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Common stock is subordinate to all other equity of the issuer and is often referred to as residual equity. A share of common stock usually provides its holder with voting rights, which enables it to influence the operating and financial policies of an investee. Common stock represents the residual value of an entity after all senior interests (e.g., liabilities, senior classes of equity) have been accounted for.

1.2.1 In-substance common stock investments

An investor may hold stock or other instruments that have risk and reward characteristics that are substantially similar to common stock. These instruments are commonly referred to as in-substance common stock investments.
To determine whether an investment is “substantially similar” to common stock, an investor should consider the following characteristics outlined in ASC 323-10-15-13:
If any of these characteristics of the investment are not substantially similar to common stock, the investment is not in-substance common stock and would not be within the scope of ASC 323. In that case, the investor should not apply the equity method of accounting, even if the investor has significant influence.
If an investor cannot make a determination based on a qualitative assessment of these characteristics, the investor should perform a quantitative assessment by analyzing whether the future changes in the fair value of the investment are expected to vary directly with the changes in the fair value of the investee’s common stock. If not, the investment is not considered in-substance common stock.
Paragraph 5 of EITF 02-14 noted that investments in other non-corporate entities, such as partnerships or limited liability companies, are not subject to the in-substance common stock guidance. While not included in the FASB codification, we believe this guidance should still be followed when determining scope. Therefore, these investments should be accounted for under ASC 323-30-15-2. See EM 1.3 for further information.

1.2.1.1 Subordination criterion — in-substance common stock

An investment without a stated liquidation preference, or with a nonsubstantive liquidation preference, over the investee’s common stock, may be substantially similar to common stock and further analysis of the other criteria will be needed. In contrast, an investment with a substantive liquidation preference over common stock is not substantially similar to that entity’s common stock. An investor should consider the following when assessing if a stated liquidation preference is substantive:
  • The liquidation preference may be substantive if it is significant in relation to the purchase price of the investment.
  • A liquidation preference in an investment is more likely to be substantive when the fair value of subordinated equity (i.e., the investee’s common stock) is significant. Conversely, if there is little or no fair value associated with the investee’s common stock, the investment would participate in substantially all of the investee’s losses in the event of liquidation, and the liquidation preference would not be considered substantive.
Example EM 1-1, Example EM 1-2, and Example EM 1-3 illustrate the evaluation of whether an investment has substantially similar subordination as common stock.
EXAMPLE EM 1-1
Investee’s common stock has little fair value
On January 1, 20X0, Investor purchased 200,000 shares of preferred stock of Investee in exchange for $20,000,000 ($100 par value, liquidation preference of $100 per share). On January 1, 20X0, the fair value of Investee’s outstanding common stock was $300,000.
Investor has the ability to exercise significant influence over Investee’s operating and financial policies through its investment in Investee.
Are the subordination characteristics of Investor’s investment in the preferred stock of Investee substantially similar to the subordination characteristics of Investee’s common stock?
Analysis
The liquidation preference stated in the preferred stock of Investee is equal to the purchase price (and fair value) of the preferred stock on the date of purchase. Therefore, the stated liquidation preference is significant in relation to the purchase price of the investment. However, the fair value of Investee’s common stock ($300,000), compared to the fair value of Investee’s preferred stock ($20,000,000), indicates that Investee’s common stock has little fair value compared to the investment.
