Down-Round Treatment Simplified

Transcription

1 The classification of financial instruments as debt or equity is a complex area of accounting and one of the most common causes of financial statement restatements. The Financial Accounting Standards Board (FASB) has finalized two targeted changes to simplify this accounting guidance. The first set of improvements relates to down rounds. Under Accounting Standard Update (ASU) , a financial instrument with a down-round feature would no longer be classified as a liability solely because that feature exists. Rather than creating a new measurement model as proposed, the ASU relies on existing guidance for subsequent measurement, depending on whether the instrument is classified as equity or a liability. The changes will provide the greatest relief in accounting for freestanding warrants with a down-round feature; 1 the earnings effect will be eliminated and an earnings-per-share (EPS) adjustment would be made instead. A small number of instruments with down-round features will continue to be classified as a liability; bifurcation would no longer be required, and accounting would be governed by existing, complicated guidance on beneficial conversion features (BCF). Entities issuing financial instruments with down-round features that do not present EPS information will not recognize a balance sheet effect in value transferred between certain classes of shareholders. The second set of amendments relates to mandatory redeemable interests. The changes eliminate an indefinite deferral and replace it with a permanent scope exception, simplifying navigation of the guidance. There are no accounting effects as a result of this change. I. Down Rounds A down-round feature aims to protect investors from a decline in value. It is an instrument with a strike price that adjusts down based on the pricing of future equity offerings, e.g., an option with a $10 strike price that would adjust down if there is a subsequent $8 equity offering. This feature can be in a freestanding warrant or embedded within a host debt or equity contract most commonly in convertible preferred shares and convertible debt instruments issued by private companies and development-stage public companies. Current Accounting Treatment The accounting treatment for a financial instrument with a down-round feature is complicated and requires two sets of accounting guidance; entities must first look to Topic 480, Distinguishing Liabilities from Equity, and then to Topic 815, Derivatives and Hedging. In addition, convertible debt must be analyzed to determine if the embedded option must be bifurcated into two separate instruments. If the instrument or bifurcated option meets the definition of a derivative, further evaluation is required to determine if a scope exception exists before concluding which accounting guidance to follow. Under current generally accepted accounting principles (GAAP), a down-round feature precludes an equity classification because it is not considered indexed to an entity s own stock. Liability classification generally requires the freestanding financial instrument or the bifurcated conversion option to be remeasured at each reporting date, which can be time-consuming and costly, especially for private companies. The effect of remeasurement also can cause earnings volatility. 1 FASB research indicated that the majority of instruments with down-round features for both public and private companies are warrants. A review of 2015 filings of public companies that disclosed information about instruments with a down-round feature revealed 79 percent were warrants.

2 New Accounting Treatment Under ASU , a down-round feature shall be excluded from the consideration of whether the instrument is indexed to an entity s own stock. An instrument may still be classified as a liability if it contains a term or feature other than the down round that would cause liability classification under Topic 480 or Topic 815. ASU relies on existing guidance for subsequent measurement, depending on whether the instrument is classified as equity or a liability. A down-round feature only would have an accounting effect if it is triggered the date the strike price is reduced. If a feature other than the down round results in an instrument s liability classification, an entity should continue to apply other existing GAAP, i.e., Topic 480 rather than the BCF guidance. Equity Classification Each time a down round is triggered, an entity would adjust EPS in accordance with existing guidance in Topic 260, Earnings per Share. The effect would be treated as a dividend and a reduction of income available to common shareholders in basic EPS. The dividend s value would be the difference between the fair values of two instruments with the same terms as the actual instrument but no down-round feature, where one instrument has the original strike price and the other the adjusted strike price after the trigger date. Topic 260 requires all entities that have issued common or potential common stock, i.e., options, warrants, convertible securities or contingent stock arrangements, to present EPS if those securities trade in a public market either on a stock exchange or in the over-the-counter market, including securities only quoted locally or regionally. Entities that voluntarily choose to present EPS in their financial statements also must follow the guidance in Topic 260. See example in Appendix A. Liability Classification By excluding down-round features from the analysis of whether an instrument is indexed to an entity s own stock, entities would no longer be required to bifurcate convertible instruments under Topic 815 s guidance. Such instruments instead will be subject to the specialized guidance for contingent BCF in Subtopic , Debt Debt with Conversion and Other Options. A BCF exists when an embedded conversion feature is in the money at the issuance, i.e., the conversion price is lower than the fair value of the issuer s stock price. If a BCF exists, it must be measured at intrinsic value and accounted for as equity. Sometimes the conversion feature may not be beneficial at issuance, but may become beneficial upon a future event, such as an initial public offering. This is known as a contingent BCF, which is only recognized when the contingency is resolved and measured using the commitment date stock price. Under this guidance, an issuer recognizes the intrinsic value of the feature only when the feature becomes beneficial at the time the strike price is adjusted instead of bifurcating the conversion option and measuring it at fair value each reporting period. The EPS effect upon the trigger of the down-round feature for an equity classified instrument is similar to the effect of EPS on convertible preferred stocks that include a beneficial conversion feature. 2

