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8.4 Accounting for freestanding instruments issued together
Publication date: 31 Dec 2021
us Financing guide
A reporting entity may issue multiple freestanding instruments in a bundled transaction. Typically, a debt or preferred equity instrument is issued with a share issuance contract, such as a warrant or variable share delivery agreement. A reporting entity may issue freestanding instruments together to meet its financing objectives, meet its investors’ objectives, or for tax purposes.
If a reporting entity issues a non-detachable equity derivative that is not deemed to be a freestanding instrument (see FG 5.3), such as a warrant, with a debt or preferred stock instrument (e.g.,, the debt or equity security must be surrendered or repaid in order to exercise the warrant), the combined instrument is substantially equivalent to convertible debt or convertible preferred stock. In that case, the reporting entity should account for the combined instrument using the guidance for convertible debt or convertible preferred stock. See FG 6 for information on accounting for convertible debt after the adoption of ASU 2020-06, FG 6A for information on accounting for convertible debt before the adoption of ASU 2020-06, and FG 7 for information on the accounting for convertible preferred stock.
When multiple investors invest in multiple classes of instruments (e.g., preferred stock, common stock, and warrant) in different quantities, the allocation of proceeds to each instrument should be performed at the investor level, not the class level. See FG 8.4.1 for information on allocating proceeds to each instrument.
8.4.1 Warrants issued in connection with debt or equity
Detachable warrants (or warrants that are deemed to be freestanding instruments (see FG 5.3)) issued in a bundled transaction with debt and equity offerings are accounted for separately. The allocation of the sales proceeds between the base instrument (i.e., the debt or equity instrument) and the warrants depends on the whether the warrants should be accounted for as equity or a liability. See FG 5.2 for information on the analysis of equity-linked instruments.
If the warrants are classified as equity, then the proceeds should be allocated based on the relative fair values of the base instrument and the warrants following the guidance in ASC 470, Debt.
Proceeds from the sale of a debt instrument with stock purchase warrants (detachable call options) shall be allocated to the two elements based on the relative fair values of the debt instrument without the warrants and of the warrants themselves at time of issuance. The portion of the proceeds so allocated to the warrants shall be accounted for as paid-in capital. The remainder of the proceeds shall be allocated to the debt instrument portion of the transaction. This usually results in a discount (or, occasionally, a reduced premium), which shall be accounted for under Topic 835 [Interest].
Although this guidance is for debt instruments issued with warrants, preferred shares issued with equity-classified warrants should be accounted for in a similar manner.
If the warrants are classified as a liability and recorded at fair value with changes in fair value recorded in the income statement, then the proceeds should be allocated first to the warrants based on their fair value (not relative fair value). The residual should be allocated to the remaining debt and/or equity instruments. This approach avoids the possibility of recording a day one gain or loss on the warrant which could arise if the allocation were made on a relative fair value basis.
The allocation of proceeds to the warrant, using either method, will typically create a discount in the associated debt or equity instrument, which should be recognized as interest expense or a dividend in some cases.
In rare cases, the fair value of the liability-classified warrants may exceed the proceeds received in the bundled transaction. The guidance described in FG 5.4.5 related to the issuance of a hybrid instrument when the fair value of the embedded derivative liability required to be measured at fair value (e.g., bifurcated derivative) exceeds the net proceeds received should be applied by analogy to the bundled transaction. As a result, if the fair values are appropriate, the transaction was conducted on an arm’s length basis, and there are no rights or privileges that require separate accounting recognition, the difference between the fair value of the liability-classified warrants and the net proceeds received is recognized as a day-one loss in earnings. See FG 5.4.5 for additional considerations related to the application of the guidance.
Example FG 8-2 illustrates the model for allocating proceeds when equity classified warrants are issued in connection with a debt instrument. Example FG 8-3 illustrates the model for allocating proceeds when liability classified warrants are issued in connection with a debt instrument.
