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Once a reporting entity has determined that a freestanding financial instrument should not be accounted for using the guidance in ASC 480, the next step is to determine whether the instrument should be accounted for as (1) an equity instrument or (2) a liability (or in some cases an asset) under the guidance in ASC 815-40, Derivatives and Hedging–Contracts in Entity’s Own Equity. Figure FG 5-5 summarizes the steps in the analysis of a freestanding equity-linked instrument.
Figure FG 5-5
Analysis of a freestanding equity-linked instrument
As illustrated in Figure FG 5-5, the steps used to analyze a freestanding equity-linked instrument differ from the analysis of an embedded equity-linked component in that an embedded equity-linked component need not be evaluated under ASC 815-40 if it does not meet the definition of a derivative. Consequently, an embedded non-derivative equity-linked component should not be accounted for separately.
The guidance in ASC 815-40 must be applied to freestanding instruments, regardless of whether the instrument meets the definition of a derivative. For example, a freestanding warrant on the shares of a private reporting entity may not meet the definition of a derivative because it cannot be net settled and the underlying equity is not readily convertible to cash. However, the instrument should be analyzed to determine whether it would be considered indexed to the reporting entity’s own stock and, if so, to determine whether the instrument meets the additional requirements for equity classification.
If an instrument is not considered indexed to the reporting entity’s own stock, it should be classified as an asset or a liability and recorded at fair value with changes in fair value recorded in the income statement. This applies to freestanding instruments that meet the definition of a derivative, and those that do not.
An instrument that is considered indexed to a reporting entity’s own stock based on the guidance in ASC 815-40-15 should be evaluated to determine if it meets the requirements for equity classification in ASC 815-40-25; see FG 5.6.3. If these requirements are also met, equity classification is appropriate and there is no subsequent remeasurement. If the requirements for equity classification are not met, the instrument should be classified as an asset or liability and recorded at fair value with changes in fair value recorded in the income statement. This applies to freestanding instruments that meet the definition of a derivative, and those that do not.
See FG 8 for discussion of the model for allocating proceeds and issuance costs to freestanding instruments issued together, such as debt with detachable warrants.

5.6.1 Whether the instrument meets the definition of a derivative—after adoption of ASU 2020-06

ASC 815-10-15-83 provides the definition of a derivative instrument. Many equity derivatives meet two of the three criteria necessary to meet the definition of a derivative: (1) there is an underlying and a notional amount or payment provision, and (2) there is little or no initial net investment. The third criterion, “net settlement,” is often the determining criterion.
A freestanding equity-linked instrument meets the net settlement criterion in ASC 815-10-15-83(c)(1) if it can be net share settled, even if the underlying shares are not readily convertible to cash, as illustrated in ASC 815-10-55-90.

ASC 815-10-55-90

This Example illustrates the concept of net share settlement. Entity A has a warrant to buy 100 shares of the common stock of Entity X at $10 a share. Entity X is a privately held entity. The warrant provides Entity X with the choice of settling the contract physically (gross 100 shares) or on a net share basis. The stock price increases to $20 a share. Instead of Entity A paying $1,000 cash and taking full physical delivery of the 100 shares, the contract is net share settled and Entity A receives 50 shares of stock without having to pay any cash for them. (Net share settlement is sometimes described as a cashless exercise.) The 50 shares are computed as the warrant’s $1,000 fair value upon exercise divided by the $20 stock price per share at that date.

A freestanding instrument may also meet the net settlement criterion if there is a market that offers a ready opportunity to sell the contract, or if the shares underlying the instrument are readily convertible to cash. See FG 5.4.2 and DH 2.3.5 for further information on the definition of a derivative.

5.6.2 Whether the instrument is indexed to entity’s own stock—after adoption of ASU 2020-06

The guidance in ASC 815-40-15 requires a reporting entity to apply a two-step approach—it requires the evaluation of an instrument’s or embedded component’s contingent exercise provisions and then the instrument’s or embedded component’s settlement provisions. The determination of which step a feature should be analyzed under is critical to the analysis as the evaluation under each step is significantly different.
Before application of the two-step approach to determine whether the instrument is indexed to the entity’s own stock, it is important for a reporting entity to understand the unit of account for freestanding contracts or the terms of the embedded derivative being analyzed. For freestanding contracts (that are not embedded in host instruments) judgment is required to determine whether the unit of account should be the overall contract or separate contracts within the overall arrangement. Specifically, a reporting entity must evaluate whether the overall contract represents a single freestanding financial contract or if the overall contract is comprised of a number of separate freestanding financial contracts. See FG 5.3 for further information, including the definition of a freestanding financial instrument. Similarly, judgment is required in determining the terms of the feature being evaluated and whether it consists of a single embedded derivative or multiple embedded derivatives.
ASC 815-40-55-26 through ASC 815-40-55-48 contain a number of examples illustrating the application of the two-step approach to determining whether an instrument is indexed to a reporting entity’s own stock.

5.6.2.1 Step one—exercise contingencies—after adoption of ASU 2020-06

Any contingent provision that affects the holder’s ability to exercise the instrument or embedded component must be evaluated. For example, holders may have a contingent exercise right or may have their right to exercise accelerated, extended, or eliminated upon satisfaction of a contingency.
ASC 815-40-15-7A and ASC 815-40-15-7B provide guidance on the evaluation of contingent exercise provisions (step 1).

ASC 815-40-15-7A

An exercise contingency shall not preclude an instrument (or embedded feature) from being considered indexed to an entity's own stock provided that it is not based on either of the following:
a. An observable market, other than the market for the issuer's stock (if applicable)
b. An observable index, other than an index calculated or measured solely by reference to the issuer's own operations (for example, sales revenue of the issuer; earnings before interest, taxes, depreciation, and amortization of the issuer; net income of the issuer; or total equity of the issuer).
If the evaluation of Step 1 (this paragraph) does not preclude an instrument from being considered indexed to the entity's own stock, the analysis shall proceed to Step 2 (see paragraph 815-40-15-7C).

ASC 815-40-15-7B

If an instrument's strike price or the number of shares used to calculate the settlement amount would be adjusted upon the occurrence of an exercise contingency, the exercise contingency shall be evaluated under Step 1 (see the preceding paragraph) and the potential adjustment to the instrument's settlement amount shall be evaluated under Step 2 (see the guidance beginning in the following paragraph).

