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Figure FG 7-3 provides a flowchart outlining the analysis to determine the classification of and accounting for preferred stock after the adoption of ASU 2020-06. Figure FG 7-3A provides a flowchart outlining the analysis to determine the classification and accounting of preferred stock before the adoption of ASU 2020-06. Put and call options embedded in preferred stock should also be evaluated to determine whether they should be accounted for separately as a derivative. See FG 7.3.3 for more information.
Figure FG 7-3
Classification and accounting treatment of preferred stock (after adoption of ASU 2020-06)
Figure FG 7-3A
Classification and accounting treatment of preferred stock (before the adoption of ASU 2020-06)
ASC 480, Distinguishing Liabilities from Equity, defines “mandatorily redeemable” financial instruments, which may include some preferred shares. At the same time, the SEC prescribes specific accounting for “preferred stock subject to mandatory redemption,” which is codified in ASC 480-10-S99. While the two terms are similar, they are not synonymous and the respective accounting treatments differ. If a preferred share meets the definition of a mandatorily redeemable financial instrument in ASC 480-10-20, the SEC guidance in ASC 480-10-S99 is not applicable.

7.3.1 Determine if the preferred stock is a liability under ASC 480

The first step to determine the appropriate accounting classification for preferred stock is to evaluate the instrument’s provisions to determine whether the share should be classified as a liability because it is a mandatorily redeemable financial instrument or is required to be classified as a liability based on another provision in ASC 480.
To determine whether preferred stock is a mandatorily redeemable financial instrument, all provisions that could result in the redemption of the preferred stock should be assessed. This includes provisions labeled as a redemption feature, call option or conversion option. For example, a conversion option that requires the issuer to deliver a variable number of shares with a value equal to the redemption amount of a preferred share is, in substance, a redemption feature. See FG 7.3.1.2 for additional information about preferred stock that must be settled in a variable number of shares

7.3.1.1 Mandatorily redeemable financial instrument

ASC 480-10-20 provides a definition of a mandatorily redeemable financial instrument, which is classified as a liability based on the guidance in ASC 480-10-25-4.

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

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.

Provisions that defer, delay, or accelerate the timing of redemption do not affect the classification of a mandatorily redeemable financial instrument as a liability, as long as the unconditional requirement to redeem the instrument remains.
Common examples of mandatorily redeemable preferred stock include the following:
  • Preferred stock (nonconvertible, or convertible, if conversion option is not substantive) that must be redeemed on a specified date
  • Preferred stock that must be redeemed in the event of the employee’s death or termination of employment
  • Preferred stock that is redeemable subject to a liquidity provision (such as a requirement to maintain adequate liquidity). A liquidity provision may affect the timing of the unconditional requirement for redemption but does not eliminate the redemption requirement.
The definition of mandatorily redeemable specifically excludes instruments that are redeemable only upon the liquidation or termination of the issuer.
Certain mandatorily redeemable financial instruments issued by nonpublic entities are not within the scope of ASC 480. See FG 5.5.1.4 for information.
Question FG 7-1 discusses whether preferred stock redeemable upon liquidation of a partnership or upon the death or termination of a partner are considered mandatorily redeemable.
Question FG 7-1

A partnership has a life of 25 years. It issues two series of preferred stock. Series A is redeemable upon liquidation of the partnership. Series B is redeemable upon the death or termination of the partner holding the shares.

Are the Series A and Series B shares mandatorily redeemable financial instruments?
PwC response
The Series A shares are not mandatorily redeemable financial instruments because the guidance in ASC 480-10-25-4 specifically excludes instruments redeemable only upon the liquidation or termination of the issuer.
The Series B shares are also not mandatorily redeemable because the redemption event (death or termination of the partner) is not certain to occur within the life of the partnership (25 years). If, however, the life of the partnership is 100 years, and the partner is 50 years old, the partner’s equity interest would be considered mandatorily redeemable as it is based on an event (death or termination of the partner within 100 years) that is certain to occur.
Contingently redeemable preferred stock
Contingently redeemable preferred stock is redeemable only upon the satisfaction of a specified contingency. For example, the following instruments are contingently redeemable.
  • Preferred stock that is automatically redeemed if there is a change in control or successful initial public offering
  • Preferred stock that the holder has the option to redeem (e.g., preferred stock with a put option or puttable stock). In this case, the holder may or may not exercise its option
As discussed in ASC 480-10-25-7, contingently redeemable preferred stock with a substantive condition for redemption is not considered a mandatorily redeemable financial instrument until the contingency is met.

ASC 480-10-25-7

If a financial instrument will be redeemed only upon the occurrence of a conditional event, redemption of that instrument is conditional and, therefore, the instrument does not meet the definition of mandatorily redeemable financial instrument in this Subtopic. However, that financial instrument would be assessed at each reporting period to determine whether circumstances have changed such that the instrument now meets the definition of a mandatorily redeemable instrument (that is, the event is no longer conditional). If the event has occurred, the condition is resolved, or the event has become certain to occur, the financial instrument is reclassified as a liability.

