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5.5 Application of ASC 480
Publication date: 31 Dec 2022
us Financing guide
The guidance in ASC 480 applies to freestanding equity and equity-linked financial instruments and requires a reporting entity to classify certain freestanding financial instruments as liabilities (or in some cases as assets). FG 5.5 discusses the application of ASC 480 relating to when certain instruments are classified as liabilities. This section does not discuss ASC 480-10-S99, which determines whether certain entities should report instruments as mezzanine equity.
5.5.1 Scope of ASC 480
One of the instruments within the scope of ASC 480 is a mandatorily redeemable financial instrument, which is defined in ASC 480-10-20.
Definition from ASC 480-10-20
Mandatorily redeemable financial instrument: Any of various financial instruments issued in the form of shares that embody an unconditional obligation requiring the issuer to redeem the instrument by transferring its assets at a specified or determinable date (or dates) or upon an event that is certain to occur.
ASC 480-10-25-4, ASC 480-10-25-5, ASC 480-10-25-8 and ASC 480-10-25-14 provide guidance on which instruments are within the scope of ASC 480. Certain mandatorily redeemable financial instruments issued by nonpublic entities are not within the scope of ASC 480, as discussed in FG 5.5.1.4.
A mandatorily redeemable financial instrument shall be classified as a liability unless the redemption is required to occur only upon the liquidation or termination of the reporting entity.
A financial instrument that embodies a conditional obligation to redeem the instrument by transferring assets upon an event not certain to occur becomes mandatorily redeemable if that event occurs, the condition is resolved, or the event becomes certain to occur.
An entity shall classify as a liability (or an asset in some circumstances) any financial instrument, other than an outstanding share, that, at inception, has both of the following characteristics:
- It embodies an obligation to repurchase the issuer’s equity shares, or is indexed to such an obligation.
- It requires or may require the issuer to settle the obligation by transferring assets.
A financial instrument that embodies an unconditional obligation, or a financial instrument other than an outstanding share that embodies a conditional obligation, that the issuer must or may settle by issuing a variable number of its equity shares shall be classified as a liability (or an asset in some circumstances) if, at inception, the monetary value of the obligation is based solely or predominantly on any one of the following:
- A fixed monetary amount known at inception (for example, a payable settleable with a variable number of the issuer’s equity shares)
- Variations in something other than the fair value of the issuer’s equity shares (for example, a financial instrument indexed to the Standard and Poor’s S&P 500 Index and settleable with a variable number of the issuer’s equity shares)
- Variations inversely related to changes in the fair value of the issuer’s equity shares (for example, a written put option that could be net share settled).
See paragraph 480-10-55-21 for related implementation guidance.
The ASC Master Glossary defines monetary value; ASC 480-10-55-2 provides application examples.
Definition from ASC Master Glossary
Monetary value: What the fair value of the cash, shares, or other instruments that a financial instrument obligates the issuer to convey to the holder would be at the settlement date under specified market conditions.
Question FG 5-1
Is a purchased option within the scope of ASC 480?
Is a purchased option within the scope of ASC 480?
PwC response
No. A purchased option, such as a purchased call option, does not create an obligation to repurchase shares; it provides the reporting entity with the right but not the obligation to repurchase shares. Further, ASC 480 does not apply to contracts that will always be in an asset position by the reporting entity as a purchased option would be.
Question FG 5-2
Are instruments settled in, or indexed to, the common stock of a consolidated subsidiary within the scope of ASC 480?
Are instruments settled in, or indexed to, the common stock of a consolidated subsidiary within the scope of ASC 480?
PwC response
It depends. ASC 480-10-20 defines an issuer’s equity shares.
Definition from ASC 480-10-20
Issuer’s equity shares: The equity shares of any entity whose financial statements are included in the consolidated financial statements.
