share forward delivery
9 - 10 / Share Issuance Contracts
agreement and (2) the carrying value of the debt. See FG section 5.6 for further
discussion of debt extinguishment accounting.
• The portion of the repurchase price attributable to the variable share forward
delivery agreement (used in calculating the gain or loss on extinguishment) is
recorded as an increase in additional paid-in capital.
There may be other acceptable methods of performing this calculation.
9.3.3
EPS Considerations
The diluted EPS treatment of a units structure depends on whether the debt can be
tendered to satisfy the investor’s payment of the exercise price for the share issuance
derivative.
ASC 260-10-55-9 specifies that instruments that require or permit the tendering
of debt in satisfaction of the exercise price should be included in diluted EPS by
assuming (1) the share issuance is exercised and (2) the debt is tendered.1 This
method results in EPS dilution similar to the use of the if-converted method (see FG
section 4.3).
If the debt cannot be tendered to satisfy the investor’s payment of the exercise price
for the share issuance derivative, the instrument is included in diluted EPS as follows:
• The coupon on the debt instrument is included as interest expense and a
reduction of earnings available to common shareholders, and
• The share issuance derivative is included as a potentially issuable common share
using the treasury stock method (see FG section 4.4)
Typically, the base security in the units offering will be remarketed at some point
prior, but close, to the maturity of the share issuance contract. For example, the debt
security may have a five year life, with a remarketing after 2.75 years, and the share
issuance contract will mature at the end of 3 years. Most securities allow the investor
to use the debt to satisfy the exercise price of the share issuance derivative in the
event of a failed remarketing.
Thus, in determining the method for including a units structure in diluted EPS, an
issuer must consider whether the debt can be used to satisfy the exercise price (1)
unconditionally or (2) upon a failed remarketing. If the debt is usable only upon a
failed remarketing, then provided a successful remarketing is probable of occurring,
use of the treasury stock method is generally appropriate.
How PwC Can Help
Our capital market transaction consultants and Assurance professionals frequently
advise companies regarding the interpretation and application of the accounting rules
for share issuance transactions, including:
• Classification (i.e., liability or equity) of share issuance transactions, including
advice regarding the analyses needed to determine the appropriate classification
(e.g., analysis of whether a transaction is predominantly indexed to a fixed
monetary amount).
1
Interest (net of tax) on any debt assumed to be tendered is added back as an adjustment to the
numerator of the diluted EPS calculation.
Share Issuance Contracts / 9 - 11
• Earnings per share impacts.
• Appropriate disclosure items.
If you have questions regarding the accounting for share issuance transactions or
would like help in assessing the impact a share issuance transaction could have on
your company’s financial statements, please contact your PwC engagement partner
or one of the subject matter experts listed in the contacts section at the end of this
Guide.
9 - 12 / Share Issuance Contracts
Chapter 10:
Derivative Share Repurchase Contracts
Derivative Share Repurchase Contracts / 10 - 1
10.1
Summary of Share Repurchase Contracts
In a share repurchase (or stock buyback) a company distributes cash to existing
shareholders to reacquire a portion of the company’s outstanding stock. The
company can retire the reacquired shares or hold them as treasury stock. Share
repurchases:
• Reduce cash,
• Reduce equity, and
• Reduce the number of common shares outstanding, which generally increases
earnings per share.
There are many ways to execute a share repurchase, such as:
• An open market repurchase program, which involves an issuer simply purchasing
shares in the market along with all other prospective buyers and sellers.
• Privately negotiated stock repurchases with individual shareholders.
• Derivative share repurchase contracts such as (1) a forward repurchase, (2) a
written put option, or (3) an accelerated stock repurchase (ASR) program.
This chapter discusses the recognition and measurement of derivative share
repurchase contracts. The following table summarizes, at a high level, the
instruments discussed in this chapter.
Summary of Share Repurchase Contracts
Contract
Summary of Terms
Mandatory or Optional
Share Repurchase
Forward Repurchase
Company agrees to purchase shares,
in exchange for cash, on a specified
date in the future.
Mandatory
Written Put Option
Company must buy shares at a fixed
price if its stock price falls below a
specified level.
Counterparty’s Option
Prepaid Written Put Option
Company pays cash at inception of
the contract. At maturity:
• If the stock price is above a
specified level the company will
receive a fixed amount of cash or
a variable number of shares with a
monetary value equal to the fixed
cash amount.
• If the stock price is below the
specified level it will receive a fixed
number of shares.
Counterparty’s Option
Accelerated Stock
Repurchase (ASR)
Company pays cash at inception and
receives shares. The final purchase
price is determined by an average
market price over the life of the
contract. The difference between the
initial and final purchase price can
be settled in cash or shares at the
company’s option.
Mandatory
10 - 2 / Derivative Share Repurchase Contracts
10.2
Forward Repurchase of a Company’s Own Stock
A forward repurchase contract on a company’s own stock obligates the company
to buy its own shares at a future date. Generally, forward contracts on a company’s
own stock are physically settled (the company receives the shares and pays the
price agreed with the counterparty) as this form of settlement allows the company
to achieve the objective of buying its own shares. See FG section 10.2.1 for a
discussion of the accounting for a physically settled forward repurchase contract.
Forward repurchase contracts can also be settled net in cash (the party with a loss
delivers to the party with a gain a cash payment equal to the gain and no shares are
exchanged) or settled net in the company’s shares (the party with a loss delivers
to the party with a gain shares with a current fair value equal to the gain). However,
these settlement options are typically not used when the company’s objective
is to reacquire its shares, since the company would not receive shares under
either of these settlement options and could be required to issue shares. See FG
section 10.2.2 for a discussion of the accounting for a net cash or net share settled
repurchase contract.
10.2.1
Physically Settled Forward Repurchase
Physically settled forward repurchase contracts, in which an issuer will repurchase a
fixed number of its shares in exchange for cash, should initially be measured at the
fair value of the shares at the contract’s inception (the spot price of the shares at that
date), adjusted for any unstated rights or privileges. At the inception of a physically
settled forward repurchase contract, the issuer should reduce equity and recognize a
liability for the fair value of the shares. Essentially these contracts are accounted for
as financed purchases of treasury stock.
The subsequent measurement of a physically settled forward repurchase contract
depends on whether the amount to be paid and the settlement date are fixed or can
vary.
If both (a) the amount to be paid and (b) the settlement date are fixed, the liability
should be accreted to the amount to be paid on the settlement date. Interest cost
should accrue based on the implicit interest rate at inception of the instrument
(generally the difference between the spot price at the inception of the contract and
the contractually agreed upon forward price).
If either (a) the amount to be paid or (b) the settlement date varies based upon
specified conditions, ASC 480-10-35-3 requires the instrument to be subsequently
measured at the amount of cash that would have been paid under the conditions
specified in the contract if a settlement had occurred on the reporting date.
• If the amount to be paid to settle the liability varies, the amortization amount
should be adjusted such that the liability will reach the amount to be paid on the
settlement date.
• If the settlement date varies, the amortization amount and period should be
adjusted to reflect that change.
Changes in the value of the instrument since the previous reporting date should be
recognized as interest expense.
Derivative Share Repurchase Contracts / 10 - 3
Example 10-1: Physically Settled Forward Repurchase
Background/Facts:
On July 1, 2011, Company A enters into a forward repurchase contract with Bank B.
Under the terms of the forward contract Company A is obligated to purchase 1,000
shares of its own stock at a price of $125 per share on June 30, 2012. Company A’s
stock price is $122.50 on July 1, 2011; therefore, there is a 2.00% financing cost
associated with this forward contract.
Question:
What are the journal entries to record (1) commencement of the forward contract, (2)
periodic interest over the life of the contract, and (3) maturity of the forward contract?
Analysis/Conclusion:
1. Commencement of the forward contract. Record a reduction in equity equal
to the fair value of the shares (spot price) and a corresponding liability for the
obligation to deliver cash under the forward contract.