For example, if a warrant becomes exercisable only if the S&P 500 increases by 10% or the price of oil decreases by 10%, the contingency would fail this step and the warrant would not be considered indexed to the reporting entity’s own stock. In contrast, if the warrant became exercisable only if the reporting entity’s stock price increased 10%, this step of the guidance would be met, and the analysis would proceed to step two.
Example FG 5-5 and Example FG 5-6 illustrate the application of step one of the indexation guidance.
EXAMPLE FG 5-5
Evaluation of exercise contingencies – two potential settlement alternatives
A company enters into an arrangement to issue shares with the following provisions:
  • Three-year maturity
  • 1,000 shares will be issued if the volume weighted average price (VWAP) of the company’s stock is greater than $15 for any 20 days within a 30-day trading period
Analysis
Since this arrangement provides for only two potential settlement alternatives (either no shares are issued or 1,000 shares are issued), it would be analyzed under step one of the indexation guidance (i.e., it is an exercise contingency). The event that triggers the issuance of a fixed number of shares is based on an observable market price, but it is the price of the company’s shares. If the other requirements in ASC 815-40 are met (see FG 5.6.3), this arrangement may be considered an equity instrument.
EXAMPLE FG 5-6
Evaluation of multiple exercise contingencies
A company enters into an arrangement under which a fixed number of shares will be issued if, during the subsequent three-year period:
  • the VWAP of the company’s stock is greater than $15 for any 20 days within a 30-day trading period or
  • there is a change in control of the company.
Analysis
Since this arrangement only provides for two potential settlement alternatives (either no shares are issued or a fixed number of shares are issued) it would be analyzed under step one of the indexation guidance (i.e., each alternative is an exercise contingency). In instances when there are multiple contingencies that could cause the issuance of shares, each contingency and the interaction of the contingencies needs to be analyzed. One of the events that triggers the issuance of a fixed number of shares is based on an observable market price, but it is the price of the company’s shares. The other event that could trigger the issuance of a fixed number of shares is if there is a change in control, which is not an observable price or an observable index. If the other requirements in ASC 815-40 are met (see FG 5.6.3), this arrangement may be considered an equity instrument.

5.6.2.2 Step two—settlement provisions—after adoption of ASU 2020-06

ASC 815-40-15-7C provides guidance on how to evaluate an instrument’s settlement provisions to determine whether the instrument is indexed to the reporting entity’s own stock. This guidance is often referred to as the “fixed for fixed” rule.

ASC 815-40-15-7C

Unless paragraph 815-40-15-7A precludes it, an instrument (or embedded feature) shall be considered indexed to an entity’s own stock if its settlement amount will equal the difference between the following:
a. The fair value of a fixed number of the entity’s equity shares
b. A fixed monetary amount or a fixed amount of a debt instrument issued by the entity.
For example, an issued share option that gives the counterparty a right to buy a fixed number of the entity’s shares for a fixed price or for a fixed stated principal amount of a bond issued by the entity shall be considered indexed to the entity’s own stock.

The strike price or the number of shares used to calculate the settlement amount is not considered fixed if the terms of the instrument or embedded component allow for any potential adjustment (except as discussed below), regardless of the probability of the adjustment being made or whether the reporting entity can control the adjustment.
ASC 815-40-15-7E discusses the exception to the “fixed for fixed” rule. This exception allows an instrument to be considered indexed to the reporting entity’s own stock even if adjustments to the settlement amount can be made, provided those adjustments are based on standard inputs used to determine the value of a “fixed for fixed” forward or option on equity shares (and the step one analysis does not preclude such a conclusion).

ASC 815-40-15-7E

A fixed-for-fixed forward or option on equity shares has a settlement amount that is equal to the difference between the price of a fixed number of equity shares and a fixed strike price. The fair value inputs of a fixed-for-fixed forward or option on equity shares may include the entity’s stock price and additional variables, including all of the following:
a. Strike price of the instrument
b. Term of the instrument
c. Expected dividends or other dilutive activities
d. Stock borrow cost
e. Interest rates
f. Stock price volatility
g. The entity’s credit spread
h. The ability to maintain a standard hedge position in the underlying shares.
Determinations and adjustments related to the settlement amount (including the determination of the ability to maintain a standard hedge position) shall be commercially reasonable.

Including other variables, or incorporating a leverage factor that increases the instrument’s exposure to the variables in ASC 815-40-15-7E, would preclude the instrument from being considered indexed to the reporting entity’s own stock.
Example FG 5-7 through Example FG 5-11 illustrate the application of step two of the indexation guidance.
EXAMPLE FG 5-7
Evaluation of an arrangement with multiple potential settlement alternatives
A company enters into an arrangement to issue shares with the following provisions:
  • Three-year maturity
  • 100,000 shares will be issued if the VWAP of the company’s stock is greater than $15 for any 20 days within a 30-day trading period
  • An additional 100,000 shares will be issued if the VWAP of the company’s stock is greater than $20 for any 20 days within a 30-day trading period
  • An additional 100,000 shares will be issued if the VWAP of the company’s stock is greater than $25 for any 20 days within a 30-day trading period
Analysis
This arrangement provides for multiple settlement alternatives. The contract could result in the issuance of 0, 100,000, 200,000, or 300,000 shares based on whether VWAP exceeds targeted prices. When evaluated under step one of the indexation guidance, in all scenarios, the event that triggers the issuance of shares is based on an observable market price, but it is the price of the company’s shares. However, unlike Example FG 5-5, since there could be a different number of shares issued as a result of the multiple settlement alternatives (i.e. 0, 100,000, 200,000, or 300,000 shares), the arrangement would need to be analyzed under step two of the indexation guidance.
Under step two of the indexation guidance, stock price determines the number of shares to be issued, which is an input into a “fixed-for-fixed” valuation model. If the other requirements in ASC 815-40 are met (see FG 5.6.3), this arrangement may be considered an equity instrument.
EXAMPLE FG 5-8
Evaluation of an arrangement with multiple potential settlement alternatives, including a change in control event
A company enters into an arrangement under which additional shares will be issued if during the subsequent three-year period, certain thresholds are met, as follows:
  • 100,000 shares will be issued if the VWAP of the company’s stock is greater than $15 for any 20 days within a 30-day trading period
  • An additional 100,000 shares will be issued if the VWAP of the company’s stock is greater than $20 for any 20 days within a 30-day trading period
  • An additional 100,000 shares will be issued if the VWAP of the company’s stock is greater than $25 for any 20 days within a 30-day trading period
  • 300,000 shares will be issued if there is a change in control of the company
Analysis
This arrangement provides for multiple settlement alternatives. The contract could result in the issuance of 0, 100,000, 200,000, or 300,000 shares based on whether the VWAP exceeds targeted prices. In addition, if there is a change in control, 300,000 shares are issued. Since there could be a different number of shares issued, it would be analyzed under step two of the indexation guidance.
Stock price impacts the number of shares to be issued, which is an input into a “fixed-for-fixed” valuation model. However, in the event of a change in control, 300,000 shares are issued, which is not an input into a “fixed-for-fixed” valuation model. As a result, this arrangement would be required to be classified as a liability and measured at fair value with changes in fair value recorded in current earnings.

