Introduction
BC1. The following summarizes the Task Force’s considerations in reaching the conclusions in this Update. It includes the Board’s basis for ratifying the Task Force conclusions when needed to supplement the Task Force’s considerations. It also includes reasons for accepting certain approaches and rejecting others. Individual Task Force and Board members gave greater weight to some factors than to others.
Background Information
BC2. The Board is issuing this Update to clarify and reduce diversity in an issuer’s accounting for modifications or exchanges of freestanding equity-classified written call options (for example, warrants) that remain equity classified after modification or exchange.
BC3. Stakeholders asserted that there is diversity in an issuer’s accounting for economically similar modifications or exchanges of freestanding equity-classified written call options due to a lack of explicit guidance in the Codification. Stakeholders requested that the Board provide guidance that would clarify whether an issuer would account for a modification or an exchange of a freestanding equity-classified written call option that remains equity classified after modification or exchange as (a) an adjustment to equity and, if so, the related EPS effects, if any, or (b) an expense and, if so, the manner and pattern of recognition.
BC4. On September 18, 2019, the Board added a narrow scope project to the EITF agenda with the objective of providing authoritative guidance to clarify and reduce the diversity in an issuer’s accounting for modifications or exchanges of freestanding equity-classified warrants that remain equity classified after modification. At that meeting, the Board clarified that the scope of that project included all freestanding written call options that are similar to warrants in economic substance but may differ in legal form. In deliberating that issue, one Task Force member noted the similarities with an issuer’s considerations in accounting for modifications or exchanges of other freestanding equity-classified derivative instruments (such as forwards) that remain equity classified after modification or exchange because there is a lack of explicit guidance in the Codification. That Task Force member suggested that the scope of the project should be expanded to address forwards and options. The Task Force reached a consensus-for-exposure to expand the scope of the project to include modifications or exchanges of freestanding equity-classified forwards and options that remain equity classified after modification or exchange.
BC5. The Board issued proposed Accounting Standards Update, Earnings Per Share (Topic 260), Debt—Modifications and Extinguishments (Subtopic 470-50), Compensation—Stock Compensation (Topic 718), and Derivatives and Hedging— Contracts in Entity’s Own Equity (Subtopic 815-40): Issuer’s Accounting for Certain Modifications or Exchanges of Freestanding Equity-Classified Forwards and Options, on October 26, 2020, with comments due by December 28, 2020. The Board received nine comment letters. Overall, respondents supported the amendments in the proposed Update, noting that the proposed amendments would clarify and reduce diversity in an issuer’s accounting for modifications of equity-classified freestanding written call options that remain equity classified after modification. However, many respondents raised concerns about the decision to expand the scope of the proposed amendments beyond written call options to include forwards and purchased options. Specifically, stakeholders highlighted that the application of the proposed amendments to purchased call options could result in unintended consequences of entities (a) recognizing gains for modifications or exchanges that result in increased fair value of purchased call options or (b) not recognizing economically detrimental modifications or exchanges that result in decreased fair value of purchased call options.
BC6. The Task Force considered feedback received on the proposed Update at its March 11, 2021 meeting and reached a consensus. In redeliberating this issue, the Task Force decided to limit the scope of the amendments in the final Update to an issuer’s accounting for modifications of freestanding equity-classified written call options that remain equity classified after modification. The Board ratified the consensus on March 24, 2021, resulting in the issuance of this Update.
Benefits and Costs
BC7. The objective of financial reporting is to provide information that is useful to present and potential investors, creditors, donors, and other capital market participants in making rational investment, credit, and similar resource allocation decisions. However, the benefits of providing information for that purpose should justify the related costs. Present and potential investors, creditors, donors, and other users of financial information benefit from improvements in financial reporting, while the costs to implement new guidance are borne primarily by present investors. The Task Force’s assessment of the costs and benefits of issuing new guidance is unavoidably more qualitative than quantitative because there is no method to objectively measure the costs to implement new guidance or to quantify the value of improved information in financial statements.
