The accounting guidance for instruments with characteristics of both debt and equity can be a complex area of U.S. GAAP. There are three main areas of the Accounting Standards Codification (ASC) that serve as a road map to accounting for instruments with characteristics of both debt and equity, ASC Topic 470, Debt, ASC Topic 480, Distinguishing Liabilities from Equity and ASC Topic 815, Derivatives and Hedging. A missed step early in the evaluation process could result in an incorrect accounting conclusion.
Reporting entities often have difficulty applying guidance for two types of instruments in particular, freestanding warrants and conversion options embedded in debt instruments. Understanding common accounting mistakes related to these instruments as well as the accounting guidance to which the instruments may be subject can assist with navigating through complex debt and equity transactions.
Common Application Errors with Distinguishing Liabilities from Equity
A significant evaluation in the accounting for freestanding warrants and conversion options embedded in debt instruments is the misapplication of certain sections within ASC Topic 480 and ASC Topic 815. Mistakes tend to arise when reporting entities incorrectly answer one of the following five questions:
Is the instrument freestanding?
If a reporting incorrectly concludes the instrument is not a freestanding instrument, the reporting entity would then not consider additional provisions in ASC Topic 480, which provides situations in which a warrant would be classified as a liability.
Is the instrument indexed to an obligation to repurchase the issuer's equity shares?
Such redemption features in question are typically not found in a warrant agreement but an operating agreement where the terms and the rights of the underlying shares are defined. As a result, reporting entities may overlook the correct answer to the question.
Is the embedded instrument clearly and closely related to the host contract?
This question is frequently applied incorrectly when the debt instrument is convertible into redeemable preferred stock or similar instruments that have a cash conversion feature.
Does the embedded conversion option meet the definition of a derivative?
For an embedded conversion option to be classified as a liability under ASC Topic 815, the underlying shares generally must be readily convertible to cash. Nonpublic entities in particular often overlook this detail.
Does the instrument meet the additional conditions required for equity classification?
Freestanding warrants must consider the guidance in ASC Topic 480 and ASC Topic 815. In order to remain classified as equity instruments, such instruments must meet seven additional criteria. Reporting entities frequently forgo the criteria evaluation on the assumption that they are scoped out of ASC Topic 815.
A More Detailed Look at Freestanding Warrant Instruments
An instrument is considered a freestanding warrant instrument if:
- It is entered into separately and apart from any of the entity's other financial instruments or equity transactions; or
- It is entered into in conjunction with some other transaction and is legally detachable and separately exercisable.
Entities that ascertain they have a freestanding warrant then begin with an analysis of whether the instrument is subject to ASC Topic 480. Embedded financial instruments, such as conversion options embedded in debt instruments are not subject to the Distinguishing Liabilities from Equity guidance. If a freestanding warrant is provided in conjunction with a debt instrument, then it is subject to ASC Topic 480.
Freestanding warrants subject to ASC Topic 480 will be accounted for as liabilities if the warrants have the following characteristics:
- It is a mandatory redeemable financial instrument (excluding those triggered upon the reporting entity's liquidation or termination);
- It has a conditional obligation to redeem the instrument when the condition or event occurs, is resolved or is certain to occur;
- It has the following two characteristics at inception:
- Embodies an obligation to repurchase the issuer's equity shares or is indexed to such an obligation; and
- Requires or may require the issuer to settle the obligation by transferring assets
- It has an unconditional or conditional obligation to be settled by issuing a variable number of equity shares if the fixed monetary amount is known at inception, variations are indexed to something other than the fair value of equity shares (such as S&P 500) or variations are inversely related to the changes in the fair value of the issuer's equity.
Accounting for Freestanding Warrants When ASC Topic 480 Does Not Apply
If an instrument is not classified a liability in accordance with ASC Topic 480, the reporting entity then evaluates whether the freestanding warrants meet the definition of a derivative under the guidance in ASC Topic 815. A derivative instrument is a financial instrument with an underlying, a notional amount, payment provisions, and an initial net investment and can be settled net. If the reporting entity determines that the freestanding warrants meet the definition of a derivative, then the reporting entity should evaluate whether the equity-linked financial instrument is considered indexed to its stock (i.e. indexed to, and settled in its own stock).
