On July 13, 2017, the Financial Accounting Standard Board (“FASB”) issued Accounting Standards Update (“ASU”) 2017-11, Earnings Per Share (ASC 260), Distinguishing Liabilities from Equity (ASC 480), Derivatives and Hedging (ASC 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 Interest with a Scope Exception. This new standard will reduce income statement volatility for many companies that issue warrants and convertible instruments containing such features. The ASU, in its entirety, is available here.
Often early-stage companies issue financial instruments with embedded features that protect investors from a decline in the value of their investment. Pursuant to the simplification, financial
instruments with a down-round feature are no longer automatically to be classified as a liability solely based on the existence of the down round feature. A down round feature is a contractual term to protect the investor in an equity linked instrument such as a warrant or convertible debt from declines in the issuer’s share price under certain circumstances. It results in the strike price being reduced on the basis of the pricing of future equity offerings. Down rounds are common in warrants, convertible preferred shares, and convertible debt instruments issued by private companies and development stage public companies. Under existing GAAP, a down round feature often results in liability classification for a warrant or in bifurcation of a conversion option, which is then remeasured to fair value through earnings each period.
Part I of ASU 2017-11, simplifies the analysis of financial instruments (warrants, convertible debt and preferred stock) that contain down round features. Part II adds a scope exception to Accounting Standards Codification (“ASC”) 480 by replacing the indefinite deferral for certain mandatorily redeemable noncontrolling interests and mandatorily redeemable financial instruments of nonpublic entities, though does not impact the accounting for mandatorily redeemable financial instruments. As the amendments contained in Part II do not have an accounting effect, our focus will be on Part I of the new standard.
All Companies who regularly issue financial instruments with embedded features that protect investors from a decline in the value of their investment.
The amendments in Part 1 of this update are effective as follows:
- Public Entities
- First interim period with annual reporting periods beginning after December 15, 2018.
- Nonpublic Entities
- Annual reporting periods beginning after December 15, 2019 and interim periods within annual periods beginning after December 15, 2020.
- Early Adoption
- Early application is permitted for all entities.
ASU 2017-11 changes the classification analysis of certain equity-linked financial instruments (or embedded features) with down round features. Provided below are some of the key concepts addressed:
- 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. A standard antidilution provision is not considered a down round feature.
- 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.
- When determining whether certain financial instruments should be classified as liabilities or equity instruments, a down round feature no longer precludes equity classification when assessing whether the instrument is indexed to an entity’s own stock. As a result, a freestanding equity-linked financial instrument (or embedded conversion option) no longer would be accounted for as a derivative liability at fair value as a result of the existence of a down round feature.
- For freestanding equity-classified financial instruments, the amendment requires entities that present earnings per share (“EPS”) in accordance with ASC 260 to recognize the effect of the down round feature when it is triggered. That effect is treated as a dividend and as a reduction of income available to common shareholders in basic EPS and an increase to the instrument’s carrying amount.
- The amendments clarify existing disclosure requirements for equity-classified instruments.
- ASC 505 – Equity has been amended by the ASU and requires additional disclosures surrounding down round features. Entities that report EPS are also now required to disclose the amount recognized as a dividend upon triggering a down round feature in a freestanding instrument. Additionally, an entity should also disclose within the financial statements actual changes to conversion or exercise prices that occur during the reporting period.
- Convertible instruments with embedded conversion that have down round features will be accounted for under existing specialized guidance for contingent beneficial conversion features in Subtopic 470-410, including the related EPS guidance.
The amendments in this Update should be applied in either of the following 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 fiscal year and interim period(s) of adoption.
- Retrospectively to outstanding financial instruments with a down and round feature for each prior reporting period presented in accordance with the guidance on accounting changes in paragraphs 250-10-45-5 through 45-10.
A SU 2017-11 was released by the FASB to address the complexity and cost associated with the accounting for certain financial instruments with down round features that require fair value measurement of the entire instrument or conversion option. In addition, to address the reporting burden and income statement volatility associated with freestanding and embedded instruments
with down round features classified as a liability on a Company’s balance sheet. By meeting the required criteria for equity classification in Subtopic 815-40, the Company will no longer need to re-measure the instrument at fair value at each reporting period or separately account for a bifurcated derivative based on the existence of a down round feature.
For Companies that present EPS in accordance with ASC 260, ASU 2017-11 incorporates new guidance relevant to freestanding instruments with down round features. When the down round feature is triggered in an equity classified financial instrument, the value created is accounted for as a dividend through a reduction to retained earnings and an increase to the carrying amount. In effect, when the strike price is reduced so is income available to common shareholders. The equity classified financial instrument is not adjusted unless the down round feature is triggered again.
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