Contingently redeemable preferred stock that is redeemable upon the occurrence of a nonsubstantive contingency is considered mandatorily redeemable. A conversion price that is so high relative to the current share price that the likelihood of the stock price ever reaching the conversion price is remote, is an example of a nonsubstantive condition. The determination of whether a conditional redemption feature is substantive should generally be performed only upon issuance and should not be reevaluated. An issuer should consider reevaluation when an instrument is modified so significantly that it is considered an extinguishment of the original instrument and the issuance of a new instrument. See FG 5.5 for further information on the application of ASC 480.
In addition, preferred stock that contains a redemption provision that only affects the timing of the redemption (but does not remove the redemption requirement), such as an adequate liquidity clause or term-extending option, is also mandatorily redeemable. This preferred stock should be classified as a liability under the guidance in ASC 480.
A contingently redeemable financial instrument should be reclassified as a liability when the contingent event has occurred or becomes certain to occur, making the instrument unconditionally redeemable. The reclassification should be recorded by debiting equity and crediting a liability equal to the fair value of the preferred stock. The difference between the fair value and the carrying amount of the preferred stock should be subtracted from (if fair value is higher than the carrying amount) or added to (if fair value is less than the carrying amount) net income available to common shareholders when computing basic and diluted EPS as discussed in ASC 260-10-S99.
Question FG 7-2 addresses whether an issuer is required to periodically reassess if preferred stock that is callable and mandatorily redeemable is considered contingently redeemable or mandatorily redeemable.
Question FG 7-2

A reporting entity issues Series C preferred stock that is callable beginning five years after issuance and mandatorily redeemable only upon a change in control of the reporting entity. Should the reporting entity periodically reassess whether the Series C preferred stock is contingently redeemable (i.e., classified as equity) or mandatorily redeemable (i.e., classified as a liability)?
PwC response
Yes. ASC 480 requires an issuer to assess whether an instrument is mandatorily redeemable at each reporting period. The Series C preferred stock should be initially classified as equity because redemption is conditional upon the occurrence of an event that is not certain to occur. However, upon a change in control, the Series C shares should be reclassified as a liability.

Question FG 7-3 discusses how an issuer should classify preferred stock when it exercises an irrevocable call for redemption prior to the period-end date, but settles the call after period end.
Question FG 7-3

If an issuer calls its preferred stock on 12/15/X1 for redemption on 1/15/X2 and the call is irrevocable, should it classify the preferred stock as mandatorily redeemable in its 12/31/X1 financial statements?
PwC response
Yes. If the call is irrevocable, the preferred stock should be reclassified as a liability until the shares are redeemed.
Convertible preferred stock with mandatory redemption date
Convertible preferred stock with a substantive conversion option and a date-certain redemption date is not mandatorily redeemable because the redemption event is not certain to occur; the conversion option could be exercised prior to the redemption date. Preferred stock that contains a conversion feature with a conversion price that is so high relative to the current share price that the likelihood of the stock price ever reaching the conversion price is remote is an example of an instrument with a nonsubstantive conversion option. See FG 5.5.1.3 for information on nonsubstantive or minimal features.

7.3.1.2 Preferred stock settled in a variable number of shares

Convertible preferred stock may contain settlement provisions that cause it to be a liability pursuant to ASC 480. For example, a convertible preferred share that requires the delivery of a variable number of shares upon conversion could be within the scope of ASC 480-10-25-14a through ASC 480-10-25-14c. That guidance requires preferred stock that will result in the delivery of a variable number of shares that have a value solely or predominantly based (at inception) on (1) a fixed monetary amount, (2) variations in something other than the fair value of the issuer’s equity shares, or (3) variations inversely related to changes in the fair value of the issuer’s equity shares to be accounted for as a liability. See FG 5.5 for additional information on the application of ASC 480.
Question FG 7-4 addresses whether convertible preferred stock that automatically converts into a fixed number of common shares on a specified date is a liability within the scope of ASC 480.
Question FG 7-4
Is convertible preferred stock that automatically converts into a fixed number of common shares on a specified date a liability within the scope of ASC 480?
PwC response
No. This instrument is outside the scope of ASC 480. ASC 480-10-25-14 potentially applies only if the number of shares is variable.

Question FG 7-5 addresses whether convertible preferred stock that automatically converts into the number of common shares equivalent to the stated value of the preferred stock is considered a liability within the scope of ASC 480.
Question FG 7-5
Is convertible preferred stock that automatically converts into a number of common shares with a fair value equivalent to the $1,000,000 stated value of the preferred stock a liability within the scope of ASC 480?
PwC response
Yes. The preferred stock converts into a variable number of shares and the monetary value of the obligation is based solely on a fixed monetary amount (stated value) known at inception. Accordingly, it should be classified as a liability under the guidance in ASC 480-10-25-14a.

Question FG 7-6 discusses if preferred stock that converts to a variable number of shares based upon the then-current market price of the common stock should be recorded as a liability within the scope of ASC 480.
Question FG 7-6
A reporting entity issues convertible preferred stock that automatically converts into a variable number of shares based on the then-current market price of the common stock. If the market price of the common stock is (1) less than $50, the reporting entity will issue 1 share, (2) between $50 and $62.50, the reporting entity will issue a pro rata portion of shares between 1 share and 0.8 share equaling $50, (3) greater than $62.50, the reporting entity will issue 0.8 shares. Should the preferred stock be recorded as a liability within the scope of ASC 480?
PwC response
It depends. The issuer should assess whether the settlement alternative that results in the issuance of a variable number of shares with a fixed monetary value (i.e., when the stock price is between $50 and $62.50) is the predominant settlement alternative at issuance of the convertible preferred stock. The determination of predominance depends on the facts and circumstances of each transaction. See FG 5.5.1.1 for further information on the meaning of predominantly.
If the issuer determines that the monetary value of the obligation to issue common shares is based predominantly on a fixed monetary amount known at issuance, the preferred stock should be classified as a liability under the guidance in ASC 480-10-25-14a.

7.3.1.3 Preferred stock exchangeable into debt

Some preferred stock contains a provision that requires a mandatory exchange into debt on a specified date. This feature allows the issuer to “swap” after-tax dividends for tax deductible interest payments. This type of preferred stock is a liability within the scope of ASC 480.
Preferred stock with a mandatory exchange-into-debt feature that is convertible into common shares at the option of the holder is outside the scope of ASC 480 because the holder could convert the preferred stock into common stock prior to the mandatory exchange date. This stock should be presented as mezzanine equity because it is redeemable at a fixed or determinable amount upon on an event that is outside of the issuer’s control.