Dr Equity1
Cr Forward contract liability
$122,500
$122,500
2. Periodic interest over the life of the contract. Record interest expense for the
2.0% implicit financing cost in the forward contract using the effective interest
method.
Dr Interest expense
Cr Forward contract liability
$
2,500
$
2,500
3. Maturity of the forward contract. Record the payment of cash to settle the
forward contract liability and reclassify the equity entry from APIC to treasury
stock to reflect the share delivery.
1
10.2.1.1
Dr Forward contract liability
Cr Cash
$125,000
Dr Treasury stock
Cr Equity1
$122,500
$125,000
$122,500
This can either be a separate line item within shareholder’s equity or included in additional paid-in
capital (APIC). If it is included in APIC, the company should disclose that fact in the financial statement
footnotes and separately identify amounts in the statement of changes in shareholder’s equity.
Earnings per Share Considerations
The shares underlying a physically settled forward repurchase contract should be
treated as treasury stock for purposes of calculating both basic and diluted EPS.
10.2.2
Net Cash or Net Share Settled Forward Repurchase
A forward repurchase contract that permits or requires net cash or net share
settlement (as opposed to a forward repurchase contract that only permits physical
settlement as discussed in FG section 10.2.1) is classified as a liability (or asset) and
measured initially and subsequently at fair value with changes in fair value recorded
in earnings. Classification as an asset or liability depends on the fair value of the
contract at the reporting date.
10 - 4 / Derivative Share Repurchase Contracts
Such forward contracts are within the scope of ASC 480, which requires that a
company classify the following freestanding financial instruments as liabilities (or in
some cases, assets):
• Obligations that require or may require repurchase of the issuer’s equity shares
by transferring assets (e.g., written put options and forward purchase contracts
[unless they can only be settled physically as discussed in FG section 10.2.1]),
and
• Certain obligations where at inception the monetary value of the obligation is
based solely or predominantly on variations inversely related to changes in the
fair value of the issuer’s equity shares, for example, a written put that could be net
share settled.
See FG section 2.4 for further discussion of ASC 480.
10.3
Written Put Option on Own Shares
When a company writes a put option on its own shares, it agrees to buy the shares
from a counterparty, generally in exchange for cash, when its share price falls below
a specified price. In return, the counterparty pays the company a premium for
entering into the written put option. Generally, a put option has a strike price below
the share price at inception (i.e., it is out-of-the-money). A written put option can be
either a postpaid contract or a prepaid contract, as described below.
Postpaid
• The company pays cash equal to the put strike price x the number of shares when
and if the counterparty exercises the put option.
• The counterparty pays the company the put premium either (1) at inception, (2)
over the life of the put option, or (3) upon exercise or maturity of the option.
Prepaid
• The company pays cash generally equal to the strike price x the number of shares
at inception.
• If the company’s share price is below the put strike price upon exercise, the
counterparty will deliver a fixed number of shares to the company. Generally the
strike price is adjusted from the at-market price to incorporate the payment of (a)
interest on the cash prepayment and (b) a put premium to the company from the
counterparty.
• If the company’s share price is above the put strike price upon exercise, the
counterparty will deliver a cash payment to the company equal to (a) the amount
paid by the company at inception, plus (b) interest on the cash prepayment, plus
(c) the put premium.
10.3.1
Postpaid Written Put Option
A postpaid written put option is generally settled (if exercised) in one of three ways:
• Physical settlement—the company delivers cash equal to the put strike price x the
number of shares underlying the put option and receives the shares in return.
Derivative Share Repurchase Contracts / 10 - 5
• Cash settlement—the company delivers cash equal to (1) the difference between
the company’s share price upon exercise of the put option and the put’s strike
price, multiplied by (2) the number of shares underlying the option.
• Net share settlement—the company delivers a variable number of shares with a
then current value equal to the cash settlement value.
Regardless of the form of settlement, a postpaid written put option is classified as
a liability measured initially and subsequently at fair value with changes in fair value
recorded in earnings because it is a liability within the scope of ASC 480. Fair value
accounting is required even if the postpaid written put option does not meet the
definition of a derivative instrument in ASC 815. ASC 480 requires that a company
classify certain freestanding financial instruments as liabilities (or in some cases,
assets):
• Obligations that require or may require repurchase of the issuer’s equity shares
by transferring assets (e.g., written put options and forward purchase contracts
[unless they can only be settled physically as discussed in FG section 10.2.1]),
and
• Certain obligations where at inception the monetary value of the obligation is
based solely or predominantly on variations inversely related to changes in the
fair value of the issuer’s equity shares, for example a written put that could be net
share settled.
See FG section 2.4 for further discussion of ASC 480.
In determining how to include a postpaid written put option in diluted EPS, an
issuer must determine whether cash or share settlement of the put option should
be assumed. See the discussion of instruments settlable in cash or shares in FG
section 4.5.
• If the written put option is assumed to be settled in cash, there are no adjustments
to the numerator (i.e., the change in fair value recorded in earnings remains in
the numerator) or denominator of the diluted EPS calculation as compared to the
basic EPS calculation.
• If the written put option is assumed to be settled in shares, the following
adjustments are made to the basic EPS calculation when calculating diluted EPS,
if the effect is dilutive (1) the change in fair value recorded in earnings is reversed
from the numerator and (2) the shares issuable under the written put option
(calculated by applying the reverse treasury stock method described in ASC 26010-45-35 through 45-36) are included in the denominator.
10.3.2
Prepaid Written Put Option
Generally, a prepaid written put option is not a liability within the scope of ASC 480.
To settle a fully prepaid written put option, a company is not obligated to deliver
any value (cash, other assets, or shares); the company made its cash payment at
inception of the put option. If the company has no further obligation to pay cash (or
other assets) in the future under any circumstances, a prepaid written put option is
outside the scope of ASC 480. Further, since ASC 480 does not apply to embedded
components, a company should not separately analyze the written put option
embedded in a prepaid written put option agreement using the guidance in ASC 480.
10 - 6 / Derivative Share Repurchase Contracts
If a prepaid written put option is not within the scope of ASC 480, the next step is to
determine whether it should be classified as (a) equity or (b) an asset measured at
fair value with changes in fair value recorded in earnings. See FG section 2.5 for the
analysis of a freestanding equity linked instrument.
A prepaid written put option is anti-dilutive and, as such, is not included in the
calculation of diluted EPS (see FG section 4.2).
10.4
Accelerated Share Repurchase (ASR) Programs
An accelerated share repurchase (ASR) program is a transaction executed by a
company with an investment bank counterparty that allows the company to buy a
large number of shares immediately at a purchase price determined by an average
market price over a period of time. The average market price is generally the volume
weighted average price (VWAP), which is an objectively determinable market price.
One of the primary objectives of an ASR is to enable the company to execute a large
treasury stock purchase immediately, while paying a purchase price that mirrors the
price achieved by a longer-term repurchase program in the open market.
In its most basic form, an ASR program comprises the following two transactions:
• A treasury stock purchase in which the company buys a fixed number of shares
and pays the investment bank counterparty the spot share price at the date of the
repurchase, and
• A forward contract under which the company either receives or delivers cash or
shares (generally at the company’s option) at the specified maturity date of the
forward contract. The company receives value (equal to the difference between
the VWAP over the term of the contract and the spot share price multiplied by
the number of shares purchased) from the bank if the VWAP is less than the spot
share price paid at inception, and delivers value to the bank if the VWAP is greater
than the spot share price paid at inception.
However, many ASR programs executed today have terms that vary from this basic
transaction (e.g., many ASRs have a variable maturity date, rather than a fixed
maturity date) and include additional features (such as a cap or collar) that are quite
common but may complicate the accounting analysis that must be performed. The
terms or features that may vary among ASR transactions include:
• Fixed Dollar or Fixed Share
— In a fixed dollar ASR the proceeds paid by the company are fixed and the
number of shares received varies based on the VWAP.