Therefore, an instrument settled in, or indexed to, a consolidated subsidiary’s common stock is within the scope of ASC 480 provided the instrument meets the other criteria in ASC 480. For example, a freestanding written put option on a subsidiary’s outstanding shares is within the scope of ASC 480-10-25-8 if cash settled; and within the scope of ASC 480-10-25-14(c) if net share settled. A freestanding purchased call on those same shares is not within the scope of ASC 480 because it does not obligate the reporting entity.
5.5.1.1 Application of ASC 480—meaning of “predominantly”
An obligation to issue a variable number of shares is within the scope of ASC 480 if the monetary value is based either solely or predominantly on one of the three items listed in ASC 480-10-25-14. The term predominantly is included to preclude ASC 480 from being circumvented by embedding a small amount of variability in an instrument based on the reporting entity’s equity share price.
ASC 480-10-55-44 provides guidance on performing this analysis. ASC 480-10-55-45 through ASC 480-10-55-52 provides examples of the application of ASC 480-10-25-14. Also, see FG 9.2.4.1 for an example of the evaluation of predominance for an accelerated share repurchase transaction.
In an instrument that allows the holder either to purchase a fixed number of the issuer's shares at a fixed price or to compel the issuer to reacquire the instrument at a fixed date for shares equal to a fixed monetary amount known at inception, the holder's choice will depend on the issuer's share price at the settlement date. The issuer must analyze the instrument at inception and consider all possible outcomes to judge which obligation is predominant. To do so, the issuer considers all pertinent information as applicable, which may include its current stock price and volatility, the strike price of the instrument, and any other factors. If the issuer judges the obligation to issue a variable number of shares based on a fixed monetary amount known at inception to be predominant, the instrument is a liability under paragraph 480-10-25-14. Otherwise, the instrument is not a liability under this Subtopic but is subject to other applicable guidance such as Subtopic 815-40.
ASC 480 does not provide explicit guidance on the meaning of “predominantly”; it could mean “more-likely-than-not” (i.e., 50.1%, consistent with predominance, defined as the “greater amount”) or some higher threshold (e.g., probable, consistent with the objective of not allowing the standard to be circumvented by embedding a “small” amount of variability). We believe that “predominantly,” as used in ASC 480-10-25-14, can be interpreted as either a “more-likely-than-not” or a higher threshold; a reporting entity should elect an accounting policy and apply it consistently.
5.5.1.2 Financial instrument with multiple components
ASC 480-10-55 provides several examples of the application of the scope provisions to certain freestanding instruments comprised of more than one option or forward contract.
As discussed in ASC 480-10-25-15, two or more freestanding financial instruments should generally not be combined to determine whether the instruments are within the scope of ASC 480; however, if the instruments should be combined under the provisions of ASC 815, they should also be combined for purposes of applying ASC 480. Since ASC 480 requires a separate contract-by-contract evaluation, oftentimes the accounting treatment will be dictated by whether different instruments are structured in a single contract or entered into as separate contracts. Figure FG 5-4 provides examples of instruments that may have different accounting based on whether they are executed as a single instrument or multiple instruments.
Figure FG 5-4
Accounting for instruments with multiple components
Accounting for instruments with multiple components
Separate freestanding contracts |
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a. Written put option
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b. Purchased call option
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c. Outstanding share of common stock (with no redemption features)
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d. Purchased put option
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e. Written call option on non-redeemable stock
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f. Written call option on redeemable stock
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Combined (single) contract |
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g. Collar (e.g., a written put @ $10/share and a purchased call @ $18/share)
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h. Net purchased put option (e.g., a purchased put @ $12/share and a written put @ $10/share)
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i. Net written put option (e.g., a written put @$12/share and a purchased put @$10/share)
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j. Collar embedded in an outstanding share of common stock
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k. Puttable stock (i.e., outstanding share of common stock and written put option)
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As Figure FG 5-4 illustrates:
- A freestanding written put option (a) falls within the scope of ASC 480, but a purchased call option (b) is outside the scope of ASC 480; however, if the written put option and purchased call option are combined into a single contract, that collar contract, as in (g), is within the scope of ASC 480.
