The Financial Accounting Standards Board (FASB) issued final guidance that affects all entities that issue equity-linked financial instruments with down round features. FASB Accounting Standards Update (ASU) 2017-11 applies to both freestanding instruments and embedded features.
Background
Down round features are features of certain instruments (or embedded features) that result in the strike price being reduced based on the pricing of a future equity offering. Under current accounting guidance, a down round feature requires the change in fair value of an instrument to be recognized in earnings, often creating significant complexity and cost for the issuer. Many stakeholders believe that current accounting guidance does not reflect the true economics of a down round feature primarily because changes in fair value for increases and decreases in the entity's share price are recognized in earnings, even though an increase in share price does not trigger a down round feature.
Classification of Instruments with Down Round Features
Upon issuance of the FASB's guidance, a down round feature by itself will no longer preclude an instrument (or embedded feature) from being considered indexed to the entity's own stock under ASC Topic 815-40, Derivatives and Hedging. This is a key consideration in determining whether an instrument or embedded feature qualifies for the scope exemption provided by ASC Topic 815. Under the new guidance, a freestanding financial instrument that was previously required to be classified as a liability due to the existence of a down round feature may now be classified as equity. Additionally, an embedded feature that was previously bifurcated and accounted for as a derivative may now qualify for the scope exemption noted above.
Recognition and Measurement
Under the new guidance, an entity will recognize the value of the effect of a down round feature in an equity-classified freestanding financial instrument (that is, instruments that are not convertible instruments) when the down round feature is triggered. That effect shall be treated as a dividend and as a reduction of income available to common stockholders in basic earnings per share.
As of the date that a down round feature is triggered (that is, upon the occurrence of the triggering event that results in a reduction of the strike price) in an equity-classified freestanding financial instrument, an entity shall measure the value of the effect of the feature as the difference between the following amounts determined immediately after the down round feature is triggered:
- The fair value of the financial instrument (without the down round feature) with a strike price corresponding to the currently stated strike price of the issued instrument (that is, before the strike price reduction)
- The fair value of the financial instrument (without the down round feature) with a strike price corresponding to the reduced strike price upon the down round feature being triggered.
The fair values of the financial instruments shall be measured in accordance with the guidance in ASC Topic 820, Fair Value Measurements and Disclosures.
Values recognized as dividends are not subsequently remeasured. However, in the event that the down round feature is triggered multiple times, the value transferred to the holder is measured and recognized as noted each time.
The recognition and measurement guidance applies only to freestanding equity classified financial instruments issued by entities that present earnings per share (EPS) in accordance with ASC Topic 260, Earnings Per Share. It doesn't apply to convertible instruments and freestanding financial instruments (e.g., warrants) that are classified as liabilities. Convertible instruments with embedded conversion features that have down round provisions will continue to be assessed for contingent beneficial conversion features under ASC Topic 470-20, Debt.
Transition
For public business entities, guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after Dec. 15, 2018. For all other entities, the guidance is effective for fiscal years beginning after Dec. 15, 2019, and interim periods within fiscal years beginning after Dec. 15, 2020. Early adoption is permitted for all entities, including adoption in an interim period. If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period.
The guidance should be applied in either of the following ways:
- Retrospectively to outstanding financial instruments with a down round feature by means of a cumulative-effect adjustment to the statement of financial position as of the beginning of the first fiscal year and interim period(s) in which the guidance is effective.
- Retrospectively to outstanding financial instruments with a down round feature for each prior reporting period presented in accordance with the guidance on accounting changes.
For More Information
If you have specific comments, questions or concerns about accounting for instruments with down round features, please contact James Comito of MHM's Professional Standards Group. James can be reached at jcomito@cbiz.com or 858.795.2029.
Published on August 15, 2017 © Copyright CBIZ, Inc. and MHM. All rights reserved. Use of the material contained herein without the express written consent of the firms is prohibited by law. This publication is distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice. The reader is advised to contact a tax professional prior to taking any action based upon this information. CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.
CBIZ MHM is the brand name for CBIZ MHM, LLC, a national professional services company providing tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly-traded and privately-held companies. CBIZ MHM, LLC is a fully owned subsidiary of CBIZ, Inc. (NYSE: CBZ). MHM (Mayer Hoffman McCann P.C.) is an independent CPA firm that provides audit, review and attest services, and works closely with CBIZ, a business consulting, tax and financial services provider. CBIZ and MHM are members of Kreston International Limited, a global network of independent accounting firms. This publication is protected by U.S. and international copyright laws and treaties. Material contained in this publication is informational and promotional in nature and not intended to be specific financial, tax or consulting advice. Readers are advised to seek professional consultation regarding circumstances affecting their organization.