2013

Guide to Accounting for Financing TransactionsWhat You Need To Know about Debt, Equity and the Instruments in Between

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This publication has been prepared for general information on matters of interest only, and does not constitute professional advice on facts and circumstances specific to any person or entity. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication. The information contained in this material was not intended or written to be used, and cannot be used, for purposes of avoiding penalties or sanctions imposed by any government or other regulatory body. PricewaterhouseCoopers LLP, its members, employees, and agents shall not be responsible for any loss sustained by any person or entity who relies on this publication.

The content of this publication is based on information available as of May 15, 2013. Accordingly, certain aspects of this publication may be superseded as new guidance or interpretations emerge. Financial statement preparers and other users of this publication are therefore cautioned to stay abreast of and carefully evaluate subsequent authoritative and interpretative guidance that is issued.

“Copyright © 2013 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.”

Dear Clients and Friends:

PwC is pleased to offer this Guide to Accounting for Financing Transactions: What You Need to Know about Debt, Equity and the Instruments in Between. This Guide compiles the accounting guidance an issuer should consider when:

• Issuing debt, equity and hybrid securities (including determining whether the security should be classified as debt or equity for accounting purposes),

• Creating a noncontrolling interest,

• Modifying debt or equity securities,

• Inducing an investor to convert, and

• Buying back debt or equity securities.

We have organized the Guide to first discuss the accounting literature and analyses applicable to many financing transactions and then discuss the application of this guidance to specific financing transactions. We hope you find this Guide to be a valuable tool for assessing the accounting implications of financing transactions you are considering.

The accounting guidance for the issuance, modification, conversion and repurchase of debt and equity securities has developed over many years into a complex set of rules. Before the FASB codified accounting standards, the accounting guidance applicable to a single transaction was contained in a number of separate FASB Standards, EITF Issues, interpretations, and speeches. Although the guidance is now codified within the FASB’s Accounting Standards Codification, the analysis continues to involve detailed and sequential consideration of the relevant provisions of the guidance. This Guide provides a roadmap to the applicable accounting literature to help you determine which steps are necessary for a particular transaction.

While this Guide can be a helpful tool, it cannot substitute for a thorough analysis of the relevant accounting literature in light of the facts and circumstances of proposed transactions.

PwC professionals have years of experience advising clients on the transactions discussed in this Guide. We have included a section entitled How PwC Can Help at the end of many chapters. This section lists some of the many areas in which PwC can provide advice. If you would like to discuss one of the topics covered in this Guide, please contact your PwC engagement partner or one of the contacts included at the end of the Guide.

PricewaterhouseCoopers LLP

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Table of Contents

Chapter 1: Guidelines

1.1 Accounting for Financing Transactions .................................................................1-2

1.2 Organization of this Guide ......................................................................................1-2

1.3 International Accounting Standards ......................................................................1-2

1.4 Contracts to Enter into a Financing Transaction (Forward Starting Transactions) .............................................................................1-3

1.5 Financing Transactions Reported at Fair Value ....................................................1-3

1.6 How PwC Can Help..................................................................................................1-3

Chapter 2: Analysis of Equity-Linked Instruments

2.1 Overview of Equity-Linked Instruments ................................................................2-2

2.2 Freestanding vs. Embedded ...................................................................................2-2

Example 2-1: Tranched Preferred Stock ................................................................2-4

2.3 Analysis of Embedded Equity-Linked Components .............................................2-52.3.1 Clearly and Closely Related ....................................................................................2-62.3.1.1 Preferred Stock ..........................................................................................................2-62.3.1.2 Debt Host ...................................................................................................................2-62.3.2 Definition of a Derivative .........................................................................................2-72.3.2.1 Readily Convertible to Cash ......................................................................................2-82.3.3 Scope Exception for Certain Contracts Involving an Issuer’s

Own Equity ...............................................................................................................2-92.3.4 Accounting for Separated Instruments .................................................................2-9

2.4 Analysis of Certain Freestanding Instruments (ASC 480) ..................................2-102.4.1 Scope ......................................................................................................................2-102.4.2 Recognition and Measurement ............................................................................2-112.4.2.1 Subsequent Measurement .......................................................................................2-112.4.3 Non-Substantive Features ....................................................................................2-12

Example 2-2: Impact of Declining Stock Price on Conversion Option .............2-13

2.5 Analysis of a Freestanding Equity-Linked Instrument .......................................2-132.5.1 Indexed to a Company’s Own Stock—ASC 815-40-15

(previously EITF 07-5) ............................................................................................2-142.5.1.1 Step One—Exercise Contingencies .........................................................................2-152.5.1.2 Step Two—Settlement Adjustments ........................................................................2-152.5.1.3 Anti-dilution and Price Protection Provisions (including “down-round”

provisions) ................................................................................................................2-16

Example 2-3: Down-Round Provisions in a Security Received Upon Exercise of a Warrant ............................................................................................2-16

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Example 2-4: Valuation of a Warrant with a Down-Round Provision ................2-17

2.5.1.4 Foreign Currency .....................................................................................................2-18

Example 2-5: Foreign Currency Denominated Convertible Bond .....................2-18

2.5.1.5 Indexed to Stock of Subsidiary, Affiliate, or Parent .................................................2-182.5.2 Requirements for Equity Classification—ASC 815-40-25

(previously EITF 00-19) ..........................................................................................2-192.5.2.1 Additional Requirements for Equity Classification ...................................................2-19

Example 2-6: Impact of Exchange Limits on Share Issuance ...........................2-20

Example 2-7: Impact of Master Netting Agreements .........................................2-21

Example 2-8: Option to Pay Cash Penalty in the Event Timely Filings with the SEC Are Not Made ..................................................................................2-21

Example 2-9: Convertible Debt Indexed to Subsidiary’s Stock and Settlable in Stock of Parent or Subsidiary ...........................................................2-22

2.5.2.2 Application to Convertible Bonds ............................................................................2-23

Example 2-10: Application of Conventional Convertible Bond Exception to Convertible Bonds with a Make-Whole Table ...............................2-23

2.5.2.3 Reassessment .........................................................................................................2-23

2.6 Accounting for Instruments Classified in Equity ................................................2-24

2.7 Financial Statement Disclosure of Equity-Linked Instruments .........................2-24

Chapter 3: Analyzing Put and Call Options and Other Features and Arrangements

3.1 Put and Call Options Embedded in Debt Instruments .........................................3-2

3.2 Analysis of Whether a Put or Call Is Clearly and Closely Related to a Debt Host ..........................................................................................................3-2

3.2.1 Determine the Nature of the Settlement Amount Received Upon Exercise of Put or Call Option ................................................................................3-4

3.2.2 Determine Whether the Put or Call Option Accelerates Repayment of the Debt ................................................................................................................3-5

3.2.3 Determine if the Put or Call Option Is Contingently Exercisable ........................3-53.2.4 Determine if the Debt Instrument Contains a Substantial Premium

or Discount ...............................................................................................................3-63.2.5 Analysis of Embedded Interest Rate Derivatives ..................................................3-73.2.5.1 Application of Test to Determine Whether the Investor Recovers

Substantially All of Its Investment ..............................................................................3-83.2.5.2 Application of the Double-Double Test ......................................................................3-8

Example 3-1: Debt Puttable Upon a Change in Interest Rates ............................3-9

Example 3-2: Debt Issued at Par, Puttable Upon a Change in Control .............3-10

Example 3-3: Debt Issued at a Premium, Puttable Upon a Change in Control ..................................................................................................3-10

Example 3-4: Debt Issued at a Discount, Puttable Upon a Change in Control ..................................................................................................3-11

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3.2.6 Fair Value Put and Call Options ............................................................................3-12

3.3 Put and Call Options Embedded in Equity Instruments .....................................3-12

3.4 Warrants Issued in Connection with Debt and Equity Offerings .......................3-12

Example 3-5: Warrants Classified as Equity Issued in Connection with Debt .................................................................................................................3-13

Example 3-6: Warrants Classified as Liabilities Issued in Connection with Debt .................................................................................................................3-13

3.5 Beneficial Conversion Feature ............................................................................3-143.5.1 Recognition and Measurement ............................................................................3-14

Example 3-7: Beneficial Conversion Feature (BCF) ............................................3-15

3.5.2 Commitment Date ..................................................................................................3-163.5.3 Contingent BCF Measurement .............................................................................3-16

Example 3-8: Contingent BCF Recognition and Measurement .........................3-17

3.5.4 Amortization of BCF Discount ..............................................................................3-17

3.6 Mezzanine (Temporary) Equity Classification .....................................................3-18

Example 3-9: Classification of BCF ......................................................................3-19

3.7 Issuance Costs .......................................................................................................3-193.7.1 Equity Issuance Costs ...........................................................................................3-203.7.2 Debt Issuance Costs .............................................................................................3-203.7.2.1 Convertible Debt with a Cash Conversion Feature ..................................................3-203.7.2.2 Units Structures .......................................................................................................3-203.7.3 Amortization of Issuance Costs ...........................................................................3-21

3.8 Registration Payment Arrangements ...................................................................3-21

Example 3-10: Registration Payment Arrangement ...........................................3-22

Chapter 4: Earnings per Share

4.1 Basic and Diluted Earnings per Share ...................................................................4-2

4.2 Anti-Dilution and Sequencing of Instruments .......................................................4-2

4.3 If-Converted Method ...............................................................................................4-24.3.1 Application to Convertible Debt .............................................................................4-3

Example 4-1: Application of the If-Converted Method .........................................4-3

Example 4-2: Capitalized Interest ..........................................................................4-4

4.3.2 Application to Convertible Preferred Stock ..........................................................4-4

Example 4-3: Conversion During Reporting Period ..............................................4-5

4.4 Treasury Stock Method ...........................................................................................4-5

Example 4-4: Application of the Treasury Stock Method ..................................... 4.6

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4.5 Instruments Settlable in Cash or Shares ...............................................................4-7

4.6 Convertible Debt with a Cash Conversion Feature ..............................................4-8

4.7 Contingently Convertible Instruments ...................................................................4-8

4.8 Participating Securities/Two-Class Method of Calculating Basic and Diluted EPS .......................................................................................................4-9

Example 4-5: Application of the Two-Class Method...........................................4-10

Example 4-6: Participating Securities with a Conversion Feature ....................4-11

4.8.1 Adjustments to Exercise or Conversion Prices ..................................................4-114.8.1.1 Adjustments to Convertible Securities and Options ................................................4-124.8.1.2 Adjustments to Forward Contracts ..........................................................................4-124.8.1.3 Adjustments to Variable Share Forward Delivery Agreements ................................4-12

4.9 Share Lending Agreements...................................................................................4-14

Chapter 5: Accounting for Modifications and Extinguishments

5.1 Restructuring and Extinguishment ........................................................................5-2

5.2 Analyzing a Debt Restructuring ..............................................................................5-2

Example 5-1: Repayment of Debt Instrument with Contemporaneous Issuance of Debt ......................................................................................................5-3

5.3 Troubled Debt Restructurings (TDRs) ....................................................................5-35.3.1 Determining Whether the Borrower Is Experiencing Financial

Difficulties .................................................................................................................5-35.3.2 Determining Whether the Creditor Has Granted a Concession ..........................5-45.3.3 Full Settlement of the Debt .....................................................................................5-55.3.4 Modification of Terms ..............................................................................................5-55.3.5 TDR of a Variable-Rate Instrument ........................................................................5-65.3.6 Restructuring of Debt by Existing Equity Holders ................................................5-6

Example 5-2: Troubled Debt Restructuring ...........................................................5-7

5.4 Modification vs. Extinguishment—Non-Revolving Debt Security or Term Loan ............................................................................................................5-8

5.4.1 Test to Determine Whether a Modification to Non-Revolving Debt Is Substantial ............................................................................................................5-9

5.4.1.1 Loan Syndications and Participations .....................................................................5-105.4.1.2 Third Party Intermediaries ........................................................................................5-115.4.1.3 Consideration of Multiple Debt Instruments Held by One Lender ...........................5-125.4.1.4 Prepayment Options ................................................................................................5-125.4.1.5 Non-cash Consideration ..........................................................................................5-135.4.1.6 Restructured Debt Is the Hedged Item in a Fair Value Hedge of

Interest Rates ...........................................................................................................5-145.4.1.7 Change in Currency of the Debt ..............................................................................5-145.4.1.8 Change in Principal ..................................................................................................5-145.4.1.9 Modification of Instruments Held by Multiple Lenders ............................................5-16

Example 5-3: Restructuring of Syndicated Term Loan Facility..........................5-16

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5.5 Modifications to and Payoffs of Line-of-Credit or Revolving-Debt Arrangements .............................................................................5-19

Example 5-4: Accounting for Unamortized Costs and New Fees in Revolving-Debt Arrangement ...............................................................................5-20

5.6 Debt Extinguishment Accounting .........................................................................5-215.6.1 Classification of Gain or Loss on Debt Extinguishments ...................................5-225.6.2 Debt Extinguishment as a Subsequent Event .....................................................5-22

5.7 Restructuring of Convertible Debt Instruments ..................................................5-225.7.1 Convertible Debt Modification Accounting .........................................................5-235.7.2 Convertible Debt with Cash Conversion Feature Modification

Accounting .............................................................................................................5-24

5.8 Modification vs. Extinguishment—Preferred Stock ............................................5-245.8.1 Preferred Stock Modifications ..............................................................................5-245.8.2 Preferred Stock Extinguishment Accounting ......................................................5-255.8.2.1 Extinguishment of Convertible Preferred Stock with a BCF ....................................5-25

5.9 Modification of Warrants Classified as Equity ....................................................5-25

5.10 How PwC Can Help................................................................................................5-26

Chapter 6: Debt

6.1 Debt Instrument Overview ......................................................................................6-2

6.2 Balance Sheet Classification—Current vs. Non-Current .....................................6-2

Example 6-1: Long-Term Loan Payable Upon Demand .......................................6-3

Example 6-2: Demand Provision vs. Subjective Acceleration Clause ................6-3

Example 6-3: Impact of an Approved Debt Repayment Plan ..............................6-4

6.2.1 Short-Term Debt Refinanced on a Long-Term Basis After the Balance Sheet Date .................................................................................................6-4

Example 6-4: Impact of Parent Guarantee ............................................................6-5

6.2.1.1 Subjective Acceleration Clauses ...............................................................................6-56.2.1.2 Insufficient Refinancing and Fluctuating Balances ....................................................6-6

Example 6-5: Refinancing Subject to Working Capital Requirement .................6-6

6.2.1.3 Refinancing with Successive Short-Term Borrowings ...............................................6-66.2.2 Revolving-Debt Arrangements ...............................................................................6-76.2.3 Commercial Paper ...................................................................................................6-7

Example 6-6: Reclassification of Commercial Paper to Non-Current ................6-8

6.2.4 Liquidity Facility Arrangements for Variable Rate Demand Obligations ............6-86.2.5 Covenant Violations .................................................................................................6-9

Example 6-7: Violation of a Provision in the Debt Agreement ...........................6-10

6.2.5.1 Payments Made to Effect a Change in Debt Covenants or a Waiver of a Covenant Violation ............................................................................................6-11

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6.2.6 Effect of Subjective Acceleration Clauses on the Classification of Long-Term Debt .................................................................................................6-11

6.2.6.1 Balance Sheet Classification of Borrowings Outstanding under Revolving Credit Agreements That Include both a Subjective Acceleration Clause and a Lock-Box Arrangement ..................................................................................6-12

6.3 Classification of Liabilities as “Trade Accounts Payable” or “Other Liabilities/Bank Debt” in a Structured Payable Transaction ..............................6-12

6.4 Payment in Kind .....................................................................................................6-136.4.1 Classification of Accrued Interest Payable Settlable with

Paid-in-Kind (PIK) Notes .......................................................................................6-14

Example 6-8: Accrued Interest Settlable in PIK Notes .......................................6-14

6.5 Guarantees on Debt ...............................................................................................6-15

6.6 Contingent Interest on Debt .................................................................................6-16

6.7 Joint and Several Liability .....................................................................................6-176.7.1 Scope ......................................................................................................................6-18

Example 6-9: Contingency vs. Joint and Several ................................................6-18

Example 6-10: Judicial Ruling ...............................................................................6-19

6.7.2 Recognition ............................................................................................................6-196.7.2.1 Recoveries ...............................................................................................................6-20

Example 6-11: Recording Receivables ................................................................6-20

Example 6-12: Capital Transactions .....................................................................6-21

6.7.3 Disclosures .............................................................................................................6-216.7.4 Transition ................................................................................................................6-22

6.8 How PwC Can Help................................................................................................6-22

Chapter 7: Convertible Debt

7.1 Analysis of Convertible Debt ..................................................................................7-2

7.2 Embedded Conversion Options..............................................................................7-57.2.1 Contingent Conversion Option ...............................................................................7-67.2.1.1 Contingency Based on an Event or Index Other Than the Issuer’s

Stock Price ................................................................................................................7-67.2.1.2 Contingency Based on Issuer’s Stock Price ..............................................................7-7

Example 7-1: Classification of Debt with a Contingent Conversion Option .......................................................................................................................7-7

7.2.2 Adjustment to Shares Delivered Upon Conversion in the Event of a Fundamental Change (Make-Whole Table) ....................................................7-8

7.2.3 Conversion Option Upon Trading Price Condition (Parity Provision)..................7-9

7.3 Beneficial Conversion Feature (BCF) ...................................................................7-10

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7.4 Cash Conversion Feature (previously FSP APB 14-1) ........................................7-107.4.1 Recognition and Measurement ............................................................................7-117.4.1.1 Determining the Expected Life ................................................................................7-12

Example 7-2: Impact of Change of Control Put on Expected Life.....................7-13

7.4.1.2 Determining the Nonconvertible Debt Rate .............................................................7-14

Example 7-3: Using a Purchased Call Option to Determine the Nonconvertible Debt Rate .....................................................................................7-14

7.4.1.3 Amortization of Debt Discount .................................................................................7-157.4.2 Tax Accounting Considerations ............................................................................7-15

Example 7-4: Application of ASC 470-20 to a Convertible Bond with a Cash Conversion Feature ...................................................................................7-16

Example 7-5: Change in the Expected Life of a Convertible Bond ...................7-17

7.4.3 Mezzanine (Temporary) Equity Classification .....................................................7-187.4.4 Earnings per Share ................................................................................................7-187.4.5 Derecognition (Conversion or Extinguishment) ..................................................7-19

Example 7-6: Early Conversion of a Convertible Bond with a Cash Conversion Feature ...............................................................................................7-20

7.5 Conversion into Equity ..........................................................................................7-21

Example 7-7: Conversion of Instrument Upon Issuer’s Exercise of Call Option ..............................................................................................................7-21

Example 7-8: Conversion of Bond with a Separated Conversion Option .........7-22

7.5.1 Conversion Prior to Full Accretion of BCF Discount ..........................................7-22

7.6 Induced Conversion ...............................................................................................7-23

Example 7-9: Limited Period of Time ...................................................................7-23

Example 7-10: Offer to Convert Initiated by the Investor ...................................7-24

Example 7-11: Reduction in Shares Issued Upon Conversion ..........................7-24

7.6.1 Induced Conversion of Convertible Debt with a Cash Conversion Feature ...............................................................................................7-25

7.7 Convertible Debt Extinguishment Accounting ....................................................7-257.7.1 Extinguishment Accounting—Bifurcated Conversion Option ...........................7-257.7.2 Extinguishment Accounting—Beneficial Conversion Feature (BCF) ................7-26