- A written put option may be outside the scope of ASC 480 if it only serves to reduce the potential gains of a purchased put option in a combined contract, as is the case in (h); however, if the written put option is only partially offset by the purchased put option and thus creates a net written put option, the entire contract is within the scope of ASC 480, as is the case in (i).
- A separate written put option (a) and an outstanding share of common stock (c) are accounted for different than puttable stock, as in (k), which is a combination of an outstanding share of stock and a written put option.
While a written put embedded in a share of stock generally does not require the share to be classified as a liability, reporting entities should consider other applicable reporting requirements. For reporting entities subject to SEC rules, these instruments should be presented in the mezzanine (or temporary) equity section. See FG 7.3.4 for further information on mezzanine equity classification.
5.5.1.3 Nonsubstantive or minimal features
As noted in FG 5.5, ASC 480 applies only to certain freestanding financial instruments. To avoid attempts to circumvent the application of ASC 480 by embedding a minimal or nonsubstantive feature in a freestanding financial instrument, the guidance specifies that nonsubstantive features should be disregarded when determining whether ASC 480 applies. ASC 480 provides examples of features that may be considered nonsubstantive.
The assessment of whether a feature is minimal or nonsubstantive is performed only at inception of a financial instrument; no further assessment is required. This assessment requires judgment and must consider not only the legal terms of an instrument, but also other relevant facts and circumstances.
As discussed in FG 5.5.1.2, a written put option is classified as a liability under ASC 480 because it obligates the reporting entity to deliver cash to repurchase shares. On the other hand, a written put embedded in a share of stock is not classified as a liability. However, as illustrated in ASC 480-10-55-41, a reporting entity that embeds a written put option into a nonsubstantive host instrument should disregard that host instrument and account for the written put option as a liability.
An entity issues one share of preferred stock (with a par amount of $100), paying a small dividend, and embeds in it an option allowing the holder to put the preferred share along with 100,000 shares of the issuer’s common stock (currently trading at $50) for a fixed price of $45 per share in cash. The preferred stock host is judged at inception to be minimal and would be disregarded under paragraph 480-10-25-1 in applying the classification provisions of this Subtopic. Therefore, under either paragraphs 480-10-25-8 through 25-12 or 480-10-25-14(c) (depending on the form of settlement), that instrument would be analyzed as a written put option in its entirety, classified as a liability, and measured at fair value.
If a share of mandatorily redeemable preferred stock contains a conversion feature, it would not be classified as a liability due to the inclusion of the conversion feature. However, as illustrated in ASC 480-10-55-12, if the conversion price at inception is extremely high relative to the current share price (so that the likelihood of the stock price ever reaching the conversion price is remote), it would be considered nonsubstantive and therefore, disregarded.
If the conversion option were nonsubstantive, for example, because the conversion price is extremely high in relation to the current share price, it would be disregarded as provided in paragraph 480-10-25-1. If that were the case at inception, those preferred shares would be considered mandatorily redeemable and classified as liabilities with no subsequent reassessment of the nonsubstantive feature.
A conversion option that is nonsubstantive at inception is always considered nonsubstantive in subsequent periods. Similarly, a conversion option that is substantive at inception is always considered substantive and does not subsequently become nonsubstantive as a result of a substantial decline in the issuer’s stock price.
Although a feature may be nonsubstantive for purposes of applying ASC 480, that feature should not necessarily be ignored for other accounting purposes.
5.5.1.4 Mandatorily redeemable instruments—nonpublic reporting entities
ASC 480-10-15-7A through ASC 480-10-15-7D provide a scope exception for certain mandatorily redeemable financial instruments of nonpublic reporting entities.
The classification, measurement, and disclosure guidance in this Subtopic does not apply to mandatorily redeemable financial instruments that meet both of the following:
- They are issued by nonpublic entities that are not Securities and Exchange Commission (SEC) registrants.
- They are mandatorily redeemable, but not on fixed dates or not for amounts that either are fixed or are determined by reference to an interest rate index, currency index, or another external index.