EXAMPLE FG 8-2
Warrants classified as equity issued in connection with a debt instrument
Warrants classified as equity issued in connection with a debt instrument
FG Corp issues $1,000 of debt and 100 detachable warrants to purchase its common stock, in exchange for $1,000 in cash. 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 debt instrument and warrants based on their relative fair values.
The fair values and amounts allocated to the debt instrument and warrants are shown in the following table.
Instrument |
Fair value |
Percent of total fair |
Allocated amount |
Debt |
$910 |
70% |
$700 |
Warrants |
$390 |
30% |
$300 |
Total |
$1,300 |
100% |
$1,000 |
How should FG Corp record the issuance of the debt instrument and warrants?
Analysis
FG Corp should record the following journal entry.
Dr. Cash |
$1,000 |
|
Dr. Discount on debt instrument |
$300 |
|
Cr. Debt instrument |
$1,000 |
|
Cr. Additional paid-in capital—warrants |
$300 |
EXAMPLE FG 8-3
Warrants classified as liabilities issued in connection with a debt instrument
Warrants classified as liabilities issued in connection with a debt instrument
FG Corp issues $1,000 of debt and 100 detachable warrants to purchase its common stock, in exchange for $1,000 in cash. FG Corp concludes that the warrants have a fair value of $390 and meet the requirements for liability classification.
How should FG Corp record the issuance of the debt instrument and warrants?
Analysis
Since the warrants are classified as a liability, FG Corp allocates the proceeds from the issuance of the debt instrument first to the warrants based on their fair value. The residual amount is allocated to the debt instrument.
FG Corp should record the following journal entry.
Dr. Cash |
$1,000 |
|
Dr. Discount on debt instrument |
$390 |
|
Cr. Debt |
$1,000 |
|
Cr. Warrant liability |
$390 |
8.4.1.1 Issuance costs for non-revolving debt with warrants—after adoption of ASU 2020-06
The allocation of issuance costs should mirror the accounting for the warrant itself. Issuance costs not specifically related to an instrument issued should be allocated in the same proportion as the proceeds are allocated to the debt (or preferred) and warrants. Issuance costs allocated to a warrant liability should be expensed as incurred and certain issuance costs allocated to an equity-classified warrant should be recorded in equity.
Issuance costs that relate specifically to the issuance of the debt (or preferred) or the warrant, rather than the transaction as a whole, should be allocated to that instrument.
See FG 1.2.2 for further information on which costs qualify as issuance costs.
8.4.1.1A Issuance costs for non-revolving debt with warrants—before adoption of ASU 2020-06
The allocation of issuance costs should mirror the accounting for the warrant itself. Issuance costs not specifically related to an instrument issued should be allocated in the same proportion as the proceeds are allocated to the debt (or preferred) and warrants. Issuance costs allocated to a warrant liability should be expensed as incurred and certain issuance costs allocated to an equity-classified warrant should be recorded in equity.
Issuance costs that relate specifically to the issuance of the debt (or preferred) or the warrant, rather than the transaction as a whole, should be allocated to that instrument.
This discussion does not apply to convertible debt within the cash conversion sections of ASC 470-20. These subsections apply to convertible debt instruments that allow, or require, the reporting entity to settle its obligation upon conversion, in whole or in part, in a combination of cash and stock. See FG 6.6A for information on ASC 470-20.
See FG 1.2.2 for further information on which costs qualify as issuance costs.
8.4.1.2 Detachable warrants issued to obtain a line of credit
The guidance in ASC 470-20-25-2 does not apply when warrants are issued to obtain a line of credit rather than in connection with the issuance of a debt instrument. Warrants issued to obtain a line of credit should be recorded at fair value when the line of credit agreement is signed; this is the accounting regardless of whether the warrants are classified as a liability or equity. Issuing warrants to obtain a line of credit is equivalent to paying a loan commitment or access fee (equivalent to the fair value of the warrant). As such, these costs meet the definition of an asset and should be recorded as such on the balance sheet and amortized on a straight-line basis over the stated term of the line of credit (i.e., the access period). This accounting applies even if the line is fully drawn down at inception, since the warrants are issued in exchange for access to capital.