7.3.2 Evaluate conversion options

If preferred stock includes an embedded substantive conversion option, the issuer must determine whether the conversion option should be separated from its host instrument and accounted for separately as a derivative. This analysis begins by determining whether the host instrument is considered to be more akin to debt or equity. An embedded conversion option is generally considered to be clearly and closely related to an equity host; it is not considered clearly and closely related to a debt host. If the host instrument is determined to be a debt host, the issuer must then determine whether the conversion option meets the definition of a derivative and, and if so, whether the embedded conversion option qualifies for a scope exception from derivative accounting. See FG 5.4 for more information on analyzing an embedded conversion option in preferred stock including the determination as to whether the host instrument is more akin to debt or equity.

7.3.2.1 Convertible instrument with a separated conversion option

When an issuer concludes that a conversion option should be separated from its host instrument and accounted for as a derivative, it should be accounted for as a freestanding derivative instrument under the guidance in ASC 815. That is, it should be classified on the balance sheet as a derivative liability at fair value with any changes in its fair value recognized currently in the income statement. The preferred stock host should be accounted for using the guidance applicable to similar nonconvertible preferred stock. See FG 5.4.4 for more information on accounting for separated instruments.

7.3.2.2 Accounting for a down round—after adoption of ASU 2020-06

Convertible preferred stock that is equity classified (assuming the conversion feature has not been bifurcated under ASC 815) is subject to the measurement provisions of ASC 260-10-30-1. When triggered, the value of the effect of a down round feature being triggered is recognized as a charge to retained earnings. This amount also reduces earnings available to common shareholders for EPS purposes.

ASC 260-10-30-1

As of the date that a down round feature is triggered (that is upon the occurrence of the triggering event that results in a reduction of the strike price) in an equity classified freestanding financial instrument and an equity classified convertible preferred stock (if the conversion feature has not been bifurcated in accordance with other guidance) an entity shall measure the value of the effect of the feature as the difference between the following amounts determined immediately after the down round feature is triggered:
a.  The fair value of the financial instrument (without the down round feature) with a strike price corresponding to the currently stated strike price of the issued instrument (that is, before the strike price reduction)
b.  The fair value of the financial instrument (without the down round feature) with a strike price corresponding to the reduced strike price upon the down round feature being triggered.

7.3.2.2A Beneficial conversion features—before adoption of ASU 2020-06

A convertible instrument may contain a beneficial conversion feature (BCF) or a contingent BCF if the conversion option is not accounted for separately. A warrant to acquire a convertible instrument may also contain a BCF. See FG 8.2.2.5A for additional information on warrants to acquire a convertible instrument.
The ASC Master Glossary provides the definition of a beneficial conversion feature.

Definition from ASC Master Glossary

Beneficial Conversion Feature: A nondetachable conversion feature that is in the money at the commitment date.

A convertible instrument contains a BCF when the effective conversion price is less than the fair value of the shares into which the instrument is convertible at the commitment date. See FG 7.9.2A for information on the conversion of convertible preferred stock with a BCF.
Determining the commitment date
The commitment date is the date on which an agreement meets the definition of a firm commitment. To have a firm commitment, an issuer should have a legally-enforceable agreement that specifies the significant terms and provides a disincentive for nonperformance that is sufficiently large to make performance probable.
ASC 470-20, Debt with Conversion and Other Options, provides guidance on determining a convertible instrument’s commitment date.

ASC 470-20-30-12

If an agreement includes subjective provisions that permit either party to rescind its commitment to consummate the transaction, a commitment date does not occur until the provisions expire or the convertible instrument is issued, whichever is earlier. Both of the following are examples of subjective provisions that permit either party to rescind its commitment to consummate the transaction:
a.  A provision that allows an investor to rescind its commitment to purchase a convertible instrument in the event of a material adverse change in the issuer’s operations or financial condition
b.  A provision that makes the commitment subject to customary due diligence or shareholder approval.

As a practical matter, because of clauses such as those in (a) and (b), the commitment date typically does not occur until the date the convertible instrument is issued (i.e., the date cash and securities are exchanged).
Question FG 7-7 discusses the commitment date for convertible instruments issued under an overallotment option.
Question FG 7-7
When is the commitment date for convertible instruments issued under an overallotment option (greenshoe)?
PwC response
The commitment date for instruments issued under a greenshoe is the date the underwriter exercises its greenshoe and the securities are delivered. Prior to then, there is no commitment on the part of the underwriter to purchase the securities. It is possible for a convertible instrument that was out-of-the-money when it was priced (so that there is no beneficial conversion feature for the initial securities sold) to be in-the-money on the date the greenshoe is exercised. This would result in a BCF for the securities sold under the greenshoe. See FG 6.9.2 for information on greenshoes.
Question FG 7-8 addresses how a private reporting entity that issues a convertible instrument prior to an IPO should assess whether a BCF exists.
Question FG 7-8
If a private reporting entity issues a convertible instrument prior to an IPO with a conversion price below the anticipated IPO price, should the reporting entity assess whether a BCF exists based on the commitment date estimated fair value of the shares or the IPO price?
PwC response
An issuer should consider all information available when estimating the commitment date fair value of its common stock, including the anticipated IPO price. The SEC staff has said that convertible instruments with a conversion price below the IPO price issued within one year of the filing of an initial registration statement are presumed to contain a BCF.
To overcome this presumption, an issuer would have to make an assertion that the accounting conversion price represented fair value at the commitment date (i.e., the issue date) and should ensure that appropriate evidence exists to support that assertion. As part of this process, reporting entities should consider any valuations that an underwriter has discussed with management and/or the board of directors.
Determining the conversion price
To determine whether a convertible instrument contains a BCF, an issuer should compare the conversion price and the issuer’s stock price on the commitment date. The conversion price is calculated by dividing the proceeds allocated to the convertible instrument by the number of shares into which the instrument is convertible. Often, the conversion price is the same as the instrument’s contractual conversion rate; however, in some cases, the conversion price does not equal the stated conversion rate. For example, when detachable warrants are issued with a convertible instrument, the issuer should allocate the proceeds between the convertible instrument and the warrants. This reduces the proceeds allocated to the convertible instrument and as a result, lowers the conversion price.
Issuance costs do not affect whether an instrument contains a BCF.
BCFs in instruments issued to pay dividends or interest in kind
Some convertible instruments require or allow declared dividends or accrued interest to be paid in kind (PIK) with additional units of that convertible instrument, or a different series of convertible instruments. To determine whether a convertible instrument issued to satisfy a dividend or interest payment contains a BCF, the commitment date for the newly issued convertible instrument must be determined (see FG 7.7.2A for measurement of PIK dividends). The commitment date of the newly issued convertible instrument will ultimately depend upon whether payment in kind is discretionary or not.
ASC 470-20-30-16 through ASC 470-20-30-18 provide guidance on the commitment date for instruments that pay in kind.

