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FASB May Simplify the Accounting for Instruments with Down Round Provisions

Dec. 13, 2016

On Dec. 7, 2016, the Financial Accounting Standards Board (FASB) released an exposure draft of changes to ASC Topic 480, Distinguishing Liabilities from Equity. The proposed update has two parts, accounting for certain financial instruments with down round features and updating language related to the indefinite deferral for mandatorily redeemable financial instruments of certain nonpublic entities and certain mandatorily redeemable noncontrolling interests with a scope exception.

Accounting with Financial Instruments with Down Round Features

Financial instruments that have embedded features where the strike price is reduced on the basis of the pricing of future equity offerings are considered to have down round features. Down round features are a common form of investor protection included in financial instruments that are equity-linked or convertible to protect investors from dilution that can occur if equity interests are issued at a lower price in the future.

Under current U.S. generally accepted accounting principles (U.S. GAAP) entities evaluate how to classify such a financial instrument, or embedded feature, under a multi-step approach. First they determine whether the instrument is classified as a liability. If not, they apply ASC Topic 815, Derivatives and Hedging to determine if the instrument meets the definition of a derivative. When evaluating the derivative guidance, an entity considers whether the instrument meets an exception to derivative accounting because the instrument is indexed to the reporting entity's own stock. If it does not meet the exception, the free standing instrument or bifurcated conversion option is classified as a liability and the reporting entity must measure the instrument's fair value at each reporting date.

Warrants and conversion options embedded in instruments that have a debt host with down round features typically do not meet the exception to derivative accounting, which means they are accounted for as liabilities. The FASB received comments that the requirement to measure instruments with down round features at fair value at each reporting date creates a significant burden and may also lead to income statement volatility. In the event of decreases in investment value, it was commented that recognizing increases in value—as may be required for a liability classified financial instrument with a down round provision—is not representative of the economics of the down round feature.

The exposure draft proposes a change that impacts warrants and bifurcated conversion options of certain convertible instruments that are currently classified as liabilities solely because of the existence of down round protection. Under the proposal, an entity would not consider the down round feature when evaluating whether the instrument that meets the definition of a derivative qualifies for the exception to derivative accounting for an instrument indexed to an entity's own stock.

Warrants that would no longer be required to be accounted for as liabilities under the proposal would be recognized as equity instruments and would not be measured at fair value on an annual basis. Conversion options that were bifurcated solely because of the existence of a down round feature would no longer be required to be bifurcated. As a result, the fair value of the down round feature would not be measured annually within the financial statements. Instead, reporting entities would recognize the effect of the down round feature when it is triggered .For financial instruments classified as equity, the entity would recognize the value of the effect of the down round feature as a dividend. For financial instruments classified as a liability, an entity would recognize the effect as a charge to net income.

If the down round feature were triggered during the reporting period, the entity would disclose it as well as the value of the effect of the down round feature being triggered and the financial statement line item where the value of the effect is reported.

Reworking the Indefinite Deferral

Part II of the exposure draft re-characterizes the indefinite deferral related to certain mandatorily redeemable shares of nonpublic entities that are not Securities and Exchange Commission (SEC) registrants as a scope exception to the accounting for mandatorily redeemable shares, which are otherwise accounted for as a liability. The change is not expected to have an effect on financial statement reporting; rather it is designed to improve the readability of the subtopic and make its guidance easier to follow.

Stay Tuned

Comments on the exposure draft are due to the FASB by Feb. 6, 2017. The FASB determined that the transition would be handled using a cumulative effect approach in which the cumulative change caused by adoption would be recognized in beginning retained earnings in the period of adoption. The FASB will not set an effective date for the changes until it considers its feedback.

We will monitor developments as they become available and keep you up-to-date on the latest activity related to this change. For specific comments, questions or concerns, please contact Mike Loritz of MHM's Professional Standards Group. Mike can be reached at or 816.945.5611.



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