3 Warrants Convertible Preferred Shares Convertible Debt ACCOUNTING FOR A DOWN-ROUND FEATURE Current GAAP ASU If it meets the definition of a derivative, instrument is a single liability, mark-tomarket (MTM) each period (derivative disclosures apply); if not, instrument is a single equity instrument Conversion option not bifurcated as a derivative (if clearly and closely related to the host and host is more akin to equity than debt); however, contingent BCF would be recognized upon trigger Conversion option is a liability, MTM each period (derivative disclosures apply), remaining proceeds recorded as a liability Instrument is recorded in equity, effect of trigger to retained earnings Contingent BCF* conversion option is an equity component measured at intrinsic value, remaining proceeds recorded as preferred stock in equity Contingent BCF* conversion option is an equity component measured at intrinsic value, remaining proceeds recorded as a liability *Contingent BCFs are recognized when the contingency is resolved and measured using the commitment date stock price Disclosures For financial instruments with down-round features that were triggered during the reporting period, an entity would disclose that the feature was triggered and the value of the effect of the down-round feature being triggered. Entities also should follow the disclosures related to a change in accounting principle in the period of adoption, including the nature of the change in accounting principle, the method of applying the change and either the effect on opening retained earnings or the prior period adjustments made. II. Mandatory Redeemable Interests Currently, there is an indefinite deferral in Accounting Standards Codification 480, Distinguishing Liabilities From Equity, related to mandatorily redeemable financial instruments of certain nonpublic entities and certain mandatorily redeemable noncontrolling interests. This deferral makes the accounting literature difficult to navigate. ASU eliminates the indefinite deferral and creates a permanent scope exception; there is no accounting effect as a result of this change. Effective Date For public business entities, ASU is effective for fiscal years beginning after December 15, 2018, and interim periods therein. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2019, and interim periods beginning after December 15, 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, including the interim period. 3

4 Transition The amendments would be applied to outstanding financial instruments with a down-round feature at the effective date. Retrospective adoption is required. Entities can choose a modified approach by adjusting the opening balance of retained earnings for the cumulative effect of the change or a full retrospective approach by restating any prior years presented. Contributor Anne Coughlan Director acoughlan@bkd.com 4

5 Appendix A Example: Equity-Classified Freestanding Financial Instruments That Include a Down-Round Feature Entity A issues warrants that permit the holder to buy 100 shares of its common stock for $10 per share. Entity A presents EPS in accordance with Topic 260. The warrants have a 10-year term, are exercisable at any time and contain a down-round feature. The warrants are classified as equity because they are indexed to the entity s own stock and meet the additional conditions necessary for equity classification in accordance with Subtopic Because the warrants are an equity-classified freestanding financial instrument, they are within Topic 260 s scope. The down-round s terms specify that if Entity A issues additional common stock for an amount less than $10 per share or issues an equity-classified financial instrument with a strike price below $10 per share, the strike price of the warrants would be reduced to the most recent issuance price or strike price, but the strike price cannot be reduced below $8 per share. Subsequently, Entity A issues common stock at $7 per share. Because of the subsequent round of financing occurring at a share price below the strike price of the warrants, the down-round feature in the warrants is triggered and the strike price of the warrants is reduced to $8 per share. Entity A determines that the fair value of the warrants (without the down-round feature) with a strike price of $10 per share immediately before the down-round feature is triggered is $600 and that the fair value of the warrants (without the down-round feature) with a strike price of $8 per share immediately after the down-round feature is triggered is $750. The increase in the value of $150 is the value of the effect of the triggering of the down-round feature. The $150 increase is the value of the effect of the down-round feature to be recognized in equity as follows: Retained earnings $150 Additional paid-in capital $150 Additionally, Entity A reduces income available to common stockholders in its basic EPS calculation by $150. Entity A applies the treasury stock method to calculate diluted EPS. Accordingly, the $150 is added back to income available to common stockholders when calculating diluted EPS. However, the treasury stock method would not be applied if the effect were to be antidilutive. 5