ASC 470-20-30-16

If dividends or interest on a convertible instrument must be paid in kind with the same convertible instruments as those in the original issuance and are not discretionary, the commitment date for the original instrument is the commitment date for the convertible instruments that are issued to satisfy interest or dividends requirements.

ASC 470-20-30-17

For purposes of the preceding paragraph, dividends or interest are not discretionary if both of the following conditions exist:
a. Neither the issuer nor the holder can elect other forms of payment for the dividends or interest.
b. If the original instrument or a portion thereof is converted before accumulated dividends or interest are declared or accrued, the holder will always receive the number of shares upon conversion as if all accumulated dividends or interest have been paid in kind.

Excerpt from ASC 470-20-30-18

Otherwise, the commitment date for the convertible instruments issued as paid-in-kind interest or dividends is the date that the interest or the dividends are accrued and the fair value of the underlying issuer stock at the recognition or declaration date shall be used to measure the intrinsic value of the conversion option embedded in the paid-in-kind instruments.

In evaluating whether “the holder will always receive the number of shares upon conversion as if all accumulated dividends or interest have been paid in kind,” we understand that certain convertible instruments call for the forfeiture of accrued interest or dividends from the last dividend or interest payment date to the date of conversion. We believe the presence of this provision in a convertible instrument does not necessarily preclude the paid-in-kind feature from being considered “not discretionary” as long as interest or dividends when paid, are contractually required to be paid in kind. Other views may also be acceptable.
Measurement and recognition
A BCF is measured as the intrinsic value of the conversion option at the commitment date, representing the difference between the effective conversion price and the issuer’s stock price on the commitment date.
A BCF should be separated from a convertible instrument and recorded in additional paid-in capital. SEC registrants should present the BCF as mezzanine equity in periods in which it is redeemable, as described in ASC 480-10-S99-3A.

Excerpt from ASC 480-10-S99-3A

...the equity-classified component of the convertible debt instrument should be considered redeemable if at the balance sheet date the issuer can be required to settle the convertible debt instrument for cash or other assets (that is, the instrument is currently redeemable or convertible for cash or other assets).

Although technically not required for nonpublic entities, mezzanine equity presentation is strongly encouraged. See FG 7.3.4 for more information on mezzanine presentation.
Separating a BCF will create a discount in the convertible instrument which will result in additional interest expense or deemed dividends.
Instruments with a multiple-step discount
Some convertible instruments have a conversion price that decreases over time; this is called a multiple-step discount. ASC 470-20-30-15 provides guidance on determining the intrinsic value of a convertible instrument with a multiple-step discount.

Excerpt from ASC 470-20-30-15

If an instrument incorporates a multiple-step discount, the computation of the intrinsic value shall use the conversion terms that are most beneficial to the investor.

