United States

FASB addresses down round features and indefinite deferral provisions

FINANCIAL REPORTING INSIGHTS  | 

The Financial Accounting Standards Board (FASB) recently issued a proposed Accounting Standards Update (ASU) to address some of the accounting complexity associated with instruments with characteristics of liabilities and equity. The proposed ASU consists of two parts, which are briefly summarized as follows:

  • Accounting for Certain Financial Instruments with Down Round Features

    A down round feature is a provision in an equity-linked instrument, such as a warrant or a convertible instrument, which provides for a downward adjustment of the exercise or conversion price specified in the contract if the entity subsequently issues the underlying stock at a price that is below the specified exercise or conversion price. FASB Accounting Standards Codification (ASC) 815-40, Derivatives and Hedging — Contracts in Entity’s Own Equity, provides guidance to determine whether an equity-linked financial instrument (or an embedded feature) is considered indexed to an entity’s own stock and accordingly qualifies for equity classification. Under current guidance in ASC 815-40, a down round feature results in liability classification for certain freestanding instruments such as warrants and for certain embedded conversion features, which necessitates fair value measurement, with subsequent changes in fair value reflected in the income statement.

    Stakeholders have asserted that the requirement to measure such instruments at fair value on an ongoing basis creates (a) a significant reporting burden and (b) unnecessary income statement volatility associated with changes in value of an entity’s own share price. If finalized, the proposed ASU would require that when determining whether certain financial instruments should be classified as liabilities or equity instruments, an entity would not consider the down round feature. However, an entity would recognize the effect of the feature when triggered (that is, when the exercise or conversion price of the related equity-linked financial instrument is adjusted downward because of the down round feature) as follows:

    ­
    • For a financial instrument classified as equity, an entity would recognize the value of the effect of the down round feature in equity as a dividend.
    • For a financial instrument classified as a liability, an entity would recognize the value of the effect of the down round feature through a charge to net income.
  • For financial instruments with down round features that have been triggered during the reporting period, an entity would disclose that the feature has been triggered, the value of the effect of the down round feature being triggered and the financial statement line item in which that effect is recorded.

  • Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception

    Currently, it is difficult to navigate FASB Subtopic 480-10, Distinguishing Liabilities from Equity — Overall, because of the existence of extensive pending content that relates to the indefinite deferral of accounting requirements for certain mandatorily redeemable financial instruments of nonpublic entities and certain mandatorily redeemable noncontrolling interests. If finalized, the proposed ASU would characterize the indefinite deferral provisions of Subtopic 480-10 as a scope exception, rather than pending content. This proposed amendment would not have an accounting effect.

The proposed ASU, Distinguishing Liabilities from Equity (Topic 480): I. Accounting for Certain Financial Instruments with Down Round Features and II. Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception, is available for comment until February 6, 2017.