There may be other arrangements similar to Example FG 5-8 with multiple stock price triggers and other triggers that should be analyzed. For example, an instrument with multiple stock price triggers might also include the following provisions:
  • If there is a change in control of the company, and stock price is greater than $20, then 300,000 shares are issued
  • If there is a liquidation of the company, then 300,000 shares are issued
  • If there is a change in control of the company, and stock price is greater than $10, then a pro-rata number of shares between 0 and 100,000 will be issued
Similar to Example FG 5-8, when analyzed under step two, these fact patterns (when coupled with multiple stock price triggers) will result in the instrument being liability classified and measured at fair value with changes in fair value reported in current earnings because change in control or a liquidation of the company are not inputs into a “fixed-for-fixed” pricing model.
EXAMPLE FG 5-9
Evaluation of an arrangement to issue shares with multiple settlement alternatives and measures
A company enters into an arrangement under which additional shares will be issued if during the subsequent three-year period, certain thresholds are met, as follows:
  • 100,000 shares will be issued if the VWAP of the company’s stock is greater than $15 for any 20 days within a 30-day trading period
  • An additional 100,000 shares will be issued if the VWAP of the company’s stock is greater than $20 for any 20 days within a 30-day trading period
  • An additional 100,000 shares will be issued if the VWAP of the company’s stock is greater than $25 for any 20 days within a 30-day trading period
  • If there is a change in control of the company, the price at which the change in control occurred will be used to determine the number of shares to be issued (based upon the same stock price triggers above) as opposed to the VWAP
Analysis
This arrangement provides for multiple settlement alternatives. The contract could result in the issuance of 0, 100,000, 200,000, or 300,000 shares based on whether the VWAP or the change in control price exceeds targeted prices. For the purposes of this example, the application of step 1 of the indexation guidance is not illustrated. Since there could be a different number of shares issued (0, 100,000, 200,000, or 300,000), it would be analyzed under step two of the indexation guidance.
In evaluating the arrangement under step two, it is important to determine if stock price is the only measure that can determine the number of shares to be issued because stock price is an input into a “fixed-for-fixed” valuation model. If the manner in which the change in control price is determined and VWAP over a short time period are both reasonable means in which to measure the fair value of the company’s stock, the arrangement may be considered indexed to the entity’s own stock.
Assessing whether the change in control price is a reasonable measure of the fair value of the company’s stock requires careful consideration of (1) the events considered to be a change in control under the arrangement and (2) the manner in which the change in control price is calculated. For example, many change in control provisions include a company selling substantially all of its assets. If the change in control price calculation does not consider the potential dilutive impact of this arrangement (and potentially other arrangements), it would not be deemed to be a reasonable manner in which to calculate the fair value of the company’s stock. If, however, the change in control price calculation considers the potential dilutive impact of this arrangement (and potentially other arrangements), it may be deemed to be a reasonable manner in which to calculate the fair value of the company’s stock. Calculations that consider the dilutive impact of the arrangement itself are complex and likely require iterative or simultaneous equation calculations.
If the change in control price calculation is not a reasonable manner in which to calculate the fair value of the company’s stock, the arrangement would be required to be classified as a liability and measured at fair value with changes in fair value recorded in current earnings.
If the change in control price calculation is a reasonable manner in which to calculate the fair value of the company’s stock and the other requirements in ASC 815-40 are met (see FG 5.6.3), this arrangement may be considered an equity instrument.
EXAMPLE FG 5-10
Evaluation of a warrant issued in a SPAC transaction
A warrant issued in a SPAC transaction exercisable for 1 share of common stock over a five-year term has a strike price of $11.50 and includes the following provisions:
  • In the event that the stock price of the company exceeds $18, the company can redeem the warrant for $0.01.
  • If the company elects to redeem the warrant, the warrant holder can exercise the warrant.
  • The company cannot redeem the warrant while it is held by the sponsor/founder of the SPAC; the company is only able to redeem the warrant if the sponsor/founder transfers the warrant.
  • In the event that there is a change in control in which shareholders receive a specified form of consideration:
    • the warrant holders will have the ability to exercise their warrants,
    • the exercise price is reduced in an effort to compensate the holders for lost time value of the option (because they would be exercising before the warrant’s maturity date - a make-whole provision) based on an option valuation model, and
    • the option valuation model works differently if the warrant is held by the founder/sponsor (not reflecting any ability of the company to redeem the warrants if transferred to a third party) or a third party (reflecting the company’s ability to redeem the warrants).
Analysis
In this example, the make-whole provision (exercise price reduction) is calculated differently depending on who holds the warrant (the founder/sponsor or a third party). The identity of the holder of the warrant is not an input to a “fixed-for-fixed” valuation model. This warrant would not be considered indexed to a company’s own stock. As a result, this warrant would be required to be classified as a liability and measured at fair value with changes in fair value recorded in current earnings.
In analyzing these features, it is important to understand if the warrant’s settlement amount can be impacted by who holds the warrant. In this example, the warrants issued to sponsors/founders contain provisions that change potential settlement amounts if the warrants are transferred to a third party. However, the SPAC warrants that are held by the public may not contain such features. If the warrants do not have any features that could change the settlement amount or how settlement is calculated, the warrants may be considered indexed to an entity’s own stock.
We understand that this is an example of a provision addressed in the SEC’s public statement (see FG 5.6.4 for additional information).