— In a fixed share ASR the number of shares purchased is fixed and the amount
paid for those shares varies based on the VWAP.
• Variable Maturity or Fixed Maturity
— In a variable maturity ASR, the investment bank has the option to choose the
maturity date of the ASR, subject to a minimum and maximum maturity. The
investment bank pays a premium (which generally takes the form of a discount
on the share repurchase price) for this option.
— A fixed maturity ASR has a stated maturity date.
Derivative Share Repurchase Contracts / 10 - 7
• Uncollared, Capped, or Collared
— In an uncollared ASR the company participates in all changes in VWAP over the
term of the ASR.
— In a capped ASR the company participates in changes in VWAP subject to
a cap, which limits the price the company will pay to repurchase the shares.
A cap protects the company from paying a price for its shares above what it
believes to be reasonable. The company pays the investment bank a premium
for this protection.
— In a collared ASR the company participates in changes in VWAP subject to
a cap and a floor. The cap protects the company from paying a price for its
shares above what it believes to be reasonable and the floor limits the benefit
the company receives from a declining share price. The company receives a
payment from the investment bank counterparty for selling the floor which can
partially or fully offset the premium paid for the cap.
• Share Holdback
— In an effort to avoid legal and EPS complications that arise when a company
delivers shares upon settlement of the forward contract, many companies
elect to receive fewer shares than they are entitled to at contract inception. In
some cases, the company may receive staggered partial share deliveries over
the term of the forward contract. The partial delivery of shares reduces the
likelihood of the company being required to deliver shares back to the bank to
settle the forward contract.
Despite these alternatives, all ASR transactions follow the same basic framework,
depicted below.
Illustration of ASR Mechanics
Trade Date
At trade date, the investment bank borrows
Company
2
shares
$
3
1
Stock
Lender
The company makes a cash payment to the
investment bank and all or a portion of the
borrowed shares are delivered to the company
(by the investment bank).
Bank
shares
forward
contract
the company’s shares from the stock lenders
(parties independent of the company) at the
spot price. Often the investment bank will
provide cash collateral to the stock lenders,
who are typically institutional investors.
cash
collateral
The company agrees to a future settlement
based on a VWAP. This is also known as the
forward contract (or make-up contract) of the
ASR program.
Stock
Market
(continued)
10 - 8 / Derivative Share Repurchase Contracts
Averaging or Repurchase Period
During the repurchase period, the investment

bank purchases shares in the open market on
a daily basis on behalf of the company.
Company
The shares are returned to the stock lenders to
settle the bank’s share borrowings.
5
4
Bank
shares cash
collateral $
Stock
Lender
shares
The length of the repurchase period varies

depending on the size of the treasury share
purchase relative to the average trading volume
of the company’s shares. As discussed above,
the investment bank may be able to change
this period.
Stock
Market
Maturity and Settlement Date
At the settlement date (or maturity) the

Company
company will settle the forward contract based
on the terms of the contract.
6
forward
contract
Bank
Stock
Lender
10.4.1
Stock
Market
Generally, if the VWAP during the averaging
period is less than the company’s stock price
at trade date, the company will have paid a
lower price for its shares through the ASR
than it would have in a spot repurchase at
trade date. If the VWAP during the averaging
period is higher than the company’s stock price
at trade date, the company will have paid a
higher price for its shares through the ASR than
it would have in a spot repurchase at the trade
date. Note that practically, a company could
not execute a spot repurchase of the number
of shares underlying most ASR programs
without significantly affecting its share price.
Economically the company has paid VWAP for
its share repurchase.
Recognition and Measurement
ASR programs are generally accounted for as two separate transactions:
• A treasury stock transaction recorded on the date the shares are received, and
• A contract on a company’s own stock (i.e., the forward contract).
The treasury stock purchase should be recorded as an immediate reduction of
common shares outstanding on the company’s statement of financial position (i.e.,
as a treasury stock purchase). This should be based upon the fair value of the shares
delivered.
The forward contract must first be assessed to determine whether it meets the
requirements for equity classification. If not, it would be classified as a liability
reported at fair value with changes in fair value recorded in earnings. As discussed in
FG section 2.1, the first step in analyzing a freestanding equity linked instrument is to
determine whether it is within the scope of ASC 480.
Derivative Share Repurchase Contracts / 10 - 9
10.4.1.1
Application of ASC 480
As previously noted, ASC 480 requires certain contracts on a company’s own stock
to be classified as a liability (or in some cases, an asset) at fair value with changes
in fair value recorded in earnings. Instruments included in the scope of ASC 480
include:
1. Obligations that require or may require repurchase of the issuer’s equity shares
by transferring assets (e.g., written put options and forward purchase contracts
[unless they can only be settled physically as discussed in FG section 10.2.1]),
and
2. Certain obligations where at inception the monetary value of the obligation is
based solely or predominantly on:
a. A fixed monetary amount known at inception, for example, a payable settlable
with a variable number of the issuer’s equity shares,
b. Variations inversely related to changes in the fair value of the issuer’s equity
shares, for example, a written put that could be net share settled.
Typically, an ASR transaction does not require the company to transfer cash or other
assets to settle the contract (however, cash is paid at inception of the transaction).
Most ASR transactions allow the company to settle the forward contract in cash or
shares at the company’s option. If the company has the option to deliver shares, then
the contract does not meet the requirements in (1) above for inclusion in the scope of
ASC 480.
A company must also assess whether the forward contract embodies an obligation
that may require it to issue a variable number of shares. If there is no requirement
for the company to deliver value to the investment bank counterparty in any
circumstance, then the forward contract would not meet the requirements in (2)
above for inclusion in ASC 480. However, this is generally not the case.
More often, the forward contract will contain provisions that could require the
company to deliver a variable number of shares. In that case, the company must
determine, at inception, whether the monetary value of the number of shares to be
delivered at settlement is based predominantly on (a) a fixed monetary amount or (b)
variations inversely related to changes in the fair value of the issuer’s equity shares.
In the basic ASR transaction described in FG section 10.4, a company could be
required to deliver a variable number of shares at maturity of the forward contract. In
such a transaction, the monetary value received or delivered is equal to the difference
between (a) the VWAP over the term of the contract and the spot share price
multiplied by (b) the number of shares purchased at inception. Since the monetary
value changes as the VWAP changes, it is not predominantly based on a fixed
monetary amount. In addition, the company could be required to deliver value as the
price of its shares (i.e., VWAP) increases and could receive value as the price of its
shares decreases; therefore, the monetary value would not be based on variations
inversely related to changes in the fair value of the company’s equity shares.
The monetary value of an ASR transaction that incorporates various alternatives to
the basic structure may be more complicated to determine. Frequently, a quantitative
analysis of the possible settlement outcomes should be performed to determine how
the monetary value is affected by the terms of the transaction. A quantitative analysis
may take into account factors such as:
10 - 10 / Derivative Share Repurchase Contracts
• Terms of the contract, including the number of shares delivered at inception of the
transaction,
• The company’s stock price at trade date,
• The volatility of the company’s stock price, and
• The probability of any cap or floor on the forward contract being reached.
10.4.1.2
Analysis of Freestanding Equity-Linked Instrument
If the instrument is not within the scope of ASC 480, the next step is to determine
whether it should be classified as (a) equity or (b) a liability (or asset) measured at
fair value with changes in fair value recorded in earnings. See FG section 2.5 for the
analysis of freestanding equity linked instruments.
Example 10-2: Fixed Dollar Accelerated Share Repurchase Program
Background/Facts:
On September 30, 2011, when the Company’s stock price is $125 per share,
Company A enters into an accelerated share repurchase (ASR) program with the
following terms:
• The ASR is a fixed dollar program in which Company A will deliver $10 million to
Bank B on September 30, 2011 to repurchase a variable number of shares.