Mandatorily redeemable financial instruments issued by an SEC registrant are not eligible for the scope exception in paragraph 480-10-15-7A, even if the entity meets the definition of a nonpublic entity.
Some entities have issued shares that are required to be redeemed under related agreements. If the shares are issued with a redemption agreement and the required redemption relates to those specific underlying shares, the shares are mandatorily redeemable. If an entity with such shares and redemption agreement is a nonpublic entity that is not an SEC registrant, those mandatorily redeemable shares meet the scope exception in paragraph 480-10-15-7A if they meet the conditions specified in that paragraph.
Although the disclosure requirements of this Subtopic do not apply for those mandatorily redeemable instruments of certain nonpublic companies that meet the scope exception in paragraph 480-10-15-7A, the requirements of Subtopic 505-10 still apply. In particular, paragraph 505-10-50-3 requires information about the pertinent rights and privileges of the various securities outstanding, which includes mandatory redemption requirements. Paragraph 505-10-50-11 also requires disclosure of the amount of redemption requirements for all issues of stock that are redeemable at fixed or determinable prices on fixed or determinable dates in each of the next five years.
A reporting entity is considered nonpublic for purposes of this scope exception provided it meets the definition in ASC 480-10-20.
Definition from ASC 480-10-20
Nonpublic entity: Any entity other than one that meets any of the following criteria:
- Has equity securities that trade in a public market either on a stock exchange (domestic or foreign) or in an over-the-counter market, including securities quoted only locally or regionally
- Makes a filing with a regulatory agency in preparation for the sale of any class of equity securities in a public market
- Is controlled by an entity covered by the preceding criteria.
5.5.1.5 Mandatorily redeemable noncontrolling interests
Under ASC 480-10-15-7E, certain mandatorily redeemable noncontrolling interests are exempt from certain provisions of ASC 480.
The guidance in this Subtopic does not apply to mandatorily redeemable noncontrolling interests (of all entities, public and nonpublic) as follows:
- The classification and measurement provisions of this Subtopic do not apply to mandatorily redeemable noncontrolling interests that would not have to be classified as liabilities by the subsidiary, under the only upon liquidation exception in paragraphs 480-10-25-4 and 480-10-25-6, but would be classified as liabilities by the parent in consolidated financial statements.
- The measurement provisions of this Subtopic do not apply to other mandatorily redeemable noncontrolling interests that were issued before November 5, 2003, both for the parent in consolidated financial statements and for the subsidiary that issued the instruments that result in the mandatorily redeemable noncontrolling interest. For those instruments, the measurement guidance for redeemable shares and noncontrolling interests in other predecessor literature (for example, in paragraph 480-10-S99-3A) continues to apply.
See BCG 6.2 for additional information on the classification of noncontrolling interests.
5.5.2 ASC 480—Initial measurement and recognition
Financial instruments within the scope of ASC 480, other than physically settled forward repurchase contracts, should be initially measured at fair value. See FG 9.2.2.1 for information on physically settled forward repurchase contracts.
5.5.3 ASC 480—Subsequent measurement
Most financial instruments within the scope of ASC 480 should be subsequently measured at fair value, with changes in fair value recorded in earnings, typically as other income or expense unless other GAAP specifies another measurement attribute as stated in ASC 480-10-35-5. The two instruments whose subsequent measurement is addressed by ASC 480 that are not measured at fair value are (1) mandatorily redeemable financial instruments and (2) physically settled forward repurchase contracts for a fixed number of shares.
Financial instruments that fall into the scope of ASC 480 subsequent to issuance (e.g., conditionally redeemable preferred stock that becomes mandatorily redeemable) should be reclassified as a liability and initially measured at fair value. No gain or loss should be recorded as a result of the reclassification.
See FG 7.3.1.1 for information on mandatorily redeemable instruments. See FG 9.2.2.1 for information on physically settled forward repurchase contracts.
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