There may be other features in a warrant agreement that result in changes to settlement amounts or how settlement amounts are calculated depending on who holds the warrant. For example:
  • In the event the company elects to redeem certain warrants and the holders exercise their warrants, the settlement amount may be different if the holder is a director or officer of the company.
  • Some warrants permit net share settlement upon exercise (frequently referred to as a cashless exercise). In some warrant agreements, the inputs used to calculate the net settlement amount (i.e., shares to be delivered) may be different depending on if the warrant is held by the founder/sponsor or if it is held by a third party. For example, settlement could be based on:
    • the ten day VWAP when held by a sponsor/founder and the average closing price of the stock over a ten-day period when held by another party, or
    • the trailing average of stock price based on the date a warrant is exercised when held by the sponsor/founder and based on the date the warrant is redeemed by the company if held by others
Based on the guidance in the SEC’s public statement (see FG 5.6.4), these warrants would not be considered indexed to a company’s own stock because the holder of the warrant can impact the settlement amount and the identity of a holder is not an input into a “fixed for fixed” valuation model. As a result, these warrants would be classified as liabilities and reported at fair value with changes in fair value reported in current earnings.
EXAMPLE FG 5-11
Evaluation of arrangements when the number of shares issuable may increase based on employee behavior (sometimes referred to as a “last person standing provision")
Arrangements in the company’s stock are issued to investors and employees with vested and unvested stock compensation awards. Assume that additional shares will be issued if during a three-year period, certain thresholds are met, as follows:
  • 100,000 shares will be issued if the VWAP of the company’s stock is greater than $15 for any 20 days within a 30-day trading period
  • An additional 100,000 shares will be issued if the VWAP of the company’s stock is greater than $20 for any 20 days within a 30-day trading period
  • An additional 100,000 shares will be issued if the VWAP of the company’s stock is greater than $25 for any 20 days within a 30-day trading period
The arrangements issued to employees with unvested options are subject to continued employment vesting requirements (which may be based on the employment vesting requirements in their unvested stock compensation awards). In the event that these arrangements are forfeited by employees, the number of shares that could be issued under these arrangements are “re-allocated” on a pro-rata basis to the other holders. This is sometimes referred to as a “last person standing provision”.
Analysis
The arrangements issued to unvested option holders in this case would be considered compensation and subject to the guidance in ASC 718. See SC 1.3 for further discussion on awards in the scope of ASC 718 as well as SC 2 and SC 3 for measurement and classification considerations. For the arrangements not subject to ASC 718, analysis under ASC 815-40 is required.
These arrangements provide for multiple settlement alternatives. In total the arrangement could result in the issuance of 0, 100,000, 200,000, or 300,000 shares based on whether the VWAP exceeds targeted prices. In addition, the number of shares an individual holder may receive is also based on the continued employment of certain employees that were granted these arrangements. The number of shares an individual holder receives may increase based on the forfeiture of the arrangements granted to employees with unvested options. Since there could be a different number of shares issued depending on certain events, the arrangements would be analyzed under step two of the indexation guidance. For the purposes of this example, the application of step 1 of the indexation guidance is not illustrated.
In evaluating the arrangements under step two, the vesting/continued employment of certain employees is not an input into a “fixed-for-fixed” valuation model. As a result, the arrangements subject to ASC 815-40 would be required to be classified as a liability and measured at fair value with changes in fair value recorded in current earnings.

Antidilution features
Settlement adjustments designed to protect a holder’s position from being diluted by a transaction initiated by an issuer will generally not prevent a freestanding instrument or embedded component from being considered indexed to the issuer’s own stock provided the adjustments are limited to the effect that the dilutive event has on the shares underlying the instrument. Common examples of adjustments that do not preclude a contract from being considered indexed to the issuer’s own stock include the occurrence of a stock split, rights offering, stock dividend, or a spinoff. In addition, settlement adjustments due to issuances of shares for an amount below current fair value, and repurchases of shares for an amount that exceeds the current fair value of those shares, do not preclude the contract from being considered indexed to the issuer’s own stock.
Not all “antidilution” settlement adjustments will meet the criteria for being considered indexed to a reporting entity’s own stock in ASC 815-40-15. Settlement adjustments that overcompensate the holder (i.e., the potential adjustments exceed the potential impact of the dilution) prevent a freestanding instrument or embedded component from being considered indexed to the reporting entity’s own stock.
Down round features
Some equity-linked financial instruments may contain price protection provisions requiring a reduction in an instrument’s strike price as a result of a subsequent at-market issuance of shares below the instrument’s original strike price, or as a result of the subsequent issuance of another equity-linked instrument with a lower strike price. This is typically referred to as a “down round” feature. Down round features are most often found in warrants and conversion options embedded in debt or preferred equity instruments issued by private entities, but may also be found in financial instruments issued by public companies.
The issuance of shares for an amount equal to the current market price of those shares is not dilutive. Further, the possibility of a market price transaction occurring at a price below an instrument’s strike price is not an input to the valuation of a standard “fixed for fixed” instrument. The guidance in ASC 815-10-15-75A effectively makes an exception with respect to down round features to the base model for determining when an instrument or an embedded feature is considered solely indexed to an entity’s own stock.
The term “down round” can be applied to provisions with varying terms. As such, a reporting entity should evaluate the specific provision to determine whether it affects the reporting entity’s ability to consider an instrument indexed to its own stock.
Adjustment provisions should be evaluated to determine whether they meet the definition of a down round.
The ASC Master Glossary provides the definition of a down round feature.

Definition from ASC Master Glossary

Down round feature: A feature in a financial instrument that reduces the strike price of an issued financial instrument if the issuer sells shares of its stock for an amount less than the currently stated strike price of the issued financial instrument or issues an equity-linked financial instrument with a strike price below the currently stated strike price of the issued financial instrument.
A down round feature may reduce the strike price of a financial instrument to the current issuance price, or the reduction may be limited by a floor or on the basis of a formula that results in a price that is at a discount to the original exercise price but above the new issuance price of the shares, or may reduce the strike price to below the current issuance price. A standard antidilution provision is not considered a down round feature.