For example, assume convertible preferred stock has a conversion price of (1) $10 at issuance, (2) $9 six months after issuance, (3) $8 twelve months after issuance and (4) $7 twenty-four months after issuance. The issuer should compare the most favorable conversion price to the investor (in this example, the conversion price of $7, twenty-four months after issuance) and compare that with the commitment date stock price to determine the BCF amount, if any.
Contingently adjusting conversion prices
Some convertible instruments have a conversion price that adjusts if certain contingent events occur. As noted in ASC 470-20-30-7, an issuer should measure a BCF using the most favorable conversion price that will be in effect at the conversion date presuming there will be no change in circumstances other than the passage of time. That is, it should not include future contingent adjustments in the measurement of the BCF but would nonetheless need to consider whether a BCF is present without the contingent adjustment.
Example FG 7-1 and Example FG 7-2 illustrate how to measure and record a BCF in convertible preferred stock issued with warrants.
EXAMPLE FG 7-1
BCF measurement and recognition
FG Corp issues $1,000 stated value convertible preferred stock and 100 detachable warrants to purchase its common stock, in exchange for $1,000 in cash. FG Corp’s stock price on the date the instruments are issued, which is the commitment date, is $18 per share.
The convertible preferred stock has a stated conversion price of $20; therefore, it is convertible into 50 shares of FG Corp’s common stock ($1,000 stated value / $20 conversion price).
FG Corp concludes that the warrants meet the requirements for equity classification. Since the warrants are classified as equity, FG Corp allocates the proceeds from the issuance of the preferred stock and warrants using the relative fair value method. The sales proceeds allocated to the convertible preferred stock and warrants are $700 and $300, respectively.
How should FG Corp record the issuance of the convertible preferred stock and warrants?
Analysis
FG Corp should first determine whether the convertible preferred stock contains a BCF by determining the effective conversion price and comparing it to FG Corp’s stock price on the commitment date.
The effective conversion price is calculated by dividing (1) the proceeds allocated to the convertible preferred stock ($700) by (2) the number of shares into which the debt is convertible (50 shares).
$700 / 50 shares = $14 conversion price
The convertible preferred stock does contain a BCF because the $18 commitment date stock price is greater than the $14 effective conversion price.
The BCF is measured as the difference between the commitment date stock price ($18) and the conversion price ($14) multiplied by the number of shares into which the preferred stock is convertible (50 shares).
($18 - $14) x 50 = $200
To record the issuance of the convertible debt and warrants, FG Corp should record the following journal entry.
Dr. Cash
$1,000
Dr. Discount on convertible preferred stock (warrants)
$300
Dr. Discount on convertible preferred stock (BCF)
$200
Cr. Convertible preferred stock
$1,000
Cr. Additional paid-in capital (warrants)
$300
Cr. Additional paid-in capital (BCF)
$200
EXAMPLE FG 7-2
BCF measurement and recognition
FG Corp issues $1,000 of convertible perpetual preferred stock and 100 detachable warrants to purchase its common stock in exchange for $1,000 cash. The convertible preferred stock is convertible into 100 shares ($1,000 convertible preferred stock / 100 shares = $10 conversion price) immediately upon issuance. The warrants have a strike price of $10 per share.
FG Corp’s stock price on the date the instrument is issued, which is the commitment date, is $10 per share. The fair value of the warrants on that date is $300.
FG Corp concludes that the warrants should be classified as a liability. Since the warrants are classified as a liability, FG Corp first allocates the proceeds to the warrant based on its fair value ($300); the remaining proceeds ($700) are allocated to the convertible preferred stock.
How should FG Corp record the issuance of the convertible preferred stock and warrants?
Analysis
FG Corp should first determine whether the convertible preferred stock contains a BCF by determining the effective conversion price and comparing that to FG Corp’s stock price on the commitment date.
The effective conversion price would be calculated by dividing (1) the proceeds allocated to the convertible preferred stock ($700) by (2) the number of shares into which it is convertible (100 shares).
$700 / 100 shares = $7 conversion price
The convertible preferred stock contains a BCF because the $10 commitment date stock price is greater than the $7 effective conversion price.
The BCF is measured as the difference between the commitment date stock price ($10) and the accounting conversion price ($7) multiplied by the number of shares into which the preferred stock is convertible (100 shares).
($10 - $7) × 100 = $300
To record the issuance of the convertible debt and warrants, FG Corp would record the following journal entry.
Dr. Cash
$1,000
Dr. Discount on convertible preferred stock (warrants)
$300
Dr. Discount on convertible preferred stock (BCF)
$300
Cr. Warrant liability
$300
Cr. Convertible preferred stock
$1,000
Cr. Additional paid-in capital (BCF)
$300
Because the convertible preferred shares are perpetual (have no stated maturity date) and are convertible at any time, the discount created in the convertible preferred stock is fully amortized at issuance (i.e., recorded as a deemed dividend), thereby increasing the convertible preferred stock’s carrying amount from $400 to $700.
Dr. Retained earnings
$300
Cr. Discount on convertible preferred stock (BCF)
$300

Contingent BCFs
An issuer may issue convertible preferred stock with a conversion price that adjusts over the term of the instrument. For example, the conversion price may be reduced if the fair value of the underlying stock declines to, or below, a specified price after the commitment date.
In such situations, the issuer must determine not only whether a BCF is present at inception, but must also measure and account for the contingently adjustable conversion ratio, which is described in ASC 470-20-35-1 through ASC 470-20-35-5. Often, these adjustments decrease the instrument’s conversion price, which may have the effect of creating a new BCF if one has not been previously recorded or may increase the intrinsic value of a previously recorded BCF.
ASC 470-20-25-6 provides guidance on the measurement of a contingent BCF.

ASC 470-20-25-6

A contingent beneficial conversion feature shall be measured using the commitment date stock price (see paragraphs 470-20-30-9 through 30-12) but, as discussed in paragraph 470-20-35-3, shall not be recognized in earnings until the contingency is resolved.

In some situations, it is not possible to measure a contingent BCF at the commitment date. For example, there may be a conversion feature that will be adjusted for the future issuance of shares at a price below the instrument’s original strike price, commonly referred to as a “down-round” provision. In such situations, the contingent BCF should be measured when the contingency is resolved.
When a contingent event occurs and an instrument either becomes convertible or the conversion price is adjusted, the issuer should recalculate the BCF using the current conversion price. If the newly calculated BCF amount exceeds the previously recorded BCF, the issuer should record the additional BCF amount as an increase to additional paid-in capital.
If an instrument’s conversion price increases so that the newly calculated BCF amount is less than the previously recorded BCF amount, the issuer should record the difference as a decrease to additional paid-in capital. However, any previously recognized amortization of the discount created by initially separating the BCF should not be reversed.
Example FG 7-3 illustrates how to measure and record a contingent BCF.
EXAMPLE FG 7-3
Contingent BCF measurement and recognition
FG Corp issues $1,000 of convertible preferred stock in exchange for $1,000 cash. FG Corp’s stock price on the date the instrument is issued, which is the commitment date, is $18 per share.
The convertible preferred stock has a stated conversion price of $20 at issuance; therefore, it is convertible into 50 shares of FG Corp’s common stock ($1,000 preferred stock / $20 conversion price). The terms of the instrument include a down-round provision, requiring the conversion price to be reduced for any subsequent at market issuance of shares at a price below the instrument’s original strike price.
One year after issuance, FG Corp issues shares at $13 per share, which is the then market price for its shares. Accordingly, FG Corp reduces the instrument’s conversion price to $13; therefore, it is convertible into 77 shares of FG Corp’s common stock ($1,000 preferred stock / $13 conversion price).
No BCF existed at inception as FG Corp’s stock price of $18 was less than the conversion price of $20.
When and how should FG Corp record the contingent BCF triggered by issuance of additional shares?
Analysis
The contingent BCF cannot be calculated until additional shares are issued; therefore, the contingent BCF should be measured and recorded when FG Corp issues the additional shares.
We believe the BCF amount should be calculated as the intrinsic spread between the adjusted effective accounting conversion price ($13) and the original commitment date market price ($18), multiplied by the new number of shares into which the security is legally convertible when the contingent event occurs (77 shares).
($18 - $13) × 77 shares = $385
To record the BCF, FG Corp should record the following journal entry.
Dr. Discount on convertible preferred stock (BCF)
$385
Cr. Additional paid-in capital (BCF)
$385
This approach to calculating a contingent BCF (the “intrinsic method”) is referenced in ASC 470-20-55-24. However, a literal read of ASC 470-20-35-1 would indicate that the BCF amount should be calculated by multiplying the additional shares to be received once the conversion price is adjusted by the commitment date stock price. In this example, this would result in a charge of $486 ((77 shares – 50 shares) × $18). These methods produce the same result when the original conversion option strike price is equal to the stock price at the commitment date (i.e., the option is at the money) but produce different results when the original conversion option strike price differs from the commitment date stock price. The approach described in ASC 470-20-35-1 would result in an inaccurate contingent BCF whenever the original conversion option is issued at other than at-the-money. For that reason, we believe that the intrinsic method is more reliable.