See FG 5.2 for information on the analysis of equity-linked instruments including warrants.
8.4.1.3 Repurchase of debt with detachable warrants
When a reporting entity extinguishes debt with detachable warrants that are classified as equity, it should allocate the repurchase price to the debt instrument and the warrants using a relative fair value allocation.
The repurchase price amount allocated to the debt instrument should be used to calculate any gain or loss on debt extinguishment. See FG 3.7 for information on debt extinguishment accounting.
The repurchase price amount allocated to the warrants is recorded as a reduction of additional paid-in capital. There is no gain or loss recognized in the income statement when a common equity instrument is retired provided the reporting entity does not convey additional rights and privileges.
8.4.2 Mandatory units
Mandatory units are equity-linked financial products often marketed under different proprietary names by different financial institutions (e.g., ACES, PRIDES, or DECS). Typically, from the reporting entity’s perspective, a mandatory unit consists of (a) a term debt instrument with a remarketing feature and (b) a “variable share forward delivery agreement,” i.e., a detachable forward sale contract that obligates the investor to purchase shares of the reporting entity’s common stock at a specified time and at a specified price before the maturity of the debt instrument. The number of shares to be received by the holder is based on the market price of the reporting entity’s stock on the settlement date of the contract.
Typically, the terms of the debt instrument issued as part of a mandatory unit structure include:
- A stated principal amount equal to the settlement price of the variable share forward delivery agreement. The debt instrument is initially pledged to secure the investor’s obligation to pay the settlement price of the variable share forward delivery agreement.
- A fixed maturity with a “remarketing” of the instrument prior to the exercise date of the variable share forward delivery agreement
- The interest rate is a fixed rate for the period from issuance to the remarketing date
- At the remarketing date, the debt instrument is sold to new investors at par with a new interest rate equal to the then market rate for debt with the remaining term to maturity. The debt instrument must be sold for an amount at least equal to par, which is equal to the settlement price of the variable share forward delivery agreement. If the remarketing does not result in a successful sale at the minimum required price (i.e., a failed remarketing), then the debt instrument is typically delivered to the reporting entity to pay the settlement price of the variable share forward delivery agreement. Generally, the interest rate a reporting entity will pay upon remarketing is not limited, making a failed remarketing less likely to occur.
The number of shares issued under the variable share forward delivery agreement will depend on the price of the underlying stock at the end of the contract. For example, an agreement may be structured as follows, assuming an investor pays $50 to settle the variable share forward delivery agreement:
If the stock price is: |
The reporting entity issues: |
Less than $50 |
1 share |
Between $50 and $62.50 |
A pro rata portion of a share, between 1 and 0.8 shares, equal to $50 |
Greater than $62.50 |
0.8 shares |
In this example, the variable share forward delivery agreement comprises three features from the issuer’s perspective:
- A purchased put on the issuer’s own shares (a put on one share with an exercise price of $50)
- A written call option on the issuer’s own shares (a call on 0.8 shares with an exercise price of $62.50)
- An agreement to issue the issuer’s own shares at their prevailing fair values (if the share price is between $50 and $62.50)
Because the variable share forward delivery agreement is legally detachable from the debt instrument, it is typically considered a freestanding instrument and accounted for separately. See FG 5.3 for further information on determining whether an instrument is freestanding or embedded.
ASC 480-10-55-50 provides guidance for analyzing a variable share forward delivery contract.
Entity D enters into a contract to issue shares of Entity D’s stock to Counterparty in exchange for $50 on a specified date. If Entity D’s share price is equal to or less than $50 on the settlement date, Entity D will issue 1 share to Counterparty. If the share price is greater than $50 but equal to or less than $60, Entity D will issue $50 worth of fractional shares to Counterparty. Finally, if the share price is greater than $60, Entity D will issue .833 shares. At inception, the share price is $49. Entity D has an obligation to issue a number of shares that can vary; therefore, paragraph 480-10-25-14 may apply. However, unless it is determined that the monetary value of the obligation to issue a variable number of shares is predominantly based on a fixed monetary amount known at inception (as it is in the $50 to $60 share price range), the financial instrument is not in the scope of this Subtopic.
