United States

FASB tentative decisions regarding 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. Financial Accounting Standards Board (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, a proposed Accounting Standards Update (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, 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.

On May 10, 2017, the FASB completed its redeliberations of the proposed ASU, and reaffirmed that a down round feature would no longer cause liability treatment. The FASB departed from the recognition provisions included in the proposed ASU for when a down round feature is triggered and tentatively decided:

  • To require an earnings per share (EPS) numerator adjustment to income available to common shareholders in basic EPS for equity-classified freestanding financial instruments. That adjustment would be required for entities within the scope of ASC 260, “Earnings Per Share,” or entities that voluntarily provide EPS. The adjustment would be measured 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 current strike price of the instrument issued (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
    • An entity that is required to make this EPS adjustment would recognize the adjustment in the balance sheet (as an equity adjustment between retained earnings and additional paid-in capital). Entities that do not report EPS will not record any entries upon a down round feature being triggered.

  • That an entity that is required to present the EPS adjustment should disclose the value of the effect of the down round trigger. Additionally, the Board decided to amend the disclosure requirements in ASC 505, “Equity,” to clarify the application of those requirements to changes in conversion or exercise prices.
  • To affirm the transition guidance in the proposed ASU that an entity would apply a modified retrospective method of transition. That transition would be applied to outstanding instruments as of the effective date of the change, with a cumulative-effect adjustment to the opening balance of retained earnings in the fiscal year or interim period of adoption. The Board also decided to allow entities to apply a full retrospective method of transition.
  • On the following effective dates for the final guidance:
    • Public business entities: Fiscal years beginning after December 15, 2018, including interim reporting periods within that fiscal year
    • All other entities: Fiscal years beginning after December 15, 2019, and interim reporting periods within fiscal years beginning after December 15, 2020
    • For all entities, early adoption would be allowed for financial statements of fiscal years or interim periods that have not yet been issued or that have not yet been made available for issuance