• The variable number of shares will be determined by dividing the $10 million
contract amount by the VWAP observed during the term of the ASR contract.
• Bank B delivers 76,000 shares to Company A on September 30, 2011.
• Company A is not obligated to deliver any cash to Bank B after the initial cash
delivery of $10 million.
• The ASR has a variable maturity, at Bank B’s option, with a minimum maturity of 3
months (12/31/11) and a maximum maturity of 6 months (3/31/12).
Company A analyzes the ASR contract and determines that:
• It is not a liability within the scope of ASC 480 since:
— there is no obligation to deliver cash after inception of the transaction, and
— based on a quantitative analysis, the monetary value of the forward contract
is not predominantly based on (1) a fixed monetary amount or (2) variations
inversely related to Company A’s stock price
• It meets the requirements for equity classification (see FG section 2.5)
Company A determines that the ASR should be accounted for as (1) a treasury stock
transaction for the initial delivery of shares and (2) a freestanding forward contract on
its own stock, which is classified as an equity instrument.
Bank B does not exercise its variable maturity option and the contract continues for
the maximum term, maturing at 3/31/12. The VWAP over the term of the contract is
$117.00, thus upon maturity Company A receives an additional 9,470 shares ([$10
million ÷ $117 = 85,470] less 76,000 initial share delivery).
(continued)
Derivative Share Repurchase Contracts / 10 - 11
Question:
What are the journal entries to record the (1) commencement and (2) settlement of
the ASR transaction?
Analysis/Conclusion:
1. Commencement of the ASR transaction. Record the cash payment, increase in
treasury stock and fair value of the forward contract.
Dr Treasury stock
Dr Equity—APIC
Cr Cash
$9,500,000
500,000
$10,000,000
2. Settlement of the ASR transaction. Reclassify the amount recorded in APIC to
treasury stock. Note that the amount recorded is not equal to the fair value of the
additional 9,470 shares received upon settlement.
Dr Treasury stock
Cr Equity—APIC
10.4.2
$ 500,000
$
500,000
Earnings per Share Considerations
ASR programs are included in EPS as two separate transactions:
• A treasury stock transaction recorded on the date the shares are received, and
• A freestanding derivative on a company’s own stock (i.e., the forward contract).
The treasury stock transaction reduces the weighted average shares outstanding,
used to calculate both basic and diluted EPS, as of the date the shares are received
by the company.
The freestanding derivative on the company’s own stock is generally included in
diluted EPS using the treasury stock method (see FG section 4.4); however, the
issuer should consider (1) the terms of the specific ASR program and (2) their
company specific facts and circumstances to determine the appropriate EPS
treatment.
10.4.2.1
Settlement in Cash or Shares
Most ASR contracts give the company the option to elect to receive, or pay, any
value owed under the ASR contract at maturity in cash or shares. If a company has
established a pattern of settling ASR contracts in cash, the use of the treasury stock
method may not be appropriate. Rather, the company may be required to include
the ASR in diluted EPS as though it were accounted for as an asset or liability (with
fair value changes recorded in earnings available to common shareholders). See FG
section 4.5 for a discussion of instruments settlable in cash or shares.
10.4.2.2
Anti-Dilution
In addition, a company must determine whether an ASR contract is anti-dilutive (see
FG section 4.2) at the end of each reporting period. Most capped and collared ASR
contracts are structured so that the issuer will receive additional shares at maturity;
typically the issuer has to deliver shares under a capped or collared ASR only when
specified events occur. In addition, in many ASR programs that are not capped or
collared, the investment bank counterparty will under deliver shares at inception,
10 - 12 / Derivative Share Repurchase Contracts
such that it is expected the issuer will receive shares at maturity of the ASR, rather
than issue them. In both of these fact patterns, the ASR contracts are likely to be
anti-dilutive, and excluded from the calculation of diluted EPS.
10.5
How PwC Can Help
Our capital market transaction consultants and Assurance professionals frequently
advise companies regarding the interpretation and application of the accounting rules
for share repurchase transactions, including:
• Appropriate classification (i.e., liability or equity) of share repurchase transactions,
including advice regarding the analyses needed to determine the appropriate
classification (e.g., analysis of whether a transaction is predominantly indexed to a
fixed monetary amount).
• Earnings per share impacts.
• Appropriate disclosure items.
If you have questions regarding the accounting for share repurchase transactions
or would like help in assessing the impact a share repurchase transaction has on
your company’s financial statements, please contact your PwC engagement partner
or one of the subject matter experts listed in the contacts section at the end of this
Guide.
Derivative Share Repurchase Contracts / 10 - 13
Chapter 11:
Noncontrolling Interest as a Source of Financing
Noncontrolling Interest as a Source of Financing / 11 - 1
11.1
Overview of Noncontrolling Interests
When a parent company owns only a portion of the equity of a controlled subsidiary
a noncontrolling interest (NCI) is created. For example, a NCI is recorded in a parent
company’s financial statements in the following cases:
• A parent company acquires a controlling interest but does not acquire all of the
common or preferred stock of a consolidated subsidiary.
• A parent is required to consolidate an entity in which it has little or no equity
interest (e.g., pursuant to the variable interest model under ASC 810).
• A parent sells a portion of the common stock it holds in a subsidiary.
• A subsidiary issues preferred stock, classified as equity or temporary equity to a
third party.
• A parent issues options to employees or third parties based on a subsidiary’s
shares (or a subsidiary issues options on its own shares).
In some cases, a parent may not own all of a subsidiary’s equity for strategic
reasons. In other cases, the creation of a NCI may be driven by tax or legal
requirements. Alternatively, a NCI may serve as a source of financing. For example,
an acquiring company may choose to buy a controlling interest in a target company
and leave the remainder of the equity outstanding.
A company that acquires a controlling, but not wholly-owned, interest in a subsidiary
typically wants the ability to obtain the remainder of the subsidiary’s shares; a
forward or option contract executed with the NCI holder will give it the ability to do
so. Alternatively, a seller may want to retain an equity interest in the company it is
selling to participate in the results of its ongoing performance. Since these shares
are typically not marketable, a NCI holder may execute an agreement (i.e., forward or
option contract) to provide liquidity for its interests. Agreements with the NCI holder
may be executed between (1) the parent and the NCI holder or (2) the subsidiary and
the NCI holder.
A NCI does not result when a third-party investor holds an instrument that is
classified as a liability. Therefore, if an investor holds preferred stock in a subsidiary
that is classified as a liability under ASC 480 (see FG section 2.4), there is no NCI
related to that preferred stock recorded in the parent company’s financial statements.
See FG section 8.2 for a discussion of the classification of preferred stock. The same
is true for instruments indexed to a subsidiary’s shares issued to investors; if those
instruments do not meet the requirements for equity classification, they do not create
a NCI. See FG section 2.1 for the analysis of equity-linked instruments.
This chapter does not address all aspects of accounting for NCI. Many NCI-related
issues, such as changes in a parent’s ownership interest in a subsidiary, attribution of
net income, and intercompany eliminations, are addressed in PwC’s A Global Guide
to Accounting for Business Combinations and Noncontrolling Interests—2012.
11.2
Analysis of Instruments Indexed to a Subsidiary’s Shares Executed with
NCI Holders
An instrument issued by a parent indexed to the stock of a consolidated subsidiary
should be considered indexed to its own stock (provided the subsidiary is a
substantive entity) based on the guidance in ASC 815-40-15-5C. This is the case
11 - 2 / Noncontrolling Interest as a Source of Financing
whether an instrument that is executed with a NCI holder is entered into by the parent
or by the subsidiary. Therefore, the analysis to determine the appropriate accounting
treatment for an instrument issued by a parent indexed to the stock of a consolidated
subsidiary is similar to the analysis to determine the accounting treatment for an
equity-linked instrument on a company’s own stock (see FG section 2.1).