7.8 Put and Call Options Embedded in Convertible Debt ........................................7-267.8.1 Put Options .............................................................................................................7-267.8.2 Put Upon a Fundamental Change (Change in Control Put) ...............................7-27

Example 7-12: Fundamental Change Put at Higher of Par or Conversion Value ...................................................................................................7-27

7.8.3 Issuer Call Options ................................................................................................7-27

7.9 Contingent Interest ................................................................................................7-28

7.10 Instruments Executed in Conjunction with a Convertible Bond .......................7-28

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7.10.1 Detachable Warrants .............................................................................................7-287.10.2 Greenshoe (Overallotment Option) ......................................................................7-297.10.3 Call Options Overlay (Call Spread, Capped Call) ................................................7-307.10.3.1 Earnings per Share ..................................................................................................7-307.10.3.2 Tax Considerations ..................................................................................................7-317.10.4 Share Lending Agreement ....................................................................................7-317.10.4.1 Earnings per Share ..................................................................................................7-31

7.11 How PwC Can Help................................................................................................7-32

Chapter 8: Preferred Stock

8.1 Characteristics of Preferred Stock ........................................................................8-2

8.2 Analysis of Preferred Stock ....................................................................................8-3

8.3 Redemption Features in Preferred Stock ..............................................................8-38.3.1 Mandatorily Redeemable Preferred Stock ............................................................8-4

Example 8-1: Preferred Stock Redeemable Upon Liquidation of an Entity or Death/Termination of a Partner ...............................................................8-5

Example 8-2: Redemption of Preferred Shares Funded by Insurance ................8-5

8.3.2 Contingently Redeemable Preferred Stock ...........................................................8-6

Example 8-3: Reassessment of Contingently Redeemable Instruments ...........8-6

8.3.3 Perpetual Preferred Stock (No Redemption) .........................................................8-7

Example 8-4: Perpetual Preferred Stock with Liquidated Damages ...................8-7

Example 8-5: Increasing Rate Perpetual Preferred Stock ...................................8-8

8.4 Conversion Features in Preferred Stock ...............................................................8-88.4.1 Non-Redeemable Preferred Stock Convertible into a Fixed or

Variable Number of Shares .....................................................................................8-98.4.2 Redeemable Convertible Preferred Stock ...........................................................8-108.4.3 Analysis of the Conversion Option .......................................................................8-11

8.5 Preferred Stock Exchangeable into Debt ............................................................8-12

8.6 Participation Rights ...............................................................................................8-12

8.7 Put and Call Options Embedded in Preferred Stock ..........................................8-12

8.8 Tranched Preferred Stock .....................................................................................8-138.8.1 Right to Issue Shares Is a Freestanding Instrument ..........................................8-138.8.2 Right to Issue Shares Is an Embedded Feature ..................................................8-14

8.9 Preferred Stock Measurement .............................................................................8-148.9.1 Initial Measurement ...............................................................................................8-148.9.2 Subsequent Measurement ....................................................................................8-14

8.10 Preferred Stock Dividends ....................................................................................8-15

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8.11 Conversion into Equity ..........................................................................................8-168.11.1 Conversion Prior to Full Accretion of a Beneficial Conversion

Feature (BCF) Discount .........................................................................................8-16

Example 8-6: Treatment of Unallocated BCF Upon Conversion .......................8-17

8.11.2 Induced Conversion ...............................................................................................8-17

8.12 Preferred Stock Extinguishment Accounting ......................................................8-188.12.1 Extinguishment of Convertible Preferred Stock with a BCF ..............................8-18

8.13 How PwC Can Help................................................................................................8-18

Chapter 9: Share Issuance Contracts

9.1 Summary of Share Issuance Contracts .................................................................9-2

9.2 Forward Sale Contract, Purchased Put Option, and Written Call Option (Warrant) on a Company’s Own Stock.......................................................9-2

9.2.1 Instruments on Redeemable Shares ......................................................................9-3

Example 9-1: Warrant on Puttable Shares .............................................................9-4

9.2.2 Prepaid Forward Sale of a Company’s Own Shares .............................................9-49.2.2.1 Fully Prepaid Forward Sale of a Company’s Own Shares .........................................9-59.2.2.2 Partially Prepaid Forward Sale of a Company’s Own Shares ....................................9-5

9.3 Units Structures .......................................................................................................9-59.3.1 Debt Issued with Detachable Warrants .................................................................9-59.3.1.1 Repurchase of Debt with Detachable Warrants .........................................................9-69.3.2 Mandatory Units .......................................................................................................9-69.3.2.1 Contract Payments Paid by the Issuer ......................................................................9-8

Example 9-2: Accounting for Mandatory Units .....................................................9-8

9.3.2.2 Repurchase of Mandatory Units ..............................................................................9-109.3.3 EPS Considerations ...............................................................................................9-11

9.4 How PwC Can Help................................................................................................9-11

Chapter 10: Derivative Share Repurchase Contracts

10.1 Summary of Share Repurchase Contracts ..........................................................10-2

10.2 Forward Repurchase of a Company’s Own Stock ..............................................10-310.2.1 Physically Settled Forward Repurchase ..............................................................10-3

Example 10-1: Physically Settled Forward Repurchase .....................................10-4

10.2.1.1 Earnings per Share Considerations .........................................................................10-410.2.2 Net Cash or Net Share Settled Forward Repurchase .........................................10-5

10.3 Written Put Option on Own Shares ......................................................................10-510.3.1 Postpaid Written Put Option .................................................................................10-610.3.2 Prepaid Written Put Option ...................................................................................10-6

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10.4 Accelerated Share Repurchase (ASR) Programs................................................10-710.4.1 Recognition and Measurement ............................................................................10-910.4.1.1 Application of ASC 480 ..........................................................................................10-1010.4.1.2 Analysis of Freestanding Equity-Linked Instrument ..............................................10-11

Example 10-2: Fixed Dollar Accelerated Share Repurchase Program ...........10-12

10.4.2 Earnings per Share Considerations ...................................................................10-1310.4.2.1 Settlement in Cash or Shares ................................................................................10-1310.4.2.2 Anti-Dilution ...........................................................................................................10-13

10.5 How PwC Can Help..............................................................................................10-14

Chapter 11: Noncontrolling Interest as a Source of Financing

11.1 Overview of Noncontrolling Interests ..................................................................11-2

11.2 Analysis of Instruments Indexed to a Subsidiary’s Shares Executed with NCI Holders ...................................................................................11-2

11.2.1 Freestanding vs. Embedded .................................................................................11-311.2.1.1 Separately and Apart ...............................................................................................11-311.2.1.2 Legally Detachable and Separately Exercisable ......................................................11-4

Example 11-1: Analysis of Put Right ....................................................................11-5

11.2.2 Accounting for a Freestanding Instrument Executed with NCI Holders ............................................................................................................11-5

11.2.2.1 Combination of Written Put and Purchased Call Options .......................................11-611.2.3 Accounting for an Instrument Embedded in a NCI .............................................11-7

11.3 Redeemable NCI ....................................................................................................11-811.3.1 Initial Measurement ...............................................................................................11-811.3.2 Subsequent Measurement ....................................................................................11-8

Example 11-2: Adjustment to the Carrying Value of Redeemable Equity Securities ....................................................................................................11-9

11.4 How PwC Can Help..............................................................................................11-10

Appendices

A Technical References and Abbreviations ............................................................. A-1

B Definition of Key Terms .......................................................................................... B-1

C Summary of Changes from 2012 Edition ..............................................................C-1

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Table of Contents by Instrument

Accelerated Share Repurchase (ASR) Programs

2.1 Overview of Equity-Linked Instruments .....................................................................2-22.4 Analysis of Certain Freestanding Instruments (ASC 480) ........................................2-102.5 Analysis of a Freestanding Equity-Linked Instrument .............................................2-132.6 Accounting for Instruments Classified in Equity ......................................................2-242.7 Financial Statement Disclosure of Equity-Linked Instruments ................................2-244.1 Basic and Diluted Earnings per Share .......................................................................4-24.2 Anti-Dilution and Sequencing of Instruments ............................................................4-24.4 Treasury Stock Method ..............................................................................................4-54.5 Instruments Settlable in Cash or Shares ...................................................................4-74.8 Participating Securities/Two-Class Method of Calculating Basic and

Diluted EPS ................................................................................................................4-910.1 Summary of Share Repurchase Contracts ..............................................................10-210.4 Accelerated Share Repurchase (ASR) Programs .....................................................10-7

Convertible Debt—Cash Conversion Feature

2.1 Overview of Equity-Linked Instruments .....................................................................2-22.3 Analysis of Embedded Equity-Linked Components ..................................................2-53.1 Put and Call Options Embedded in Debt Instruments...............................................3-23.2 Analysis of Whether a Put or Call Is Clearly and Closely Related

to a Debt Host ............................................................................................................3-23.4 Warrants Issued in Connection with Debt and Equity Offerings ..............................3-123.6 Mezzanine (Temporary) Equity Classification ..........................................................3-183.7 Issuance Costs ........................................................................................................3-193.8 Registration Payment Arrangements .......................................................................3-214.1 Basic and Diluted Earnings per Share .......................................................................4-24.2 Anti-Dilution and Sequencing of Instruments ............................................................4-24.3 If-Converted Method .................................................................................................4-24.4 Treasury Stock Method ..............................................................................................4-54.5 Instruments Settlable in Cash or Shares ...................................................................4-74.6 Convertible Debt with a Cash Conversion Feature ....................................................4-84.7 Contingently Convertible Instruments .......................................................................4-84.8 Participating Securities/Two-Class Method of Calculating Basic and

Diluted EPS ................................................................................................................4-94.9 Share Lending Agreements .....................................................................................4-145.1 Restructuring and Extinguishment.............................................................................5-25.2 Analyzing a Debt Restructuring .................................................................................5-25.3 Troubled Debt Restructurings (TDRs) ........................................................................5-35.7 Restructuring of Convertible Debt Instruments .......................................................5-226.1 Debt Instrument Overview .........................................................................................6-26.2 Balance Sheet Classification—Current vs. Non-Current ...........................................6-26.5 Guarantees on Debt .................................................................................................6-157.1 Analysis of Convertible Debt......................................................................................7-27.2 Embedded Conversion Options ................................................................................7-57.4 Cash Conversion Feature (previously FSP APB 14-1) .............................................7-107.6 Induced Conversion .................................................................................................7-237.8 Put and Call Options ................................................................................................7-267.9 Contingent Interest ..................................................................................................7-287.10 Instruments Executed in Conjunction with a Convertible Bond ..............................7-28

xii / Table of Contents

Convertible Debt—Share Settled

2.1 Overview of Equity-Linked Instruments .....................................................................2-22.3 Analysis of Embedded Equity-Linked Components ..................................................2-53.1 Put and Call Options Embedded in Debt Instruments...............................................3-23.2 Analysis of Whether a Put or Call Is Clearly and Closely Related

to a Debt Host ............................................................................................................3-23.4 Warrants Issued in Connection with Debt and Equity Offerings ..............................3-123.5 Beneficial Conversion Feature ................................................................................3-143.6 Mezzanine (Temporary) Equity Classification ..........................................................3-183.7 Issuance Costs ........................................................................................................3-193.8 Registration Payment Arrangements .......................................................................3-214.1 Basic and Diluted Earnings per Share .......................................................................4-24.2 Anti-Dilution and Sequencing of Instruments ............................................................4-24.3 If-Converted Method .................................................................................................4-24.7 Contingently Convertible Instruments .......................................................................4-84.8 Participating Securities/Two-Class Method of Calculating Basic and

Diluted EPS ................................................................................................................4-94.9 Share Lending Agreements .....................................................................................4-145.1 Restructuring and Extinguishment.............................................................................5-25.2 Analyzing a Debt Restructuring .................................................................................5-25.3 Troubled Debt Restructurings (TDRs) ........................................................................5-35.7 Restructuring of Convertible Debt Instruments .......................................................5-226.1 Debt Instrument Overview .........................................................................................6-26.2 Balance Sheet Classification—Current vs. Non-Current ...........................................6-26.5 Guarantees on Debt .................................................................................................6-157.1 Analysis of Convertible Debt......................................................................................7-27.2 Embedded Conversion Options ................................................................................7-57.3 Beneficial Conversion Feature (BCF) .......................................................................7-107.5 Conversion into Equity .............................................................................................7-217.6 Induced Conversion .................................................................................................7-237.7 Convertible Debt Extinguishment Accounting .........................................................7-257.8 Put and Call Options ................................................................................................7-267.9 Contingent Interest ..................................................................................................7-287.10 Instruments Executed in Conjunction with a Convertible Bond ..............................7-28

Convertible Preferred Stock

2.1 Overview of Equity-Linked Instruments .....................................................................2-22.3 Analysis of Embedded Equity-Linked Components ..................................................2-53.3 Put and Call Options Embedded in Equity Instruments ..........................................3-123.4 Warrants Issued in Connection with Debt and Equity Offerings ..............................3-123.5 Beneficial Conversion Feature ................................................................................3-143.6 Mezzanine (Temporary) Equity Classification ..........................................................3-183.7 Issuance Costs ........................................................................................................3-193.8 Registration Payment Arrangements .......................................................................3-214.1 Basic and Diluted Earnings per Share .......................................................................4-24.2 Anti-Dilution and Sequencing of Instruments ............................................................4-24.3 If-Converted Method .................................................................................................4-24.7 Contingently Convertible Instruments .......................................................................4-84.8 Participating Securities/Two-Class Method of Calculating Basic and

Diluted EPS ................................................................................................................4-95.8 Modification vs. Extinguishment—Preferred Stock .................................................5-248.1 Characteristics of Preferred Stock .............................................................................8-28.2 Analysis of Preferred Stock........................................................................................8-3

Table of Contents / xiii

8.3 Redemption Features in Preferred Stock...................................................................8-38.4 Conversion Features in Preferred Stock ....................................................................8-88.5 Preferred Stock Exchangeable into Debt ................................................................8-128.6 Participation Rights ..................................................................................................8-128.7 Put and Call Options Embedded in Preferred Stock ...............................................8-128.8 Tranched Preferred Stock ........................................................................................8-138.9 Preferred Stock Measurement .................................................................................8-148.10 Preferred Stock Dividends .......................................................................................8-158.11 Conversion into Equity .............................................................................................8-168.12 Preferred Stock Extinguishment Accounting ...........................................................8-18

Debt with Detachable Warrants (accounted for as freestanding instruments)

2.1 Overview of Equity-Linked Instruments .....................................................................2-22.2 Freestanding vs. Embedded ......................................................................................2-22.4 Analysis of Certain Freestanding Instruments (ASC 480) ........................................2-102.5 Analysis of a Freestanding Equity-Linked Instrument .............................................2-132.6 Accounting for Instruments Classified in Equity ......................................................2-242.7 Financial Statement Disclosure of Equity-Linked Instruments ................................2-243.1 Put and Call Options Embedded in Debt Instruments...............................................3-23.2 Analysis of Whether a Put or Call Is Clearly and Closely Related

to a Debt Host ............................................................................................................3-23.4 Warrants Issued in Connection with Debt and Equity Offerings ..............................3-123.6 Mezzanine (Temporary) Equity Classification ..........................................................3-183.7 Issuance Costs ........................................................................................................3-193.8 Registration Payment Arrangements .......................................................................3-214.1 Basic and Diluted Earnings per Share .......................................................................4-24.2 Anti-Dilution and Sequencing of Instruments ............................................................4-24.4 Treasury Stock Method ..............................................................................................4-54.5 Instruments Settlable in Cash or Shares ...................................................................4-74.8 Participating Securities/Two-Class Method of Calculating Basic and

Diluted EPS ................................................................................................................4-95.1 Restructuring and Extinguishment.............................................................................5-25.2 Analyzing a Debt Restructuring .................................................................................5-25.3 Troubled Debt Restructurings (TDRs) ........................................................................5-35.4 Modification vs. Extinguishment—Non-Revolving Debt Security or

Term Loan ..................................................................................................................5-85.9 Modification of Warrants Classified as Equity .........................................................5-256.1 Debt Instrument Overview .........................................................................................6-26.2 Balance Sheet Classification—Current vs. Non-current ............................................6-26.5 Guarantees on Debt .................................................................................................6-156.6 Contingent Interest on Debt ....................................................................................6-169.1 Summary of Share Issuance Contracts .....................................................................9-29.2 Forward Sale Contract, Purchased Put Option, and Written Call Option

(Warrant) on a Company’s Own Stock .......................................................................9-29.3 Units Structures .........................................................................................................9-5

Forward Repurchase of Equity

2.1 Overview of Equity-Linked Instruments .....................................................................2-22.4 Analysis of Certain Freestanding Instruments (ASC 480) ........................................2-102.5 Analysis of a Freestanding Equity-Linked Instrument .............................................2-132.6 Accounting for Instruments Classified in Equity ......................................................2-242.7 Financial Statement Disclosure of Equity-Linked Instruments ................................2-244.1 Basic and Diluted Earnings per Share .......................................................................4-2

xiv / Table of Contents

4.2 Anti-Dilution and Sequencing of Instruments ............................................................4-24.4 Treasury Stock Method ..............................................................................................4-54.5 Instruments Settlable in Cash or Shares ...................................................................4-74.8 Participating Securities/Two-Class Method of Calculating Basic and

Diluted EPS ................................................................................................................4-910.1 Summary of Share Repurchase Contracts ..............................................................10-210.2 Forward Repurchase of a Company’s Own Stock...................................................10-3

Forward Sale of Equity

2.1 Overview of Equity-Linked Instruments .....................................................................2-22.4 Analysis of Certain Freestanding Instruments (ASC 480) ........................................2-102.5 Analysis of a Freestanding Equity-Linked Instrument .............................................2-132.6 Accounting for Instruments Classified in Equity ......................................................2-242.7 Financial Statement Disclosure of Equity-Linked Instruments ................................2-244.1 Basic and Diluted Earnings per Share .......................................................................4-24.2 Anti-Dilution and Sequencing of Instruments ............................................................4-24.4 Treasury Stock Method ..............................................................................................4-54.5 Instruments Settlable in Cash or Shares ...................................................................4-74.8 Participating Securities/Two-Class Method of Calculating Basic and

Diluted EPS ................................................................................................................4-99.1 Summary of Share Issuance Contracts .....................................................................9-29.2 Forward Sale Contract, Purchased Put Option, and Written Call Option

(Warrant) on a Company’s Own Stock .......................................................................9-2

Joint and Several Liability

6.7 Joint and Several Liability ........................................................................................6-17

Line-of-Credit or Revolving-Debt Arrangement

3.1 Put and Call Options Embedded in Debt Instruments...............................................3-23.2 Analysis of Whether a Put or Call Is Clearly and Closely Related

to a Debt Host ............................................................................................................3-23.4 Warrants Issued in Connection with Debt and Equity Offerings ..............................3-123.7 Issuance Costs ........................................................................................................3-193.8 Registration Payment Arrangements .......................................................................3-214.1 Basic and Diluted Earnings per Share .......................................................................4-25.1 Restructuring and Extinguishment.............................................................................5-25.2 Analyzing a Debt Restructuring .................................................................................5-25.3 Troubled Debt Restructurings (TDRs) ........................................................................5-35.5 Modifications to and Payoffs of Line-of-Credit or Revolving-Debt

Arrangements ..........................................................................................................5-195.6 Debt Extinguishment Accounting ............................................................................5-216.1 Debt Instrument Overview .........................................................................................6-26.2 Balance Sheet Classification—Current vs. Non-Current ...........................................6-26.5 Guarantees on Debt .................................................................................................6-156.6 Contingent Interest on Debt ....................................................................................6-16

