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Journal entry — Liabilities and equity — FASB begins deliberating targeted improvements

Published on: Sep 17, 2015

At its meeting yesterday, the FASB began deliberating the first phase of its targeted-improvements project related to liabilities and equity. In this phase, the Board plans to address (1) the accounting for equity-linked financial instruments containing “down-round” features and (2) the indefinite deferral of the liability classification requirements in ASC 4801 for certain instruments and entities.

Down-Round Features

With respect to down-round features, the Board tentatively decided to create a new accounting model that would replace the existing guidance on such features in ASC 815-40.

Editor’s Note: A down-round feature is a provision within an equity-linked financial instrument (e.g., a freestanding warrant contract or an equity conversion feature embedded within a host debt or equity contract) that triggers a downward adjustment to the instrument’s strike price (or conversion price) if the entity issues equity shares at a lower price (or equity-linked financial instruments with a lower strike price) than the instrument’s strike price. The purpose of the feature is to protect the instrument’s counterparty from future issuances of equity shares at a more favorable price. For example, a warrant may specify that the strike price is the lower of $5 per share or the common stock offering price in any future initial public offering of the shares. Under current U.S. GAAP, a contract that contains a down-round feature does not qualify as equity because it precludes a conclusion that the contract is indexed to the entity’s own stock under ASC 815-40-15 (as illustrated in ASC 815-40-55-33 and 55-34).

Unlike current U.S. GAAP, the Board’s tentative approach related to down-round features would not preclude an entity from concluding that an instrument is indexed to the entity’s own stock. For example, when an entity evaluates whether it is required to classify a freestanding warrant to acquire the entity’s common stock as a liability under ASC 815-40, the existence of the down-round feature would not affect the analysis. Similarly, a down-round feature would be excluded from the analysis of whether an embedded conversion feature in a debt host contract must be bifurcated as an embedded derivative under ASC 815-15 or whether it qualifies for the derivative accounting scope exception in ASC 815-10-15-74 for contracts indexed to an entity’s own stock and classified in stockholders’ equity.

Under the tentative approach, a down-round feature would result in an accounting impact if it is triggered, at which time the accounting treatment would be in line with the classification of the related instrument. For an equity-classified instrument, the transfer of value from the entity to the holder at the time the down-round feature is triggered would result in the recognition of a dividend to the investor. If the instrument is classified as a liability, the transfer of value resulting from the down-round feature when triggered would be recognized through a charge to earnings. 

With respect to disclosures, the Board was not in favor of creating any new requirements since it believes that existing U.S. GAAP requirements sufficiently address disclosures related to instruments with down-round features. However, the Board did support establishing an additional narrow requirement for entities to disclose, in the period the down-round feature is triggered, the impact of recognizing the feature.

The Board also tentatively decided that the revised down-round accounting model, if adopted, would be subject to a cumulative-effect transition approach.

Indefinite Deferrals Under ASC 480-10

The transition guidance in ASC 480-10 indefinitely defers the application of some of its requirements to certain instruments and entities (i.e., certain mandatorily redeemable financial instruments of nonpublic entities that are not SEC registrants and certain mandatorily redeemable noncontrolling interests). Accordingly, such instruments may qualify as equity under U.S. GAAP even though ASC 480-10-25 suggests that they should be classified as liabilities.

Editor’s Note: ASC 480-10 requires issuers to classify mandatorily redeemable financial instruments as liabilities. In 2003, the FASB indefinitely deferred the effective date of these requirements for certain entities and instruments. Within the Codification, these requirements are labeled “pending content.” However, the transition guidance in ASC 480-10-65 provides no effective date for this pending content. Therefore, the transition guidance effectively provides scope exceptions for parts of the accounting guidance in ASC 480-10 for affected entities and instruments. The Board’s primary objective in evaluating the indefinite deferrals is to improve the navigability of the Codification. The scope of this project is narrow and not intended to change any existing requirements.

The Board tentatively agreed to replace the indefinite deferrals in ASC 480-10 with scope exceptions that have the same applicability. 

Next Steps

The Board directed its staff to prepare an exposure draft. The comment period is not expected to end before February 16, 2016.

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1 For titles of FASB Accounting Standards Codification (ASC) references, see Deloitte’s “Titles of Topics and Subtopics in the FASB Accounting Standards Codification.”

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