Analysis of Instruments Indexed to a
Subsidiary’s Shares Executed with NCI Holders
Is the instrument (or embedded
component) freestanding or
embedded in the NCI?
(FG section 11.2.1)
Embedded
Freestanding
Is the instrument within the
scope of ASC 480?
(FG section 2.4.1)
Yes
Apply the recognition and
measurement guidance in ASC 480
(FG section 2.4.2)
Consider impact of the instrument
on the classification of NCI shares
(FG section 11.2.2)
11.2.1
Accounting treatment
determined using Analysis of
Embedded Equity-Linked
Components
(FG section 2.3)
Consider impact of the
embedded component on the
classification of NCI shares
(FG section 11.2.3)
No
Accounting treatment
determined using Analysis of a
Freestanding Equity-Linked
Instrument
(FG section 2.5)
Consider impact
of the instrument on the
classification of NCI shares
(FG section 11.2.2)
Freestanding vs. Embedded
The first question that should be answered to determine the appropriate accounting
treatment of an instrument indexed to a subsidiary’s shares executed with a NCI
holder is whether the instrument is freestanding or embedded in the NCI. As
discussed in FG section 2.2, ASC Master Glossary defines a freestanding financial
instrument as:
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.
Noncontrolling Interest as a Source of Financing / 11 - 3
11.2.1.1
Separately and Apart
Factors to consider in determining whether an instrument is entered into separately
and apart from the transaction that created the NCI, include:
• Whether the counterparty to the instrument is unrelated to the NCI holder—a
counterparty that is unrelated to the NCI holder would indicate that the instrument
was entered into separately and apart from the NCI.
• When the counterparty to the instrument is the NCI holder (1) whether the
instrument is documented separately from the transaction that gave rise to the
NCI and (2) the length of time between the creation of the NCI and the execution
of the instrument—execution with the NCI holder may occur separately and apart
from the NCI if the instrument is separately documented (and there is no linkage
between to the two instruments) and there is a reasonable period of time between
the transaction that created the NCI and the execution of the instrument.
11.2.1.2
Legally Detachable and Separately Exercisable
Oftentimes an instrument indexed to a subsidiary’s shares will be executed in
connection with the transaction that created the NCI. Thus, in determining whether
the instrument is freestanding or embedded, the analysis generally hinges on
whether the instrument is legally detachable and separately exercisable. The table
below highlights indicators and considerations when determining whether an
instrument is legally detachable and separately exercisable from a NCI.
Indicator
Indicates Freestanding Indicates Embedded
Transferability
of either (1) the
shares that
represent the
NCI or (2) the
instrument
Shareholder and/or
purchase agreements
do not limit the transfer
of either instrument
(i.e., the instrument can
be transferred while the
underlying shares are
retained)
Shareholder and/or
purchase agreements
do limit the transfer of
either instrument (i.e.,
the instrument cannot
be transferred without
the underlying shares)
Significant indicator
Continued
existence of the
NCI after the
instrument is
settled
Instrument can be
settled while the NCI
remains outstanding
Once the instrument
is settled, the NCI is
subject to redemption
or is no longer
outstanding
Significant indicator
Settlement
Instrument can be or
is required to be net
settled
Instrument can only
be settled on a gross
physical basis
Significant indicator
Counterparty
If the parent is the
counterparty, then the
instrument could be
viewed as attached to
the NCI
If the subsidiary is the
counterparty, then the
equity comprising the
NCI and the instrument
are with the same
counterparty
Not a significant
indicator as from
a consolidated
perspective, a
subsidiary’s equity is
also a parent’s equity
Specific shares
The shares that
represent the NCI to
be delivered upon
settlement of the
instrument are not
specifically identified
The shares that
represent the NCI
to be delivered
upon settlement of
the instrument are
specifically identified
If the shares issued by
the subsidiary are not
publicly traded, this
indicator is less
significant because it
is not possible for the
NCI holder to obtain the
issuer’s shares in the
open market
11 - 4 / Noncontrolling Interest as a Source of Financing
Considerations
Example 11-1: Analysis of Put Right
Background/Facts:
Parent Company A acquires 80% of the common shares of Subsidiary B from
Company Z. Company Z retains the remaining common shares (20%) in Subsidiary B.
As part of the acquisition, Parent Company A and Company Z enter into an
agreement that allows Company Z to put its equity interest in Subsidiary B, in its
entirety, to Parent Company A at a fixed price on a specified date. The put option is
non-transferrable and terminates if Company Z sells its Subsidiary B shares to a third
party.
Question:
Is Company Z’s put option freestanding from or embedded in the NCI recorded in
Parent Company A’s financial statements?
Analysis/Conclusion:
The put option is embedded in the NCI recorded in Parent Company A’s financial
statements because it does not meet either of the conditions of a freestanding
financial instrument.
• The put option was executed as part of the acquisition, therefore it was not
entered into separately and apart from the transaction that created the NCI.
• The put option is not legally detachable and separately exercisable as it is nontransferrable and terminates if Company Z sells its shares.
11.2.2
Accounting for a Freestanding Instrument Executed with NCI Holders
A freestanding instrument should be accounted for on a separate basis. The
appropriate accounting treatment will be determined by the type of instrument and
its terms. The issuer should also consider what impact, if any, the freestanding
instrument has on the parent company’s accounting for the NCI. In many cases, the
NCI continues to be reported in the parent company’s financial statements based on
the contractual terms of the shares that represent the NCI. In other cases, the NCI is
recharacterized as a liability even though the instrument indexed to the subsidiary’s
shares is considered freestanding from the NCI.
Noncontrolling Interest as a Source of Financing / 11 - 5
The table below summarizes the parent company’s accounting treatment for
(1) various instruments indexed to a subsidiary’s shares and (2) NCI.
Freestanding
Derivative on
NCI Shares
11.2.2.1
Accounting for the
Instrument(s)
Accounting for NCI
Written put option
See FG section 10.3 for a
discussion of the accounting
treatment of a written put option.
Generally, a written put option
is recorded at fair value with
changes in fair value recorded in
earnings based on the guidance
in ASC 480.
Recorded as a separate
component of equity.
Purchased call
option
See FG section 2.5 for the analysis
of a freestanding equity-linked
instrument.
Recorded as a separate
component of equity.
Forward purchase
See FG section 10.2 for a
discussion of the accounting
treatment of a forward purchase
contract.
Since it is certain that the parent
will purchase the remaining
shares, the NCI is recharacterized
as a liability.
Collar
See FG section 2.4 for the
analysis of certain freestanding
instruments.
Generally, a collar is recorded
at fair value with changes in fair
value recorded in earnings based
on the guidance in ASC 480.
Recorded as a separate
component of equity.
Freestanding written See FG section 11.2.2.1 for a
put and purchased
discussion of when written put
call
options and purchased call
options should be combined.
Generally, a written put option
and purchased call option are
accounted for separately.
A written put option is recorded
at fair value with changes in fair
value recorded in earnings based
on the guidance in ASC 480 (see
FG section 10.3).
A purchased call option is
generally accounted for as
an equity contract. See FG
section 2.5 for the analysis of
a freestanding equity-linked
instrument.
Recorded as a separate
component of equity.
Combination of Written Put and Purchased Call Options
A written put option and a purchased call option with the same strike price and
exercise dates are economically equivalent to a forward purchase contract. The
accounting treatment of both (1) the instrument and (2) the corresponding NCI differ
based on whether the options are accounted for separately (i.e., as a written put option
and a purchased call option) or in combination (i.e., as a forward purchase contract).
Thus, a parent company should determine whether a written put option and purchased
call option that are freestanding from a NCI are also freestanding from each other. See
FG section 2.2 for guidance on determining whether instruments are freestanding.