See FG 5.5.1 for further information on the scope of ASC 480, including information on “predominantly.” If a reporting entity concludes that a variable share forward delivery agreement is not within the scope of ASC 480, the next step to determine the accounting treatment is to determine whether it should be classified as a liability or equity under the guidance in ASC 815-40. See FG 5.6 for further information on the analysis of a freestanding equity-linked instrument after adoption of ASU 2020-06 or FG 5.6A for further information on the analysis of a freestanding equity-linked instrument before the adoption of ASU 2020-06.
8.4.2.1 Contract payments paid by the reporting entity
Typically, the investor in a mandatory unit structure receives quarterly payments comprising both (a) interest on the debt instrument and (b) “contract payments” on the variable share forward delivery agreement. The contract payments result from the fact that the purchased put in the variable share forward delivery agreement has a greater value than the written call, resulting in a net premium which must be paid for the net purchased put on the reporting entity’s own stock. Rather than paying the premium up front, the issuer pays the premium over time in the form of contract payments.
If the variable share forward delivery agreement is accounted for as an equity instrument, the reporting entity should account for the obligation to make the contract payments as a liability measured at the present value of the payments over the life with an offsetting entry to additional paid-in capital. The liability is subsequently accreted using the effective interest method over the life of the variable share forward delivery agreement, with an offsetting entry to interest expense.
8.4.2.2 Application example
Example FG 8-4 illustrates the accounting for mandatory units.
EXAMPLE FG 8-4
Accounting for mandatory units
Accounting for mandatory units
FG Corp issues 10 mandatory units to investors. Each mandatory unit has a stated par value of $1,000 and consists of:
- A five-year debt security of FG Corp with principal amount of $1,000 and an initial rate of 4%, paid quarterly, for the first thirty-three months. At the end of 33 months, the debt security will be remarketed and the interest rate will reset to the market rate for the remaining life of the debt security.
- A three-year variable share forward delivery agreement with a 1% contract payment. At maturity, each investor will pay FG Corp $1,000 per unit and get a variable number of shares depending on FG Corp’s stock price at the maturity date, as summarized below.
If the stock price is: |
FG Corp issues: |
Less than $50 |
20 shares |
Between $50 and $62.50 |
A pro rata number of shares equal to $1,000 |
Greater than $62.50 |
16 shares |
FG Corp’s common stock has a $1.00 par value.
FG Corp determines that the debt security and the variable share forward delivery agreement are freestanding instruments and should be accounted for separately because they are legally detachable and separately exercisable. In addition, FG Corp performs an analysis of the variable share forward delivery agreement and concludes that (1) it is not within the scope of ASC 480 and (2) it is indexed to its own stock and meets the additional requirements for equity classification in ASC 815-40 and, therefore, should be accounted for as an equity instrument. As a result, the proceeds are allocated to the debt security and the variable share forward delivery contract based on their relative fair values. The obligation associated with the variable share forward delivery agreement has a fair value of $275; the fair value is imputed based upon the present value of the contract payments discounted at FG Corp’s three-year financing rate.
Upon remarketing, the interest rate on the debt resets to FG’s then current borrowing rate of 3.8%. At settlement of the variable share forward delivery agreement, FG Corp’s stock price is $65.00.
How should FG Corp record (1) the issuance of the mandatory units, (2) the periodic entries over the life of the instruments, (3) the remarketing of the debt security, (4) the maturity of the variable share forward delivery agreement, and (5) the maturity of the debt?
Analysis
Issuance of the mandatory units
FG Corp records the issuance of its mandatory units by recording the cash proceeds, the debt security, and the present value of the contract payments related to the variable share forward delivery agreement.