As discussed in ASC 815-10-15-75A, a reporting entity can disregard a down round feature that meets this definition when determining whether the instrument is considered indexed to the reporting entity’s own stock. However, when a down round feature is triggered, there are earnings per share implications for certain instruments, as discussed in ASC 260-10-45-12B and FSP 7.4.1.5.
If a feature does not meet the definition of a down round, the instrument must be evaluated under the base model to determine whether it is solely indexed to an entity’s own stock.
Example FG 5-12 and Example FG 5-13 illustrate the evaluation of down round features.
EXAMPLE FG 5-12
Strike price adjustment based on common stock valuation
Company A, a private company, issues a warrant for the purchase of 100,000 shares of Company A common stock, with a strike price of $10.00. The warrant provides for net settlement in shares and meets the definition of a derivative under ASC 815. The terms of the warrant state that the strike price of the warrant will be reduced if a subsequent valuation indicates that the fair value of Company A’s common stock is below the current strike price. Historically, Company A has prepared a valuation when it issues instruments such as common stock, warrants, and convertible instruments, but it also has had valuations prepared when it issues equity-linked compensation to its employees.
Is the provision regarding the change in the warrant’s strike price a down round feature as defined in the guidance?
Analysis
While this feature is similar to a down round feature in that it is designed to protect warrant holders against declines in stock price, the provision does not meet the definition of a down round.
A down round feature contemplates a sale of a company’s stock or issuance of an equity-linked financial instrument. If Company A were to obtain or prepare a valuation of its common stock, this could trigger a reset of the instrument’s strike price, even if no instrument is issued by Company A. For example, Company A may be contemplating issuing equity to raise capital, but may decide to issue debt based upon the valuation of the common stock. Further, if Company A grants stock options to its employees with vesting requirements, they are not considered issued until they vest under GAAP. In addition, if Company A were to issue warrants, convertible debt, or convertible preferred stock with a strike price higher than the strike price on the outstanding warrant, but the common stock valuation indicated a common stock price below the outstanding warrant strike price (i.e., Company A issued an out-of-the-money instrument), the strike price on the outstanding warrant would be adjusted downward. This would not be consistent with the definition of a down round, which indicates that the strike price on the outstanding warrant should only be adjusted if the strike price on the issued equity-linked instrument is below the outstanding warrant’s strike price.
EXAMPLE FG 5-13
Adjustment to the number of shares
Company B issues a warrant for the purchase of 100,000 shares of Company B common stock, with a strike price of $10.00. The warrant provides for net settlement in shares and meets the definition of a derivative under ASC 815. The terms of the warrant provide that when Company B sells common stock below the strike price on the warrant or issues a financial instrument with a strike price below the strike price on the warrant, the warrant will be exercisable into more than the initial 100,000 shares. The strike price of the warrant is not adjusted. This feature is designed to ensure that Company B receives a fixed amount of proceeds upon exercise of the warrant.
Is the provision to adjust the number of shares upon exercise of the warrant a down round feature?
Analysis
Although the definition of a down round refers only to a reduction in strike price, we believe that an increase in shares underlying the warrant can achieve the same economic objective. Therefore, we believe the provision could be considered a down round feature. As a result, it would not, in isolation, cause an instrument to not be considered indexed to an entity’s own stock. Increasing the number of shares an instrument is exercisable into is the only practical manner in which a down round can be implemented in a convertible instrument.
Although we believe that an increase in the number of shares underlying a warrant and reducing the strike price achieve the same economic objective, we believe that the increase in the number of shares pursuant to such a provision should not permit a transfer of more value to the holder than a reduction of a strike price would. For example, while the definition of a down round would permit the strike price of an instrument to be adjusted below the issuance or strike price of the issued instrument, the amount of value that could be transferred by a strike price reduction is limited as the strike price cannot be reduced below zero.

5.6.2.3 Foreign currency denominated strike price—after adoption of ASU 2020-06

As discussed in ASC 815-40-15-7I, if an instrument’s strike price is denominated in a currency other than the reporting entity’s functional currency, the instrument is not considered indexed to the reporting entity’s own stock. Whether the shares issuable under the instrument are traded in a market in which transactions are denominated in the same foreign currency is irrelevant to the analysis.

5.6.2.4 Indexed to stock of subsidiary or affiliate—after adoption of ASU 2020-06

ASC 815-40-15-5C provides guidance on instruments indexed to the shares of a subsidiary.

Excerpt from ASC 815-40-15-5C

Freestanding financial instruments (and embedded features) for which the payoff to the counterparty is based, in whole or in part, on the stock of a consolidated subsidiary are not precluded from being considered indexed to the entity’s own stock in the consolidated financial statements of the parent if the subsidiary is a substantive entity.

This guidance applies to freestanding instruments and embedded components indexed to the stock of a consolidated subsidiary, whether the instrument is entered into by the parent or the subsidiary. The same is not true for instruments indexed to the stock of an affiliate that is not a consolidated subsidiary or stock of an equity method investee. The stock of such an affiliate or equity method investee is not considered the reporting entity’s own stock.
Although not specifically addressed, we believe that the guidance in ASC 815-40 also applies to convertible debt issued by a subsidiary that is convertible into the stock of the parent in the consolidated financial statements of the parent. However, in the separate financial statements of the subsidiary, debt convertible into the parent’s stock would generally not be considered indexed to the entity’s own stock. See FG 6.4.2.1 for additional information.

5.6.3 Whether instrument meets equity classification requirements—after adoption of ASU 2020-06

ASC 815-40-25-1 and ASC 815-40-25-2 provide the general framework for determining whether an instrument that is considered indexed to an issuer’s own stock should be classified as a liability (or in some cases, an asset) or equity. Application of this guidance requires a detailed understanding of the settlement provisions and other terms of the instrument being analyzed.
A reporting entity is required to perform the analysis to determine whether the requirements for equity classification have been met. Liability classification is not a default classification; thus, a reporting entity cannot forgo the analysis and assume liability classification. In some cases, the evaluation of various contractual terms may be complicated. In such cases, assistance from legal counsel may be required.

ASC 815-40-25-1

The guidance in this Section applies for the purpose of determining whether an instrument or embedded feature qualifies for the second part of the scope exception in paragraph 815-10-15-74(a). The first part of the scope exception in paragraph 815-10-15-74(a) is addressed in Section 815-40-15. The initial balance sheet classification of contracts within the scope of this Subtopic generally is based on the concept that:
a. Contracts that require net cash settlement are assets or liabilities.
b. Contracts that require settlement in shares are equity instruments.