11 - 6 / Noncontrolling Interest as a Source of Financing
If the written put option and purchased call option were issued as a single instrument
(freestanding from the NCI), the combined instrument is recorded as an asset or
liability at fair value with changes in fair value recorded in earnings based on the
guidance in ASC 480 (see FG section 2.4).
As discussed in ASC 480-10-25-15, a freestanding written put option that is
accounted for as a liability within the scope of ASC 480 should not be combined with
a freestanding purchased call option that is outside the scope of ASC 480. A written
put option is recorded as a liability at fair value with changes in fair value recorded in
earnings based on the guidance in ASC 480 (see FG section 2.4). A purchased call
option may be recorded as (1) equity, which is not remeasured, or (2) an asset recorded
at fair value with changes in fair value recorded in earnings (see FG section 2.5).
11.2.3
Accounting for an Instrument Embedded in a NCI
Once the parent company determines that an instrument is embedded in a NCI, it
should assess whether the agreement meets the requirements to be accounted for
separately from the host NCI. See FG section 2.3 for the analysis of embedded
equity-linked components. Frequently, embedded components in a NCI are not
required to be accounted for as derivatives and thus are not accounted for separately.
If a parent company determines that an embedded component should not be
accounted for separately, it should assess whether the embedded component has an
impact on the classification of the NCI shares. The table below summarizes the potential
effect that various embedded components may have on the classification of NCI shares.
Embedded
Component
Impact on Accounting for NCI
Written put option
An embedded written put option may affect the classification of the
NCI shares as mezzanine or permanent equity. See FG section 11.3.
Purchased call
option
Typically would not affect the classification of the NCI shares.
Forward purchase
A forward contract embedded in a NCI results in mandatorily
redeemable NCI shares. See FG section 8.3.1 for a discussion of
mandatorily redeemable shares.
The parent company should (1) eliminate the NCI shares from equity
and (2) record mandatorily redeemable shares as a liability.
Collar
The impact of a collar is generally determined by the terms of the
options. See written put option and purchase call option discussion
above.
Written put and
purchased call with
the same fixed strike
price and exercise
date
Based on the guidance in ASC 480-10-55-59 and 55-60, the
written put option and purchased call option should be viewed on
a combined basis with the NCI and accounted for as a financing of
the parent’s purchase of the NCI.
The parent consolidates 100 percent of the subsidiary. The derivative
is recorded as a liability and accreted, through interest expense, to
the strike price over the period until settlement.
As discussed in ASC 480-10-55-62, this treatment would also apply
if the exercise prices of the written put option and purchase call
option were not identical as long as they are not significantly different.
Written put and
purchased call with
floating strike prices
A NCI with an embedded put and call with a floating strike price is
not considered a mandatorily redeemable instrument under ASC
480. This is because the fair value of the shares at the exercise date
could be equal to the strike price; in that situation, the embedded
put and call may not be exercised. This makes the NCI shares
contingently redeemable rather than mandatorily redeemable. See FG
section 8.3.2 for a discussion of contingently redeemable securities.
Noncontrolling Interest as a Source of Financing / 11 - 7
11.3
Redeemable NCI
A redeemable NCI results when (1) an embedded put option is not separated from its
host NCI or (2) when the subsidiary’s shares are redeemable.
For SEC registrants, ASC 480-10-S99 requires equity securities redeemable for cash
or other assets to be classified outside of permanent equity (in the “mezzanine”
equity or “temporary” equity section) if their redemption is:
• At a fixed or determinable price on a fixed or determinable date.1
• At the option of the holder.
• Based upon the occurrence of an event that is not solely within the control of the
issuer.
Although the SEC’s guidance applies to public entities, we believe that the
mezzanine equity presentation is preferable for a non-public entity’s equity securities
that meet any one of these criteria.
11.3.1
Initial Measurement
Upon issuance, redeemable equity securities are generally recorded at fair value. If
the securities are issued in conjunction with other securities, such as debt or equity
instruments, the sales proceeds from the issuance should be allocated to each
security based on their relative fair values.
11.3.2
Subsequent Measurement
The objective in accounting for redeemable equity securities subsequent to issuance
is to report the securities at their redemption value no later than the date they
become redeemable by the holder.
A discount may arise from a redeemable equity security when it is issued:
• On a stand-alone basis with a fair value less than its redemption value.
• In conjunction with other securities, and the proceeds are allocated between the
redeemable equity security and the other securities issued.
A redeemable equity security recorded at a value less than its redemption
value should be accreted to its redemption value in some cases. Accretion of a
redeemable equity security is recorded as a deemed dividend, which reduces
retained earnings and earnings available to common shareholders in calculating
basic and diluted EPS.
• If the equity security is currently redeemable (e.g., at the option of the holder),
it should be adjusted to its maximum redemption amount as of each reporting
period.
1
Preferred stock with redemption at a fixed or determinable date can be classified as equity if it has a
substantive conversion option (see FG section 8.4).
11 - 8 / Noncontrolling Interest as a Source of Financing
• If the equity security is not currently redeemable and it is probable the instrument
will become redeemable, then it should be either (i) accreted to its redemption
value over the period from the date of issuance to the earliest redemption date or
(ii) recognized immediately at its redemption value.
• If the equity security is not currently redeemable (e.g., the contingency that
triggers the holder’s redemption right has not been met) and it is not probable
that it will become redeemable, subsequent adjustment is not necessary until
redemption is probable. The parent company should disclose why redemption of
the equity security is not probable.
A reduction in the carrying value of a redeemable equity security is appropriate
only to the extent the carrying value had previously been increased. Thus, if the
redemption price of an instrument decreases, it should not be adjusted below its
initial carrying value. An exception to this rule exists for redeemable securities
that participate in the earnings of the subsidiary. In that case, the adjustment to
the carrying value is determined after the attribution of net income or loss of the
subsidiary pursuant to the consolidation procedures in ASC 810.
Example 11-2: Adjustment to the Carrying Value of Redeemable Equity Securities
Background/Facts:
• Parent Company A acquires 80% of the common shares of Subsidiary B
from Company Z. Company Z retains the remaining common shares (20%) in
Subsidiary B. As part of the acquisition, Parent Company A and Company Z enter
into an agreement that allows Company Z to put its equity interest in Subsidiary B,
in its entirety, to Parent Company A for $100 million.
• The fair value of the NCI at the acquisition date is $100 million.
• Parent Company A concludes that the put option is embedded in the NCI
(i.e., it is a puttable NCI). As a result, the NCI is accounted for at fair value as
mezzanine equity because the interest is redeemable at the option of the minority
shareholder.
• The put option is immediately exercisable.
• At the end of the first year, Subsidiary B records a net loss of $50 million. The
amount of the net loss attributable to the NCI shares is $50 million x 20% = $10
million.
• The redemption value of $100 million does not change as a result of Subsidiary B
generating a net loss.
Question:
How should Parent Company A account for the $10 million net loss attributable to
the NCI shares?
Analysis/Conclusion:
Since the redemption value of the NCI remains unchanged, the $10 million net loss
attributable to the NCI shares should be recorded to retained earnings as a deemed
dividend to the NCI holder. The dividend is deducted from earnings available to
common shareholders in calculating Parent Company A’s basic and diluted earnings
per share.
Noncontrolling Interest as a Source of Financing / 11 - 9
How PwC Can Help
Our capital market transaction consultants and Assurance professionals frequently
advise companies regarding the interpretation and application of the accounting
rules for noncontrolling interests and instruments indexed to noncontrolling interests,
including:
• Classification (i.e., liability or equity) and measurement of noncontrolling interests.
• Whether embedded components should be separated and accounted for at fair
value with changes in fair value recorded in earnings.
• Earnings per share impacts.
• Appropriate disclosure items.