Dr. Cash |
$ 10,000 |
|
Dr. Equity – APIC |
$275 |
|
Cr. Debt security |
$10,000 |
|
Cr. Contract payment liability |
$275 |
Periodic entries over the life of the instrument
FG Corp calculates the quarterly interest expense as follows:
$10,000 × 4% × ¼ = $100
FG Corp records interest payments made to investors.
Dr. Interest expense |
$100 |
|
Cr. Cash |
$100 |
FG Corp calculates the quarterly contract payment as follows:
$10,000 × 1% × ¼ = $25
FG Corp records the cash paid for the contract payment obligation; the offsetting entry is recorded to reduce the contract payment liability and recognize interest expense using the interest method on the contract payment liability.
Dr. Contract payment liability |
$21 |
|
Dr. Interest expense |
$4 |
|
Cr. Cash |
$25 |
Upon remarketing of the debt security
Once the debt security is remarketed, FG Corp records quarterly interest expense of $95 ($10,000 × 3.8% × ¼ = $95) over the remaining life.
Dr. Interest expense |
$95 |
|
Cr. Cash |
$95 |
The actual remarketing is not recognized by FG Corp as an extinguishment and reissuance because it is a transaction among third party market participants.
Upon maturity of the variable share forward delivery agreement
FG Corp records the proceeds received upon settlement of the variable share forward delivery agreement and the issuance of shares at par value (10 units × 16 shares per unit × $1.00 par value = $160) with the remainder recorded to APIC.
Dr. Cash |
$10,000 |
|
Cr. Equity – par value common stock |
$160 |
|
Cr. Equity – APIC |
$9,840 |
Upon maturity of the debt security
FG Corp records the cash paid upon redemption of the debt security.
Dr. Debt |
$10,000 |
|
Cr. Cash |
$10,000 |
8.4.2.3 Issuance costs
In many cases, the variable share delivery agreement is accounted for as an equity instrument and the issuance costs should be allocated to the debt instruments and the variable share delivery agreement in a rational manner. One acceptable method is to allocate issuances costs to the debt and equity instruments based on their relative fair values on an absolute value basis.
See FG 1.2.2 for further information on which costs qualify as issuance costs.
8.4.2.4 Earnings per share
The diluted earnings per share (EPS) treatment of a unit structure with an equity classified variable share delivery agreement depends on whether (1) the debt instrument can be tendered to satisfy the investor’s payment of the exercise price for the variable share forward delivery agreement and (2) whether the debt instrument and variable share forward delivery agreement mature on, or close to, the same date.
ASC 260-10-55-9 provides guidance on the computation of diluted EPS for instruments that require or permit the tendering of a debt instrument in satisfaction of the exercise price.
Options or warrants may permit or require the tendering of debt or other securities of the issuer (or its parent or its subsidiary) in payment of all or a portion of the exercise price. In computing diluted EPS, those options or warrants shall be assumed to be exercised and the debt or other securities shall be assumed to be tendered. If tendering cash would be more advantageous to the option holder or warrant holder and the contract permits tendering cash, the treasury stock method shall be applied. Interest (net of tax) on any debt assumed to be tendered shall be added back as an adjustment to the numerator. The numerator also shall be adjusted for any nondiscretionary adjustments based on income (net of tax). The treasury stock method shall be applied for proceeds assumed to be received in cash.
This method results in EPS dilution similar to the use of the if-converted method. See FSP 7.5.6 (after adoption of ASU 2020-06) or FSP 7.5.6A (before adoption of ASU 2020-06) for information on the if-converted method. This same treatment should be applied if the debt instrument and variable share forward delivery agreement mature on, or close to, the same date.