ASC 815-40-25-2

Further, an entity shall observe both of the following:
a. If the contract provides the counterparty with a choice of net cash settlement or settlement in shares, this Subtopic assumes net cash settlement.
b. If the contract provides the entity with a choice of net cash settlement or settlement in shares, this Subtopic assumes settlement in shares.

Therefore:
  • Contracts that are settled by gross physical delivery of shares or net share settlement may be equity instruments (see FG 5.6.3.1).
  • Contracts that require or permit the investor to require a reporting entity to net cash settle are accounted for as assets or liabilities at fair value with changes in fair value recorded in earnings.
  • Contracts that a reporting entity could be required to settle in cash should be accounted for as an asset or liability at fair value, regardless of whether net cash settlement would only occur under a remote scenario.

5.6.3.1 Additional requirements for equity classification—after adoption of ASU 2020-06

It is important to note that not all share-settled contracts qualify for equity classification. For a share-settled contract to be classified as equity, each of the additional conditions in ASC 815-40-25-10 must be met to ensure that the issuer has the ability to settle the contract in shares.
These conditions are intended to identify situations in which net cash settlement could be forced upon the issuer by investors/counterparties or in any other circumstance, regardless of likelihood, except for (1) liquidation of the issuer or (2) a change in control in which the issuer’s shareholders also receive cash.

ASC 815-40-25-8

Generally, if an event that is not within the entity's control could require net cash settlement, then the contract shall be classified as an asset or a liability. However, if the net cash settlement requirement can only be triggered in circumstances in which the holders of the shares underlying the contract also would receive cash, equity classification is not precluded.

ASC 815-40-25-9

This Subtopic does not allow for an evaluation of the likelihood that an event would trigger cash settlement (whether net cash or physical), except that if the payment of cash is only required upon the final liquidation of the entity, then that potential outcome need not be considered when applying the guidance in this Subtopic.

ASC 815-40-25-10

Because any contract provision that could require net cash settlement precludes accounting for a contract as equity of the entity (except for those circumstances in which the holders of the underlying shares would receive cash, as discussed in paragraphs 815-40-25-8 through 25-9 and paragraphs 815-40-55-2 through 55-6), all of the following conditions must be met for a contract to be classified as equity:
a. Subparagraph superseded by Accounting Standards Update No. 2020-06.
b. Entity has sufficient authorized and unissued shares. The entity has sufficient authorized and unissued shares available to settle the contract after considering all other commitments that may require the issuance of stock during the maximum period the derivative instrument could remain outstanding.
c. Contract contains an explicit share limit. The contract contains an explicit limit on the number of shares to be delivered in a share settlement.
d. No required cash payment (with the exception of penalty payments) if entity fails to timely file. There is no requirement to net cash settle the contract in the event the entity fails to make timely filings with the Securities and Exchanges Commission (SEC).
e. No cash-settled top-off or make-whole provisions. There are no cash settled top-off or make-whole provisions.
f. Subparagraph superseded by Accounting Standards Update No. 2020-06.
g. Subparagraph superseded by Accounting Standards Update No. 2020-06.
Paragraphs 815-40-25-39 through 25-42 explain the application of these criteria to convertible debt and other hybrid instruments.

ASC 815-40-25-10A

The following conditions are not required to be considered in an entity’s evaluation of net cash settlement (that is, if any one of these provisions is in a contract [or the contract is silent on these points], they should not preclude equity classification, except as described below):
a. Whether settlement is required in registered shares, unless the contract explicitly states that an entity must settle in cash if registered shares are unavailable. Requirements to deliver registered shares do not, by themselves, imply that an entity does not have the ability to deliver shares and, thus, do not require a contract that otherwise qualifies as equity to be classified as a liability.
b. Whether counterparty rights rank higher than shareholder rights. If the provisions of the contract indicate that the counterparty has rights that rank higher than the rights of a shareholder of the stock underlying the contract, this provision does not preclude equity classification.
c. Whether collateral is required. A provision requiring the entity to post collateral at any time for any reason does not preclude equity classification.

ASC 815-40-55-2

An event that causes a change in control of an entity is not within the entity's control and, therefore, if a contract requires net cash settlement upon a change in control, the contract generally must be classified as an asset or a liability.

ASC 815-40-55-3

However, if a change-in-control provision requires that the counterparty receive, or permits the counterparty to deliver upon settlement, the same form of consideration (for example, cash, debt, or other assets) as holders of the shares underlying the contract, permanent equity classification would not be precluded as a result of the change-in-control provision.  In that circumstance, if the holders of the shares underlying the contract were to receive cash in the transaction causing the change in control, the counterparty to the contract could also receive cash based on the value of its position under the contract.

ASC 815-40-55-4

If, instead of cash, holders of the shares underlying the contract receive other forms of consideration (for example, debt), the counterparty also must receive debt (cash in an amount equal to the fair value of the debt would not be considered the same form of consideration as debt).

ASC 815-40-55-5

Similarly, a change-in-control provision could specify that if all stockholders receive stock of an acquiring entity upon a change in control, the contract will be indexed to the shares of the purchaser (or issuer in a business combination accounted for as a pooling of interests) specified in the business combination agreement, without affecting classification of the contract.

ASC 815-40-55-6

In the event of nationalization, cash compensation would be the consideration for the expropriated assets and, as a result, a counterparty to the contract could receive only cash, as is the case for a holder of the stock underlying the contract. Because the contract counterparty would receive the same form of consideration as a stockholder, a contract provision requiring net cash settlement in the event of nationalization does not preclude equity classification of the contract.

