No. 2016-55
15 December 2016
To the Point
FASB — proposed guidance
FASB proposes simplifying the
accounting for instruments with
’down round’ features
All entities that
issue equity-linked
financial instruments
(freestanding or
embedded) with
down round features
would be affected.
What you need to know
•
The FASB proposed eliminating today’s requirement to consider “down round”
features when determining whether certain equity-linked financial instruments or
embedded features are indexed to an entity’s own stock.
•
Entities would be required to recognize the effect of a down round feature only when
it is triggered as either a dividend or a charge to net income, depending on the
balance sheet classification of the instrument (i.e., equity or a liability).
•
The proposal would require additional disclosures for financial instruments with down
round features.
•
Comments are due by 6 February 2017.
Overview
The Financial Accounting Standards Board (FASB or Board) proposed 1 simplifying the
accounting for certain equity-linked financial instruments or embedded features with down
round features, which are provisions that reduce the exercise price of the related financial
instrument when the pricing of a future round of financing is lower.
Current US GAAP often requires issuing entities to account for these instruments or
embedded features at fair value with changes in fair value recorded through earnings, which
creates measurement complexity and a reporting burden. The proposal would reduce these
costs and complexity.
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The FASB also proposed replacing today’s indefinite deferral of the guidance in Accounting
Standards Codification (ASC) 480-10 2 for certain mandatorily redeemable financial
instruments and mandatorily redeemable noncontrolling interests with a scope exception.
This change would not have an accounting effect.
Background
A down round feature is a provision in an equity-linked financial instrument or embedded
feature (e.g., a freestanding warrant, a conversion option in a convertible instrument) that
reduces the exercise price of the instrument or embedded feature if the entity sells stock or
another equity-linked instrument for a price (or with an exercise price) lower than the current
exercise price of the existing instrument or embedded feature. Down round features, which
are most prevalent in warrants and convertible instruments (debt or preferred stock), are
designed to protect the holder of the instrument from declines in the issuer’s share price.
The most common form of down round feature adjusts the exercise price to the new issuance
or exercise price. For example, if an entity has an outstanding warrant with an exercise price
of $10 and a down round feature, and the entity subsequently issues convertible debt with a
conversion price of $8, the down round feature would require the warrant’s exercise price to
be adjusted to $8 (i.e., the price of the conversion option in the new round of financing).
Down round features also may reduce the exercise price based on a formula.
ASC 815-40 3 requires that a freestanding equity-linked financial instrument be indexed to
the issuer’s own stock to be classified as equity. Embedded features that meet the definition
of a derivative also must be indexed to the issuer’s own stock to avoid bifurcation and
derivative accounting. A freestanding financial instrument (or embedded feature) currently isn’t
considered indexed to the issuer’s own stock if it has a down round feature.
Consequently, a freestanding financial instrument that is classified as a liability (or asset) and
meets the definition of a derivative must be measured at fair value with changes in fair value
recorded through earnings. An embedded equity-linked feature that is bifurcated and
separately accounted for as a derivative is also measured at fair value through earnings.
Measuring these instruments and features at fair value is complex and costly. Further, many
stakeholders suggest that this accounting does not reflect the true economics of a down
round feature because changes in the fair value of the instrument (or embedded feature) are
recognized in earnings for both increases and decreases in the entity’s share price, but an
increase in share price does not cause a down round feature to be triggered.
Key considerations
Under the proposal, entities would no longer be required to consider a down round feature
when determining whether a freestanding financial instrument (e.g., a warrant) or an
embedded equity-linked feature (e.g., a conversion option) that contains a down round
feature is considered indexed to the entity’s own equity under ASC 815-40. As discussed
above, this is the key criterion for an instrument to be classified as equity and for an
embedded feature to be exempt from bifurcation and derivative accounting.
How we see it
Under the proposal, more equity-linked financial instruments would likely be classified as
equity and fewer embedded features would likely have to be bifurcated and accounted for
as derivatives. This would reduce the complexity of measuring these instruments and
features at fair value, thereby achieving the Board’s objective of reducing cost and
complexity in this area of accounting.
2 | To the Point FASB proposes simplifying the accounting for instruments with ’down round’ features 15 December 2016
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Effects recognized when the feature is triggered
The proposal would require an entity to recognize the value of a down round feature when it is
triggered (i.e., when the exercise price of the equity-linked instrument or embedded feature is
adjusted downward). The Board believes that reporting the effect of a down round feature
only when the value it provides is transferred to the holder better aligns the accounting for
financial instruments with the feature and the economics of the feature.