If the debt instrument cannot be tendered to satisfy the investor’s payment of the exercise price for the share issuance derivative, the instrument is included in diluted EPS as follows:
- The coupon on the debt instrument is included as interest expense and therefore results in a reduction of earnings available to common shareholders
- The variable share forward delivery agreement is included as a potentially issuable common share using the treasury stock method; see FSP 7.5.5 for information on applying the treasury stock method
Typically, the base security in the unit offering will be remarketed at some point prior, but close to, the maturity of the variable share forward delivery agreement. For example, the debt instrument may have a five year life, with a remarketing after 2.75 years, and the variable share forward delivery agreement will mature at the end of 3 years. With at least 90 days difference between the debt instrument’s remarketing date and the maturity of the variable share forward delivery agreement, the two instruments are not considered coterminous so the treasury stock method should be applied. However, most securities also allow the investor to use the debt instrument to satisfy the exercise price of the share issuance derivative in the event of a failed remarketing. If this occurs, the two instruments do co-terminate and the approach similar to the if-converted method should be applied.
In determining the method for including a unit structure in diluted EPS, a reporting entity should consider the likelihood that the debt instrument will be used to satisfy the exercise price of the variable share forward delivery agreement (i.e., they will co-terminate). If the instruments are coterminous only upon a failed remarketing, then provided the likelihood of a failed remarketing is considered remote, use of the treasury stock method is generally appropriate.
If the likelihood of a failed remarketing became reasonably possible (i.e., more than remote likelihood), the reporting entity would need to begin to use the “if-converted method” in computing earnings per share. Some reporting entities may wish to build flexibility into the remarketing provisions permitting changes to the terms of the debt instrument. While this may increase the likelihood of a successful remarketing, we believe that providing too much flexibility in modifications that can be made in conjunction with the remarketing of the debt would place stress on the reporting entity’s ability to use the treasury stock method of computing diluted EPS. This is because providing too much flexibility in the arrangement may suggest that when utilized, a substantive modification of the debt has occurred that would need to be accounted for as an extinguishment of the old debt and issuance of a new debt instrument.
8.4.2.5 Repurchase of mandatory units
When a reporting entity extinguishes mandatory units that include an equity classified variable share forward, such as through an open market repurchase of the instruments, the accounting treatment depends on whether the variable share forward delivery agreement is economically an asset or liability to the issuer. For example, using the terms in Example FG 8-4:
- If the issuer’s stock price were $40, it would be required to deliver 20 shares of its stock with a fair value of $800 in exchange for $1,000 in cash; therefore the variable share forward delivery agreement is economically in a gain position to the issuer.
- If the issuer’s stock price were $75, it would be required to deliver 16 shares of its stock with a fair value of $1,200 in exchange for $1,000 in cash, therefore the variable share forward delivery agreement is economically in a loss position to the issuer.
The contract payment liability discussed in FG 8.4.2.1 is an additional liability that should be included in the debt extinguishment analysis discussed below.
If the variable share forward delivery agreement is economically a liability to the issuer, the repurchase price (cash and fair value of the common stock) should be allocated to the debt instruments (i.e., the debt instrument and contract payment liability) and variable share forward delivery agreement using a relative fair value methodology.
- A gain or loss on extinguishment equal to the difference between (1) the amount allocated to the debt instruments and (2) the carrying value is recognized in earnings; see FG 3.7 for further discussion of debt extinguishment accounting
- The portion of the repurchase price attributable to the equity-classified variable share forward delivery agreement is recorded as a reduction of additional paid-in capital. There is no loss recognized when a common equity instrument is retired provided the issuer does not convey additional rights and privileges that require recognition of income or expense
If, however, the variable share forward delivery agreement is economically an asset to the issuer, we believe the fact that the forward is being used as consideration to extinguish the obligation should be considered. One method of doing this is to record:
- A gain or loss on extinguishment equal to the difference between (1) the consideration paid plus the fair value of the equity-classified variable share forward delivery agreement and (2) the carrying value of the debt instrument; see FG 3.7 for further discussion of debt extinguishment accounting
- The portion of the repurchase price attributable to the equity-classified variable share forward delivery agreement (i.e., its fair value used in calculating the gain or loss on extinguishment) is recorded as an increase in additional paid-in capital
There may be other acceptable methods of performing this calculation.
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