Mandatory Units (accounted for as freestanding instruments)

2.1 Overview of Equity-Linked Instruments .....................................................................2-22.2 Freestanding vs. Embedded ......................................................................................2-22.4 Analysis of Certain Freestanding Instruments (ASC 480) ........................................2-102.5 Analysis of a Freestanding Equity-Linked Instrument .............................................2-13

Table of Contents / xv

2.6 Accounting for Instruments Classified in Equity ......................................................2-242.7 Financial Statement Disclosure of Equity-Linked Instruments ................................2-243.1 Put and Call Options Embedded in Debt Instruments...............................................3-23.2 Analysis of Whether a Put or Call Is Clearly and Closely Related

to a Debt Host ............................................................................................................3-23.6 Mezzanine (Temporary) Equity Classification ..........................................................3-183.7 Issuance Costs ........................................................................................................3-193.8 Registration Payment Arrangements .......................................................................3-214.1 Basic and Diluted Earnings per Share .......................................................................4-24.2 Anti-Dilution and Sequencing of Instruments ............................................................4-24.4 Treasury Stock Method ..............................................................................................4-54.5 Instruments Settlable in Cash or Shares ...................................................................4-74.8 Participating Securities/Two-Class Method of Calculating Basic and

Diluted EPS ................................................................................................................4-95.1 Restructuring and Extinguishment.............................................................................5-25.2 Analyzing a Debt Restructuring .................................................................................5-25.3 Troubled Debt Restructurings (TDRs) ........................................................................5-35.4 Modification vs. Extinguishment—Non-Revolving Debt Security

or Term Loan ..............................................................................................................5-86.5 Guarantees on Debt .................................................................................................6-156.6 Contingent Interest on Debt ....................................................................................6-169.1 Summary of Share Issuance Contracts .....................................................................9-29.2 Forward Sale Contract, Purchased Put Option, and Written Call Option

(Warrant) on a Company’s Own Stock .......................................................................9-29.3 Units Structures .........................................................................................................9-5

Preferred Stock

3.3 Put and Call Options Embedded in Equity Instruments ..........................................3-123.4 Warrants Issued in Connection with Debt and Equity Offerings ..............................3-123.6 Mezzanine (Temporary) Equity Classification ..........................................................3-183.7 Issuance Costs ........................................................................................................3-193.8 Registration Payment Arrangements .......................................................................3-214.1 Basic and Diluted Earnings per Share .......................................................................4-24.8 Participating Securities/Two-Class Method of Calculating Basic and

Diluted EPS ................................................................................................................4-95.8 Modification vs. Extinguishment—Preferred Stock .................................................5-248.1 Characteristics of Preferred Stock .............................................................................8-28.2 Analysis of Preferred Stock........................................................................................8-38.3 Redemption Features in Preferred Stock...................................................................8-38.5 Preferred Stock Exchangeable into Debt ................................................................8-128.6 Participation Rights ..................................................................................................8-128.7 Put and Call Options Embedded in Preferred Stock ...............................................8-128.8 Tranched Preferred Stock ........................................................................................8-138.9 Preferred Stock Measurement .................................................................................8-148.10 Preferred Stock Dividends .......................................................................................8-158.11 Conversion into Equity .............................................................................................8-168.12 Preferred Stock Extinguishment Accounting ...........................................................8-18

Term Debt

3.1 Put and Call Options Embedded in Debt Instruments...............................................3-23.2 Analysis of Whether a Put or Call Is Clearly and Closely Related

to a Debt Host ............................................................................................................3-23.4 Warrants Issued in Connection with Debt and Equity Offerings ..............................3-12

xvi / Table of Contents

3.7 Issuance Costs ........................................................................................................3-193.8 Registration Payment Arrangements .......................................................................3-214.1 Basic and Diluted Earnings per Share .......................................................................4-25.1 Restructuring and Extinguishment.............................................................................5-25.2 Analyzing a Debt Restructuring .................................................................................5-25.3 Troubled Debt Restructurings (TDRs) ........................................................................5-35.4 Modification vs. Extinguishment—Non-Revolving Debt Security

or Term Loan ..............................................................................................................5-85.6 Debt Extinguishment Accounting ............................................................................5-216.1 Debt Instrument Overview .........................................................................................6-26.2 Balance Sheet Classification—Current vs. Non-Current ...........................................6-26.4 Payment in Kind .......................................................................................................6-136.5 Guarantees on Debt .................................................................................................6-156.6 Contingent Interest on Debt ....................................................................................6-16

Warrants

2.1 Overview of Equity-Linked Instruments .....................................................................2-22.4 Analysis of Certain Freestanding Instruments (ASC 480) ........................................2-102.5 Analysis of a Freestanding Equity-Linked Instrument .............................................2-132.6 Accounting for Instruments Classified in Equity ......................................................2-242.7 Financial Statement Disclosure of Equity-Linked Instruments ................................2-243.4 Warrants Issued in Connection with Debt and Equity Offerings ..............................3-123.6 Mezzanine (Temporary) Equity Classification ..........................................................3-183.7 Issuance Costs ........................................................................................................3-193.8 Registration Payment Arrangements .......................................................................3-214.1 Basic and Diluted Earnings per Share .......................................................................4-24.2 Anti-Dilution and Sequencing of Instruments ............................................................4-24.4 Treasury Stock Method ..............................................................................................4-54.5 Instruments Settlable in Cash or Shares ...................................................................4-74.8 Participating Securities/Two-Class Method of Calculating Basic and

Diluted EPS ................................................................................................................4-95.9 Modification of Warrants Classified as Equity .........................................................5-259.1 Summary of Share Issuance Contracts .....................................................................9-29.2 Forward Sale Contract, Purchased Put Option, and Written Call Option

(Warrant) on a Company’s Own Stock .......................................................................9-2

Written Put Option or Prepaid Written Put Option

2.1 Overview of Equity-Linked Instruments .....................................................................2-22.2 Freestanding vs. Embedded ......................................................................................2-22.4 Analysis of Certain Freestanding Instruments (ASC 480) ........................................2-102.5 Analysis of a Freestanding Equity-Linked Instrument .............................................2-132.6 Accounting for Instruments Classified in Equity ......................................................2-242.7 Financial Statement Disclosure of Equity-Linked Instruments ................................2-244.1 Basic and Diluted Earnings per Share .......................................................................4-24.2 Anti-Dilution and Sequencing of Instruments ............................................................4-24.8 Participating Securities/Two-Class Method of Calculating Basic and

Diluted EPS ................................................................................................................4-910.1 Summary of Share Repurchase Contracts ..............................................................10-210.3 Written Put Option on Own Shares ..........................................................................10-5

Guidelines / 1 - 1

Chapter 1: Guidelines

1 - 2 / Guidelines

1.1 Accounting for Financing Transactions

Determining the appropriate accounting treatment for the issuance, modification, conversion and repurchase of debt and equity securities under U.S. GAAP can be challenging. To do so, an issuer must understand all of the terms of a transaction, including provisions that may be included in side agreements or not explicitly stated but result from laws or regulations.

The applicable accounting literature can be prescriptive, is dispersed among various sections of the FASB’s Accounting Standards Codification (ASC), and is generally tailored for specific types of instruments. To determine the appropriate accounting treatment of a financing transaction, an issuer may need to consider the relevant provisions of several sections of the ASC, and do so in a logical sequence. Additionally, in some cases the accounting literature may not be clear or may permit acceptable alternatives.

We believe good financial reporting reflects the economic substance of a transaction. However, at times, accounting standards require the reporting to reflect the form of the transaction. If the required accounting for a transaction and the economics of that transaction appear to diverge because the form must be followed, we believe the issuer should consider including disclosure in the financial statements to provide users with an understanding of the economic substance of the transaction.

1.2 Organization of this Guide

This Guide provides a roadmap through the applicable accounting literature to help you determine which steps are necessary for a particular transaction.

• In Chapters 2–5 we discuss the accounting literature and analyses applicable to many financing transactions.

• In Chapters 6–11 we discuss the application of the accounting literature to specific financing transactions, such as debt, convertible debt, and preferred stock.

We have included two tables of contents in the front of the Guide. The first lists the contents of the Guide in the order they are presented. The second lists the applicable sections of the Guide by financing transaction type. We have included this second table of contents to help readers understand the accounting literature that may apply to a particular transaction type.

All literature references in the Guide are defined in Appendix A. In Appendix B we have included definitions of key terms used in the Guide. In addition, in this Guide the terms the “company” and the “issuer” are used interchangeably, as are the terms “security” and “instrument.”

1.3 International Accounting Standards

This Guide covers the accounting for financing transactions under U.S. GAAP only. The accounting for financing transactions under IFRS is very different than under U.S. GAAP. IFRS has a single comprehensive standard dealing with classification, IAS 32, which addresses the classification of financial instruments as a financial liability or equity from a company’s perspective. The measurement guidance for financial liabilities is provided in IAS 39.

Guidelines / 1 - 3

1.4 Contracts to Enter into a Financing Transaction (Forward Starting Transactions)

This Guide does not explicitly address situations involving forward starting transactions. A company may enter into a contract in which it commits to enter into a financing transaction in the future. For example, a company may:

• Agree to issue debt to an investor upon the occurrence of a specified event, or

• Enter into a contract to buy back its stock after it releases earnings in 3 weeks time.

These contracts (or agreements) may have accounting implications if the terms of the underlying financing transaction have been set. For example, if a company agrees to issue 5-year debt that pays a coupon of 3.00% to an investor in 3 months, the company should record changes in the fair value of the obligation to issue that debt in earnings. On the other hand, if a company agrees to issue debt with market terms to an investor in 3 months, that contract is likely to have a fair value of zero, and thus would not have an accounting impact.

1.5 Financing Transactions Reported at Fair Value

In the past several years, the FASB has issued standards that provide issuers with the option of reporting certain financial statement items at fair value. These standards allow issuers to elect a fair value option for certain qualifying financing transactions. A majority of the accounting analyses discussed in this Guide does not apply to financing transactions that are accounted for at fair value.

There are certain financing transactions that issuers are prohibited from reporting at fair value. Convertible debt instruments that are bifurcated into a debt and an equity component based on the guidance in ASC 470-20, such as debt with (1) a cash conversion feature (as defined in FG section 7.4) or (2) a beneficial conversion feature (as described in FG section 7.3), are not eligible for the fair value option under ASC 825 based on the guidance in ASC 825-10-15-5(f).

1.6 How PwC Can Help

PwC professionals have years of experience advising clients on the transactions discussed in this Guide. At the end of each chapter in which we discuss the application of guidance to specific financing transactions we have included a section entitled How PwC Can Help. This section lists some of the many areas in which PwC can provide advice. If you would like to discuss one of the topics covered in this Guide, please contact your PwC engagement partner or one of the contacts included at the end of the Guide.

Analysis of Equity-Linked Instruments / 2 - 1

Chapter 2:Analysis of Equity-Linked Instruments

2 - 2 / Analysis of Equity-Linked Instruments

2.1 Overview of Equity-Linked Instruments

Equity-linked instruments are entered into to issue shares (see FG section 9), repurchase shares (see FG section 10) or raise financing at a reduced rate. Investors in equity-linked financing transactions typically receive a lower cash coupon or dividend to compensate the issuer for selling an option on its equity. Examples of equity-linked financing transactions include debt instruments with detachable warrants for preferred or common equity instruments, conventional or non-conventional convertible debt instruments and convertible preferred stock. The complexity inherent in all equity-linked instruments requires a detailed analysis to understand the terms of each instrument issued, any related instruments and the underwriting agreement.

The analysis to determine the appropriate accounting for equity-linked instruments is best performed using a multi-step approach. In this chapter we discuss each of the steps and important points to consider when determining whether an equity-linked instrument should be accounted for in its entirety as equity or a liability (or asset), or separated into components. The overall model is illustrated below.

Analysis of Equity-Linked Instruments

Yes No

Freestanding Embedded

Is the equity-linked instrument(or embedded component)

freestanding or embedded in ahost instrument?

Embedded component is not withinthe scope of ASC 480. Hybrid instrument

in its entirety must be analyzed underASC 480. Perform analysis of embedded

equity-linked component.

(FG section 2.3)

Is the instrument within thescope of ASC 480?

(FG section 2.4.1)

Apply the recognitionand measurement

guidance in ASC 480.

(FG section 2.4.2)

Perform analysisof a freestanding equity-

linked instrument.

(FG section 2.5)

2.2 Freestanding vs. Embedded

An equity-linked component can be embedded in a host instrument, such as a debt instrument (convertible debt) or preferred stock (convertible preferred stock) that has economic value attributable to factors other than the equity-linked component. Alternatively, an instrument can comprise only the equity-linked component, as is the case with a freestanding warrant. Thus, the first step in accounting for an equity-linked instrument is to determine whether the instrument is freestanding or whether

Analysis of Equity-Linked Instruments / 2 - 3

the equity-linked component is embedded in a host instrument, such as a debt instrument or preferred stock.

The ASC Master Glossary defines a freestanding financial instrument as:

A financial instrument that meets either of the following conditions:

a. It is entered into separately and apart from any of the entity’s other financial instruments or equity transactions.

b. It is entered into in conjunction with some other transaction and is legally detachable and separately exercisable.

The concept of “freestanding” refers to a single financial instrument or contract. However, a single contract may contain more than one economic component, such as an option or forward. For example, (1) a variable share forward delivery agreement consists of a written put option and a purchased call option and (2) a capped call option consists of a purchased call option and a written call option. In both examples, neither component would be separated from the other.

In determining whether a component is a freestanding financial instrument or embedded in a host instrument, issuers must consider all substantive terms.

• An issuer should first determine whether the components were issued (1) contemporaneously and in contemplation of each other or (2) separately and at different points in time.

• Next an issuer should consider whether the components (1) may be legally transferred separately or (2) must be transferred with the instrument with which they were issued or associated. Components that may be legally transferred separately are generally freestanding. However, a component that must be transferred with the instrument with which it was issued or associated is not necessarily embedded. The issuer also needs to consider the following factor.

• An issuer should also consider whether (1) a right in a component may be exercised separately from other components that remain outstanding or (2) if once a right in a component is exercised, the other components are no longer outstanding. Separate exercisability is a strong indicator that the components are freestanding.

Determining whether a component is freestanding or embedded is important because the criterion used to determine the accounting recognition and measurement for a freestanding instrument differs from that for an embedded component. For example, ASC 480 does not apply to equity-linked components that are embedded in host instruments. In addition, the guidance in ASC 815 is applied differently to freestanding instruments than to embedded components.

The analyses described in this chapter are applicable to freestanding instruments and embedded components in host instruments that an issuer has not elected (or cannot elect) to carry at fair value.

2 - 4 / Analysis of Equity-Linked Instruments

Example 2-1: Tranched Preferred Stock

Background/Facts:• Company Z issues Series A preferred shares to investors.

• Company Z also grants investors in the Series A preferred shares a warrant to buy Series B preferred shares, if issued, at a fixed price (Series B warrant). The Series B shares will only be issued (and the warrant is only exercisable) upon the receipt of a patent for a specified technology being developed by Company Z.

• The investors can transfer the Series B warrant separately from the Series A shares (i.e., they can sell the Series B warrant and retain the Series A shares).

• If the Series B warrant is exercised, the Series A shares are unaffected and remain outstanding.

Question:Is the Series B warrant a freestanding instrument or a component embedded in the Series A shares?

Analysis/Conclusion:In making this determination, Company Z must apply judgment and consider all of the contractual terms and indicators. For example:

• Were the Series A shares and Series B warrant issued (1) separately and subsequent to an initial transaction or (2) contemporaneously and in contemplation of each other?

The Series A shares and Series B warrant were issued contemporaneously and in contemplation of each other. This indicates that the Series B warrant may be an embedded component.

• Can the Series B warrant be transferred separately from the Series A shares or must it be transferred with the Series A shares?

The Series B warrant can be separately transferred; the investor does not have to transfer the Series B warrant with the Series A shares. This indicates that the Series B warrant may be a freestanding instrument.

• Can the Series B warrant be exercised separately from the Series A shares such that the Series A shares remain outstanding? Or do the Series A shares liquidate if the Series B warrant is exercised?

The Series B warrant can be separately exercised; the Series A shares remain outstanding if the Series B warrant is exercised. This indicates that the Series B warrant may be a freestanding instrument.

Based on this preliminary analysis, the Series B warrant is a freestanding instrument. See FG section 8.8 for a discussion of tranched preferred stock.

Analysis of Equity-Linked Instruments / 2 - 5

2.3 Analysis of Embedded Equity-Linked Components

Yes

Yes

Yes

No

No

No

No

Yes

Is the hybrid instrumentaccounted for at fair value

and remeasured at fair valuethrough earnings?

Determine whether the host instrumentis a debt or equity host.

Is the embedded equity-linkedcomponent clearly and closely related

to its host instrument?

(FG section 2.3.1)

Does the embedded equity-linkedcomponent meet the definition

of a derivative?

(FG section 2.3.2)

Does the embedded derivativequalify for the scope exceptionfor certain contracts involving

an issuer’s own equity?

(FG section 2.3.3)

Do not separate embeddedcomponent from the hybrid

instrument.

Separately account for theembedded derivative, initially

record at fair valuewith changes in fair value

recorded in earnings.

ASC 815-15-25-1 calls for embedded components to be accounted for separately as derivatives if all of the following criteria are met:

a. The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract.

b. The hybrid instrument is not measured at fair value with changes in fair value recorded in earnings.

c. A separate instrument with the same terms as the embedded derivative would be a derivative instrument pursuant to the requirements of ASC 815.

2 - 6 / Analysis of Equity-Linked Instruments

2.3.1 Clearly and Closely Related

No

Do not separate embeddedcomponent from the hybrid

instrument.

Determine whether the hostinstrument is a debt or equity host.

Is the embedded equity-linkedcomponent clearly and closelyrelated to its host instrument?

(FG section 2.3.1)

Does the embedded equity-linkedcomponent meet the definition

of a derivative?

(FG section 2.3.2)

Yes

An embedded component that meets the definition of a derivative does not have to be separated from its host instrument and accounted for as a derivative if it is clearly and closely related to its host. When considering whether an embedded equity-linked component is clearly and closely related to its host instrument, an issuer must first determine whether the host is an equity host or a debt host. An embedded equity-linked component will generally be clearly and closely related to an equity host, whereas it would not be considered clearly and closely related to a debt host.

2.3.1.1 Preferred Stock

When determining whether a conversion option embedded within preferred stock is clearly and closely related to the preferred stock host contract, an issuer must first define the nature of the host contract by determining whether the convertible preferred stock is more akin to a debt instrument or equity instrument. ASC 815-15-25-17 indicates that “a typical cumulative fixed-rate preferred stock that has a mandatory redemption feature is more akin to debt, whereas cumulative participating perpetual preferred stock is more akin to an equity instrument.” However, depending on the contractual terms of the preferred stock, judgment may need to be applied and other factors, such as the existence of creditor or voting rights and the treatment of interest payments or dividends for tax purposes, may need to be considered in defining the nature of the host instrument as debt or equity.

2.3.1.2 Debt Host

When analyzing a conversion option embedded within a debt host contract, it is important to note that the changes in fair value of an equity component and the credit risk and interest rates on a debt instrument are not clearly and closely related. ASC 815-15-25-51 further explains that for a debt security that is convertible into a specified number of shares of the debtor’s common stock or another entity’s common stock, the conversion option must be separately accounted for as a derivative instrument if:

• It is not clearly and closely related to the debt host instrument,

• It meets the definition of a derivative (FG section 2.3.2),

Analysis of Equity-Linked Instruments / 2 - 7

• The hybrid instrument is not recorded at fair value in its entirety, and

• The embedded derivative does not otherwise meet the scope exception for certain contracts involving an issuer’s own equity in ASC 815-10-15-74(a) (FG section 2.3.3).