Resetting of a conversion option for a change in stock price
Some convertible instruments pay a fixed monetary amount to the investor upon conversion. To do this, the instrument’s conversion price is adjusted for increases or decreases in the fair value of the issuer’s stock. ASC 470-20-55-19 provides guidance for these instruments, which are in substance, stock-settled debt.

ASC 470-20-55-19

If the conversion price was described as $1 million divided by the market price of the common stock on the date of the conversion, that is, resetting at the date of conversion, the holder is guaranteed to receive $1 million in value upon conversion and, therefore, there is no beneficial conversion option and the convertible instrument would be considered stock-settled debt. However, if the conversion price does not fully reset (for example, resets on specified dates before maturity), the reset represents a contingent beneficial conversion feature subject to this Subtopic.

The issuer should assess the reset terms of its convertible instrument to determine whether it is stock-settled debt or a convertible instrument with a contingent BCF.
Amortization of the discount created by separating a BCF
The method of recognizing a discount created by separating a BCF, or contingent BCF, from convertible preferred stock depends on the terms of the convertible preferred stock. A BCF discount created in an equity instrument with a stated or mandatory redemption date should be amortized over the period from the issuance date through the stated maturity or redemption date using the interest method. The amortization should be accounted for as a deemed dividend, provided the preferred stock is classified as equity.
Discounts created by separating a BCF from perpetual convertible preferred stock should be amortized over the period from the issuance date through the first date the investor can exercise the conversion option (i.e., the first conversion date) using the interest method. If preferred stock is immediately convertible, the discount should be amortized all at once upon issuance.
If the convertible preferred stock is redeemable (1) at the option of the investor or, (2) upon the occurrence of an event that is not within the issuer’s control, we believe the BCF discount may be accreted over a period of time from the issuance date through (1) the first conversion date, or (2) the first put date. The amortization should be accounted for as a dividend, provided the preferred stock is classified as equity.

7.3.3 Evaluate put and call options

Due to the higher cost of issuing preferred stock, it is often callable by the issuer after a certain period (e.g., after five years). In addition, put options provide holders with liquidity and protection upon the occurrence of specified events. For example, a put option exercisable upon “a fundamental change” may be included to give holders the ability to redeem their shares in certain circumstances.
Put and call options may affect the classification of preferred stock as mezzanine or permanent equity. See FG 7.3.4 for further information on classification as mezzanine or permanent equity. An issuer should also consider whether any put or call options embedded in preferred stock should be separated and accounted for as a derivative under the guidance in ASC 815. In order to assess whether a put or call option embedded in a preferred stock instrument should be bifurcated and accounted for separately, an issuer must first determine whether the preferred stock host is more akin to debt or equity. See FG 5.4.1 for information on determining the nature of the host contract.
A put or call feature embedded in preferred stock (deemed to be a debt host) will likely meet the definition of a derivative. See FG 1.6.1 and DH 4.4.3 for information on whether a put or call option embedded in a debt host must be bifurcated and accounted for separately. A put feature embedded in preferred stock (deemed to be an equity host and that is not readily convertible to cash) which requires gross physical settlement will likely not meet the definition of a derivative. As such, the embedded put feature would not require separate accounting. A put feature embedded in exchange traded preferred stock (deemed to be an equity host and that is readily convertible to cash) which requires gross physical settlement would likely meet the definition of a derivative. In this case, the issuer would need to evaluate whether the put feature meets the requirements for the scope exception for certain contracts involving an entity’s own equity in ASC 815-10-15-74(a). See DH 4.5.2 for additional information on whether put and call options embedded in an equity host must be bifurcated and accounted for separately.

7.3.4 Preferred stock classification as mezzanine or permanent equity

Provided preferred stock is not classified as a liability based on the guidance in ASC 480, an issuer should assess whether its preferred stock should be classified as mezzanine or permanent equity. Under the SEC rules, redeemable instruments should be presented outside of permanent equity in what is generally called the mezzanine (or temporary) equity section. The purpose of mezzanine equity classification is to convey to the financial statement users that the preferred stock may not be permanently part of equity and could result in a demand for cash or other assets of the issuer in the future.
For SEC registrants, ASC 480-10-S99 requires preferred stock redeemable for cash or other assets to be classified outside of permanent equity (in the mezzanine or temporary equity section), if it meets any of the following conditions:
  • It is redeemable at a fixed or determinable price on a fixed or determinable date
  • It is redeemable at the option of the shareholder
  • It is redeemable upon the occurrence of an event that is not solely within the control of the issuer
Preferred stock with mandatory redemption at a fixed or determinable date can be classified as equity if it has a substantive conversion option. See FG 7.3.1.1 for further information.
Although technically not required for private entities, mezzanine equity presentation is strongly encouraged, especially in those circumstances when there is not a high likelihood that the capital is in fact permanent, e.g., when preferred stock is redeemable at the option of the holder at any time. On the other hand, use of a mezzanine presentation may be less relevant in other circumstances, such as when preferred stock is redeemable by the holder only upon the occurrence of a remote event. If mezzanine presentation is not elected, separate presentation from other items within equity should be considered.
If preferred stock classified as mezzanine equity is no longer required to be presented in mezzanine equity (e.g., due to the expiration of a redemption feature) it should be reclassified to permanent equity. The carrying amount of the preferred stock should not be adjusted upon the reclassification to permanent equity.
As discussed in ASC 480-10-S99-3A(4), it is not appropriate to classify preferred stock that meets the requirements for classification in temporary equity as a liability.

