United States

Reminder: Need to reevaluate preferred stock and similar instruments


September 2015

Accounting Standards Update (ASU) 2014-16, Derivatives and Hedging (Topic 815): Determining Whether the Host Contract in a Hybrid Financial Instrument Issued in the Form of a Share Is More Akin to Debt or to Equity, was issued in November 2014 by the Financial Accounting Standards Board (FASB) and comes into effect for fiscal years beginning after December 15, 2015, and for public business entities, interim periods within those fiscal years. Early adoption is permitted. It is important to note that this ASU applies not only to instruments issued or acquired after the effective date, but also to existing instruments. As a result, investors or issuers of preferred stock or other hybrid financial instruments issued in the form of a share will need to reevaluate conclusions reached on what, if any, derivative features within the instrument should be separately recognized. This necessitates a reconsideration of the nature of the host contract as more debt-like or more equity-like based on circumstances as they existed at the date of initial recognition of the instrument (i.e., upon issuance or acquisition). 

RSM’s middle market insights

The capital structure of many middle market entities includes preferred stock or other hybrid financial instruments issued in the form of a share. The accounting for these instruments may change as a result of the guidance in ASU 2014-16. In some cases, entities may be required to no longer separately recognize derivatives within these instruments that were previously separately recognized. In other cases, entities may be required to separately recognize and value derivatives within these instruments that had previously not been separately recognized. The required accounting analysis and valuation are very complex and subjective. Given that middle market entities usually do not have the same level of resources that large companies have to assess and implement new accounting standards, now is the time to start considering the impacts of ASU 2014-16. Waiting to do so could add unnecessary stress to what might already be a strained financial reporting function. 

We have prepared the following questions and answers to aid in implementation efforts. 

Question: Who does the ASU apply to?

Answer: Investors in, and issuers of, preferred stock and other hybrid financial instruments in the form of a share (hereinafter referred to as hybrid instruments) that are not accounted for at fair value through earnings in their entirety. 

Question: What is a hybrid instrument? 

Answer: A hybrid instrument is a contract that embodies both an embedded derivative and a host contract. For example, preferred stock can be a host contract that includes embedded derivatives such as conversion and redemption options. Only those hybrid instruments that are in the form of a share are within the scope of the ASU because that is where the most diversity in practice is believed to exist. 

Question: What is the significance of determining that the host contract is more akin to debt or to equity? 

Answer: This determination does not impact the balance sheet classification of the hybrid instrument as debt or equity but rather impacts what features embedded in the instrument (host contract) require separate recognition as derivatives. One of the relevant criteria in determining if an embedded feature needs to be given separate recognition as a derivative under Subtopic 815-15, Derivatives and Hedging – Embedded Derivatives, of the FASB’s Accounting Standards Codification (ASC), is whether the economic characteristics and risks of the embedded feature are clearly and closely related to the economic characteristics and risks of the host contract. Specifically, ASC 815-15-25-1 requires derivative recognition for embedded features if the following three criteria are met: 

  1. The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract 
  2. The hybrid instrument is not remeasured at fair value under otherwise applicable generally accepted accounting principles 
  3. A separate instrument with the same terms as the embedded derivative would be a derivative instrument subject to the requirements of ASC 815. 

ASU 2014-16 relates to the first criterion. In the context of a hybrid instrument issued in the form of a share, it is necessary to analyze the various characteristics of the hybrid instrument and conclude if in totality it is more akin to debt or equity. If more akin to debt, equity-like features, such as a conversion option, would meet the first criterion. Conversely, if more akin to equity, debt-like features, such as a redemption option, would meet the first criterion. 

It should also be noted that the conclusion on the nature of the host contract being equity-like versus debt-like can also impact the analysis of the third criterion. An example of this is that ASC 815-10-15-107 states that the net settlement component of a derivative exists for put and call options in debt instruments. Conversely, due to ASC 815-10-15-109, that would not be the case for equity-like host contracts unless net settlement exists under ASC 815-10-15-99. 

Question: What has changed with the ASU? Why was it issued?

Answer: The requirement to determine the nature of the host contract and determine if any embedded features must be recognized as derivatives has been in existence since 1998 when the FASB issued Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. There have been divergent views as to how this determination should be made, including whether or not the embedded feature under consideration as a potential derivative should be considered along with all other features in the instrument (referred to as a whole instrument approach) or ignored (referred to as a chameleon approach) in making the determination as to whether the host contract is more debt-like or equity-like. In practice, the whole instrument approach was most frequently employed and is what is required by the ASU. Namely, all relevant terms and features, including the embedded feature being evaluated for bifurcation, should be considered in the evaluation of the nature of the host contract. Additionally, given the subjectivity involved in the analysis and the differing conclusions that different constituents could reach for the same instrument, the ASU provides guidance as to how the analysis should be performed and clarifies that no single term or feature, including a fixed-price, noncontingent redemption feature held by the investor, is determinative. Under current practice, some considered such a feature to be determinative in concluding that the host contract was debt-like. The Emerging Issues Task Force considered, but rejected, instituting a rebuttable presumption that a fixed price noncontingent redemption option held by the investor should result in the contract being more akin to debt. 