If you have questions regarding the accounting for noncontrolling interests
or instruments indexed to noncontrolling interests, please contact your PwC
engagement partner or one of the subject matter experts listed in the contacts
section at the end of this Guide.
11 - 10 / Noncontrolling Interest as a Source of Financing
Appendix A:
Technical References and Abbreviations
Technical References and Abbreviations / A - 1
Appendix A: Technical References and Abbreviations
The following table should be used as a reference for the abbreviations utilized
throughout the Guide:
Abbreviations
Technical References
ASC 210
Accounting Standards Codification 210, Balance Sheet
ASC 260
Accounting Standards Codification 260, Earnings Per Share
ASC 450
Accounting Standards Codification 450, Contingencies
ASC 460
Accounting Standards Codification 460, Guarantees
ASC 470
Accounting Standards Codification 470, Debt
ASC 480
Accounting Standards Codification 480, Distinguishing Liabilities from Equity
ASC 505
Accounting Standards Codification 505, Equity
ASC 740
Accounting Standards Codification 740, Income Taxes
ASC 810
Accounting Standards Codification 810, Consolidation
ASC 815
Accounting Standards Codification 815, Derivatives and Hedging
ASC 825
Accounting Standards Codification 825, Financial Instruments
ASC 835
Accounting Standards Codification 835, Interest
EITF 00-19
EITF Issue No. 00-19, Accounting for Derivative Financial Instruments
(ASC 815-40-25) Indexed to, and Potentially Settled in, a Company’s Own Stock
EITF 07-5
EITF Issue No. 07-5, Determining Whether an Instrument (or Embedded
(ASC 815-40-15) Feature) Is Indexed to an Entity’s Own Stock
FSP APB 14-1
(ASC 470-20)
FASB Staff Position No. APB 14-1, Accounting for Convertible Debt
Instruments That May Be Settled in Cash upon Conversion (Including Partial
Cash Settlement)
IAS 32
International Accounting Standard No. 32, Financial Instruments:
Presentation
IAS 39
International Accounting Standard No. 39, Financial Instruments:
Recognition and Measurement
A - 2 / Technical References and Abbreviations
Abbreviations
Other References
AICPA
American Institute of Certified Public Accountants
ASC
Accounting Standards Codification
ASR
Accelerated Share Repurchase
BCF
Beneficial Conversion Feature
EITF
Emerging Issues Task Force
EPS
Earnings per Share
FASB or Board
Financial Accounting Standards Board
FG
Guide to Accounting for Financing Transactions: What You Need to Know
about Debt, Equity and the Instruments in Between
GAAP
Generally Accepted Accounting Principals
IFRS
International Financial Reporting Stanards
LOC
Line of Credit
MAC / MAE
Material Adverse Change / Material Adverse Effect
MD&A
Management’s Discussion and Analysis
NYSE
New York Stock Exchange
SAB
Staff Accounting Bulletin
SAC
Subjective Acceleration Clause
SEC
Securities and Exchange Commission
US
United States
TDR
Troubled Debt Restructuring
VRDO
Variable Rate Demand Obligation
Technical References and Abbreviations / A - 3
Appendix B:
Definition of Key Terms
Definition of Key Terms / B - 1
Accelerated Share
Repurchase (ASR)
A transaction executed by a company with a bank
counterparty that allows the company to buy a
large number of shares immediately at a purchase
price determined by an average market price over
a subsequent period of time. One of the primary
objectives of an ASR is to enable the company
to execute a large treasury stock purchase
immediately, while paying a purchase price that
mirrors the price achieved by a longer-term
repurchase program in the open market.
Beneficial Conversion
Feature
A non-detachable conversion feature that is in the
money at the commitment date.
Call Option
If a company buys a call option on its own equity,
the call option provides the company with the right
but not the obligation, to buy a specified quantity
of its shares from the counterparty (call option
seller) to the contract at a fixed price for a given
period.
If a company sells a call option on its own equity,
the call option obligates the company to sell a
specified quantity of its shares to the counterparty
(call option buyer) to the contract at a fixed price
for a given period. A warrant is economically
equivalent to a sold call option.
A call option embedded in a debt instrument
provides the issuer (borrower) with the right to
repay its debt on demand prior to the stated
maturity date.
Call Option Overlay
(Call Spread or
Capped Call)
A transaction between a convertible bond issuer
and a bank whereby the issuer purchases a call
option from the bank which mirrors the conversion
option embedded in the issuer’s convertible bond,
effectively “hedging,” or canceling, the embedded
conversion option. The issuer then sells a call
option to the bank, almost always at a higher strike
price than the embedded conversion option and
purchased call option, effectively raising the strike
price of the convertible bond transaction.
A call option overlay may be executed as two
separate call option transactions (a “call spread”)
or it can be executed as a single integrated
transaction (a “capped call”).
Change-in-control Put
B - 2 / Definition of Key Terms
A contingently exercisable put option embedded in
a debt instrument that provides the holder with the
right to put the debt back to the issuer upon the
occurrence of a fundamental change in the issuing
entity (such as a change in control).
Contingently
Convertible
Instrument
An instrument that has an embedded conversion
option that is exercisable only upon the
satisfaction of a contingency.
Convertible Debt
A debt security that provides the holder with
the option to exchange the debt security for a
specified number of the issuer’s equity securities.
Convertible Preferred
Stock
A preferred security that provides the holder with
the option to exchange the security for a specified
number of a different class of the issuer’s equity
shares.
Current Liability
An obligation whose liquidation is reasonably
expected to require the use of existing resources
properly classifiable as a current asset, or the
creation of another current liability.
Derivative Instrument
A financial instrument that meets the definition of a
derivative in ASC 815-10-15-83.
Detachable Warrant
A detachable warrant is one that is originally
issued in conjunction with another security (often
debt) that may be exercised or traded separately
following the issue date.
Embedded Derivative
Implicit or explicit terms that affect some or all of
the cash flows or the value of other exchanges
required by a contract in a manner similar to a
derivative instrument.
Equity-linked
Instrument
A hybrid instrument that contains an embedded
component linked to the equity of the issuer.
The investor’s return is dependent upon the
performance of the underlying equity to which
the instrument is linked. Including equity-linked
component in a financing transaction frequently
enables companies to lower cash interest costs.
A convertible debt instrument is an example of an
equity-linked instrument.
Factoring
Arrangement
An agreement under which a party sells or
assigns its accounts receivable to another party
(the “factor”) in exchange for a cash advance.
The factor acquires the rights to the accounts
receivable as well as assumes the associated
credit risk (without recourse to the seller). The
factor typically charges interest on the advance
as well as a commission. The price paid for the
receivables is discounted from their face amount
to account for interest, commissions and the
likelihood of uncollectibility.
Forward Contract
An agreement obligating two parties to buy or sell
a specified quantity of an underlying security at a
specified future date and price.
Definition of Key Terms / B - 3
Freestanding Financial
Instrument
A financial instrument that either (a) is entered
into separately and apart from any of the entity’s
other financial instruments or equity transactions
or (b) is entered into in conjunction with some
other transaction and is legally detachable and
separately exercisable.
Greenshoe or
Overallotment Option
A freestanding agreement between an issuer and
an underwriter which allows the underwriter to
call additional securities to “upsize” the amount
of securities issued (i.e., a 20% greenshoe on
a $100 million convertible debt offering allows
the underwriter to require the issuer to issue an
additional $20 million of debt at par value).
Host Instrument
The non-derivative component of a hybrid
instrument which “hosts” an embedded derivative
feature.
Induced Conversion
A transaction in which the issuer induces
conversion of a convertible instrument by offering
additional securities or other consideration
(“sweeteners”) to investors.
Interest Method
The method used to arrive at a periodic interest
cost (including amortization) that will represent a
level effective rate on the sum of the face amount
of the debt and (plus or minus) the unamortized
premium or discount and expense at the beginning
of each period.