7.3.4.1 Contingently redeemable preferred stock

Preferred stock that, by its terms, is contingently redeemable upon the occurrence of an event that is outside of the issuer’s control should be classified as mezzanine equity based on ASC 480-10-S99. The probability that the redemption event will occur is irrelevant, as discussed in ASC 480-10-S99-3A5.

ASC 480-10-S99-3A5

Determining whether an equity instrument is redeemable at the option of the holder or upon the occurrence of an event that is solely within the control of the issuer can be complex. The SEC staff believes that all of the individual facts and circumstances surrounding events that could trigger redemption should be evaluated separately and that the possibility that any triggering event that is not solely within the control of the issuer could occur—without regard to probability—would require the instrument to be classified in temporary equity.

Figure FG 7-4 lists common redemption provisions that may cause preferred stock to be classified as mezzanine equity.
Figure FG 7-4
Common redemption features that may result in mezzanine equity classification
Redemption event
Description
Delisting
Preferred stock is redeemed in the event the issuer is delisted from trading on any stock exchange on which it is listed
Decline in credit rating
Preferred stock is redeemed in the event the issuer's credit rating is reduced
Change of control
Preferred stock is redeemed in the event of a change in control of the issuer, or due to a merger, consolidation, or other deemed liquidation event
Failure to complete an IPO
Preferred stock is redeemed if the issuer fails to complete an IPO. Completion of an IPO is outside the issuer’s control
Failure to have a registration statement declared effective
Preferred stock is redeemed if the issuer fails to have a registration statement declared effective by a stated date.
However, if there is no specified date or time period, the ability to have the registration declared effective is considered within the issuer’s control, and therefore permanent equity classification would be permitted
Lapsed registration statement
Preferred stock is redeemed in the event an effective registration statement lapses
Failure to make timely SEC filings
Preferred stock is redeemed in the event the issuer fails to make timely SEC filings. As stated in ASC 815-40-25-29 in the context of derivatives and hedging, the ability to make timely SEC filings is not within the issuer’s control
Failure to pay dividends
Preferred stock is redeemed in the event the issuer fails to pay dividends. The ability to pay dividends may depend on the attainment of certain results (e.g., operating performance) or be restricted by the terms of loans or other securities, and therefore may not be within the issuer’s control
Failed Dutch Auction
Preferred stock sold through a Dutch Auction (auction starting with a high asking price that is subsequently lowered until a bid is made) is redeemable when there are insufficient buyers resulting in a failed auction
Failure to sell an asset or division
Preferred stock is redeemable in the event the issuer fails to sell an asset or division by a certain date
Covenant violations
Preferred stock is redeemed in the event the issuer (1) has a debt covenant violation, or (2) fails to meet a net income covenant (even if current projections indicate the occurrence of these events is remote)
Key man death
Preferred stock is redeemable in the event of the death or disability of the CEO or other key management member, and the redemption is at the option of the holder’s heir or estate.
In event the redemption will be funded from the proceeds of an insurance policy that is currently in force and that the issuer has the intent and ability to maintain in force, permanent equity classification may be permitted
Ordinary liquidation events vs. deemed liquidation events
Ordinary liquidation events generally do not result in an instrument being classified as mezzanine equity. An instrument that is redeemable upon a deemed liquidation event, however, will often be classified as mezzanine equity. The SEC staff provides guidance on whether provisions related to a deemed liquidation event should result in a security being classified as mezzanine equity in ASC 480-10-S99-3A(f).

ASC 480-10-S99-3A3(f)

Certain redemptions upon liquidation events. Ordinary liquidation events, which involve the redemption and liquidation of all of an entity's equity instruments for cash or other assets of the entity, do not result in an equity instrument being subject to ASR 268. In other words, if the payment of cash or other assets is required only from the distribution of net assets upon the final liquidation or termination of an entity (which may be a less-than-wholly-owned consolidated subsidiary), then that potential event need not be considered when applying ASR 268. Other transactions are considered deemed liquidation events. For example, the contractual provisions of an equity instrument may require its redemption by the issuer upon the occurrence of a change-in-control that does not result in the liquidation or termination of the issuing entity, a delisting of the issuer's securities from an exchange, or the violation of a debt covenant. Deemed liquidation events that require (or permit at the holder's option) the redemption of only one or more particular class of equity instrument for cash or other assets cause those instruments to be subject to ASR 268. However, as a limited exception, a deemed liquidation event does not cause a particular class of equity instrument to be classified outside of permanent equity if all of the holders of equally and more subordinated equity instruments of the entity would always be entitled to also receive the same form of consideration (for example, cash or shares) upon the occurrence of the event that gives rise to the redemption (that is, all subordinate classes would also be entitled to redeem).

