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A reporting entity may issue an equity-linked instrument to issue shares, repurchase shares or raise financing at a reduced rate. Debt with detachable warrants, convertible debt, and convertible preferred stock are all examples of equity-linked financings. Investors in an equity-linked financing typically receive a lower cash coupon or dividend to compensate the issuer for selling an option on its own equity.
Due to their complexity, understanding equity-linked instruments requires a detailed analysis of the terms, purpose and design of each instrument issued, any related instruments, the underwriting agreement, and other relevant agreements.
The determination of whether an arrangement is in the scope of the equity-linked instruments model could require judgment. In certain situations, arrangements may have different legal forms, but the underlying economics and the substance of the transaction are the same. For example, in a special purpose acquisition company (SPAC) transaction, earnout arrangements may be entered into with the SPAC’s sponsors in the form of a legally issued and outstanding shares subject to forfeiture if the performance measures are not met (and thus the share does not vest). At the same time, an earnout arrangement may be entered into with the selling shareholders of the target company as a contract to issue shares, which is conditional upon the performance measures being met. In this instance, for accounting purposes, the earnout arrangement would be treated as a contract to issue shares (similar to the arrangement entered into with the selling shareholders of the operating company) instead of an outstanding share. In this case, the equity-linked instruments model would be applicable to both arrangements despite the difference in legal form.
This chapter discusses each of the steps and important points to consider when determining whether an equity-linked instrument should be accounted for in its entirety as equity or a liability (or asset), or separated into components.
New guidance
In August 2020, the FASB issued ASU 2020-06, Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40). The ASU simplifies the accounting for certain financial instruments with characteristics of liabilities and equity. The FASB reduced the number of accounting models for convertible debt and convertible preferred stock instruments and made certain disclosure amendments to improve the information provided to users. In addition, the FASB amended the derivative guidance for the “own stock” scope exception (see FG 5) and certain aspects of the EPS guidance.
For public business entities that meet the definition of an SEC filer, excluding entities eligible to be smaller reporting companies as defined by the SEC, the guidance is effective for fiscal years beginning after December 15, 2021, including interim periods within those fiscal years. The one-time determination of whether an entity is eligible to be a smaller reporting company is based on an entity’s most recent determination as of August 5, 2020, in accordance with SEC regulations. For all other entities, the guidance is effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years. Early adoption is permitted, but no earlier than fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. The FASB also specified that an entity must adopt the guidance as of the beginning of its annual fiscal year and is not permitted to adopt the guidance in an interim period, other than the first interim period of their fiscal year.
Guidance in this chapter has been updated to reflect the new ASU and impacted sections are denoted with “after adoption of ASU 2020-06” or “before adoption of ASU 2020-06.”
New guidance
In May 2021, the FASB issued ASU 2021-04, 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). The ASU clarifies the guidance related to 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. The amendments in the ASU are effective for all entities for fiscal years beginning after December 15, 2021, including interim periods within those fiscal years. Early adoption is permitted for all entities, including adoption in an interim period. If an entity elects early adoption in an interim period, the guidance should be applied as of the beginning of the fiscal year that includes that interim period. See FG 8.3 for further information related to modifications or exchanges of equity-classified written call options.
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