In the event of liquidation, Investor’s investment, while preferred stock, would likely participate in substantially all of Investee’s losses. As a result, it’s likely that the liquidation preference in its investment in the preferred stock of Investee is not substantive and that the subordination characteristic of its investment in the preferred stock of Investee are substantially similar to that of the Investee’s common stock.
Investor should also evaluate the risks and rewards of ownership (see EM 1.2.1.2) and obligation to transfer value (see EM 1.2.1.3) to determine whether its investment in the preferred stock of Investee is in-substance common stock.
EXAMPLE EM 1-2
Liquidation preference is insignificant in relation to the purchase price of the investment
On January 1, 20X0, Investor purchased 200,000 shares of preferred stock of Investee in exchange for $20,000,000 ($100 par value, liquidation preference of $1 per share). On January 1, 20X0, the fair value of Investee’s outstanding common stock was $100,000,000.
Investor has the ability to exercise significant influence over Investee’s operating and financial policies through its investment in Investee.
Are the subordination characteristics of Investor’s investment in the preferred stock of Investee substantially similar to the subordination characteristics of Investee’s common stock?
Analysis
The liquidation preference stated in the preferred stock of Investee is equal to 1% ($1 per share divided by $100 per share) of the purchase price (and fair value) of the preferred stock on the date of purchase.
The fair value of Investee’s common stock ($100,000,000), as compared to the fair value of Investee’s preferred stock ($20,000,000), indicates that Investee has significant value associated with its common stock from a fair value perspective.
Given that the liquidation preference is only 1% of the purchase price, Investor is likely to conclude that the liquidation preference of its investment is not substantive and that the subordination characteristic is substantially similar to the subordination characteristics of Investee’s common stock.
Investor should also evaluate the risks and rewards of ownership (see EM 1.2.1.2) and obligation to transfer value (see EM 1.2.1.3) criteria in its determination of whether its investment in the preferred stock of Investee is in-substance common stock.
EXAMPLE EM 1-3
Subordination is not substantially similar to common stock
On January 1, 20X0, Investor purchased 200,000 shares of preferred stock of Investee in exchange for $20,000,000 ($100 par value, liquidation preference of $100 per share). On January 1, 20X0, the fair value of Investee’s outstanding common stock was $100,000,000.
Investor has the ability to exercise significant influence over Investee’s operating and financial policies through its investment in Investee.
Are the subordination characteristics of Investor’s investment in the preferred stock of Investee substantially similar to the subordination characteristics of Investee’s common stock?
Analysis
The liquidation preference stated in the preferred stock of Investee is equal to the purchase price (and fair value) of the preferred stock on the date of purchase and, consequently, the stated liquidation preference is significant in relation to the purchase price of the investment. Further, the fair value of Investee’s common stock ($100,000,000), as compared to the fair value of Investee’s preferred stock ($20,000,000), indicates that the Investee common stock has significant fair value.
Therefore, in the event of liquidation, Investor’s investment in the preferred stock of Investee would likely be protected through the existence of Investee’s common stock, which would most likely absorb a substantial portion of the losses of Investee. As a result, Investor might conclude that the liquidation preference in its investment in the preferred stock of Investee is substantive and that the subordination characteristics of its investment in the preferred stock of Investee are not substantially similar to the subordination characteristics of Investee’s common stock. If so, the preferred stock would not be considered in-substance common stock.
Investor would not be required to evaluate the risks and rewards of ownership and obligation to transfer value criteria once the subordination criterion is not met.