Line-of-Credit (or
Revolving Debt)
Arrangement
A line-of-credit or revolving debt arrangement is
an agreement that provides the borrower with
the option to make multiple borrowings up to a
specified maximum amount, to repay portions of
previous borrowings, and to then reborrow under
the same contract. Line-of-credit and revolving
debt arrangements may include both amounts
drawn by the debtor (a debt instrument) and a
commitment by the creditor to make additional
amounts available to the debtor under predefined
terms (a loan commitment).
Loan Participation
A transaction in which a single lender makes
a large loan to a borrower and subsequently
transfers undivided interests in the loan to groups
of banks or other entities.
Loan Syndication
A transaction in which several lenders share in
lending to a single borrower. Each lender loans a
specific amount to the borrower and has the right
to repayment from the borrower. It is common for
groups of lenders to jointly fund those loans when
the amount borrowed is greater than any one
lender is willing to lend.
B - 4 / Definition of Key Terms
Lock-box
Arrangement
An arrangement with a lender whereby the
borrower’s customers are required to remit
payments directly to the lender and amounts
received are applied to reduce the debt
outstanding. A lock-box arrangement refers to
any situation in which the borrower does not have
the ability to avoid using working capital to repay
the amounts outstanding. That is, the contractual
provisions of a loan arrangement require that,
in the ordinary course of business and without
another event occurring, the cash receipts of a
debtor are used to repay the existing obligation.
Mandatory Units
An equity-linked financial product, often marketed
under different proprietary names by different
financial institutions (e.g., ACES, PRIDES, or
DECS), which consist of a bundled transaction
comprising both (a) term debt with a remarketing
feature and (b) a detachable variable share forward
delivery agreement.
Net Cash Settlement
A form of settling a financial instrument under
which the entity with a loss delivers to the entity
with a gain cash equal to the gain.
Net Share Settlement
A form of settling a financial instrument under
which the entity with a loss delivers to the entity
with a gain shares of stock with a current fair value
equal to the gain.
Noncontrolling
Interest
The portion of equity (net assets) in a subsidiary
not attributable, directly or indirectly, to a parent;
noncontrolling interest is sometimes called a
minority interest.
Non-revolving Debt
Arrangements (Term
Debt)
Unlike a line-of-credit or revolving-debt
arrangement, a non-revolving debt arrangement
(or term debt) is a credit agreement that provides
the borrower with a fixed repayment plan within
which further credit is not extended as payments
are made.
Participation Right
A contractual right of a security holder to receive
dividends or returns from the security issuer’s
profits, cash flows, or returns on investment.
Payment-in-Kind
A bond in which the issuer has the option at each
interest payment date of making interest payments
in cash or in additional debt securities. Those
additional debt securities are referred to as baby
or bunny bonds. Baby bonds generally have the
same terms, including maturity dates and interest
rates, as the original bonds (parent payment-inkind bonds). Interest on baby bonds may also
be paid in cash or in additional like-kind debt
securities at the option of the issuer.
Definition of Key Terms / B - 5
Physical Settlement
A form of settling a financial instrument under
which (a) the party designated in the contract as
the buyer delivers the full stated amount of cash or
other financial instruments to the seller and (b) the
seller delivers the full stated number of shares of
stock or other financial instruments or nonfinancial
instruments to the buyer.
Preferred Stock
An equity security that has preferential rights
compared to common stock.
Prepayment Option
A call option embedded in a debt instrument.
Put Option
If a company buys a put option on its own equity,
the put option provides the company with the right
but not the obligation, to sell a specified quantity
of its shares to the counterparty (put option seller)
to the contract at a fixed price for a given period.
If a company sells a put option on its own
equity, the put option obligates the company to
buy a specified quantity of its shares from the
counterparty (put option buyer) to the contract at a
fixed price for a given period.
A put option embedded in a debt instrument
provides the investor (lender) with the right to
demand repayment prior to the stated maturity
date.
Subjective
Acceleration Clause
(SAC)
A subjective acceleration clause is a provision
in a debt agreement that states that the creditor
may accelerate the scheduled maturities of the
obligation under conditions that are not objectively
determinable (for example, if the debtor fails to
maintain satisfactory operations or if a material
adverse change occurs).
Troubled Debt
Restructuring (TDR)
A restructuring in which the creditor, for economic
or legal reasons related to the debtor’s financial
difficulties, grants a concession to the debtor that
it would not otherwise consider.
Units Structure
A bundled instrument that typically involves debt
securities that are issued along with a share
issuance derivative contract, such as a detachable
warrant or a variable share forward delivery
agreement.
B - 6 / Definition of Key Terms
Variable Rate Demand
Obligation (VRDO)
A debt instrument, typically a bond, that the
investor can put. Upon an investor’s exercise of
a put, a remarketing agent will resell the debt to
another investor to obtain the funds to honor the
put (i.e., to repay the investor). If the remarketing
agent fails to sell the debt (referred to as a “failed
remarketing”), the funds to pay the investor who
exercised the put will often be obtained through a
liquidity facility issued by a financial institution.
Variable Share
Forward Delivery
Agreements
In a variable share forward delivery agreement, the
issuer sells shares of its common stock at a stated
price with the number of shares to be issued
dependent upon the then current market price
of the common stock, subject to a minimum and
maximum number of shares. Typically, the investor
is required to pay the stated price to the issuer at
the settlement date. Economically, a variable share
forward delivery agreement is a combination of
a written call option and a purchased put option,
each with different strike prices.
Refer to FG section 9.3.2 for further detail,
including an illustrative example.
Warrant
A written call option on the issuer’s own common
or preferred equity shares.
Definition of Key Terms / B - 7
Acknowledgments
Our first edition of the Guide to Accounting for Financing Transactions: What You
Need to Know about Debt, Equity and the Instruments in Between (2012) represents
the efforts and ideas of many individuals within PricewaterhouseCoopers LLP,
including the members of PwC’s National Professional Services Group and various
subject matter experts.
The teams of PwC professionals that contributed to the content and review of the
2012 Guide are listed by topic below.
Topic
Team Members
Core Team
John Bishop
Ken Dakdduk
Nora Joyce
Analyzing Puts, Calls and Other
Features and Arrangements
Greg McGahan
Maria Constantinou
Krystyna Niemiec
Earnings per Share
Jay Seliber
John F. Horan III
Accounting for Modifications and Extinguishments
Jay Seliber
Maria Constantinou
Suzanne Stephani
Debt
Dave Lukach
Chad Soares
Nick Milone
Convertible Debt
Greg McGahan
John Toriello
Preferred Stock
Heather Horn
John F. Horan III
Monica Rebreanu
Share Issuance Contracts
Frederick (Chip) Currie
Kristin Orrell
Derivative Share Repurchase Contracts
Frederick (Chip) Currie
Chris Rhodes
Noncontrolling Interest as a Source of Financing
Pam Yanakopulos
John Liang
Contacts
PwC professionals have years of experience advising clients on the transactions
discussed in this Guide. The sections entitled How PwC Can Help at the end of many
chapters list some of the many areas in which PwC can provide advice. If you would
like to discuss one of the topics covered in this Guide, please contact your PwC
engagement partner or one of the PwC partners listed below.
Dave Lukach
Partner, Financial Instruments, Structured Products and Real Estate Group
Phone: 1-646-471-3150
Email: david.m.lukach@us.pwc.com
Greg McGahan
Partner, Financial Instruments, Structured Products and Real Estate Group
Phone: 1-646-471-2645
Email: gregory.mcgahan@us.pwc.com
Chris Rhodes
Partner, Capital Markets and Accounting Advisory Services
Phone: 1-646-471-5860
Email: chris.rhodes@us.pwc.com
Pam Yanakopulos
Partner, Capital Markets and Accounting Advisory Services
Phone: 1-312-298-3798
Email: pamela.yanakopulos@us.pwc.com
About PwC
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