As noted earlier, entities need to carefully consider whether their freestanding warrant instruments are within the scope of ASC Topic 815. Even if a reporting entity determines that the instrument is indexed to the entity's own stock, they are still required to consider the seven criteria in ASC Topic 815-40-25-10 to qualify for equity classification:
- Settlement permitted in unregistered shares;
- Entity has sufficient authorized and unissued shares;
- Contract contains an explicit share limit;
- No required cash payment if entity fails to timely file;
- No cash-settled top off or make whole provisions;
- No counterparty rights rank higher than shareholder rights; and
- No collateral required.
A More Detailed Look at Convertible Debt Options
The first step in accounting for embedded conversion options within a debt instrument is to determine whether the instrument should be separately accounted for as a derivative under the guidance in ASC Topic 815. An embedded derivative should be separated from the host contract and accounted for as a derivative instrument if and only if the following criteria are met:
- The economic characteristics and risks of the embedded derivative (the conversion feature) are not clearly and closely related to the economic characteristics and risks of the host contract (debt agreement without the conversion feature).
- The hybrid instrument (the combination of the host contract/agreement with the conversion feature) is not remeasured at fair value under otherwise applicable U.S. generally accepted accounting principles (GAAP), with changes in fair value reported in earnings as they occur.
- A separate instrument with the same terms as the embedded derivative would, pursuant to Section 815-10-15, be a derivative instrument subject to the requirements of this Subtopic. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.)
The nature of the host instrument and the conversion feature should then be evaluated to determine if they are more akin to debt or equity. They are not clearly and closely related if the host instrument is more akin to debt and conversion feature is more akin to equity, and vice versa.
Generally, the shares underlying the conversion feature must be readily convertible to cash for the embedded conversion option to be considered a derivative. There is a scope exception: If the contract issued or held by the reporting entity is both indexed to the reporting entity's own stock and classified in stockholder's equity in its statement of financial position.
Cash Conversion Feature
Reporting entities must then determine whether the conversion option qualifies as a cash conversion feature under ASC Topic 470. A cash conversion feature is one that allows the investor to convert the debt instrument into cash rather than shares at the fair value of the shares, rather than the principal amount of the debt. If a cash conversion option exists (in whole or part), entities will separate the instrument into a debt component (measured at fair value) and an equity component (difference between the proceeds and the fair value debt component).
Accounting for Debt Conversion Features When ASC Topic 815 Does Not Apply
If the reporting entity determines that the instrument does not qualify for accounting as a derivative instrument ASC Topic 815, it then determines whether the conversion option qualifies as a beneficial conversion feature under ASC Topic 470. A beneficial conversion feature is a nondetachable conversion feature that is in the money at the commitment date.
Beneficial conversion features should be recognized separately by allocating a portion of proceeds equal to the intrinsic value of the feature to additional paid-in capital. The effective conversion price should be used to compute the intrinsic value. A beneficial conversion feature's effective conversion price is based on the proceeds received for or allocated to the convertible instrument. Intrinsic value determination follows a three step process:
- Allocate the proceeds received to the convertible instrument and any other detachable instruments included in the exchange on a relative fair value basis,
- Apply the guidance in paragraph ASC 470-20-25-4 to the amount allocated to the convertible instrument, and then
- Calculate the effective conversion price and use the effective conversion price to measure the intrinsic value, if any, of the embedded conversion option.
Intrinsic value should be calculated at the commitment date as the difference between the conversion price and the fair value of the common stock/securities into which the security is convertible, multiplied by the number of shares into which the security is convertible.
Seek the Help of a Professional
Accounting for instruments with both debt and equity can be complex. An accountant experienced with the reporting requirements under ASC Topics 470, 480 and 815 may be able to help you navigate the correct accounting path for your instruments.
For specific comments, questions or concerns about debt and equity transactions, please contact Christine McAlarney or Mike Loritz of MHM's Professional Standards Group. Christine can be reached at email@example.com or 727.572.1400. Mike can be reached at firstname.lastname@example.org or 816.945.5611.
Published on May 16, 2017