In our experience, the exception discussed in ASC 480-10-S99-3A(f) is rarely applicable. Some preferred stock agreements provide for the distribution of proceeds in the event of a deemed liquidation event (which often includes change in control) in accordance with the liquidation preferences applicable to an ordinary liquidation. Unless all holders of equally and more subordinated equity instruments would always be entitled to also receive the same form of consideration, we believe an instrument with this provision should be classified as mezzanine equity. In other words, for a preferred share to be classified as permanent equity, there can be no possible scenario in which the preferred shareholders are entitled to be redeemed and all subordinate classes are not also entitled to be redeemed.
Question FG 7-9 discusses whether preferred stock should be classified as mezzanine or permanent equity if it is redeemable upon a deemed liquidation event outside of the issuer’s control.
Question FG 7-9
An SEC registrant issues preferred stock that is redeemable at a stated dollar amount upon the sale, liquidation, or dissolution of the issuer. In addition, the preferred stock agreement states that the acquisition of the issuer in which the former shareholders of the issuer will own less than 50% of the voting power of the surviving entity will be deemed a sale of the issuer.
The issuer’s articles of incorporation state that its board must approve all mergers, consolidations, sales, liquidations, or dissolutions of the issuer. The preferred shareholders do not control the issuer’s board.
Should the preferred stock be classified as mezzanine or permanent equity?
PwC response
The preferred stock should be classified as mezzanine equity. The shares are redeemable upon a deemed liquidation event. Since only the preferred stock (and not the common stock) will be redeemed upon the occurrence of the deemed liquidation event, and the event is not within the issuer’s control, the preferred stock should be classified as mezzanine equity.

To determine whether a deemed liquidation provision causes an instrument to be classified as mezzanine equity, an issuer must have a thorough understanding of the instrument-specific definition of deemed liquidation and all of the related redemption provisions. In some cases, the issuer’s governing documents or state law may require approval by the board of directors before any merger or consolidation can occur. Some might conclude that an instrument with this provision should be classified as permanent equity; however, there are often a number of other contractual “deemed liquidation events” that trigger redemption (e.g., squeeze-out mergers, hostile asset sales) that do not require board approval and thus are considered outside the control of the issuer. In that case, the preferred shares should be classified as mezzanine equity. As this is a legal determination, reporting entities should consult their legal counsel. See ASC 480-10-S99-3A8 for an example in which the SEC illustrates this point.

ASC 480-10-S99-3A8

A preferred security that is not required to be classified as a liability under other applicable GAAP may contain a deemed liquidation clause that provides that the security becomes redeemable if the common stockholders of the issuing company (that is, those immediately prior to a merger or consolidation) hold, immediately after such merger or consolidation, common stock representing less than a majority of the voting power of the outstanding common stock of the surviving corporation. This change-in-control provision would require the preferred security to be classified in temporary equity if a purchaser could acquire a majority of the voting power of the outstanding common stock without company approval, thereby triggering redemption.

As stated in ASC 480-10-S99-3A5, the assessment of whether a triggering event is within the control of an issuer should be made without regard to the probability of that event occurring.
Liquidated damages
The terms of preferred stock may require an issuer to pay liquidated damages upon the occurrence or nonoccurrence of an event outside its control. The payment may be a significant percentage of the preferred stock proceeds. The payment of liquidated damages does not result in a legal redemption or settlement of the preferred stock; therefore, a liquidated damages provision does not cause preferred shares to be classified as mezzanine equity. However, a liquidated damages provision could be an embedded derivative that should be accounted for separately. See FG 1.6.1 and DH 4.4.3 for information on whether this feature in a debt host must be bifurcated and accounted for separately. See DH 4.5.2 for additional information on whether this feature in an equity host must be bifurcated and accounted for separately.

7.3.4.2 Convertible preferred stock

Contractual features, in convertible preferred stock or in the instruments into which the preferred stock may be converted, may result in the shares being classified as mezzanine equity. Figure FG 7-5 lists common features that may cause convertible preferred stock to be classified as mezzanine equity. An issuer should also consider the points discussed in FG 7.3.4.1 for contingently redeemable preferred stock and in FG 7.3.4.3 for perpetual preferred stock.
Figure FG 7-5
Common features that may result in mezzanine equity classification
Feature
Description
Redemption upon conversion default
Convertible preferred stock is assumed to be redeemable in the event the issuer cannot deliver the conversion shares because (1) it does not have an adequate number of shares authorized and must seek shareholder approval for an increase to the number of authorized shares (even if the terms require that common shares be reserved for conversion and the need for an increase in authorized shares to satisfy conversion is deemed remote) or (2) delivery of the conversion shares under any circumstances would result in dilution of 20% or more of the outstanding shares of common stock, which under certain stock exchange rules requires shareholder approval prior to issuance of the conversion shares.
Preferred shares exchangeable into shares of an equity-method investee or other assets
Preferred stock is exchangeable into preferred stock of an equity-method investee of the issuer, without regard to whether the equity-method investee is a private or public entity. Preferred shares that are redeemable for cash or other assets should be reported as mezzanine equity, even when the assets to be received are not readily convertible into cash.
Preferred shares convertible into mandatorily redeemable common stock
Preferred stock convertible into mandatorily redeemable common stock is classified as mezzanine equity because conversion of the preferred stock and redemption of the resultant common stock are both outside of the issuer’s control. Once the preferred stock is converted, redemption of the common stock is certain to occur, so the common stock should be classified as a liability under the guidance in ASC 480.
Convertible preferred stock when the issuer does not control share settlement of conversion option
The guidance in ASC 815-40-25 should be used to evaluate whether the issuer controls the actions or events necessary to issue the number of required shares under the conversion option if exercised by the holder. If the issuer does not control share settlement of the conversion option embedded in convertible preferred stock, then cash settlement of the conversion option would be presumed and the convertible preferred stock would be classified as temporary equity.

7.3.4.3 Perpetual preferred stock (no redemption)

In general, perpetual preferred stock is classified as permanent equity. However, perpetual preferred stock may be classified as mezzanine equity if the preferred shareholders control the board of directors (or could control the board as a result of events outside the issuer’s control, such as a debt default) and the preferred stock contains a call option exercisable at the issuer’s discretion. In that case, it is assumed that the preferred shareholders would be able to force the issuer to redeem their shares for cash. In this case, mezzanine equity presentation would be appropriate.
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