ASC 815-40-25-18 through ASC 815-40-25-30 and ASC 815-40-25-36 through ASC 815-40-25-38 provide further guidance on the requirements for equity classification, including, but not limited to, considerations relating to uneconomic settlement alternatives, determination of whether a reporting entity has sufficient authorized and unissued shares, explicit share limits, and when a net cash payment is required for a contract in a loss position.
ASC 815-40-25-10A provides three conditions that do not have to be considered in an entity’s evaluation of net cash settlement. However, reporting entities subject to the guidance in ASC 480-10-S99 should consider whether that guidance would require instruments that could require cash settlement outside of the reporting entity’s control to be classified as mezzanine equity. Reporting entities seeking to avoid classification as mezzanine equity by analogizing to the exceptions to the evaluation of net cash settlement provided by ASC 815-40-25-10A in the evaluation under ASC 480-10-S99, should pre-clear their proposed accounting and disclosures with the Office of the Chief Accountant of the SEC.
Sequencing of instruments
When a reporting entity issues new equity or equity-settled contracts, such as employee stock options, it should assess whether the issuance has an effect on previously issued instruments. The criterion in ASC 815-40-25-10(b) that the issuer have sufficient authorized and unissued shares available to settle all of its contracts may no longer be met. When performing this assessment, a reporting entity should follow the guidance in ASC 815-40-25-20. This guidance requires the evaluation to consider the maximum number of shares that could be required to be delivered during the contract period under existing commitments. The effect of the issuance of new equity-linked or equity-settled instruments on previously issued instruments will depend on the terms of each instrument, as well as the reporting entity’s policy for evaluating the sequencing of its instruments (as discussed in Figure FG 5-6) that may be settled in shares.
For example, if a reporting entity issues warrants and concludes that those warrants should be classified as equity, it must have had sufficient authorized and unissued shares to meet the requirements of ASC 815-40-25-10(b) to reach that conclusion. If the reporting entity subsequently issues common stock, and can no longer assert that it has sufficient authorized and unissued shares to satisfy its outstanding warrants, it should determine which warrants should no longer be classified as equity. Figure FG 5-6 illustrates some alternative methods that may be applied; there may be other acceptable methods as well.
Figure FG 5-6
Examples of methods of sequencing instruments
Methodology
Description
Last-in, first-out (LIFO)
Authorized and unissued shares would first be used to satisfy the most recently issued equity-linked instruments.
First-in, first-out (FIFO)
Authorized and unissued shares would first be used to satisfy the earliest issued equity-linked instruments.
Proportionate
Authorized and unissued shares would be applied proportionately to all equity linked instruments outstanding. This methodology results in some portion of each equity-linked instrument failing to meet the requirements for equity classification.
A reporting entity should establish a policy for sequencing instruments and apply that policy consistently.
Example FG 5-14, Example FG 5-15, Example FG 5-16, and Example FG 5-17 illustrate the application of certain additional requirements for equity classification in ASC 815-40-25-10.
EXAMPLE FG 5-14
Effect of exchange limits on share issuance
Several stock exchanges in the US (e.g., NYSE and NASDAQ) have rules applicable to companies listed on the exchange that limit the number of shares issuable in an unregistered offering without shareholder approval. The rules generally apply to the issuance of common shares (or an instrument that could be settled in common shares) in excess of 20% of the outstanding common shares of the reporting entity.
FG Corp is registered on the NYSE and has 750,000 authorized shares and 500,000 shares issued and outstanding (and therefore 250,000 shares authorized and unissued).
FG Corp issues an unregistered convertible bond to multiple investors that, upon conversion, will result in the issuance of 125,000 shares (25% of outstanding shares). FG Corp concludes that the embedded conversion option meets the definition of a derivative and must be evaluated to determine whether the scope exception in ASC 815-10-15-74(a) can be applied. FG Corp has not obtained shareholder approval to issue the shares upon conversion of the bond.
Can the conversion option embedded in FG Corp’s convertible bond meet the requirements for the scope exception in ASC 815-10-15-74(a)?
Analysis
No. If FG Corp’s shareholders do not vote to approve the issuance of shares upon conversion of the bond, FG Corp will be prohibited by the NYSE from issuing shares in excess of 20% of its outstanding shares. In that case, upon conversion, the guidance assumes that investors will receive cash equal to the fair value of the share shortfall. Since shareholder approval is not within the control of FG Corp, the possibility of this outcome, however remote, precludes equity classification for any part of the contract that may require cash settlement.
EXAMPLE FG 5-15
Convertible debt indexed to subsidiary’s stock and settleable in stock of parent or subsidiary
Parent Corp, a public company, has a subsidiary, Sub Inc, which is also a public company and a substantive entity.
Parent Corp has issued convertible debt, which upon conversion can be settled in either Parent Corp or Sub Inc shares at the discretion of Parent Corp. The value that investors will receive (i.e., the conversion value) is indexed solely to the stock price of Sub Inc. The ability to satisfy the conversion value in Parent Corp’s shares is merely a settlement mechanism and does not affect the value.
Can the conversion option embedded in Parent Corp’s convertible bond meet the requirements for the scope exception in ASC 815-10-15-74(a) for contracts issued or held by the reporting entity that are both (i) indexed to its own stock and (ii) classified in stockholders’ equity in its statement of financial position?
Analysis
It depends. As discussed in ASC 815-40-15-5C, an instrument issued by a parent indexed to the stock of a consolidated subsidiary should be considered indexed to its own stock provided the subsidiary is a substantive entity. Since Sub Inc is a substantive entity, Parent Corp must determine whether the embedded conversion option meets the requirements to apply the ASC 815-10-15-74(a) scope exception.
The value of the conversion option embedded in Parent Corp’s bond is indexed to Sub Inc’s shares. Accordingly, it would be considered indexed to Parent Corp’s own stock based on the guidance in ASC 815-40-15-5C. The settlement mechanism that allows settlement in shares of either Parent Corp or Sub Inc does not affect this conclusion.
If Parent Corp were required to settle the conversion option in shares of Parent Corp, then the contract would need to be evaluated to determine whether it contained an explicit limit on the number of shares to be delivered in a share settlement. If Sub Inc’s share price rose, while Parent Corp’s share price fell, then the number of Parent Corp shares required for delivery could increase substantially. Without a maximum cap on the number of Parent Corp shares that Parent Corp could be required to deliver, and if this was the only settlement option alternative, classification of the conversion feature in shareholders’ equity would not be permitted. In addition, the potential requirement to issue an unlimited number of Parent Corp shares may have implications for other equity classified instruments. The criterion in ASC 815-40-25-10(b) that the reporting entity must have sufficient authorized and unissued shares available to settle all of its contracts may no longer be met.