1.2.1.2 Risks and rewards of ownership — in-substance common stock

An investment is not substantially similar to common stock if it is not expected to participate in the earnings (and losses) and capital appreciation (and depreciation) in a manner that is substantially similar to common stock.
For example, if an investee pays dividends on common stock and the investment participates in a substantially similar manner, it indicates that the investment is substantially similar to common stock. Investors should consider whether the investee is expected to pay dividends when determining if participation in dividends is relevant to assessing risks and rewards of ownership.
The ability to convert an investment into that investee’s common stock without any significant restrictions or contingencies may indicate that the investor may participate in capital appreciation of the investee in a manner that is substantially similar to common stock. In making a determination, an investor would also consider the risks inherent in the investment.
Example EM 1-4 and Example EM 1-5 illustrate the evaluation of whether an investment is expected to participate in the risks and rewards of ownership of common stock.
EXAMPLE EM 1-4
Investment expected to participate in risks and rewards of ownership
On January 1, 20X0, Investor purchased a warrant for $1,000,000. The warrant enables Investor to acquire 50,000 shares of Investee’s common stock at an exercise price of $1.50 per share (total exercise price of $75,000). The warrant is exercisable at any time on or before December 31, 20X0. There are no significant restrictions or contingencies associated with Investor’s ability to exercise the warrant. The warrant does not participate in dividends paid to the common shareholders of Investee. However, Investor does not expect Investee to pay dividends to its common shareholders during the exercise period (January 1, 20X0 – December 31, 20X0). On January 1, 20X0, the fair value of Investee’s common stock is approximately $21.00.
Investor has the ability to exercise significant influence over Investee’s operating and financial policies through its investment in Investee.
Is Investor’s investment expected to participate in Investee’s earnings (and losses) and capital appreciation (and depreciation) in a manner that is substantially similar to Investee’s common stock?
Analysis
Investor can exercise the warrant and convert its investment to common stock at any time during the exercise period, without any significant restrictions or contingencies; therefore, Investor’s investment enables it to participate equally with the common shareholders in increases in Investee’s fair value. Investor also does not expect Investee to pay dividends to its common shareholders during the exercise period; therefore, dividends that could become payable to common shareholders are not expected to result in a difference in the earnings and losses available to the (a) Investor’s investment (warrant) and (b) Investee’s common shares.
Investors have alternatives in making this assessment. In this case, the current fair value of Investee’s common stock ($21.00) is substantially similar to the current fair value of a warrant to purchase one share of common stock ($20.00, or $1,000,000/50,000). Therefore, the warrant’s expected participation in Investee’s capital appreciation and depreciation is substantially similar to the common shareholders’ participation.
As a result, Investor is likely to conclude that, before exercise, the warrant is expected to have risks and rewards of ownership substantially similar to common stock, i.e., the warrant participates in Investee’s earnings (and losses) and capital appreciation (and depreciation) in a manner that is substantially similar to common stock.
Investor should also evaluate the subordination (see EM 1.2.1.1) and obligation to transfer value (see EM 1.2.1.3) criteria in its determination of whether its warrant is in-substance common stock.
EXAMPLE EM 1-5
Investment not expected to participate in risks and rewards of ownership
On January 1, 20X0, Investor purchased a warrant for $150,000. The warrant enables Investor to acquire 50,000 shares of Investee’s common stock at an exercise price of $19.00 per share (total exercise price of $950,000). The warrant is exercisable at any time on or before December 31, 20X0. There are no significant restrictions or contingencies associated with Investor’s ability to exercise the warrant. The warrant does not participate in dividends paid to the common shareholders of Investee. However, Investor does not expect Investee to pay dividends to its common shareholders during the exercise period (January 1, 20X0 – December 31, 20X0). On January 1, 20X0, the fair value of Investee’s common stock is $21.00.
Investor has the ability to exercise significant influence over Investee’s operating and financial policies through its investment in Investee.
Is Investor’s investment expected to participate in Investee’s earnings (and losses) and capital appreciation (and depreciation) in a manner that is substantially similar to Investee’s common stock?
Analysis
Investor can exercise the warrant and convert its investment to common stock at any time during the exercise period, without any significant restrictions or contingencies; therefore, Investor’s investment enables it to participate equally with the common shareholders in increases in Investee’s fair value. Investor also does not expect Investee to pay dividends to its common shareholders during the exercise period; therefore, dividends that could become payable to common shareholders are not expected to result in a difference in the earnings (and losses) available to the (a) Investor’s investment (warrant) and (b) Investee’s common shares.
The current fair value of Investee’s common stock ($21.00) is substantially different from the current fair value of a warrant (for this scenario, assume intrinsic value equals fair value) to purchase one share of common stock ($3.00, or $150,000/50,000). Therefore, the warrant’s expected participation in Investee’s capital depreciation is substantially different from the common shareholders’ participation. Specifically, Investor’s investment in the warrant has substantially less at risk in the event of capital depreciation than Investee’s common shares.
As a result, Investor is likely to conclude that, before exercise, the warrant is not expected to participate in Investee’s earnings (and losses) and capital appreciation (and depreciation) in a manner that is substantially similar to common stock. Therefore, the warrant is not in-substance common stock.
Investor would not be required to evaluate the subordination and obligation to transfer value criteria once the risks and rewards of ownership criterion is not met.