BC8. Overall, the Task Force believes that the amendments in this Update will clarify and reduce the diversity in an issuer’s accounting for modifications or exchanges of freestanding equity-classified written call options that remain equity classified after modification or exchange and will either improve or maintain the decision usefulness of information provided to present and potential investors, creditors, donors, and other users. Additionally, the Task Force believes that stakeholders will benefit from reduced costs and complexity related to preparing, auditing, and regulating the financial information about those modifications or exchanges. The Task Force noted that depending on the frequency of those transactions, a full retrospective adoption could be a costly and time-intensive undertaking and, therefore, decided to require a prospective adoption.
BC9. The Task Force’s specific considerations about costs and benefits of the amendments are further discussed within each of the following sections.
Basis for Conclusions
BC10. The Task Force reached a consensus that an entity should treat a modification of the terms or conditions or an exchange of a freestanding equity-classified written call option that remains equity classified after modification or exchange as an exchange of the original instrument for a new instrument. The Task Force noted that the amendments in this Update should be applicable regardless of whether a modification is executed through an amendment to an existing instrument or a replacement of an existing instrument with a new instrument. The Task Force also noted that the amendments in this Update provide guidance for a modification or an exchange of a freestanding equity-classified written call option that is not within the scope of another Topic.
BC11. The Task Force reached a consensus that an entity should measure the effect of a modification or an exchange of a freestanding equity-classified written call option that remains equity classified after modification or exchange as follows:
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For a modification or an exchange that is a part of or directly related to a modification or an exchange of an existing debt instrument, as the difference between the fair value of the modified or exchanged written call option and the fair value of that written call option immediately before it is modified or exchanged. Specifically, an entity should consider:
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An increase or a decrease in the fair value of the modified or exchanged written call option in applying the 10 percent cash flow test and/or calculating the fees between debtor and creditor in accordance with Subtopic 470-50.
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An increase (but not a decrease) in the fair value of the modified or exchanged written call option in calculating the third-party costs in accordance with Subtopic 470-50.
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For all other modifications or exchanges, as the excess, if any, of the fair value of the modified or exchanged written call option over the fair value of that written call option immediately before it is modified or exchanged.
BC12. The Task Force noted that the measurement approach for modifications or exchanges of written call options that are related to a modification of existing debt is consistent with the requirements under Subtopic 470-50. For other modifications or exchanges of written call options within the scope of the amendments in this Update, the Task Force noted that the measurement approach in this Update is similar to the share-based payment model in Topic 718 on stock compensation, which does not result in accounting by the issuer for modifications that result in a reduction in the value of an instrument.
BC13. The Task Force deliberated whether an issuer’s recognition of modifications or exchanges of freestanding equity-classified written call options should be based on the substance of the transaction. The Task Force noted that an issuer should recognize those modifications or exchanges in the same manner as if cash were paid instead of modifying or exchanging those instruments. That is, an issuer should not reach a different accounting conclusion depending on the form of the consideration (cash or noncash). Additionally, the Task Force considered that while the facts and circumstances of those modifications or exchanges may differ and, thus, justify differences in recognition, sufficient guidance or accounting principles exist in the Codification to address those fact patterns. Therefore, the Task Force decided to provide a principles-based recognition framework that leverages existing guidance and specifies its application according to the substance of a modification or an exchange transaction.
BC14. The Task Force reached a consensus that an entity should recognize the effect of a modification or an exchange of a freestanding equity-classified written call option that remains equity classified after modification or exchange and is not within the scope of another Topic on the basis of the substance of the transaction, in the same manner as if cash had been paid as consideration, as follows:
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If the modification or exchange is executed in a financing transaction to raise equity, the effect should be recognized as an equity issuance cost in accordance with the guidance in Topic 340 on other assets and deferred costs.
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If the modification or exchange is executed in a financing transaction to raise new debt or modify existing debt, the effect should be recognized as a cost in accordance with the guidance in Topic 470 on debt and Topic 835 on interest.
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For other modifications that are not related to financings or compensation for goods or services or other exchange transactions addressed by other Topics, the effect should be recognized as a dividend. For entities that present EPS in accordance with Topic 260, that dividend should be an adjustment to net income (or net loss) in the basic EPS calculation.