EXAMPLE FG 5-16
Effect of master netting agreement
FG Corp issues a convertible bond that, upon conversion, will result in cash settlement of the conversion option.
FG Corp also enters into two contracts with a bank that each meet the definition of a freestanding financial instrument:
  • A convertible bond hedge (purchased call option) that mirrors the terms of the embedded conversion option in FG Corp’s convertible bond and requires the bank to pay cash to FG Corp equal to the value of the conversion option upon exercise.
  • A warrant with a strike price at a 20% premium to the embedded conversion option price that requires FG Corp to deliver net shares to the bank, if the warrant is in the money when the conversion option is exercised.
FG Corp and the bank enter into a master netting agreement that allows the convertible bond hedge and warrant to be netted in determining the amount due in the case of FG Corp’s or the bank’s bankruptcy.
Can the warrant meet the requirements for equity classification?
Analysis
No. Since the convertible bond hedge requires cash settlement, the requirements for equity classification are not met. Because upon bankruptcy, the warrant can be netted with a contract that does not meet the requirements for equity classification, the warrant does not meet the requirements for equity classification. The netting agreement effectively provides for net cash settlement of the warrant. Additionally, a master netting agreement is not considered the equivalent of collateral and as such the exception in ASC 815-40-25-10A(c) is not applicable when evaluating the potential for net cash settlement. However, a contract that otherwise met the requirements for equity classification, could be included in a netting arrangement with other contracts that meet the requirements for equity classification without tainting the ability to qualify for equity classification.

EXAMPLE FG 5-17
Change in control in which the issuer’s shareholders receive the same form of consideration
A company has a single class of common stock and has warrants exercisable for this common stock. Upon exercise, the warrant will be settled on a gross physical basis (the warrant holder will pay the exercise price in cash and receive shares). However, in the event that there is a tender offer as a result of which the purchaser will own more than 50% of the voting stock of the company, the holders can exercise their warrants and receive the same form and amount of consideration received by the common shareholders that participated in the tender offer.
Analysis
Liability classification is generally required when a company could be forced to settle a warrant on a net cash basis (or by delivery of assets) in circumstances outside of its control. However, there is an exception to this model (discussed in ASC 815-40-55-2 through ASC 815-40-55-6) relating to change in control provisions. This guidance states that if the warrant holder receives the same form of consideration as shareholders that participated in the change in control transaction, then equity classification would not be prohibited.
We believe that the tender offer provision in this fact pattern is not inconsistent with the guidance in ASC 815-40 and was not a fact pattern addressed in the SEC’s public statement (see FG 5.6.4). Accordingly, equity classification would not be prohibited. However, if the company has multiple classes of common stock, an understanding of the settlement provisions, the scenarios in which they become operable, and the terms of the multiple classes of common stock must be obtained in order to determine if this exception is met. If not met, equity classification is prohibited.

Question FG 5-3
Should an issuer classify convertible preferred equity certificates (CPECs) as a liability or equity for accounting purposes?
PwC response
CPECs are a tax efficient preferred security, generally issued from an issuer domiciled in Luxembourg. A CPEC may take various forms but is structured such that it is treated as debt for local tax purposes. Typically, a CPEC can be redeemed (i.e., matures) by the issuer 49 years after it is issued, is callable at the issuer’s option at any time, has a stated yield, and is convertible into common stock at the option of the investor at any time. The conversion price approximates the fair value of the common stock on the issuance date.
The payment provisions include a qualification which states that the yield or redemption value is only due and payable if the issuer becomes insolvent and will not be insolvent (as defined in the agreement) in the event the issuer makes payment.
While subordinate to the issuer’s other debt, a CPEC ranks in priority to share capital. A CPEC is legal form debt under local law; the holder is not entitled to any voting rights.
We believe CPECs should be classified as liabilities. The CPECs are not within the scope of ASC 480, despite the mandatory redemption date in 49 years, because there is a substantive conversion option. However, the investor is granted creditor rights (as it is legal form debt), including the right to force bankruptcy; therefore, we do not believe CPECs should be classified in equity. In addition, as legal form debt, CPEC’s are not considered redeemable preferred stock under ASC 480-10-S99 (i.e., they are not mezzanine equity).

5.6.4 SEC staff statement on accounting and reporting considerations for warrants issued by SPACs

The Acting Director of the SEC’s Division of Corporate Finance and the SEC’s Acting Chief Accountant issued a public statement on April 12, 2021 regarding their recent evaluation of fact patterns relating to the accounting for warrants issued in connection with a SPAC’s formation.
One of the key messages in the SEC’s public statement on accounting for warrants is if the warrants issued by SPAC entities include any provisions that could change the settlement amount or how the settlement amount is calculated based on who holds the warrants, the warrants would not be considered indexed to an entity’s own stock. As a result, the warrants would be classified as liabilities and reported at fair value with changes in fair value reported in current earnings. See Example FG 5-10 (after adoption of ASU 2020-06) for an example of this provision.
In our experience, there are a number of features in warrants that are issued to the founders/sponsors of the SPAC that may cause changes in how the warrant’s settlement amount is calculated in the event the founder/sponsor transfers the warrant to a third party. There may also be features in the warrants issued to the public that may involve different settlement terms depending on who holds the warrants. Warrant agreements should be carefully reviewed and any provisions that cause changes in the settlement amount of the warrant or how settlement is calculated, regardless of the significance of such impact, should be evaluated under the SEC’s public statement.
Another key message in the SEC’s public statement on accounting for warrants relates to tender offer provisions. Liability classification is generally required when a company could be forced to settle a warrant on a net cash basis (or by delivery of assets) in circumstances outside of its control. However, there is an exception to this model (discussed in ASC 815-40-55-2 through ASC 815-40-55-6; see FG 5.6.3.1) relating to change in control provisions. This guidance states that if the warrant holder receives the same form of consideration as shareholders that participated in the change in control transaction, then equity classification would not be prohibited. In the fact pattern from the SEC’s public statement, in the event of a tender or exchange offer made to and accepted by holders of more than 50% of the outstanding shares of a single class of common stock, all holders of the warrants would be entitled to receive cash for their warrants, while only certain of the holders of the underlying shares of common stock would be entitled to cash. In the fact pattern presented to the SEC, the tender offer did not result in a change in control, as a result, the SEC staff concluded that the tender offer provision would require the warrants to be classified as liabilities and reported at fair value with changes in fair value reported in current earnings. See Example FG 5-17 (after adoption of ASU 2020-06).
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