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An equity-linked component can be embedded in a host instrument, such as a debt (e.g., convertible debt) or preferred stock (e.g., convertible preferred stock), that has economic value other than the equity-linked component. Alternatively, an instrument can comprise only the equity-linked component, as is the case with a freestanding warrant. The term “freestanding” also applies to a single financial instrument that comprises more than one option or forward component; for example, a collar, which consists of a written put option and a purchased call option.
ASC 480, Distinguishing Liabilities from Equity, applies to an issuer’s classification and measurement of certain freestanding financial instruments. Thus, the first step in determining the accounting for an equity-linked instrument is to determine whether the equity-linked feature is freestanding or embedded in a host instrument. See FG 5.5 for further information on the application of ASC 480.
The ASC Master Glossary provides a definition of a freestanding financial instrument.

Definition from ASC Master Glossary

Freestanding financial instrument: A financial instrument that meets either of the following conditions:

  1. It is entered into separately and apart from any of the entity’s other financial instruments or equity transactions.
  2. It is entered into in conjunction with some other transaction and is legally detachable and separately exercisable.

In determining whether an equity-linked component is a freestanding financial instrument or embedded in a host instrument, a reporting entity should consider all substantive terms.
A reporting entity should first determine whether the components (1) were issued contemporaneously and in contemplation of each other or (2) were negotiated separately and/or at different points in time.
ASC 815-10-15-6 discusses the accounting for a put or call option added by a third party. While this guidance was written in the context of put or call options attached to debt instruments, the concept of whether a feature is exercisable by a party independent of the issuer or the investor may be helpful in assessing whether a feature is embedded or a freestanding financial instrument.

ASC 815-10-15-6

A put or call option that is added or attached to a debt instrument by a third party contemporaneously with or after the issuance of a debt instrument shall be separately accounted for as a derivative instrument under this Subtopic by the investor (that is, by the creditor). An option that is added or attached to an existing debt instrument by another party results in the investor having different counterparties for the option and the debt instrument and, thus, the option shall not be considered an embedded derivative. Paragraph 815-15-25-2 states that notion of an embedded derivative in a hybrid instrument refers to provisions incorporated into a single contract, and not to provisions in separate contracts between different counterparties.

A put or call exercisable with an independent third party (whether added contemporaneously with or after issuance) would be accounted for as a freestanding instrument.
Next, a reporting entity should consider whether the components (1) may be legally transferred separately, or (2) must be transferred with the instrument with which they were issued or associated. Components that may be legally transferred separately are generally freestanding. However, a component that must be transferred with the instrument with which it was issued or associated is not necessarily embedded; it may merely be attached.
A reporting entity should also consider whether (1) a right in a component may be exercised separately from other components that remain outstanding or (2) if, once a right in a component is exercised, the other components are no longer outstanding. Since separate exercisability invariably requires the component to first be detached prior to exercise, this is a strong indicator that the components are freestanding.
Example FG 5-1 illustrates an evaluation of whether an equity-linked component is a freestanding financial instrument or embedded in a host contract.
EXAMPLE FG 5-1
Tranched preferred stock
FG Corp issues Series A preferred shares to investors. FG Corp grants investors in the Series A preferred shares a warrant to buy Series B preferred shares, if issued, at a fixed price (Series B warrant). The Series B preferred shares will only be issued (and the warrant is only exercisable) upon the receipt of a patent for a specified technology being developed by FG Corp.
The investors can transfer the Series B warrant separate from the Series A shares (i.e., they can sell the Series B warrant and retain the Series A preferred shares).
If the Series B warrant is exercised, the Series A preferred shares are unaffected and remain outstanding.
Is the Series B warrant a freestanding instrument or a component embedded in the Series A preferred shares?
Analysis
To determine whether the Series B warrant is a freestanding instrument or a component embedded in the Series A preferred shares, FG Corp should consider all of the contractual terms and relevant indicators, including the following points.
  • The Series A preferred shares and Series B warrant were issued contemporaneously and in contemplation of each other. This indicates that the Series B warrant may be an embedded component.
  • The Series B warrant can be separately transferred; the investor does not have to transfer the Series B warrant with the Series A preferred shares. This indicates that the Series B warrant may be a freestanding financial instrument.
  • The Series B warrant can be separately exercised; the Series A preferred shares remain outstanding if the Series B warrant is exercised. This indicates that the Series B warrant may be a freestanding financial instrument.
Based on the above facts, the Series B warrant should be considered a freestanding financial instrument. See FG 7.6 for further information on tranched preferred stock.

Determining whether a component is freestanding or embedded is important because the criteria used to determine the accounting recognition and measurement for freestanding instruments differs from the criteria for embedded components. See FG 8.4 for additional information on allocating proceeds between freestanding financial instruments.
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