2.3.2 Definition of a Derivative

Does the embedded derivativequalify for the scope exceptionfor certain contracts involving

an issuer’s own equity?

(FG section 2.3.3)

Does the embedded equity-linkedcomponent meet the definition

of a derivative?

(FG section 2.3.2)

Do not separate theembedded component

from the hybrid instrument.

Yes

No

ASC 815-10-15-83 defines a derivative instrument as a financial instrument or other contract with all of the following characteristics:

a. One or more underlyings and one or more notional amounts or payment provisions, or both,

b. No initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors, and

c. Net settlement provisions.

A contract may be considered net settled when its settlement meets one of the following criteria in ASC 815-10-15-99:

a. Net settlement under contract terms.

b. Net settlement through a market mechanism.

c. Net settlement by delivery of a derivative instrument or an asset readily convertible to cash.

An embedded component can be net settled if the issuer (or counterparty investor) is permitted, by the terms of the contract, to settle the embedded component in cash. For example, if upon conversion a convertible debt instrument allows the issuer to deliver cash equal to the conversion value (par amount of the debt plus conversion option value), the embedded component (the conversion option) can be net settled under the contract terms.

Generally, embedded components cannot be net settled through a market mechanism. Net settlement through a market mechanism requires that an issuer (or counterparty) have the ability to transfer the derivative instrument to another party for a price approximately equal to fair value. This would be the case for certain

2 - 8 / Analysis of Equity-Linked Instruments

instruments, such as a freestanding exchange traded stock option. However, when a component is embedded in a host instrument, it generally cannot be transferred without transferring the entire instrument.

Chapter 2 of PwC’s Guide to Accounting for Derivative Instruments and Hedging Activities 2012 edition provides additional guidance on how to determine whether a contract meets the definition of a derivative.

2.3.2.1 Readily Convertible to Cash

A contract that requires delivery of the underlying asset in an amount equal to the notional amount of the contract is considered to contain a net settlement provision if the asset is readily convertible to cash. Such a contract puts the receiving party in a position that is equivalent to a net settlement. When a contract is net settled, neither party accepts the risks and costs customarily associated with owning and delivering the asset associated with the underlying (e.g., storage, maintenance, and resale costs). However, if the asset to be delivered is readily convertible to cash, those risks are minimal, and therefore the parties should be indifferent as to whether there is a gross physical exchange of the asset or a net settlement in cash.

An example of a contract with this form of net settlement is a forward contract that requires delivery of a liquid exchange-traded equity security. A liquid exchange-traded security is readily convertible to cash.

ASC 815 defines the phrase readily convertible to cash in the Glossary. This definition refers to the following characteristics as support that an asset is readily convertible to cash:

1. Interchangeable (fungible) units, and

2. Quoted prices that are available in an active market, which can rapidly absorb the quantity held by an entity without significantly affecting the price.

Based on this definition, a security traded in a deep and active market is an asset that is readily convertible to cash provided the minimum number of shares to be exchanged is relatively small when compared to the daily trading volume. Conversely, securities that are not actively traded, as well as an unusually large block of thinly traded securities, would not be considered readily convertible to cash in most circumstances, even though the owner might be able to use such securities as collateral in a borrowing arrangement. In addition, securities that are restricted from sale for a period of at least 32 days upon receipt may not be considered readily convertible to cash, as discussed in ASC 815-10-15-131 through 15-138.

An asset is considered to be readily convertible to cash only if the net amount of cash received from its sale is equal to or not significantly less than the amount an entity would typically have received under a net settlement provision.

An issuer must assess the estimated costs that would be incurred to immediately convert the asset to cash. If those costs are significant, then the asset is not considered readily convertible to cash and would not meet the definition of net settlement. For purposes of assessing significance of such costs, an entity shall consider those estimated conversion costs to be significant only if they are 10 percent or more of the gross sales proceeds (based on the spot price at the inception of the contract) that would be received from the sale of those assets in the closest or most economical active market (ASC 815-10-15-126).

Analysis of Equity-Linked Instruments / 2 - 9

The evaluation of whether the assets to be delivered under a contract are readily convertible to cash should be performed on an ongoing basis as discussed in ASC 815-10-15-139.

2.3.3 Scope Exception for Certain Contracts Involving an Issuer’s Own Equity

An embedded equity-linked component that meets the definition of a derivative does not have to be separated from its host instrument if the component qualifies for the scope exception for certain contracts involving an issuer’s own equity in ASC 815-10-15-74(a).

ASC 815-10-15-74 states:

Notwithstanding the conditions of paragraphs 815-10-15-13 through 15-139, the reporting entity shall not consider the following contracts to be derivative instruments for purposes of this Subtopic:

a. Contracts issued or held by that reporting entity that are both:

1. Indexed to its own stock

2. Classified in stockholders’ equity in its statement of financial position.

An embedded component is considered indexed to a company’s own stock if it meets certain specified requirements in ASC 815-40-15. See FG section 2.5.1 for discussion of these requirements.

An embedded component would be classified in stockholders’ equity if it meets the requirements for equity classification in ASC 815-40-25. See FG section 2.5.2 for discussion of these requirements.

2.3.4 Accounting for Separated Instruments

When an issuer does not elect to account for an entire hybrid instrument at fair value, and an embedded derivative must be separated from the hybrid instrument and accounted for separately, the accounting for the host contract should be based on the accounting guidance that is applicable to similar host contracts of that type. ASC 815-15-30-2 provides guidance on allocating the carrying amount of the hybrid instrument between the host contract and the derivative. The guidance requires the derivative to be recorded at fair value and the carrying value assigned to the host contract to represent the difference between the previous carrying amount of the hybrid instrument and the fair value of the derivative. Therefore, there will be no immediate gain or loss from the initial recognition and measurement of an embedded derivative that is accounted for separately from its host contract.

If the embedded derivative is an option, ASC 815-15-30-6 provides that the embedded option-based contract can have a fair value other than zero at the inception of the contract. The contractual terms of the embedded option, including its strike or conversion price, should not be adjusted to result in the option being at-the-money at the inception of the hybrid contract. As such, the intrinsic value of the embedded option may be other than zero at issuance of the contract. This intrinsic value would be included in the fair value of the embedded derivative at the time it is initially recognized. For a debt host contract, this would require additional debt discount or premium to be recorded that is equal to the initial fair value of the option. If the embedded derivative is not an option (e.g., it is a forward component), the terms of the non-option embedded derivative should be determined in a manner that results in its fair value generally being equal to zero at the inception of the hybrid instrument.

2 - 10 / Analysis of Equity-Linked Instruments

2.4 Analysis of Certain Freestanding Instruments (ASC 480)

Is the instrument within thescope of ASC 480?

(FG section 2.4.1)

Apply the recognitionand measurement

guidance in ASC 480.

(FG section 2.4.2)

Perform analysisof a freestanding equity-

linked instrument.

(FG section 2.5)

Yes No

2.4.1 Scope

The guidance in ASC 480 applies to freestanding equity-linked financial instruments and requires that issuers classify the following freestanding financial instruments as liabilities (or in some cases as assets):

• Mandatorily redeemable financial instruments issued in the form of shares (see FG section 8.3),

• Obligations that require or may require repurchase of the issuer’s equity shares by transferring assets (e.g., written put options and forward purchase contracts), and

• Certain obligations to issue a variable number of shares where at inception the monetary value of the obligation is based solely or predominantly on:

— A fixed monetary amount known at inception, for example, a payable settlable with a variable number of the issuer’s equity shares,

— Variations in something other than the fair value of the issuer’s equity shares, for example, a financial instrument indexed to the S&P 500 and settlable with a variable number of the issuer’s equity shares, or

— Variations inversely related to changes in the fair value of the issuer’s equity shares, for example, a written put option that could be net share settled.

Note that a purchased option, such as a purchased call option, does not create an obligation to repurchase shares under ASC 480 because a purchased option provides the issuer with a right but not an obligation. Further, ASC 480 does not apply to contracts that will always be classified as an asset by the issuer as a purchased option would be.

Whether a transaction is within the scope of ASC 480 may be dictated by the legal form of the transaction. ASC 480 specifies that, generally, two or more freestanding financial instruments (e.g., a written put option, a purchased call option, and a share of common stock) should not be considered in combination; rather they should be evaluated separately on a contract-by-contract basis. However, ASC 480 does require instruments that must be combined pursuant to the provisions

Analysis of Equity-Linked Instruments / 2 - 11

of ASC 815-10-15-8 and 15-9 to be combined for purposes of determining the applicability of ASC 480.1

2.4.2 Recognition and Measurement

Financial instruments, other than physically settled forward repurchase contracts, that fall within the scope of ASC 480 should be initially measured at fair value. This includes mandatorily redeemable instruments. Financial instruments that, subsequent to issuance, fall into the scope of ASC 480 (e.g., the instrument was conditionally redeemable, and thus not in the scope, and the condition is later met such that it becomes mandatorily redeemable) should be reclassified as a liability and also measured at fair value. No gain or loss should be recorded as a result of the reclassification.

Physically settled forward repurchase contracts, in which an issuer will repurchase a fixed number of its shares in exchange for cash, should initially be measured at the fair value of the shares at the contract’s inception (the spot price of the shares at that date), adjusted for any unstated rights or privileges. At the inception of a physically settled forward repurchase contract, the issuer should reduce equity and recognize a liability for the fair value of the shares. Essentially these contracts are accounted for as financed purchases of treasury stock.

2.4.2.1 Subsequent Measurement

Most financial instruments that fall within the scope of ASC 480 should be subsequently measured at fair value, with changes in fair value recorded in earnings, typically as other income or expense.

An exception to the fair value measurement principal in ASC 480 is provided for (1) mandatorily redeemable instruments and (2) physically settled forward repurchase contracts (FG section 2.4.2). These contracts should be measured in one of two ways:

• If both (a) the amount to be paid and (b) the settlement date are fixed, the instrument should be accreted to the amount to be paid on the settlement date (or stated value). Interest cost should accrue based on the rate implicit at inception of the instrument (for a forward repurchase contract this is generally the difference between the spot price at inception of the contract and the contractually agreed upon forward price). The stated dividend rate on mandatorily redeemable instruments should generally be accrued even if it is not declared.

• If either (a) the amount to be paid or (b) the settlement date varies based upon specified conditions, subsequent measurement of the instrument should be based on the amount of cash that would have been paid under the conditions specified in the contract if a settlement had occurred on the reporting date.

— If the amount to be paid to settle the liability varies, the amortization amount should be adjusted such that the liability will reach the amount to be paid on the settlement date.

1 ASC 815-10-15-9 generally requires contracts with the following characteristics to be combined:

• The instruments were entered into contemporaneously and in contemplation of one another,

• The instruments have the same counterparty,

• The instruments relate to the same risk,

• There is no substantive business purpose for executing two instruments rather than combining them into a single instrument.

2 - 12 / Analysis of Equity-Linked Instruments

— If the settlement date varies, the amortization amount and period should be adjusted to reflect that change.

Changes in the value of the instrument since the previous reporting date should be recognized as interest expense.

ASC 480-10-55-14 through 55-17 includes an example of how a physically settled forward purchase contract should be measured initially and accounted for in subsequent periods.

2.4.3 Non-Substantive Features

As noted in FG section 2.4.1, ASC 480 applies only to certain freestanding financial instruments. To avoid attempts to circumvent the application of ASC 480 by embedding a minimal or non-substantive feature in a freestanding financial instrument, the guidance specifies that non-substantive features should be disregarded when determining whether ASC 480 applies. The following examples from ASC 480-10-55-12 and 55-41 illustrate features that may be considered non-substantive:

• If a mandatorily redeemable preferred stock contains a conversion feature, it would not be classified as a liability due to the inclusion of the conversion feature (FG section 8.4). However, if the conversion price at inception is extremely high relative to the current share price (so that the likelihood of the stock price ever reaching the conversion price is remote), it would be considered non-substantive and therefore, disregarded as provided in ASC 480-10-25-1. This would result in the preferred stock being considered mandatorily redeemable and classified as a liability. The issuer would not be permitted to reassess that classification on the basis of the conversion option becoming substantive (the likelihood of the stock price reaching the conversion price increases) after issuance.

• As discussed in FG section 2.4.1, a written put option is classified as a liability under ASC 480 because it obligates the company to deliver assets (cash) to repurchase shares. A company that embeds a written put option into a non-substantive host instrument would disregard that host instrument and account for the written put option as a liability. For example, a company issues one share of preferred stock (with a par value of $100), paying a small dividend, with an embedded option that allows the holder to put the preferred share along with 100,000 shares of the issuer’s common stock (currently trading at $50) for a fixed price of $45 per share in cash. The preferred stock host is judged at inception to be minimal and would be disregarded under ASC 480-10-25-1. Therefore, the entire instrument would be analyzed as a written put option, classified as a liability, and measured at fair value.

The assessment of whether a feature is minimal or non-substantive is performed only at inception of a financial instrument; no further assessment is required. This assessment requires significant judgment and must consider not only the legal terms of an instrument, but also other relevant facts and circumstances.

Although a feature may be non-substantive for purposes of applying ASC 480, that feature should not necessarily be ignored for other accounting purposes.

Analysis of Equity-Linked Instruments / 2 - 13

Example 2-2: Impact of Declining Stock Price on Conversion Option

Background/Facts:• On January 1, 2012 Company A issued preferred shares convertible into

Company A common shares. The preferred shares are redeemable five years after issuance if they are not converted by the investor prior to the redemption date. The embedded conversion option is struck at a 20% premium to Company A’s common stock price on January 1, 2012 and is deemed to be a substantive conversion option.

• Since the preferred shares are conditionally redeemable (redeemable only if investors do not exercise their conversion option prior to the redemption date) the shares are classified as equity.

• On December 31, 2012, the conversion option is at a 200% premium to Company A’s common stock price on that date due to a decline in Company A’s stock price.

Question:Does the decline in stock price cause the embedded conversion option to be deemed non-substantive as of December 31, 2012 such that the preferred shares become mandatorily redeemable and subject to liability classification?

Analysis/Conclusion:No. Although the embedded conversion option would likely be deemed non-substantive if the instrument had been issued and evaluated on December 31, 2012, the evaluation of whether a feature is minimal or non-substantive is performed only at issuance of the instrument. A conversion option that is deemed substantive upon issuance of an instrument does not subsequently become non-substantive as a result of a substantial decline in common stock price.

2.5 Analysis of a Freestanding Equity-Linked Instrument

Is the freestanding instrumentconsidered indexed

to the company’s own stock?

(FG section 2.5.1)

Classify as asset or liability, initially record at fair value with changes in fair value

recorded in earnings.

No

Does the freestanding instrument meet the requirements

for equity classification?

(FG section 2.5.2)

Yes

Yes

No

Classify as equity, initially record at fair value,

no subsequent remeasurement.

(FG section 2.6)

2 - 14 / Analysis of Equity-Linked Instruments

Once an issuer has determined that a freestanding financial instrument should not be accounted for in accordance with 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) in accordance with the guidance in ASC 815.

As illustrated in the flowchart above, the steps used to analyze a freestanding equity-linked instrument differ from the analysis of an embedded equity-linked component. The key difference between the analyses is:

• An embedded equity-linked component must meet the definition of a derivative in ASC 815-10-15-83 to be subject to the guidance in ASC 815-40, which may require separation and classification of the embedded derivative as a liability measured at fair value.

• A freestanding instrument does not need to meet the definition of a derivative to be subject to the guidance in ASC 815-40, which may require classification of the instrument as a liability measured at fair value.

Contracts that are indexed to an issuer’s own equity must be analyzed as described in the flowchart even if the freestanding instrument does not meet the definition of a derivative in ASC 815-10-15-83. For example, a freestanding warrant on private company shares 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 it must still be analyzed to determine whether it should be classified as a liability pursuant to the guidance in ASC 815-40.

2.5.1 Indexed to a Company’s Own Stock—ASC 815-40-15 (previously EITF 07-5)

NoIs the freestanding instrument

considered indexed to thecompany’s own stock?

(FG section 2.5.1)

Does the freestanding instrumentmeet the requirements

for equity classification?

(FG section 2.5.2)

Classify as asset or liability,initially record at fair valuewith changes in fair value

recorded in earnings.

Yes

ASC 815-40-15, addresses when an instrument or embedded component that meets the definition of a derivative is considered indexed to the company’s own stock for purposes of applying the scope exception in ASC 815-10-15-74(a). The guidance requires an issuer 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.

Analysis of Equity-Linked Instruments / 2 - 15

2.5.1.1 Step One—Exercise Contingencies

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.

• If an exercise contingency is based on the occurrence of an event, such as an IPO, the contingency does not impact the conclusion that the freestanding instrument or embedded component is indexed to a company’s own stock.

• If an exercise contingency is based on an observable index, then the presence of the exercise contingency precludes a freestanding instrument or embedded component from being considered indexed to a company’s own stock with two exceptions. A contingency based on the following would not preclude the instrument or embedded component from being considered indexed to the company’s own stock.

— The company’s stock price, or

— One measured solely by reference to the issuer’s own operations (e.g., sales revenue, EBITDA).

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 issuer’s own stock. In contrast, if the warrant became exercisable only if the issuer’s stock price increased 10%, this step of the guidance would be met and the analysis would proceed to Step 2.

2.5.1.2 Step Two—Settlement Adjustments

If the settlement amount equals the difference between the fair value of a fixed number of the issuer’s equity shares and a fixed monetary amount, then the instrument or embedded component would be considered indexed to the company’s own stock. The same is true if the settlement amount equals the difference between the fair value of a fixed number of the issuer’s equity shares and a fixed principal amount of debt issued by the issuer. The strike price or the number of shares used to calculate the settlement amount cannot be 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 issuer can control the adjustment.

The exception to the “fixed-for-fixed” rule relates to certain adjustments made to the strike price or number of shares used to calculate the settlement amount. Those terms may be adjusted provided the inputs to the adjustment are variables that are standard inputs to the value of a “fixed-for-fixed” forward or option on equity shares. These variables include items such as the term of the instrument, expected dividends, stock borrow costs, interest rates, stock price volatility, and the ability to maintain a standard hedge position. Including other variables, or incorporating a leverage factor that increases the instrument’s exposure to those variables, would preclude the instrument from being considered indexed to the company’s own stock.

2 - 16 / Analysis of Equity-Linked Instruments

2.5.1.3 Anti-dilution and Price Protection Provisions (including “down-round” provisions)

Settlement adjustments designed to protect a holder’s position from being diluted by a transaction initiated by the issuer will generally not prevent a freestanding instrument or embedded component from being considered indexed to the company’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 acceptable adjustments include the occurrence of a stock split, rights offering, stock dividend, or a spin-off. Similarly, settlement adjustments due to issuances of shares for an amount below current fair value, or repurchases of shares for an amount that exceeds the current fair value of those shares would also be acceptable.

Not all “anti-dilution” settlement adjustments will meet the criteria for being considered indexed to a company’s own stock in ASC 815-40-15. 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” provision. 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 and thus it would not qualify for the exception discussed in FG section 2.5.1.2. Therefore any settlement adjustments related to such events would preclude the issuer from considering the instrument or embedded component as indexed to its own stock.