1.2.1.3 Obligation to transfer value – in-substance common stock

An investment is not substantially similar to common stock if the investee is expected to transfer substantive value to the investor that is not also available to common shareholders. An example of this may be an investment that includes a fixed price mandatory redemption provision or a non-fair value put option that is not available to common shareholders.
An investor should evaluate whether provisions to transfer value are substantive obligations. For example, preferred stock with a mandatory redemption in 100 years is not considered a substantive obligation to transfer value through the redemption feature, given the extreme long-dated nature of the specified future date. Alternatively, if an investee does not have the ability to pay the related redemption price that the investor is or would be entitled to at the time of investment, the redemption provision would also not be considered a substantive obligation to transfer value.
Example EM 1-6 and Example EM 1-7 illustrate the assessment if an Investee is obligated to transfer substantive value.
EXAMPLE EM 1-6
Investee not obligated to transfer substantive value
On January 1, 20X0, Investor purchased 1,000,000 shares of redeemable convertible preferred stock in Investee for $5,000,000. At the date of the investment, 100% of Investee’s common stock was valued at $400,000. The preferred shares can be converted into common shares on a one-for-one basis, or redeemed for $5,000,000. The common shareholders of Investee do not have a redemption feature.
Investor has the ability to exercise significant influence over Investee’s operating and financial policies through its investment in Investee.
Does the redemption feature obligate Investee to transfer substantive value to Investor that is not also available to common shareholders?
Analysis
The $5,000,000 redemption feature is substantive as compared to the fair value of the investment ($5,000,000) on the investment date. However, given that the fair value of the Investee’s common stock was $400,000, Investor is likely to conclude that Investee would not have the ability to pay the redemption amount if exercised. If Investee’s operating results deteriorated, the common shareholders would not be able to absorb significant losses and it would be unlikely that Investee would have the ability to redeem Investor’s preferred stock at the $5,000,000 redemption amount. Therefore, Investor’s redemption feature is not considered substantive as Investee is not expected to transfer substantive value to the Investor.
Investor should also evaluate the subordination (see EM 1.2.1.1) and risks and rewards of ownership (see EM 1.2.1.2) criteria in its determination of whether its investment is in-substance common stock.
EXAMPLE EM 1-7
Investee obligated to transfer substantive value
On January 1, 20X0, Investor purchased 1,000,000 shares of redeemable convertible preferred stock in Investee for $5,000,000. At the date of the investment, 100% of Investee’s common stock was valued at $10,000,000. The preferred shares can be converted into common shares on a one-for-one basis, or redeemed for $5,000,000. The common shareholders of Investee do not have a redemption feature.
Investor has the ability to exercise significant influence over Investee’s operating and financial policies through its investment in Investee.
Does the redemption feature obligate Investee to transfer substantive value to Investor that is not also available to common shareholders?
Analysis
The redemption feature is substantive. The fair value of Investee’s common stock was $10,000,000 and Investor concluded when it made the investment that Investee had the ability to pay the redemption amount if exercised. Therefore, Investor’s investment in the redeemable convertible preferred stock obligates Investee to transfer substantive value to Investor that is not available to Investee’s common shareholders. As such, the redeemable convertible preferred stock is not in-substance common stock.
Investor would not be required to evaluate the subordination and risk and rewards of ownership criteria once the obligation to transfer value criterion was not met.

1.2.1.4 Initial determination and reconsideration events

Investors should determine whether an investment is substantially similar to common stock based on information that exists on the date the investor determines that it has the ability to exercise significant influence. This date may be subsequent to the date that the investment was originally acquired. For example, subsequent to an initial investment, an investor may obtain representation on the board of directors that gives it the ability to exercise significant influence over the investee’s operating and financial policies. At this point, the investor would perform the initial assessment as to whether its investment is considered in-substance common stock.
As noted in ASC 323-10-15-16, an investor should reconsider its initial determination if any of the following occur:
  • The contractual terms of the investment are amended, resulting in a change in one or all of the characteristics described in EM 1.2.1. For example, a change in the form of the investment, such as an exchange of preferred stock for another series of stock, is generally considered a reconsideration event. An expected change provided for in the original terms of the contractual agreement would generally not be considered a reconsideration event.
  • There is a significant change in the investee’s capital structure, including the investee’s receipt of additional subordinated financing. For example, an increase in both the number of shares and value of outstanding common stock could affect whether the subordination characteristics of an investment are substantially different from that of common stock.
  • The investor obtains an additional interest in the investment. When reconsidering the characteristics of the investment, an investor should consider its cumulative position in the investment (including both new and existing interests) and the facts and circumstances that existed at the time the additional interest was acquired.
The determination of whether an investment is similar to common stock should not be reconsidered solely due to losses of the investee, even if those losses change the investee’s capital structure. Rather, an investor should only reconsider whether its investment is substantially similar to common stock when one of the identified reconsideration events or conditions occurs.

1.2.1.5 Put or call option representing in-substance common stock

An investor may obtain an instrument, such as a put or call option, that provides it with the right to purchase or sell the voting common stock of an investee at a future point in time. The investor must determine whether these instruments represent in-substance common stock. In performing this evaluation, an investor should first determine whether the instrument is a freestanding instrument or an embedded feature within a host agreement that might require bifurcation and separate accounting.
If the instrument is freestanding, the investor should determine whether it should be accounted for pursuant to ASC 815, Derivatives and Hedging. If the instrument is an embedded feature within a host agreement, the investor should evaluate whether the instrument should be bifurcated and accounted for separate from the host agreement pursuant to ASC 815. See DH 3 for more information.
The equity method of accounting does not apply to investments accounted for in accordance with ASC 815. Therefore, the investor should only evaluate those instruments that are not within the scope of ASC 815 to determine whether they represent in-substance common stock of the investee. Put options, call options, and other instruments that are not accounted for pursuant to ASC 815 may meet the characteristics of in-substance common stock.
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