The ASU clarifies that an entity should assess the substance of the relevant terms and features when considering how much weight to place on a specific term or feature in ultimately concluding on the nature of the host contract. This assessment should incorporate consideration of: (a) the characteristics of the terms and features themselves (e.g., the likelihood that the feature will be exercised), (b) the circumstances under which the instrument was issued or acquired (e.g., issuer-specific characteristics, such as whether the issuer is thinly capitalized or profitable and well-capitalized) and (c) the potential outcomes of the hybrid instrument and whether the most likely outcome is a debt-like or equity-like outcome.

Question: What are the potential ramifications of the ASU on the accounting for existing instruments?

Answer: Reporting entities that used a chameleon approach need to reperform the analysis using a whole instrument approach. Additionally, even those entities who analyzed embedded features using a whole instrument approach need to reconsider conclusions reached on the nature of the host contract in light of the guidance in the ASU based on facts and circumstances that existed at the time the hybrid instrument was issued or acquired. The adoption of the ASU could result in the need to bifurcate (i.e., separately recognize) derivatives that had previously not been bifurcated or, conversely, derivatives that had previously been bifurcated may no longer be required to be bifurcated if the conclusion on whether the host instrument is more debt-like or equity-like changes. 

Question: What are the transition requirements of the ASU in the event a different conclusion is reached when performing the evaluation on an existing instrument as required by the ASU?

Answer: The ASU provides for a cumulative-effect adjustment directly to retained earnings as of the beginning of the year of adoption if an entity had not bifurcated an embedded derivative feature, but is required to do so as a result of applying the new guidance. The carrying amount of any recognized derivatives should be fair value as of the effective date. The carrying amount of the host contract (exclusive of the separately recognized derivatives) at the effective date should be based on a lookback to what the balance would have been on the effective date had the embedded derivative feature been bifurcated as of the date the entity issued or acquired the hybrid instrument, with consideration given to the host contract’s subsequent accounting before the effective date. The transition adjustment should be the difference between the total carrying amount of the individual components of the newly bifurcated hybrid instrument and the carrying amount of the combined hybrid financial instrument before bifurcation. 

If an entity had bifurcated an embedded derivative feature, but is no longer required to do so as a result of applying the new guidance, the carrying amount of the hybrid financial instrument at the effective date should be the total carrying amount of the host contract and the fair value of the previously bifurcated embedded derivative feature, with no cumulative-effect adjustment to beginning retained earnings warranted. 

Alternatively, retrospective application is permitted. 

Early adoption, including adoption in an interim period, is permitted. If an entity early adopts in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. Certain disclosures of the change in accounting principle are required under ASC 250, Accounting Changes and Error Corrections, in both the interim and annual periods of the change. 

Question: What are important action steps to be taken? 

Answer: Reporting entities will want to allow plenty of time to conduct the accounting analysis for both new and existing hybrid instruments as the analysis is very complex and subjective. Keep in mind that if conclusions change related to whether or not a derivative requires separate recognition, this will impact whether or not it is necessary to obtain an estimate of fair value for the derivatives. Given the complexity and subjectivity of the accounting analysis and valuation, it is also important to have robust internal controls and processes in place to promote accurate and appropriate accounting, valuation and disclosure. Management may require external assistance in performing or reperforming the accounting analysis, understanding the ramifications to the financial statements and determining the fair value of any bifurcated derivatives. The chart provided below may be useful to management in structuring the analysis of the nature of the host contract. In addition, our whitepaper, What Management Should Know Before Issuing Equity-Linked Instruments in Financing Transactions, may be useful in understanding the overall accounting for debt and equity instruments issued in financing transactions, including preferred stock. 

The analysis of the nature of the host contract should be based on all relevant terms and features. Common features and factors to consider when determining how much weight to place on a specific term or feature and ultimately reaching a conclusion on the nature of the host contract as more debt-like or equity-like are provided below. 

Factors to consider

Redemption rights

  • Is redemption mandatory or contingent?
  • Who holds the redemption right?
  • Is the redemption right in-the-money or out-of-the money?
  • Is a conversion option also provided and, if so, how favorable is this option in comparison to the redemption right?
  • Are there legal restrictions and (or) solvency factors that would prohibit the issuer from redeeming the instrument?
  • Are there issuer specific considerations (e.g., is the entity thinly capitalized or unprofitable)?

Conversion rights

  • Who holds the conversion right?
  • Is conversion mandatory?
  • Is the conversion right contingent?
  • Is the conversion right in-the-money or out-of-the money?
  • If the instrument is also redeemable, what is more likely to occur first, conversion or redemption? 

Rights upon liquidation

  • Is there a stated liquidation preference? 
  • Does the holder participate in the residual value of the entity?

Voting rights

  • Does the holder have voting rights and if so, are they entitled to vote on all or limited matters? 
  • How much influence can the holder’s class of stock exercise based on these voting rights?

Dividend rights

  • Are the dividends mandatory or discretionary? 
  • Are dividends stated or participating? 
  • Are dividends cumulative or noncumulative?

Protective covenants

  • Are there collateral requirements akin to collateralized debt?
  • If the instrument contains a redemption option held by the investor/holder, is the issuer’s performance upon redemption guaranteed by the parent of the issuer or otherwise? 
  • Does the instrument provide the holder with certain rights akin to creditor rights (e.g., the ability to force bankruptcy or a preference in liquidation)? 

Conclusion (In light of the factors to consider and the most likely outcome of the instrument, conclude as to the nature of the host contract as more debt-like or equity-like and the weight placed on the various features in reaching that conclusion.)


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