Under the proposal, entities would measure the value of a down round feature as the difference
between (1) the fair value of the financial instrument (without the down round feature) with its
current exercise price and (2) the fair value of the financial instrument (without the down round
feature) with the adjusted exercise price (i.e., the price after the down round feature is triggered).
How we see it
The “without the down round” approach the FASB proposed is a practical way for issuers
to measure the value of a down round feature. The approach would reduce the complexity
of measuring instruments that contain down round features at fair value.
A down round
feature, by itself,
would not preclude
an instrument or
embedded feature
from being indexed
to the entity’s
own stock.
The effect of a down round feature would be recognized as either a dividend or a charge to net
income, depending on the balance sheet classification of the instrument (i.e., equity or a liability) that
includes the down round feature. The value recognized would not be subsequently remeasured.
Illustration 1 — Warrants with a down round feature
On 1 January 2016, Entity A issues warrants that permit the holder to buy 100 shares of
its common stock for $10 per share. The warrants have a five-year term and can be
exercised at any time. The terms specify that if Entity A issues common stock with an
issuance price per share, or convertible securities or warrants with an exercise price per
share, lower than the warrants’ current exercise price, the exercise price of existing
warrants will be reduced to the issuance price of the shares or the exercise price of the
newly issued convertible securities or warrants. On 1 July 2016, Entity A issues convertible
debt with a conversion price of $8. Because the debt can be converted to common stock
for less than the warrants’ exercise price, the down round feature is triggered and Entity A
adjusts the warrants’ exercise price to $8 per share.
On 1 July 2016, Entity A compares (1) the fair value of the warrants (without the down
round feature) with an exercise price of $10 and (2) the fair value of the warrants (without
the down round feature) with an exercise price of $8 and determines that the value
transferred to the warrant holders is $80. As a result, Entity A would make the following
entries, depending on the classification of the warrants:
If warrants are classified in equity pursuant to the proposal:
Dr. Retained earnings
$
80
Cr. Additional paid-in capital
$
80
$
80
If warrants are classified in liability pursuant to the proposal:
Dr. Earnings
Cr. Warrant liability
$
80
The $80 recorded in the additional paid-in capital or warrant liability would not be
subsequently remeasured.
3 | To the Point FASB proposes simplifying the accounting for instruments with ’down round’ features 15 December 2016
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The proposal would require that the increase in the carrying amount of liability-classified
instruments that are not measured at fair value be amortized by using the effective interest
method pursuant to ASC 835. Any remaining unamortized amount would be recognized as
part of the extinguishment gain or loss of the liability-classified instrument when it is
subsequently extinguished.
Because down round features may be triggered multiple times, the value transferred to the
holder would be measured and recognized in the same way each time.
Scope exceptions
The proposal provides a separate recognition and measurement model for down round
features but excludes from its scope certain items, including (1) financial instruments that are
classified as assets or liabilities under ASC 480-10; (2) freestanding financial instruments and
embedded features that are measured at fair value with changes in fair value recorded through
earnings for other reasons; and (3) convertible instruments that are required to be separated
into liability and equity components (e.g., under the guidance on beneficial conversion features
or cash conversion guidance in ASC 470-20 4).
How we see it
Because convertible instruments with down round features are subject to the contingent
beneficial conversion feature guidance in ASC 470-20, we believe the recognition and
measurement model for down round features under the proposal would generally not
apply to them. This outcome is consistent with the Board’s objective of reducing complexity
in accounting for financial instruments with characteristics of liabilities and equity.
Disclosures, transition and effective date
For an instrument with a down round feature that was triggered during a reporting period, the
proposal would require disclosure of that fact, the value of the reduction in exercise price and
where in the financial statements that value is recorded.
The FASB will determine an effective date after considering stakeholders’ feedback. The
cumulative effect of the change would be recognized as an adjustment to the opening balance
of retained earnings in the period of adoption.
Endnotes:
1
2
3
4
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SCORE No. 04398-161US
ey.com/us/accountinglink
Proposed Accounting Standards Update, Distinguishing Liabilities from Equity (Topic 480): (I) Accounting for
Certain Financial Instruments with Down Round Features (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.
ASC 480-10, Distinguishing Liabilities from Equity — Overall.
ASC 815-40, Derivatives and Hedging — Contracts in Entity’s Own Equity.
ASC 470-20, Debt — Debt with Conversion and Other Options.
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4 | To the Point FASB proposes simplifying the accounting for instruments with ’down round’ features 15 December 2016