The term “down-round protection” is not defined by GAAP and can be applied to provisions with varying terms. As such, an issuer must evaluate the specific provision to determine whether it impacts the issuer’s ability to consider an instrument to be indexed to its own stock in ASC 815-40-15.

Example 2-3: Down-Round Provisions in a Security Received Upon Exercise of a Warrant

Background/Facts:• Company A issues warrants that permit the investor to buy 100 shares of its

Series B preferred stock for $100 per share. The warrants have 3-year terms and are exercisable at any time.

• The warrants for Series B preferred stock contain permitted anti-dilution provisions, but do not contain a down-round provision that compensates the investor for the sale of Series B preferred shares at a price less than $100.

• The Series B preferred stock is (1) perpetual and (2) convertible into 5 shares of Company’s A common stock at any time, which equates to a $20 conversion price.

• In addition to containing standard anti-dilution provisions, the Series B preferred stock contains a down-round provision that compensates the investor for the sale of Company A’s common stock at a price below $20.

(continued)

Analysis of Equity-Linked Instruments / 2 - 17

Question:Does the inclusion of a down-round provision in the Series B convertible preferred shares prevent the warrant to purchase the Series B preferred shares from being indexed to the company’s own stock?

Analysis/Conclusion:No, provided the warrant is a substantive instrument. If (1) the Series B shares will be classified as equity and (2) the warrants meet the requirements for equity classification, the warrants should be accounted for as an equity instrument. Generally, there is no requirement to “look through” a substantive instrument to evaluate the terms of the underlying equity.

In this case, the Series B preferred shares should be classified as equity since the shares are perpetual and the conversion option would be considered clearly and closely related to the equity host.

If, on the other hand, the conversion option embedded in the Series B preferred shares should be separated and accounted for as a derivative liability, the warrant should also be accounted for as a liability. This could be the case if the Series B preferred shares were a debt-like host (FG section 2.3.1.1). In that case, the embedded conversion option may have to be separated based on the guidance in ASC 815-15-25-1 (FG section 2.3) as (1) the conversion option is not clearly and closely related to the Series B preferred because the preferred is a debt-like host (FG section 2.3.1), (2) the conversion would meet the definition of a derivative if the underlying equity is readily convertible to cash (FG section 2.3.2), and (3) the conversion option would not qualify for the scope exception for certain contracts involving an issuer’s own equity in ASC 815-10-15-74(a) as the down-round provision would cause the embedded conversion option not to be indexed to the company’s own stock.

Example 2-4: Valuation of a Warrant with a Down-Round Provision

Background/Facts:Company B issues warrants that permit the investor to buy 100 shares of its common stock for $50 per share. The warrants have 5-year terms and are exercisable at any time. The warrants contain a down-round provision that compensates the investor for the sale of Company B’s common stock at a price below $50. The inclusion of the down-round provision causes the warrant to not be considered indexed to the company’s own stock. As such, the warrant is classified as a liability and carried at fair value with changes in fair value recorded in earnings.

Question:Can Company B use the Black-Scholes-Merton model (Black-Scholes) to value the warrant?

Analysis/Conclusion:No, the Black-Scholes model has inherent limitations and should only be used when the inputs to the model are static throughout the life of the warrant. In the case of a warrant with a down-round provision, the strike price can be adjusted downward. Black-Scholes can be used to calculate the minimum value of a warrant with a down-round provision. However, in order to calculate the fair value of the warrant, an issuer (or investor) must consider the impact of the down-round provision using a binomial or lattice model.

2 - 18 / Analysis of Equity-Linked Instruments

2.5.1.4 Foreign Currency

If an instrument’s strike price is denominated in a currency other than the issuer’s functional currency, the issuer is exposed to changes in foreign currency exchange rates. ASC 815-40-15-7I specifically precludes an instrument from being considered indexed to an issuer’s own stock if it creates an exposure to changes in a foreign currency. 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.

Example 2-5: Foreign Currency Denominated Convertible Bond

Background/Facts:Company C, whose functional currency is the Chinese Renminbi (RMB), issues debt denominated in U.S. dollars (USD). The debt is convertible into 100 shares of its USD denominated American Depository Receipts (ADR). An ADR is a negotiable security that represents ownership of the underlying securities of a non-U.S. company and can be traded in the U.S. financial markets. Since the RMB is a non-deliverable currency, Company C cannot issue an RMB denominated bond, in a price-efficient manner, to foreign investors.

Question:Can the embedded conversion option meet the requirements for the scope exception for certain contracts involving an issuer’s own stock in ASC 815-10-15-74(a)?

Analysis/Conclusion:No. An instrument is precluded from being considered indexed to a company’s own stock if it creates an exposure to changes in currency exchange rates. ASC 815-40-15-7I states “an equity-linked financial instrument (or embedded component) shall not be considered indexed to the entity’s own stock if the strike price is denominated in a currency other than the issuer’s functional currency (including a conversion option embedded in a convertible debt instrument that is denominated in a currency other than the issuer’s functional currency).”

2.5.1.5 Indexed to Stock of Subsidiary, Affiliate, or Parent

An instrument issued by a parent indexed to the stock of a consolidated subsidiary should be considered indexed to its own stock based on the guidance in ASC 815-40-15-5C. That guidance applies to freestanding financial instruments and embedded components for which payoff to the counterparty is based, in whole or in part, on the stock of a consolidated subsidiary, whether those instruments were 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 company’s own stock.

Instruments issued by a subsidiary indexed to the stock of a parent would not be considered indexed to the company’s own stock in the stand-alone financial statements of the subsidiary. However, in the consolidated financial statements, the instruments would be considered indexed to the company’s own stock.

Analysis of Equity-Linked Instruments / 2 - 19

2.5.2 Requirements for Equity Classification—ASC 815-40-25 (previously EITF 00-19)

Classify as asset or liability, initially record at fair value with changes in fair value

recorded in earnings.

Does the freestanding instrumentmeet the requirements

for equity classification?

(FG section 2.5.2)

No

Yes

Classify as equity, initially recordat fair value, no subsequent

remeasurement.

(FG section 2.6)

Application of the guidance in ASC 815-40-25 is premised on obtaining a detailed understanding of the settlement and other terms of the contract.

• Contracts that are settled by gross physical delivery of shares or net share settlement may qualify to be equity instruments (FG section 2.5.2.1).

• Contracts that require or permit the investor to require an issuer to net cash settle are accounted for as assets or liabilities at fair value with changes in fair value recorded in earnings.

• Contracts that an issuer 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.

2.5.2.1 Additional Requirements for Equity Classification

It is important to note that not all share settled contracts qualify for equity classification. In order for a share settled contract to be classified as equity, each of the additional specific conditions in ASC 815-40-25-10 must be met to ensure that the issuer has the ability to settle the contract in shares.

25-10 Because any contract provision that could require net cash settlement precludes accounting for a contract as equity of the entity … all of the following conditions must be met for a contract to be classified as equity:

a. Settlement permitted in unregistered shares. The contract permits the entity to settle in unregistered shares.

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.

2 - 20 / Analysis of Equity-Linked Instruments

d. No required cash payment if entity fails to timely file. There are no required cash payments to the counterparty 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. No counterparty rights rank higher than shareholder rights. There are no provisions in the contract that indicate that the counterparty has rights that rank higher than those of a shareholder of the stock underlying the contract.

g. No collateral required. There is no requirement in the contract to post collateral at any point or for any reason.

These conditions are intended to identify situations in which net cash settlement could be forced upon the issuer by investors or in any other circumstance, regardless of likelihood, except for (1) liquidation of the company or (2) a change in control in which the company’s shareholders also receive cash.

An issuer 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, an issuer 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 815-40-25-11 through 25-38 provide further guidance on the requirements for equity classification.

Example 2-6: Impact of Exchange Limits on Share Issuance

Background/Facts:Several stock exchanges in the U.S. (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 company.

Company A 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). Company A issues an unregistered convertible bond to multiple investors that, upon conversion, will result in the issuance of 125,000 shares (25% of outstanding shares). Company A 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. Company A has not obtained shareholder approval to issue the shares upon conversion of the bond.

Question:Can the conversion option embedded in Company A’s convertible bond meet the requirements for the scope exception in ASC 815-10-15-74(a)?

Analysis/Conclusion:No, because the requirements for equity classification are not met. If Company A’s shareholders do not vote to approve the issuance of shares upon conversion of the bond, Company A will be prohibited by the NYSE from issuing shares in excess of

(continued)

Analysis of Equity-Linked Instruments / 2 - 21

20% of its outstanding shares. In that case, upon conversion, investors would likely receive cash equal to the fair value of the share shortfall. Since shareholder approval is not within the control of Company A, the possibility of this outcome, however remote, would preclude equity classification.

Example 2-7: Impact of Master Netting Agreements

Background/Facts:• Company A issues a convertible bond that, upon conversion, will result in cash

settlement of the conversion option.

• Company A also enters into two contracts with Bank B:

— A convertible bond hedge (purchased call option) that mirrors the terms of the embedded conversion option in Company A’s convertible bond and requires Bank B to pay cash to Company A equal to the value of the conversion option upon exercise, and

— A warrant with a strike price at a 20% premium to the embedded conversion option price that requires Company A to deliver net shares to Bank B, if the warrant is in the money when the conversion option is exercised.

• Since the convertible bond hedge requires cash settlement, the requirements for equity classification are not met; therefore it is accounted for as a liability at fair value with changes in fair value recorded in earnings.

• Company A and Bank B 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 Company A’s bankruptcy.

Question:Can the warrant meet the requirements for equity classification?

Analysis/Conclusion:No, because upon bankruptcy, the warrant can be netted with a contract that does not meet the requirements for equity classification (the convertible bond hedge). An arrangement that provides for the netting of contracts that meet the requirements for equity classification with those that do not meet the requirements provides the counterparty (Bank B) with rights that rank higher than those of other shareholders. However, a contract that otherwise would meet the requirements for equity classification, can be included in a netting arrangement with other contracts that (1) are indexed to the same class of shares (i.e., common shares) and (2) meet the requirements for equity classification without tainting the ability to qualify for equity classification.

Example 2-8: Option to Pay Cash Penalty in the Event Timely Filings with the SEC Are Not Made

Background/Facts:Company B issues a convertible bond with contractual terms that allow Company B to make cash payments to investors in the event it does not make timely filings with the SEC. If Company B chooses not to make the payments, investors can trigger an

(continued)

2 - 22 / Analysis of Equity-Linked Instruments

event of default, upon which investors would be unable to force Company B to issue cash to settle any value of the conversion option embedded in the bond.

Question:Can the conversion option embedded in Company B’s convertible bond meet the scope exception in ASC 815-10-15-74(a)?

Analysis/Conclusion:Yes, an optional cash payment to prevent an event of default would not preclude equity classification. If, however, the terms of the bond required Company B to make cash payments to investors in the event it does not make timely filings with the SEC, the requirements for equity classification would not be met.

Example 2-9: Convertible Debt Indexed to Subsidiary’s Stock and Settlable in Stock of Parent or Subsidiary

Background/Facts:• Company P, a public company, has a subsidiary, Company S, which is also a

public company.

• Company P has issued convertible debt, which upon conversion can be settled in either Company P or Company S shares at the discretion of Company P. The value that investors will receive (i.e., the conversion value) is indexed solely to the stock price of Company S; the ability to satisfy the conversion value in Company P’s shares is merely a settlement mechanism and does not affect the value transfer.

Question:Can the conversion option embedded in Company P’s convertible bond meet the requirements for the scope exception in ASC 815-10-15-74(a)?

Analysis/Conclusion:Probably. ASC 815-40-15-5C states that “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.” Since Company S is a substantive entity, Company P must determine whether the embedded conversion option meets the requirements to apply the ASC 815-10-15-74(a) scope exception (FG section 2.3.3).

The value of the conversion option embedded in Company P’s bond is indexed to Company S’s shares. Accordingly, it would be considered indexed to Company P’s own stock based on the guidance in ASC 815-40-15-5C. The settlement mechanism that allows settlement in shares of either Company P or Company S does not affect this conclusion.

If Company P were required to settle the conversion option in shares of Company P, then the contract should be evaluated to determine whether it contains an explicit limit on the number of shares to be delivered in a share settlement. If Company S’s share price rises, while Company P’s share price falls, then the number of Company P shares required for delivery could be extremely high, possibly indeterminate. Without a maximum cap on the number of Company P shares that Company P could be required to deliver, classification of the conversion feature in stockholders’ equity would not be permitted if this was the only settlement alternative.

Analysis of Equity-Linked Instruments / 2 - 23

2.5.2.2 Application to Convertible Bonds

To apply the requirements for equity classification to a conversion option embedded in a convertible bond, the issuer must first determine whether the convertible bond is considered “conventional.” ASC 815-40-25-39 defines conventional convertible debt as debt whereby the holder will, at the issuer’s option, receive a fixed amount of shares or the equivalent amount of cash as proceeds when the holder exercises the conversion option. If the convertible bond is considered “conventional,” the issuer only needs to consider the settlement alternatives (i.e., who controls the settlement and whether the settlement will be in shares or cash) to determine whether the embedded conversion option meets the requirements for equity classification; the additional requirements for equity classification in ASC 815-40-25-10 are not applicable. If the convertible debt is not “conventional,” the issuer must consider all of the requirements for equity classification in ASC 815, including the additional requirements for equity classification in ASC 815-40-25-10.

A bond with a cash conversion feature that is within the scope of ASC 470-20 (FG section 7.4) is not considered conventional. Similarly, a convertible bond that contains a make-whole provision upon a fundamental change (FG section 7.2.2), a very common feature among publicly issued bonds, is not considered conventional.

ASC 815-40-25-39 through 25-42 provide further guidance on convertible debt and other hybrids.

Example 2-10: Application of Conventional Convertible Bond Exception to Convertible Bonds with a Make-Whole Table

Background/Facts:An issuer does not need to consider the additional requirements for equity classification in ASC 815-40-25-10 when determining whether the embedded conversion option in a “conventional” convertible bond meets the requirements for the scope exception for certain contracts involving an issuer’s own equity in ASC 815-10-15-74(a).

Question:Is a convertible bond that provides for an adjustment to the number of shares deliverable upon conversion via a “make-whole” provision or table (FG section 7.2.2), as is market standard practice, considered a “conventional” convertible bond?

Analysis/Conclusion:No. Typically an adjustment to the conversion option for anything other than standard anti-dilution provisions (e.g., adjustments for stock split, rights offering, dividend, or spin-off) would cause the convertible bond to be considered not “conventional.” Whether an adjustment is market standard is not relevant in determining whether the convertible bond is “conventional” as defined in ASC 815-40-25-39.

2.5.2.3 Reassessment

ASC 815-40-35-8 requires that the classification or accounting treatment of a contract be reassessed at each balance sheet date. If the previously determined classification or accounting treatment changes, for example, due to a change in the number of authorized and unissued shares available to settle the contract due to the issuance or retirement of other securities, the contract should be reclassified as of

2 - 24 / Analysis of Equity-Linked Instruments

the date of the event that resulted in the reclassification. That reclassification would be accounted for as follows:

• If a contract is reclassified from equity to an asset or a liability, the change in fair value of the contract during the time the contract was classified as equity should be accounted for as an adjustment to equity.

• If a contract is reclassified from an asset or a liability to equity, gains or loses previously recognized in accounting for the contract at fair value during the period that the contract was classified as an asset or a liability should not be reversed.

There is no limit to the number of times a contract can be reclassified.

If an equity-linked instrument classified as a liability becomes exercisable into equity classified shares the issuer should record the final period change in fair value of the liability in earnings. That final change in fair value should be based on the fair value of the underlying shares on the date the liability becomes an equity instrument (e.g., date of exercise).

2.6 Accounting for Instruments Classified in Equity

Instruments classified in equity are initially measured at fair value. Subsequent changes in fair value should not be recognized as long as the instrument continues to be classified as equity. If an equity classified instrument is ultimately settled in cash, the amount of cash paid or received should be reported as a reduction of, or an addition to, contributed capital.

See FG 3.6 for a discussion of mezzanine (temporary) equity classification.

2.7 Financial Statement Disclosure of Equity-Linked Instruments

ASC 815-40-50-5 sets forth the disclosures required for all equity-linked instruments (whether accounted for as equity or as an asset or liability) within the scope of ASC 815-40 (i.e., equity-linked instruments that are not within the scope of ASC 480). Furthermore, the SEC staff has stated that an issuer with a history of settling equity-linked instruments in cash is encouraged to disclose that fact in the liquidity section of MD&A, even for instruments classified in equity. The SEC Observer noted that S-X 10-01(a)(5) would require these disclosures in all quarterly reports for instruments that are considered to be material contingencies even when a significant change since year end may not have occurred.

If an equity-linked instrument is accounted for as a derivative asset or liability under ASC 815-10 the disclosure requirements in ASC 815-10-50 also apply.

In addition, written put options on an issuer’s own shares (see FG 10.3) that meet the characteristics of a guarantee are subject to the disclosure requirements of ASC 460.

Analyzing Put and Call Options and Other Features and Arrangements / 3 - 1

Chapter 3:Analyzing Put and Call Options and Other Features and Arrangements

3 - 2 / Analyzing Put and Call Options and Other Features and Arrangements

3.1 Put and Call Options Embedded in Debt Instruments

Many debt instruments include embedded put and call options. A put option allows the investor (lender) to demand repayment, and a call option allows an issuer (borrower) to extinguish debt on demand. Put and call options embedded in debt instruments should be evaluated to determine whether they need to be accounted for separately at fair value with changes in fair value recorded in earnings under the guidance in ASC 815.

A put or call option should be accounted for separately if all of the following general criteria in ASC 815-15-25-1 are met:

a. The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract.

b. The hybrid instrument is not remeasured at fair value through earnings with changes in fair value recorded in earnings.

c. A separate instrument with the same terms as the embedded put or call option would be accounted for as a derivative under the guidance in ASC 815.

Provided the host debt instrument is not accounted for at fair value with changes in fair value recorded in earnings, the first step in assessing whether an embedded put or call should be separately accounted for is to determine whether the embedded option would be accounted for as a derivative under the guidance in ASC 815 if it were a freestanding instrument. To do this, an issuer should assess whether the embedded put or call option (1) meets the definition of a derivative or (2) qualifies for a scope exception to derivative accounting in ASC 815. See FG section 2.3.2 and Chapter 2 of PwC’s Guide to Accounting for Derivative Instruments and Hedging Activities—2012 for a discussion of the definition of a derivative and a discussion of scope exceptions to ASC 815.

• An embedded put or call option that (1) does not meet the definition of a derivative or (2) qualifies for a scope exception to derivative accounting in ASC 815 would not be accounted for separately.

• An embedded put or call option that (1) does meet the definition of a derivative and (2) does not qualify for a scope exception to derivative accounting in ASC 815 may need to be accounted for separately. These puts and calls should be evaluated to determine whether they are clearly and closely related to their host debt instrument.

3.2 Analysis of Whether a Put or Call Is Clearly and Closely Related to a Debt Host

Generally, put and call options are considered clearly and closely related to their debt hosts unless they are leveraged (i.e., create more interest rate and credit risk than is inherent in the host instrument). For example, debt issued at par value that is puttable at two times the par value upon the occurrence of a specified event may have an embedded component that is not clearly and closely related to its debt host.

Analyzing Put and Call Options and Other Features and Arrangements / 3 - 3

The analysis to determine whether a put or call option is clearly and closely related to a debt host instrument is best performed using a multi-step approach as illustrated below.