BC15. The Task Force noted that if a modification or exchange is executed to compensate for the transfer of goods or services, the effect should be recognized in accordance with the guidance in Topic 718.
BC16. Additionally, the Task Force noted that to determine the substance of a modification or an exchange, an entity should analyze all relevant facts and circumstances of the modification such as reasons for the modification, relationship of the holder of the freestanding equity-classified written call option to the entity, other relationships affecting the transaction, other transactions consummated with or entered into in contemplation of the modification, and other rights and privileges obtained or obligations incurred.
BC17. The Task Force considered whether the substance of a modification or an exchange executed in a financing transaction to raise equity, such as that described in Example 22, Case A in paragraph 815-40-55-50 of Subtopic 815-40 on contracts in entity’s own equity, might be viewed as a dividend because the modification is not made available to all common stockholders and because recognizing the modification as an equity issuance cost is not consistent with the accounting for the inducement of conversion of convertible preferred stock. The Task Force noted, however, that had the issuer paid cash to the holder (instead of modifying warrants) to raise equity in that example, the issuer would recognize it as an equity issuance cost. The Task Force considered that the issuer should not reach a different accounting conclusion depending on the form of the consideration and concluded that recognizing the effect of the warrant modification as an equity issuance cost is appropriate in that example. One Task Force member disagreed with the view that the effect of a modification or exchange executed in a financing transaction to raise equity should be recognized as an equity issuance cost and preferred recognizing the effect as a dividend. That member noted that a modification or an exchange made available disproportionately to some common stockholders is akin to a preferential distribution of dividends and should be reflected in EPS, consistent with the accounting for the inducement of conversion of convertible preferred stock.
BC18. While the Task Force noted that modifications or exchanges that are not related to financings or compensation for goods or services (as discussed in paragraph 815-40-35-17(d)) are not prevalent in practice, the Task Force concluded that a transaction that does not represent costs of financing and is not within the scope of other Topics (for example, compensation cost under Topic 718) should be recognized as a dividend by the issuer. Some Task Force members disagreed with including that category in the recognition framework because in their view that type of modification or exchange is not common in practice. Some Task Force members disagreed with dividend treatment for the modifications or exchanges in that category because their preferred recognition approach for that category was either (a) as an expense or (b) as a dividend or an expense based on the facts and circumstances of the transaction.
BC19. Additionally, the Task Force noted that if a modification or an exchange is executed in exchange for an agreement by the holder of the written call option to abandon certain acquisition plans, forgo other planned transactions, settle litigation, settle employment contracts, or voluntarily restrict its purchase of shares of the issuing entity or the issuing entity’s affiliates within a stated time period, those rights and privileges obtained, both stated and unstated, or other elements of the transaction should be accounted for according to their substance (that is, as a cost to the issuing entity) rather than as a dividend distribution.
BC20. The Task Force rejected alternatives that would have required that an entity recognize the effects of all modifications or exchanges within the scope of this Update as an expense or a dividend because the Task Force concluded that the accounting outcome under those alternatives would not necessarily represent the substance of the transaction.
BC21. In a multiple-element transaction (for example, one that includes both debt financing and equity financing), an entity should allocate the total effect of the modification or exchange to the respective elements in the transaction.
BC22. The Task Force decided to require incremental disclosures for an issuer to improve transparency about the nature and effects of the transactions within the scope of the amendments in this Update.
Effective Date and Transition
BC23. The Task Force decided that the amendments in this Update should be effective for all entities for fiscal years beginning after December 15, 2021, including interim periods within those fiscal years.
BC24. The Task Force reached a consensus that an entity should apply the amendments in this Update prospectively to all new modifications or exchanges occurring after the effective date of the amendments. Early adoption is permitted. If early adoption is elected in an interim period, the guidance will be effective as of the beginning of the fiscal year that includes that interim period.
BC25. The Task Force reached a consensus to require that in accordance with Topic 250, Accounting Changes and Error Corrections, an entity disclose in the period of adoption the nature of and reasons for the change in accounting principle, the transition method, and a qualitative description of the financial statement line items affected by the change.