New standard on accounting for down round features
INSIGHT ARTICLE |
On July 13, 2017, the Financial Accounting Standards Board issued Accounting Standards Update (ASU) 2017-11, Earnings Per Share (Topic 260), Distinguishing Liabilities from Equity (Topic 480), Derivatives and Hedging (Topic 815): 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. Part I applies to entities that issue financial instruments such as warrants, convertible debt or convertible preferred stock that contain down round features. Part II simply replaces the indefinite deferral for certain mandatorily redeemable noncontrolling interests and mandatorily redeemable financial instruments of nonpublic entities contained within Accounting Standards Codification (ASC) Topic 480 with a scope exception and does not impact the accounting for these mandatorily redeemable instruments. Given that Part I can significantly impact the accounting for instruments within its scope, it is the focus of the summary that follows.
The ASU adds the following definition of a down round feature to the Master Glossary of the ASC:
A feature in a financial instrument that reduces the strike price of an issued financial instrument if the issuer sells shares of its stock for an amount less than the currently stated strike price of the issued financial instrument or issues an equity-linked financial instrument with a strike price below the currently stated strike price of the issued financial instrument. A down round feature may reduce the strike price of a financial instrument to the current issuance price, or the reduction may be limited by a floor or on the basis of a formula that results in a price that is at a discount to the original exercise price but above the new issuance price of the shares, or may reduce the strike price to below the current issuance price.
Standard antidilution provisions that adjust the strike price for events such as stock dividends or stock splits are not considered to be down round features.
In practice, we have most commonly observed down round features in warrants, as well as convertible debt and preferred stock. Under the existing guidance in ASC 815-40, Derivatives and Hedging – Contracts in Entity’s Own Equity, a freestanding instrument, such as a warrant, that has a down round feature is required to be accounted for as a liability, typically at fair value with changes in fair value recognized in earnings. Additionally, a conversion option in both convertible debt and convertible preferred stock that is subject to potential adjustment due to a down round feature is required to be separately recognized at fair value as a derivative liability, with changes in fair value recognized in earnings if the conversion option by definition is a derivative and the other requirements for separation in ASC 815-15-25-1 are met.
As a result of amendments to ASC 815-40 made by the ASU, upon its adoption, freestanding equity-linked financial instruments, such as warrants and conversion options in convertible debt or preferred stock, should no longer be accounted for as a derivative liability at fair value as a result of the existence of a down round feature. It is important to note that ongoing derivative treatment may be required for other reasons; thus, a careful accounting analysis is necessary to determine the impact of the ASU as is elaborated on in the “Important implementation considerations” section later in this summary.
Accounting upon triggering a down round feature
The ASU amends ASC 260 to incorporate new guidance relevant to freestanding equity classified financial instruments (e.g., warrants) with down round features. This guidance applies only to entities that are required to or voluntarily present earnings per share (EPS). Each time a down round feature is triggered in a freestanding equity classified financial instrument (i.e., the strike price is reduced), the effect (value created) is accounted for by an entity that presents EPS as a dividend through a reduction to retaining earnings and an increase to the instrument’s carrying amount (e.g., additional paid in capital for warrants). This amount also reduces income available to common shareholders in basic EPS. The carrying amount of the equity classified instrument is not subject to further adjustment unless the down round feature is triggered again.
The amount to be recognized as a dividend is the difference between the following two amounts determined in accordance with ASC 820, Fair Value Measurement, immediately after the down round feature is triggered:
- The fair value of the financial instrument (ignoring the down round feature) with the strike price that was in effect before the strike price reduction
- The fair value of the financial instrument (ignoring the down round feature) with the reduced strike price resulting from the down round being triggered
An example of this accounting is provided at ASC 260-10-55-95 to 55-97. This accounting does not apply to liability classified instruments, which generally require ongoing fair value measurement.
Convertible instruments are not subject to the guidance added to ASC 260 as there is existing guidance in ASC 470-20, Debt – Debt with Conversion and Other Options, as well as relevant EPS guidance in ASC 260, to address conversion features that are not required to be accounted for as a derivative. (ASC 815 requires ongoing fair value measurement through earnings to conversion features that are required to be accounted for as a derivative.) A beneficial conversion feature will likely need to be recognized in accordance with ASC 470-20-35 when a down round feature is triggered in a convertible instrument, assuming separate recognition of the conversion option is not required under ASC 815 or the Cash Conversion provisions of ASC 470-20.
In addition to requiring various disclosures related to the impact of adoption, ASC 505, Equity, was amended by the ASU to require disclosure of certain terms, such as down round features, that may change conversion or exercise prices, as well as disclosure of actual changes that occur to the prices during the reporting period. This requirement does not extend to standard antidilution provisions as defined. Entities that report EPS are also required to disclose the amount recognized as a dividend upon triggering a down round feature in a freestanding instrument.
Effective date and transition
The effective date for public business entities is fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018, and for all other entities, fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020. Early adoption is permitted, including adoption in an interim period, in which case any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period.
We anticipate entities that have been required to account for an instrument or embedded feature as a derivative due solely to the existence of a down round feature will be interested in early adoption to avoid the cost and income statement volatility associated with fair value accounting.
The ASU permits the amendments to be applied in one of two 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) of adoption (i.e., modified retrospective application)
- Retrospectively to outstanding financial instruments with a down round feature for each prior reporting period presented (i.e., retrospective application)
As is more fully elaborated on in the “Basis for Conclusions” of the ASU (beginning at BC50), if, upon adoption, a freestanding instrument is reclassified from a liability to equity, the difference in retained earnings that would have been reported if the ASU was in effect at the issuance and throughout the term of the financial instrument is recognized as a cumulative-effect adjustment of the opening balance of retained earnings. The carrying amount of the instrument in equity is determined on the basis of the proceeds received at issuance or on the basis of its relative fair value, as applicable.
If, upon adoption, a conversion option in a convertible instrument no longer requires derivative treatment, it is recombined with the host instrument at the date of adoption. The difference in retained earnings that would have been reported if the ASU was in effect at issuance of the convertible instrument is recognized as a cumulative-effect adjustment of the opening balance of retained earnings and as an adjustment of the carrying amount of the recombined instrument. The recombined instrument should be classified as a liability or equity instrument in its entirety as appropriate. However, if the convertible instrument has a cash conversion feature or a beneficial conversion feature (as elaborated on in ASC 470-20) that was triggered before the effective date of the ASU, upon adoption of the ASU, a portion of the convertible instrument would be reported in additional paid in capital as if ASC 470-20 had been applied upon issuance or upon trigger, as appropriate, with any resulting difference in retained earnings recognized as a cumulative-effect adjustment of the opening balance of retained earnings.
Important implementation considerations
The accounting for convertible instruments and equity-linked instruments such as warrants is very complex and is the subject of our guide, Accounting for debt and equity instruments in financing transactions. To determine the impact of adoption, an entity will need to reperform the accounting analysis for instruments with down round features that are outstanding at the date of adoption as though the ASU was in effect throughout the life of each instrument. Careful consideration needs to be given to all the terms of an instrument, as well as other facts and circumstances, before concluding that as a consequence of the ASU an instrument or conversion option no longer requires derivative treatment, given that features other than a down round and various other circumstances may necessitate liability treatment for a freestanding instrument or derivative treatment for a conversion option. We encourage you to refer to our guide for assistance in performing this analysis and to reach out to your RSM representative with questions.