Analysis of Whether a Put or Call Option Is Clearly and Closely Related to a Debt Host

Yes

No

No

No

No

No

Yes

Yes

Yes

Yes

The put or call option is clearly and closely related to

its debt host. It should notbe accounted for separately.

If the only exercisecontingency is based oninterest rates, performanalysis to determine

whether there is an interestrate derivative that should

be accounted for separately.

(FG section 3.2.5)

Is the amount paid uponexercise of the put or calloption based on changes

in an index?

(FG section 3.2.1)

Is the amount paid upon exerciseof the put or call optionbased on an index other

than interest rates or credit?

(FG section 3.2.1)

Does the put or call optionaccelerate repayment of

the debt?

(FG section 3.2.2)

Is the put or call optioncontingently exercisable?

(FG section 3.2.3)

Does the debt involve asubstantial premium

or discount?1

(FG section 3.2.4)

Perform analysis todetermine whether there isan interest rate derivativethat should be accounted

for separately.2

(FG section 3.2.5)

The put or call option isnot clearly and closelyrelated to its debt host.

It should be separated fromthe debt host and recordedat fair value with changes

in fair value recordedin earnings.

1 As discussed in FG section 3.2.4, a put or call option that requires the debt to be repaid at accreted value does not typically involve a substantial premium or discount.

2 This analysis is performed when the only underlying (or indexation) is an interest rate index. If there is another underlying, for example, credit, this analysis is not required. See FG section 3.2.5 for additional discussion.

3 - 4 / Analyzing Put and Call Options and Other Features and Arrangements

3.2.1 Determine the Nature of the Settlement Amount Received Upon Exercise of Put or Call Option

Is the amount paid upon exerciseof the put or call optionbased on an index other

than interest rates or credit?

(FG section 3.2.1)

Is the amount paid upon exercise of the put or call option

based on changes in an index?

(FG section 3.2.1)

Does the put or call optionaccelerate repayment of

the debt?

(FG section 3.2.2)

The put or call option is not clearly and closely related to its debt host.

It should be separated from the debt host and recorded

at fair value with changes in fair value recorded

in earnings.

Yes

No No

No

Yes

First, the issuer must determine if the amount paid upon exercise of a put or call option is based on changes in an index rather than simply being the repayment of principal at par or a premium. For example, a put option that entitles the holder to receive an amount determined by the change in the S&P 500 index (i.e., par value of the debt multiplied by the change in the S&P 500 index over the period the debt was outstanding) is based on changes in an equity index. On the other hand, debt callable at a fixed price of 101 is not based on changes in an index. Debt callable at a price of 108 at the end of year 1, 106 at the end of year 2, and 104 at the end of year 3 is also not based on changes in an index because the premium changes simply due to the passage of time.

If the amount paid upon exercise of a put or call option is based on changes in an index, then the issuer should determine whether the index is an interest rate index or credit index. If the index is not an interest rate or credit index, the put or call option is not clearly and closely related to the debt host instrument and should be accounted for separately at fair value with changes in fair value recorded in earnings under the guidance in ASC 815.

If the amount paid upon exercise of the put or call option is (1) not based on changes in an index or (2) based on changes in an interest rate or credit index, further analysis is required to determine whether the put or call is clearly and closely related (FG section 3.2.2).

Analyzing Put and Call Options and Other Features and Arrangements / 3 - 5

3.2.2 Determine Whether the Put or Call Option Accelerates Repayment of the Debt

Does the put or call optionaccelerate repayment of

the debt?

(FG section 3.2.2)

The put or call option is not clearly and closely related to its debt host.

It should be separated from the debt host and recorded

at fair value with changes in fair value recorded

in earnings.

Yes

No

Is the put or call optioncontingently exercisable?

(FG section 3.2.3)

Next, the issuer should determine whether exercise of the put or call option accelerates the repayment of the debt. As discussed in ASC 815-15-25-41, put and call options that do not accelerate the repayment of the debt, but instead require a cash settlement that is equal to the price of the option at the date of exercise, would not be considered to be clearly and closely related to its debt host instrument.

If exercise of the put or call accelerates the repayment of the debt, further analysis is required to determine whether the put or call is clearly and closely related to the debt host (FG section 3.2.3).

3.2.3 Determine if the Put or Call Option Is Contingently Exercisable

Perform analysis todetermine whether there isan interest rate derivativethat must be accounted

for separately.

(FG section 3.2.5)

Yes

No

Does the debt involve asubstantial premium or

discount?

(FG section 3.2.4)

Is the put or call optioncontingently exercisable?

(FG section 3.2.3)

The issuer should then determine whether (1) the put or call option is contingently exercisable and (2) the contingency is based solely on interest rates.

• If the put or call option is not contingently exercisable, the next step is for the issuer to perform the analysis to determine whether there is an interest rate derivative that should be accounted for separately (FG section 3.2.5).

3 - 6 / Analyzing Put and Call Options and Other Features and Arrangements

• If the put or call option is contingently exercisable and the contingency is based solely on interest rates, the issuer should first determine whether the debt instrument involves a substantial premium or discount (FG section 3.2.4) and if it does not, then determine whether there is an interest rate derivative that should be accounted for separately (FG section 3.2.5).

• If the put or call option is contingently exercisable and the contingency is not based solely on interest rates, the next step is for the issuer to determine whether the debt instrument involves a substantial premium or discount (FG section 3.2.4).

3.2.4 Determine if the Put or Call Option Is Contingently Exercisableor Discount

The put or call optionis clearly and closely

related to its debt host.It should not be accounted

for separately.

YesNo

Does the debt involve asubstantial premium or

discount?

(FG section 3.2.4)

The put or call option is not clearly and closely related to its debt host.

It should be separated from the debt host and recorded

at fair value with changes in fair value recorded

in earnings.

Practice generally considers a premium or discount equal to or greater than ten percent of the par value of the host debt instrument to be substantial. Similarly, a spread between the debt’s issuance price and the price at which the put or call option can be exercised that is equal to or greater than ten percent is also generally considered substantial. However, a ten percent premium or discount is not a bright-line; all relevant facts and circumstances should be considered to determine whether the premium or discount is substantial. A put or call option that requires the debt to be repaid at its accreted value is generally not considered to involve a substantial premium or discount.

If a put or call option analyzed per the flowchart in FG section 3.2 (1) accelerates repayment of the debt, (2) is contingently exercisable, and (3) involves a substantial premium or discount, the put or call option is not clearly and closely related to the host debt instrument. It is not clearly and closely related because exercise of the put or call, which is indexed to a contingent event, will result in the investor receiving (or making) a substantial payment (the difference between the accreted value of the debt and the repayment amount). A put or call option that is not clearly and closely related to the host debt instrument should be separately accounted for at fair value with changes in fair value recorded in earnings.

If a put or call option analyzed per the flowchart in FG section 3.2 (1) accelerates repayment of the debt, (2) is contingently exercisable, and (3) does not contain a substantial premium or discount, the put or call option is clearly and closely

Analyzing Put and Call Options and Other Features and Arrangements / 3 - 7

related to its host debt instrument. However, if the put or call option is contingently exercisable and the contingency is based solely on interest rates, the issuer should also consider whether there is an interest rate derivative that should be accounted for separately (FG section 3.2.5).

3.2.5 Analysis of Embedded Interest Rate Derivatives

The guidance in ASC 815-15-25-26 should be applied if a put or call option embedded in a debt instrument is:

• Contingently exercisable and the only contingency is based on interest rates, or

• Not contingently exercisable and the only underlying is interest rates.

Although it could be argued that the decision to exercise a put or call option embedded in a debt instrument is based on interest rates and credit, “plain vanilla” and “non-contingent” calls are considered to be solely indexed to interest rates as contemplated in ASC 815-15-25-26.

The guidance in ASC 815-15-25-26 states that the embedded interest rate component is considered clearly and closely related (and does not need to be accounted for separately) unless either of the following is true.

a. The hybrid instrument (the debt host and embedded put or call) can contractually be settled (non-payment due to default should not be considered) such that the investor would not recover substantially all of its initial recorded investment, or

b. The embedded put or call meets both of the following conditions. These conditions together are referred to as the “double-double” test.

1. There is a possible future interest rate scenario (even though it may be remote) under which exercise of the put or call option would at least double the investor’s initial rate of return on the host contract, and

2. For any possible interest rate scenario in which the investor’s initial rate of return would be doubled, exercise of the put or call option would also result in a rate of return that is at least double what otherwise would be the then-current market return for the same host contract without the embedded component.

ASC 815-15-25-29 clarifies that in the case of a put option that permits, but does not require, the investor to settle the debt instrument in a manner that causes it not to recover substantially all of its initial recorded investment, the guidance in paragraph (a) above is not applicable.

ASC 815-15-25-37 and 25-38 clarify that in the case of a call option that permits, but does not require, the issuer to accelerate the repayment of the debt, the guidance in paragraph (b) above is not applicable.

The following flowchart combines all of this guidance. We have also assumed that a put option is only exercisable by the investor (thus, does not have to be analyzed under paragraph (a) above based on the guidance in ASC 815-15-25-29) and a call option is only exercisable by the issuer (thus, does not have to be analyzed under paragraph (b) above based on the guidance in ASC 815-15-25-37 and 25-38). In evaluating a put or call option that is not truly an option, but rather is automatically settled once the condition for exercise is met, both paragraphs (a) and (b) above would have to be considered.

3 - 8 / Analyzing Put and Call Options and Other Features and Arrangements

Analysis of Embedded Interest Rate Derivatives1

The put or call option does not create an interest rate derivative to be

accounted for separately.

NoNo

YesYes

There is an interest rate derivative to be accounted for separately at

fair value with changes in fair valuerecorded in earnings.

Is there any possible interest ratescenario under which the investorwould both (a) double its initial rate

of return and (b) double the thencurrent market rate of return for the

host instrument?

(FG section 3.2.5.2)

Call Put

Can the debt instrument be settledsuch that the investor receives less

than substantially all of itsinvestment upon the issuer’sexercise of the call option?

(FG section 3.2.5.1)

Is the embedded component a call or a put option?

1 As discussed above, this flowchart applies to put options that are only exercisable by the investor and call options that are only exercisable by the issuer.

3.2.5.1 Application of Test to Determine Whether the Investor Recovers Substantially All of Its Investment

We believe “substantially all” means approximately 90 percent of the investment. Therefore, if the exercise of a call option embedded in a debt instrument could result in the investor receiving less than 90 percent of its initial recorded investment, it likely creates an embedded interest rate derivative that should be accounted for separately. This analysis should be performed without regard to the probability of the event occurring as long as it is possible.

3.2.5.2 Application of the Double-Double Test

We believe the initial rate of return that should be used in the double-double test is that of the host debt instrument without the embedded put option, not the combined hybrid instrument (debt instrument with the embedded put option). The initial rate of return on the host debt instrument may differ from the initial rate of return on the hybrid instrument, as the yield on the hybrid may be impacted by the embedded put option. The analysis should be performed without regard to the probability of the event occurring as long as it is possible.

When considering transactions with multiple elements, such as debt issued with warrants, the double-double test should be performed after proceeds have been allocated to the individual transactions as discussed in FG section 3.4. However, the terms of the combined transaction should be considered when performing the test. For example, if upon the exercise of a call option embedded in a debt instrument

Analyzing Put and Call Options and Other Features and Arrangements / 3 - 9

issued with warrants, the investor will receive par value for the combination of the debt and warrants, it is less likely to meet the double-double test than if the investor would receive par value for the debt and the warrants remain outstanding.

For convertible debt with a cash conversion feature, the double-double test should be performed before the bond is bifurcated as described in FG section 7.4. Therefore, when evaluating whether an embedded put or call option should be accounted for separately, the discount created by separating the conversion option would not be considered.

Example 3-1: Debt Puttable Upon a Change in Interest Rates

Background/Facts:Company A issues 5-year fixed-rate debt at par value that contains a put option, exercisable by the investor when there is an increase in the 6-month LIBOR rate of 150 basis points. The put option requires the issuer to settle the debt at 105% of the par value upon exercise.

Question:Is the embedded put option clearly and closely related to the debt host? Does the embedded put option create an embedded interest rate derivative that should be accounted for separately?

Analysis/Conclusion: Is the amount paid upon exercise of the put option based on changes in an index?

No, upon exercise of the put option the investor will receive 105% of the par value of the bond.

Does exercise of the put option accelerate the repayment of the debt?

Yes, the put option requires the issuer to repay the debt instrument at 105% of the par value upon exercise of the put option.

Is the put option contingently exercisable?

Yes, the put option can only be exercised by the investor when there is an increase in the 6-month LIBOR rate of 150 basis points.

Does the debt involve a substantial premium or discount?

No, the debt was issued at par value and the premium received upon exercise of the put option (5%) is less than 10% of the par value of the bond.

Perform the analysis to determine whether there is an interest rate derivative that should be accounted for separately.

Since this is a put option, the guidance in ASC 815-15-25-26 (b) should be considered. Due to the fact that the 5-year interest rate inherent in the host debt instrument could change in a manner different than the 6-month LIBOR rate on which the exercise of the put option is based, it is possible for the investor, through exercise of its put option, to double its initial rate of return and double the then-current market rate of return for the host debt instrument. Therefore, there is an embedded interest rate derivative to be accounted for separately.

3 - 10 / Analyzing Put and Call Options and Other Features and Arrangements

Example 3-2: Debt Issued at Par, Puttable Upon a Change in Control

Background/Facts:Company A issues 5-year fixed-rate debt at par value that contains a put option, exercisable by the investor upon a change in control. The put option requires the issuer to settle the debt at 105% of the par value upon exercise.

Question:Is the embedded put option clearly and closely related to the debt host? Does the embedded put option create an embedded interest rate derivative that should be accounted for separately?

Analysis/Conclusion: Is the amount paid upon exercise of the put option based on changes in an index?

No, upon exercise of the put option the investor will receive 105% of the par value of the bond.

Does exercise of the put option accelerate the repayment of the debt?

Yes, the put option requires the issuer to repay the debt instrument at 105% of the par value upon exercise of the put option.

Is the put option contingently exercisable?

Yes, the put option can only be exercised by the investor when there is a change in control.

Does the debt involve a substantial premium or discount?

No, the debt was issued at par value and the premium received upon exercise of the put option (5%) is less than 10% of the par value of the bond.

Perform the analysis to determine whether there is an interest rate derivative that should be accounted for separately.

The put option is contingently exercisable based on a change in control, therefore is based on a contingency other than interest rates. As such, the put option would not be analyzed under the guidance in ASC 815-15-25-26.

Example 3-3: Debt Issued at a Premium, Puttable Upon a Change in Control

Background/Facts:Company A issues fixed-rate debt at 102% of par value that contains a put option, exercisable by the investor upon a change in control. Upon exercise of the put option the issuer must settle the debt at par value.

Question:Is the embedded put option clearly and closely related to the debt host? Does the embedded put option create an embedded interest rate derivative that should be accounted for separately?

(continued)

Analyzing Put and Call Options and Other Features and Arrangements / 3 - 11

Analysis/Conclusion: Is the amount paid upon exercise of the put option based on changes in an index?

No, upon exercise of the put option the investor will receive the par value of the bond.

Does exercise of the put option accelerate the repayment of the debt?

Yes, the put option requires the issuer to repay the debt instrument at par value upon exercise of the put option.

Is the put option contingently exercisable?

Yes, the put option can only be exercised by the investor when there is a change in control.

Does the debt involve a substantial premium or discount?

No, the debt was issued at 102% of par value, thus the premium is less than 10% of the par value of the bond. There is no premium received upon exercise of the put option.

Perform the analysis to determine whether there is an interest rate derivative that must be accounted for separately.

The put option is contingently exercisable based on a change in control, therefore is based on a contingency other than interest rates. As such, the put option would not be analyzed under the guidance in ASC 815-15-25-26.

Example 3-4: Debt Issued at a Discount, Puttable Upon a Change in Control

Background/Facts:Company A issues fixed-rate debt at 80% of par value that contains a put option, exercisable by the investor upon a change in control. The put option requires the issuer to settle the debt at par value upon exercise.

Question:Is the embedded put option clearly and closely related to the debt host? Does the embedded put option create an embedded interest rate derivative that should be accounted for separately?

Analysis/Conclusion: Is the amount paid upon exercise of the put option based on changes in an index?

No, upon exercise of the put option the investor will receive the par value of the bond.

Does the put option accelerate repayment of debt?

Yes, the put option requires the issuer to repay the debt instrument at par value upon exercise of the put option.

Is the put option contingently exercisable?

Yes, the put option can only be exercised by the investor when there is a change in control.

(continued)

3 - 12 / Analyzing Put and Call Options and Other Features and Arrangements

Does the debt involve a substantial premium or discount?

Yes, the debt was issued at 80% of par value, thus the discount is greater than 10% of the par value of the bond. Therefore, the put option is not clearly and closely related to its debt host instrument and should be accounted for separately.

Since the put option is accounted for separately it should not be analyzed to determine if it creates an embedded interest rate derivative under the guidance in ASC 815-15-25-26.

3.2.6 Fair Value Put and Call Options

An embedded put or call option that allows the investor or issuer to receive the fair value of the debt at the date the option is exercised provides liquidity to the option holder. The option doesn’t otherwise have value and, therefore, its value should be immaterial. In that case, no analysis is necessary. This is consistent with other areas in accounting literature in which options at fair value are disregarded such as in ASC 815-20-25-114, in which an option to prepay a contract at its then fair value would not cause the contract to be considered prepayable because the option has no value and only provides liquidity to the holder.

3.3 Put and Call Options Embedded in Equity Instruments

Put options allow an equity investor to require the issuer to reacquire an equity instrument for cash or other assets, and call options allow the issuer to reacquire an equity instrument. As discussed in ASC 815-15-25-20, put and call options are typically not considered clearly and closely related to equity hosts. Whether these options should be separated from their host instruments is determined based on whether a separate instrument with the same terms as the embedded put or call option would be accounted for as a derivative instrument under the guidance in ASC 815. If a put or call option embedded in an instrument classified as equity qualifies for a scope exception for certain contracts involving an issuer’s own equity in ASC 815-10-15-74(a) (FG section 2.3.3) separate accounting for the put or call option is not required.

3.4 Warrants Issued in Connection with Debt and Equity Offerings

When non-detachable warrants are issued with a debt or equity instrument (i.e., 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. Issuers should account for these instruments as convertible debt (see FG section 7.1) or convertible preferred stock (see FG section 8.4) rather than separate the instrument into debt or equity with separate warrants.

Detachable warrants issued in a bundled transaction with debt and equity offerings are accounted for on a separate basis. The allocation of the sales proceeds to the base instrument and to the warrants depends on the accounting classification of the separate warrant as equity or liability. See FG section 2.1 for the analysis of equity-linked instruments.

• If the warrants are classified as equity, then the allocation is made based upon the relative fair values of the base instrument and the warrants following the guidance in ASC 470-20-25-2.

Analyzing Put and Call Options and Other Features and Arrangements / 3 - 13

• If the warrants are classified as a liability, then the sales proceeds are first allocated to the warrant based on the warrant’s full fair value (not relative fair value) and the residual amount of the sales proceeds is allocated to the base instrument.

The allocation of proceeds to the warrant, using either method, will create a discount in the associated debt or equity security, which should be recognized as interest expense or a dividend.

Example 3-5: Warrants Classified as Equity Issued in Connection with Debt

Background/Facts:• Company A issues $1,000,000 of debt and 100,000 detachable warrants to

purchase its common stock in exchange for $1,000,000 in cash.

• The warrants are considered indexed to Company A’s stock and meet the requirements for equity classification, thus Company A will classify the warrants as equity (FG section 2.5).

• Since the warrants are classified as equity, the allocation of the proceeds from the issuance of the debt and warrants is performed using the relative fair value method.

• The fair values of the debt securities and warrants are determined as follows:

Instrument Fair Value % of Total Allocated Amount

Debt $ 910,000 70% $ 700,000Warrants $ 390,000 30% $ 300,000Total $1,300,000 100% $1,000,000

Question:What is the journal entry Company A would record to reflect the issuance of the debt and warrants?

Analysis/Conclusion: Company A would record the following journal entry:

Dr Cash $1,000,000Dr Discount on Debt 300,000

Cr Debt $1,000,000Cr Additional paid in capital (warrants) 300,000

Example 3-6: Warrants Classified as Liabilities Issued in Connection with Debt

Background/Facts:• Company B issues $1,000,000 of debt and 100,000 detachable warrants to

purchase its common stock in exchange for $1,000,000 in cash.

• The warrant contract includes a down-round provision that requires a reduction in the strike price if there are additional warrants issued with a lower strike price.

(continued)

3 - 14 / Analyzing Put and Call Options and Other Features and Arrangements

• The warrants are classified as liabilities under ASC 815-40-15 as the settlement adjustment from the down-round does not allow for the strike price to be considered fixed (FG section 2.5.1).

• The fair value of the warrants is $400,000.

• Since the warrants are liabilities, they must be recorded at their full fair value of $400,000.

Question:What is the journal entry the Company would record to reflect the issuance of the debt and warrants?

Analysis/Conclusion:

Dr Cash $1,000,000Dr Discount on Debt 400,000

Cr Debt $1,000,000Cr Warrant Liability 400,000

3.5 Beneficial Conversion Feature

The Beneficial Conversion Feature (BCF) rules apply to convertible instruments other than the following:

• Convertible debt and convertible preferred stock for which the embedded conversion option is required to be accounted for separately as a derivative under the guidance in ASC 815.

• Convertible debt with a cash conversion option (FG section 7.4) that must be bifurcated into debt and equity components.

A convertible financial instrument includes a BCF if its conversion price is lower than the issuer’s stock price (it’s in the money) at the commitment date. Similarly, a contingent BCF arises when the conversion price could be adjusted at some future date to an amount that is less than the issuer’s stock price at the commitment date.

3.5.1 Recognition and Measurement

To determine whether a BCF should be recognized, an issuer should assess the relationship between the accounting conversion price and the issuer’s stock price at the commitment date (FG section 3.5.2). The accounting conversion price used to compute the BCF may not equal the stated conversion price when other securities, such as warrants, are issued with a convertible financial instrument. As discussed in FG section 3.4, in a bundled transaction the sales proceeds should be allocated between the convertible instruments and the warrants. The portion of the sales proceeds allocated to the convertible instrument is divided by the contractual number of conversion shares to determine the accounting conversion price per common share (also called the effective conversion price), which is used to measure the BCF. Costs of issuing convertible instruments do not affect the calculation of the BCF.

In general, if the issuer’s stock price is greater than the accounting conversion price, the conversion option is in the money at issuance and the conversion feature is considered “beneficial” to the holder. The intrinsic value of the conversion option (or the in-the-money amount) is recorded in equity with a corresponding reduction in the carrying value of the convertible instrument. As noted in ASC 470-20-30-8, if the

Analyzing Put and Call Options and Other Features and Arrangements / 3 - 15

intrinsic value of the BCF is greater than the proceeds allocated to the convertible instrument, the amount of the discount assigned to the BCF is limited to the amount of the proceeds allocated to the convertible instrument.

See the discussion of mezzanine (temporary) equity classification in FG section 3.6 for a discussion of the application of ASC 480-10-S99 to BCFs.

Example 3-7: Beneficial Conversion Feature (BCF)

Background/Facts:• Company A issues $1,000,000 of convertible debt and 100,000 detachable

warrants to purchase its common stock in exchange for $1,000,000 in cash.

• The warrants are classified as equity and the sales proceeds have been allocated based upon the relative fair values of the instruments (refer to Example 3-5).

• The sales proceeds allocated to the convertible debt are $700,000 and the amount allocated to the warrants is $300,000.

• The convertible debt has a stated conversion price of $20 per share and the issuer’s stock price at the commitment date is $18 per share.

Questions:How would Company A calculate a BCF, if any?

What is the journal entry Company A would record to reflect issuance of the convertible debt and warrants and the granting of a BCF in the convertible debt, if applicable?

Analysis/Conclusion: Step 1: Calculate the accounting conversion price

The accounting conversion price is equal to (a) the proceeds allocated to the convertible debt divided by (b) the contractual number of shares underlying the conversion option

$700,000 / 50,000 = $14

(50,000 shares = $1,000,000 principal / $20 conversion price)

Step 2: Determine if there is a BCF

Compare the issuer’s stock price at the commitment date to the accounting conversion price; if the issuer’s stock price is greater than the accounting conversion price, a BCF exists

$18 > $14, BCF exists

Step 3: Calculate value of BCF

BCF is equal to:

(issuer’s stock price – accounting conversion price) x contractual number of shares

($18 – $14) x 50,000 = $200,000

(continued)

3 - 16 / Analyzing Put and Call Options and Other Features and Arrangements

Step 4: Record journal entry

Dr Cash $1,000,000Dr Discount on convertible debt 500,000

Cr Convertible debt $1,000,000Cr Additional paid in capital (warrants) 300,000Cr Additional paid in capital (BCF) 200,000

3.5.2 Commitment Date

The commitment date is the date when an agreement has been reached with an unrelated party that is binding on both parties, usually legally enforceable, and has the following characteristics:

• The agreement specifies all significant terms, including the quantity to be exchanged, the fixed price, and the timing of the transaction. The fixed price may be expressed as a specified amount of an entity’s functional currency or of a foreign currency. It may also be expressed as a specified interest rate or specified effective yield.

• The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable. In the legal jurisdiction that governs the agreement, the existence of statutory rights to pursue remedies for default equivalent to the damages suffered by the nondefaulting party, in and of itself, represents a sufficiently large disincentive for nonperformance to make performance probable.

In practice there is rarely a commitment date prior to the issuance date (the date the cash and securities have been exchanged). This is because if there are subjective provisions that permit either party to rescind the transaction, the commitment date does not occur until the earlier of the expiration of the provisions or the date the convertible financial instrument is issued. Examples of subjective provisions that permit either party to rescind its commitment are:

• A material adverse change clause (included in most purchase agreements).

• A provision allowing for customary due diligence or shareholder approval.

The commitment date used to measure any BCF in a convertible instrument issued due to the exercise of a greenshoe (see FG section 7.10.2) is the date the under-writer exercises the greenshoe. Prior to then, there is no commitment on the part of the underwriter to purchase the instrument from the issuer. It is possible for a convertible instrument which was initially priced out of the money on the original commitment date to become in the money (resulting in a BCF charge) if the stock price appreciates between the two closing dates.

3.5.3 Contingent BCF Measurement

As noted in ASC 470-20-25-6 a contingent BCF should be measured using the commitment date stock price and recognized in earnings when the contingency is resolved. However, the point at which the BCF is measured can differ.

• Contingent BCFs that can be measured at the commitment date (for example, a conversion option whose conversion price is reset to a specified price below the commitment date price if an IPO occurs) should be measured at the commitment date.

Analyzing Put and Call Options and Other Features and Arrangements / 3 - 17

• Contingent BCFs that involve changes to conversion terms triggered by future events not controlled by the issuer should be measured when the triggering event occurs.

Example 3-8: Contingent BCF Recognition and Measurement

Background/Facts:Company A issues Series Z convertible preferred stock, which includes a provision that adjusts the conversion price for common stock dividends to protect the value of the Series Z conversion right. More specifically, the conversion price of outstanding Series Z shares will adjust from the initial stated conversion price to a lower conversion price, resulting in the Series Z shares converting into a greater number of common shares.

Five years after the issuance of the Series Z shares, Company A issues a special dividend. As a result of the special dividend, the conversion price of the outstanding Series Z shares is adjusted to a level that creates a BCF.

Question:When and how should Company A measure and recognize the contingent BCF on the Series Z shares triggered by issuance of the special dividend?

Analysis/Conclusion: The Series Z shares contain a contingent BCF that was triggered upon declaration of the special dividend. Since the contingent BCF on the Series Z shares could not be measured at the commitment date, ASC 470-20-35-1 requires the company to wait until the contingent event occurs. The contingent BCF is measured when Company A declares the special dividend by calculating the in-the-money amount. This is the difference between (1) the price of Company A’s shares at the commitment date and (2) the accounting conversion price of the Series Z shares after the conversion price is adjusted for the special dividend.

When the special dividend is declared, the contingency is resolved and the contingent BCF should be recognized.

3.5.4 Amortization of BCF Discount

For convertible preferred securities and convertible debt, a discount to the par value arises from the allocation of a portion of the proceeds to additional paid in capital (APIC) for the intrinsic value of the BCF.

For nonredeemable convertible instruments, such as perpetual convertible preferred stock, the discount created by the BCF is amortized through the date of earliest conversion. For instruments that are immediately convertible, a deemed dividend (and corresponding EPS effect) is recognized immediately.

For redeemable instruments, the BCF discount is amortized as a deemed dividend on preferred stock or deemed interest on debt, with a corresponding increase to the carrying value of the convertible security. ASC 470-20-35-7 requires amortization of the BCF discount over the period from the date of issuance to the stated redemption date of the convertible instrument, regardless of when the earliest conversion date occurs.

3 - 18 / Analyzing Put and Call Options and Other Features and Arrangements

3.6 Mezzanine (Temporary) Equity Classification

For SEC registrants, ASC 480-10-S99 addresses the financial statement classification and measurement of preferred stock that is redeemable or may become redeemable at a fixed or determinable price on a fixed or determinable date, at the option of the holder, or upon the occurrence of an event that is not solely within the control of the issuer. Although the rule specifically discusses preferred securities, the SEC staff has long maintained that this guidance should be applied to other equity instruments. This guidance may apply to:

• Certain convertible and redeemable preferred stock instruments that are classified as equity rather than as debt instruments.

• Redeemable noncontrolling interests.

• The equity-classified component of convertible debt with a cash conversion feature (FG section 7.4).

• BCFs allocated to equity (FG section 3.5).

The guidance in ASC 480-10-S99 is based on Rule 5-02.28 of Regulation S-X. It requires equity classified instruments redeemable for cash or other assets to be classified outside of permanent equity if their redemption is:

• At a fixed or determinable price on a fixed or determinable date,

• At the option of the holder, or

• Based upon the occurrence of an event that is not solely within the control of the issuer.

The existence of a contractual redemption provision gives rise to mezzanine equity classification even if the redemption is contingent upon the occurrence of a future event that is outside of the issuer’s control. A probability assessment of whether a redemption event’s occurrence is remote is not permitted; that is, mezzanine equity classification is required even though the likelihood of redemption is considered remote.

Examples of contingent/conditional redemption provisions that may require mezzanine equity classification of the related instrument are as follows:

• The company is delisted from trading on any stock exchange on which it is listed.

• The company fails to file a registration statement by a certain date or make timely SEC filings.

• Change in control of the company due to merger, consolidation, or otherwise.

• The company fails to effect an IPO.

• A registration statement is not declared effective by a stated date.

• The company has a debt covenant violation.

• The failure to achieve specified earnings targets.

There are many other conditions or events provided for in the terms of securities that are outside the control of the company and trigger redemption at the option of the holder and therefore require classification as mezzanine equity.

Analyzing Put and Call Options and Other Features and Arrangements / 3 - 19

Securities in the scope of this guidance are required to be classified outside of permanent equity in mezzanine equity, whether they are currently redeemable or not. However, an exception to this general rule is provided for the equity-classified component of convertible debt with a cash conversion feature as defined in FG section 7.4 or a BCF classified as equity. Under the exception, all or a portion of the equity-classified component must be classified in mezzanine equity only in periods in which the convertible instrument is currently redeemable or convertible for cash or other assets. See FG section 7.4.3 for a discussion of mezzanine classification of the equity-classified component of convertible debt with a cash conversion feature. The exception also requires the unamortized portion of the BCF to be classified as mezzanine equity only in periods the convertible instrument is currently redeemable. The requirement to classify the BCF as mezzanine equity does not change the measurement of the BCF or the period over which it is amortized. It is merely a balance sheet presentation requirement.

Although the SEC’s guidance is aimed at public entities, we believe that the mezzanine equity presentation is preferable for a non-public entity’s instruments that meet these criteria.

Example 3-9: Classification of BCF

Background/Facts:• Company A issued Series Z convertible preferred stock that is puttable in years

3–5 but not before then. If the Series Z shares are not put after year 5, they are automatically converted into common shares.

• The Series Z shares contain a BCF.

• Based upon the guidance in ASC 480-10-S99-3A the classification of the Series Z shares is determined to be mezzanine equity.

Question:How should Company A classify the BCF?

Analysis/Conclusion: The BCF should be recorded in equity in the period the instrument is not puttable (years 1 and 2). When the instrument becomes puttable (in years 3 through 5) the remaining BCF should be reclassified into mezzanine equity.

3.7 Issuance Costs

Issuance costs are specific incremental costs directly attributable to an offering of equity or debt securities. Costs that qualify as issuance costs include printing bonds and other documents, commissions, investment banker fees, due diligence costs, legal and accounting costs, underwriter fees, registration and listing fees, and other external, incremental expenses paid to advisors that are directly attributable to the instrument issued. Costs that do not qualify as issuance costs include cash bonuses to employees, employee performance stock options wherein the milestone is raising capital through the issuance of equity shares, and premiums for Directors and Officers’ insurance policies (even if mandated by the underwriters).

3 - 20 / Analyzing Put and Call Options and Other Features and Arrangements

3.7.1 Equity Issuance Costs

Costs of obtaining new capital by issuing common or preferred stock that is classified as permanent equity are considered a reduction of the related proceeds, and the net amount should be recorded in permanent equity (i.e., as a reduction of the carrying value of the related equity capital). If the shares are classified as permanent equity, it is preferable that issue costs be charged directly to additional paid in capital. However, retained earnings may be charged when applicable regulations prohibit charging stock issue costs to paid in capital accounts.

Issuance costs related to preferred stock that is classified in the mezzanine section of the balance sheet should be recorded in the mezzanine section as a reduction of the related proceeds from such securities (i.e., the securities would be reported at the net carrying amount). Subsequent accretion, if required, is based on increasing this net recorded amount to the redemption amount.

The accounting for issuance costs related to common or preferred shares that are classified as a liability and not remeasured at fair value should generally be treated in the same manner as debt issuance costs.

3.7.2 Debt Issuance Costs

Debt issuance costs should be reported on the balance sheet as deferred charges. Deferred debt issuance costs are subsequently amortized using the interest method to interest expense, generally over the contractual life of the debt. If the fair value option is elected for a debt instrument, issuance costs should be expensed immediately.

3.7.2.1 Convertible Debt with a Cash Conversion Feature

The issuer of a convertible debt instrument with a cash conversion feature should bifurcate the convertible debt into a debt and an equity component, as described in FG section 7.4. Costs associated with the issuance of a convertible debt instrument with a cash conversion feature should be allocated between the debt and equity components in proportion to the allocation of the proceeds.

The portion of the debt issuance costs allocated to the debt component should be amortized using the interest method. In applying the interest method to instruments with a cash conversion feature the debt issuance costs should be amortized over the expected life of a similar liability without an associated equity component (considering the effects of any embedded features other than the conversion option, such as prepayment options). It should also be noted that if an issuer uses an income valuation approach, or a valuation technique that is consistent with that approach, to measure the fair value of the debt component at initial recognition, the issuer should consider the periods of cash flows used to measure fair value when identifying the appropriate discount amortization period. The expected life is not reassessed in subsequent reporting periods unless the instrument is modified.

3.7.2.2 Units Structures

Issuance costs associated with the issuance of units structures (FG section 9.3), such as debt with detachable warrants or mandatory units (FG section 9.3.2) should generally be allocated between the components in a rational manner. Some issuers allocate issuance costs based on the relative fair values of the base instrument and of the share issuance contract. Another method used by issuers is the with-and-without method.

Analyzing Put and Call Options and Other Features and Arrangements / 3 - 21

3.7.3 Amortization of Issuance Costs

When the fair value option is not elected, the issuance costs for instruments classified as liabilities should be amortized over the contractual life of the instrument using the interest method. Other methods of amortization may be used if the results obtained are not materially different from those that would result from use of the interest method. The contractual life of the instrument should be used to amortize the issuance costs unless embedded features in the instrument support a shorter life over which to amortize the issuance costs. For example, if a debt instrument is puttable an issuer may fully amortize the debt issuance costs by the first put date, not over the instrument’s contractual life.

3.8 Registration Payment Arrangements

Registration rights may be provided to investors in the form of a separate agreement, such as a registration rights agreement, or included as part of an investment agreement, such as an investment purchase agreement, warrant agreement, debt indenture, or preferred stock indenture. The guidance in ASC 825-20 applies to the issuer of a registration payment arrangement whether it is issued as a separate agreement or included as part of another agreement. A registration payment arrangement is an arrangement with both of the following characteristics:

• It specifies that the issuer will endeavor to (1) file a registration statement for the resale of specified financial instruments (or for the resale of equity shares that are issuable upon exercise or conversion of specified financial instruments) that is declared effective by the SEC or other applicable securities regulators and/or (2) maintain the effectiveness of the registration statement for a specified period of time or in perpetuity, and

• It requires the issuer to transfer consideration to the counterparty (investor) if the registration statement for the resale of the financial instrument or instruments subject to the arrangement is not declared effective or if effectiveness of the registration statement is not maintained.

ASC 825-20 does not apply to the following arrangements:

• Those that require registration or listing of convertible debt instruments or convertible preferred stock if the form of consideration that would be transferred to the investor is an adjustment to the conversion ratio.

• Those in which the amount of consideration transferred is determined by reference to (a) an observable market, other than the market for the issuer’s stock, or (b) an observable index.

• Those in which the financial instrument or instruments subject to the arrangement are settled when the consideration is transferred. An example is a common stock warrant that is contingently puttable if an effective registration statement for the resale of the equity shares that are issuable upon exercise of the warrant is not declared effective by the SEC within a specified time period.

There is no recognition of a registration payment arrangement unless transfer of consideration under such an arrangement is probable and the payment amount or a range of payment amounts can be reasonably estimated. In that case, the contingent liability under the registration payment arrangement should be included in the allocation of proceeds from the related financing transaction. The remaining proceeds should be allocated to the financial instruments issued in conjunction with

3 - 22 / Analyzing Put and Call Options and Other Features and Arrangements

the arrangement based on the provisions of other GAAP. For example, if debt and equity classified warrants are issued with a registration payment arrangement, the registration payment proceeds are first recognized and measured under ASC 450. The remaining proceeds are allocated on a relative fair value basis between the debt and the warrants.

Example 3-10: Registration Payment Arrangement

Background/Facts:• Company A issues $50 million of notes in a private placement. In connection

with the offering Company A enters into a registration payment arrangement that requires Company A to (1) file a registration statement with the SEC within 90 days of the offering’s closing date and (2) once the registration statement is effective, to maintain effectiveness for three years.

• If the registration statement is not declared effective or if it ceases to be effective during the 3 year period, investors are entitled to an increase of 40 basis points of interest per year.

• At closing Company A files a registration statement with the SEC within 90 days. However, after one year Company A determines that the effectiveness of the registration statement will not be maintained for some portion of the remaining two years. Company A determines that the registration statement will not be effective for a period between 1 and 1.5 years.

Question:How should Company A estimate the range of loss and account for the obligation to investors?

Analysis/Conclusion: Company A should record a contingent liability under ASC 450 when it is probable that the company will be required to remit payments and the range of loss can be reasonably estimated.

The range of loss would be between $200,000 ($50 million x 0.4% x 1 year) and $300,000 ($50 million x 0.4% x 1.5 years). Company A would then determine if an amount within the range is a better estimate than any other amount and accrue that amount. In the event no amount within the range is a better estimate, then the minimum amount should be accrued.

Earnings per Share / 4 - 1

Chapter 4: Earnings per Share

4 - 2 / Earnings per Share

4.1 Basic and Diluted Earnings per Share

ASC 260-10 requires public companies to report both basic and diluted earnings per share (EPS) as of each reporting period.

• Basic EPS is calculated by dividing earnings available to common shareholders by the number of weighted average common shares outstanding. It is impacted by interest expense, preferred stock dividends, and the issuance of shares in connection with financing transactions.

• Diluted EPS is calculated by dividing earnings available to common shareholders by the number of weighted average common shares outstanding plus potentially issuable shares, such as those that result from the conversion of a convertible instrument or exercise of a warrant. Diluted EPS can be impacted by equity-linked financing transactions in complex, and sometimes unexpected, ways.

In this chapter we explain several methodologies used in calculating EPS and highlight some of the key considerations in determining which method should be used to include a particular instrument in EPS.

4.2 Anti-Dilution and Sequencing of Instruments

Instruments that, if included in diluted EPS, would increase diluted EPS as compared to basic EPS (or decrease a loss per share amount) are considered anti-dilutive and should generally not be included in the calculation of diluted EPS. Examples of anti-dilutive instruments include purchased call options on a company’s own stock as well as many prepaid share repurchase contracts, such as accelerated stock repurchase contracts and prepaid written put options. However, market conditions impacting each contract must be evaluated to determine whether it is dilutive or anti-dilutive in any given reporting period. An instrument that is anti-dilutive and excluded from diluted EPS in one reporting period (for example, due to a company’s current stock price being lower than the exercise price of a warrant) may be dilutive in another period and should be included in diluted EPS.

In determining whether potential common shares are dilutive, each instrument should be considered separately, rather than in the aggregate. Instruments should be considered in sequence from the most dilutive to the least dilutive. That is, potential dilutive common shares with the lowest “earnings add-back per incremental share” shall be included in diluted EPS before those with a higher “earnings add-back per incremental share.” Each instrument should be included sequentially in the diluted EPS calculation until the next instrument is incrementally anti-dilutive.

4.3 If-Converted Method

Share settled convertible debt and convertible preferred stock are generally included in diluted EPS using the if-converted method. Convertible debt with a cash conversion feature (as discussed in FG section 7.4), on the other hand, is typically included in diluted EPS using a method similar to the treasury stock method (see discussion in FG section 4.6).

Whether a convertible instrument is dilutive under the if-converted method is determined by the adjustments to the numerator (e.g., interest expense on a convertible debt instrument) and the denominator (shares to be delivered upon conversion) of the diluted EPS calculation as compared to basic EPS. The required adjustments are not affected by the issuer’s current stock price in relation to the conversion price. That is, a convertible security has the same effect on diluted EPS

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when the conversion option is very out of the money (i.e., the security has little chance of being converted) as it does when it’s deep in the money (i.e., the security has a high likelihood of being converted). The adjustments to the diluted EPS numerator and denominator required under the if-converted method are discussed in FG sections 4.3.1 and 4.3.2.

Convertible securities that have a dilutive effect on EPS should be included in the weighted average shares outstanding for purposes of calculating diluted EPS from the beginning of the period or from the time of issuance, if later. Dilutive convertible securities that are extinguished or redeemed should be included in weighted average shares outstanding for the period that they were outstanding as should securities in which the conversion options lapse. Also, dilutive convertible securities converted during the period are included in the weighted average number of shares outstanding for purposes of calculating diluted EPS for the period prior to their conversion. Thereafter, the shares issued are included in the weighted average calculation of shares outstanding used for both basic and diluted EPS.

4.3.1 Application to Convertible Debt

Under the if-converted method, income available to common shareholders would be adjusted as follows for a convertible debt instrument:

• Interest expense related to the convertible debt, including deemed interest expense from amortization of a beneficial conversion feature or other discount, is added back.

• Nondiscretionary adjustments based on income made during the period that would have been computed differently had the interest on convertible debt not been recognized are eliminated.

• The income tax effect of both the interest expense and nondiscretionary adjustments would also be reflected in the adjustment.

The diluted EPS denominator should be increased by the number of shares issuable upon conversion of the convertible debt as though the instrument were converted at the beginning of the reporting period, or as of the issuance date, if later.

If the number of shares to be issued upon conversion varies based on (1) the stock price at the conversion date, (2) an average of stock prices around the conversion date, or (3) a formula based on stock prices, the number of shares included in the diluted EPS denominator should be determined by applying the conversion formula to the stock prices at the end of the reporting period.

Example 4-1: Application of the If-Converted Method

Background/Facts:On January 1, 2011, Company A issued $10 million of convertible bonds (10,000 bonds) in $1,000 increments, at par, to investors. On the issuance date, Company A’s common stock price was $100 per share. The terms of the bonds include:

• A coupon rate of 2.00 percent paid semi-annually, which results in after-tax interest expense of $30,000 per quarter ($10 million x 2% x 1/4 = $50,000 less income tax of $20,000 (40% tax rate x $50,000)).

(continued)

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• A requirement that Company A deliver 8 shares per bond to investors upon conversion (which equates to a conversion price of $125), or 80,000 shares (10,000 bonds x 8 shares per bond) in total.

Company A has 10,000,000 weighted average common shares outstanding and net income for the quarter ended March 31, 2011, is $50,000,000.

Question:How should Company A include the convertible bonds in the diluted EPS calculation for the period ended March 31, 2011?

Analysis/Conclusion:Company A should include the convertible bond in diluted EPS using the if-converted method, if it is dilutive.

Basic EPS Adjustments Diluted EPS

Earnings $50,000,000 $30,000 $50,030,000

Weighted average common shares and common share equivalents 10,000,000 80,000 10,080,000

EPS $ 5.00 $ 4.96

Example 4-2: Capitalized Interest

Background/Facts:• Company A issued $10,000,000 of convertible notes in January. The notes have a

10-year term and bear interest at 5 percent per year.

• Company A capitalized $50,000 of interest on these notes under the provisions of ASC 835-20 during the year ended December 31, 2011.

Question:Should the capitalized interest be added back to earnings available to common shareholders when calculating diluted EPS?

Analysis/Conclusion: No. Capitalized interest is not a current period expense. If interest associated with the convertible debt is capitalized, assumed conversion of the debt at the beginning of the current period would likely not have affected earnings available to common shareholders. The issuer should, however, consider whether assumed conversion at the beginning of the period would have ultimately impacted earnings. To do this, the issuer should perform a “with conversion” and “without conversion” calculation of capitalized interest to determine if assumed conversion at the beginning of the period would have affected earnings in the current period.

4.3.2 Application to Convertible Preferred Stock

In the case of convertible preferred stock, income available to common shareholders would be adjusted as follows:

• Preferred dividends, declared or cumulative (even if undeclared), related to the convertible preferred stock are added back.

Earnings per Share / 4 - 5

• Deemed dividends in the period from amortization of a beneficial conversion feature or inducement charge are added back.

• Any adjustments charged or credited to equity in the period to accrete preferred stock to its cash redemption price are added back/deducted.

The diluted EPS denominator should be increased by the number of shares issuable upon conversion of the convertible preferred stock as though the instrument was converted at the beginning of the reporting period, or as of the issuance date, if later.

If the number of shares to be issued upon conversion varies based on (1) the stock price at the conversion date, (2) an average of stock prices around the conversion date, or (3) a formula based on stock prices, the number of shares included in the diluted EPS denominator should be determined by applying the conversion formula to the stock prices at the end of the reporting period.

Example 4-3: Conversion During Reporting Period

Background/Facts:• Company A had $50,000,000 of convertible preferred stock outstanding for the

period January 1 to June 30 of the current year.

• On June 30 the holders of the preferred stock exercised their conversion option and converted the preferred stock into common shares.

Question:Should the convertible securities be included in diluted EPS for the annual reporting period ended December 31 even though they are no longer outstanding at the end of the reporting period?

Analysis/Conclusion: Yes, dilutive convertible securities converted (or extinguished) during a period should be included in diluted EPS for the period of time they were outstanding prior to their conversion (or extinguishment) using the if-converted method.

The if-converted method assumes that the instrument is converted as of the beginning of the reporting period. If convertible preferred shares were converted at the beginning of the reporting period, there would be no dividends during the period. Therefore, any dividends reflected prior to the conversion or extinguishment date, and any charge/credit on conversion or extinguishment, should be added back to earnings available to common shareholders.

The number of shares deliverable upon conversion should be included in weighted average shares outstanding for diluted EPS for the period prior to conversion or extinguishment. If common shares are issued upon conversion, those shares are included in the weighted average number of shares outstanding (used to calculate both basic and diluted EPS) for the period from their date of issuance through period-end.

4.4 Treasury Stock Method

The treasury stock method is generally used to include forward sale contracts, options, and warrants on an issuer’s stock in diluted EPS. To apply the treasury stock method:

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• Exercise or settlement of the instrument is assumed at the beginning of the period (or at the time of issuance, if later) and common shares are assumed to have been issued.

• The proceeds from exercise or settlement are assumed to have been used to repurchase the company’s common shares at their average market price during the period.

• The incremental shares (shares assumed to be issued less shares assumed to have been repurchased) are included in the denominator of the diluted EPS calculation.

Dilutive instruments that are (1) issued, (2) expire unexercised or (3) are cancelled during the period should be included in the weighted average number of shares outstanding for purposes of calculating diluted EPS for the period that they were outstanding. Additionally, dilutive instruments exercised during the period should be included in the weighted average number of shares outstanding for purposes of calculating diluted EPS for the period prior to exercise. Thereafter, the shares issued will be included in the weighted average calculation of shares outstanding used for both basic and diluted EPS.

As discussed in ASC 260-10-55-9, to apply the treasury stock method to an option (or warrant) that permits or requires the holder to tender securities (e.g., debt) of the issuer to pay some or all of the strike price, the issuer should assume the option is exercised and the security is tendered in calculating diluted EPS if that is more advantageous to the holder. This methodology also applies to forward contracts that permit or require the holder to tender securities to pay some, or all, of the forward price.

• If securities are assumed to be tendered, interest (net of tax) or dividends associated with the security should be added back to income available to common shareholders in the numerator. The total shares underlying the contract are assumed to be issued.

• If cash is assumed to be tendered, the treasury stock method should be applied to determine the number of incremental shares associated with settlement or exercise of the instrument.

Example 4-4: Application of the Treasury Stock Method

Background/Facts:• Company A has outstanding warrants to issue 500,000 shares of its common

stock.

• The warrants have a strike price of $10 per share.

• The average market price of the common stock during the period is $20.

Question:How should Company A include the warrants in the diluted EPS calculation for the period?

Analysis/Conclusion: Company A should include the incremental shares calculated using the treasury stock method in the denominator of the diluted EPS calculation.

(continued)

Earnings per Share / 4 - 7

The incremental shares are calculated assuming the warrants are exercised at the beginning of the periods, as follows:

Step 1: Calculate the assumed proceeds

Assumed proceeds = Number of warrants x strike price

$5,000,000 = 500,000 x $10

Step 2: Calculate the shares to be repurchased

Shares = Assumed proceeds / average market price

250,000 = $5,000,000 / $20

Step 3: Calculate the incremental shares assumed to be issued

Incremental shares = Common shares issued upon exercise of warrants – shares to be repurchased

250,000 = 500,000 – 250,000

4.5 Instruments Settlable in Cash or Shares

Certain instruments may allow the issuer, at its election, to settle in cash or shares.

Under ASC 260-10-55-32 through 55-36A, when the entity has the choice of, and controls the settlement method, share settlement should be presumed for EPS purposes. However, this presumption may be overcome, and cash settlement may be assumed, when there is a past practice or substantive stated policy that provides a reasonable basis to believe that the contract will be paid partially or wholly in cash.

The SEC staff looks to a number of factors in evaluating whether a company’s stated policy to cash settle a portion of its convertible debt instruments is substantive, including:

• Settlement alternatives as a selling point—the extent to which the ability to share settle factored into senior management’s decision to approve the issuance of the instrument rather than an instrument that only allowed for cash settlement.

• Intent and ability to cash settle—the extent to which the company has the positive intent and ability to cash settle the face value and interest components of the instrument upon conversion. Both current and projected liquidity should be considered in determining whether positive intent and ability exists. Management’s representation attesting to the company’s positive intent and ability to cash settle is also a factor.

• Disclosure commensurate with the company’s intention—the extent to which the disclosures included in current period financial statements, as well as those included in the instrument’s offering documents, acknowledge and support the company’s positive intent and ability to adhere to its stated policy.

• Past practice—whether the company has previously share-settled contracts that provided a choice of settlement alternatives.

If the instrument provides the counterparty (or investor) with the choice of settlement method, the more dilutive outcome should be utilized each period.

4 - 8 / Earnings per Share

For contracts accounted for as equity that are treated as cash settled for EPS, an adjustment should be made to income available to common shareholders when computing diluted EPS to reflect the income or loss on the contract that would have resulted during the period if the contract had been reported as an asset or liability. Similarly, in computing the more dilutive effect of cash or share settlement for a contract that provides the holder a choice of settlement method (and is being accounted for as a liability with changes in fair value recorded in earnings), the calculation of assumed share settlement would include an adjustment of the diluted EPS numerator to eliminate the effects of the contract that have been recorded in net income and an adjustment of the denominator to include the impact of the share settled contract.

4.6 Convertible Debt with a Cash Conversion Feature

Most convertible debt with a cash conversion feature (FG section 7.4) is included in diluted EPS using a method similar to the treasury stock method, which is illustrated in ASC 260-10-55-84 through 55-84B. Under this method:

• There is no adjustment for the cash-settled portion of the instrument; interest expense (including the accretion of the discount created by separating the equity component at issuance) remains in income available to common shareholders (i.e., the numerator of the diluted EPS calculation).

• The number of shares included in the denominator of the diluted EPS calculation is determined by dividing the “conversion spread value” by the share price. The “conversion spread value” is the value that would be delivered to investors in shares based on the terms of the bond, upon an assumed conversion. An issuer should elect a policy of determining the share price to be used to calculate diluted EPS. We believe an average share price over the reporting period or the share price at the end of the reporting period are both permissible.

However, the issuer of a debt instrument that may settle in any combination of cash or stock at the issuer’s option (known in practice as an Instrument X bond) must consider the guidance on instruments settlable in cash or shares (FG section 4.5).

• If the issuer has a stated policy or past practice of settling the principal amount of the debt instrument in cash and the conversion spread value in shares, diluted EPS should be calculated using the method described above.

• If the issuer cannot assert a stated policy to settle the principal amount of the debt instrument in cash, or has a past practice of settling similar debt instruments entirely in shares, the issuer may need to include the debt instruments in diluted EPS using the if-converted method (FG section 4.3.1).

4.7 Contingently Convertible Instruments

Some conversion options can only be exercised by the investor upon satisfaction of a contingency. There are two broad categories of conversion option contingencies:

• Contingencies tied to an event or index other than the issuer’s stock price—for example, the investor can only exercise the conversion option upon the issuer’s successful completion of an IPO.

• Contingencies tied to the issuer’s stock price—for example, the investor cannot exercise the conversion option until the issuer’s stock price reaches a level of 120% of the conversion price.

Earnings per Share / 4 - 9

If the instrument’s conversion is based on achieving a substantive contingency based on an event or index other than the issuer’s stock price, the instrument would not be included in diluted EPS until the non-market based contingency has been met or is being met based on circumstances at the end of the reporting period.

On the other hand, contingently convertible instruments that are tied to the issuer’s stock price must be treated in the same manner as other convertible securities and included in diluted EPS, if the effect is dilutive, regardless of whether the stock price trigger has been met.

Depending on the terms of the security, it could be included in diluted EPS using either the if-converted method (FG section 4.3) or a method that approximates the treasury stock method in the case of a convertible bond with a cash conversion feature (FG section 4.6).

4.8 Participating Securities/Two-Class Method of Calculating Basic and Diluted EPS

The two-class method is an earnings allocation method that treats a participating security as having rights to earnings that otherwise would have been available to common shareholders. As defined in ASC 260-10-20, a participating security is any security that may participate in undistributed earnings with common shareholders. The form of the participation does not have to be a dividend. Any form of participation in undistributed earnings constitutes participation by that security, regardless of whether the payment is referred to as a dividend unless participation is contingent upon a future event, such as the subsequent exercise of an option (FG section 4.8.1). The key to applying the two-class method is identifying the instruments that, in their current form (i.e., prior to exercise, settlement, conversion, or vesting), are entitled to receive dividends if and when declared on common stock.

Under the two-class method, an issuer deducts common and preferred stock dividends declared as well as undeclared contractual preferred stock dividends from current period earnings to determine the amount of undistributed earnings to be allocated to equity holders. The undistributed earnings are allocated between the common shareholders and the participating security holders based on their respective rights to receive dividends as if all undistributed earnings for the period were distributed. The allocation of earnings is based on reported income and the terms of the participating security, without regard to the practical or legal limitations of the issuer paying dividends.

Losses are allocated to a participating security only if the terms of the security include a contractual obligation requiring the participating security holder to share in the losses of the issuing entity on a basis that is objectively determinable. Since this is often not the case, participating securities will generally be allocated earnings in periods of net income, but not allocated losses in periods of net loss. Although this treatment is not symmetrical, it is consistent with the notion that EPS should reflect the most dilutive results. The determination of whether a participating security holder has an obligation to share in the losses of the issuing entity in a given period should be made on a period by period basis.

The two-class method does not require the presentation of basic and diluted EPS for securities other than common stock; however, it is not precluded.

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Example 4-5: Application of the Two-Class Method

Background/Facts:• Company A has 10,000,000 shares of common stock and 2,000,000 shares of

convertible preferred stock (issued at $10 par value per share) outstanding.

• Company A’s net income is $50,000,000.

• Each share of preferred stock is convertible into 3 shares of common stock.

• The preferred stock participates on a 1:1 basis in any common dividends that would have been payable had the preferred stock been converted immediately prior to the record date of any dividend declared on the common stock (i.e., as converted basis).

• At year-end, dividends of $2 per share were paid to the common stockholders. Preferred shareholders were paid $6 per share since each preferred share converts into 3 common shares.

Question:What would basic EPS be under the two-class method?

Analysis/Conclusion: Step 1: Calculate the undistributed earnings

Net income $50,000,000Less dividends declared:

Common stock1 $20,000,000Participating preferred stock dividend2 12,000,000 32,000,000

Undistributed earnings $18,000,000

1 Common stock dividend $20,000,000 = 10,000,000 shares x $2 dividend

2 Participating preferred stock dividend $12,000,000 = 6,000,000 “as converted” shares of common stock (2,000,000 preferred shares x 3 shares of common stock per share of preferred) x $2 per share dividend paid on common stock.

Step 2: Allocate undistributed earnings to the two classes

To common:

[(Common shares outstanding) / (common shares outstanding + “as converted” shares of preferred)] x undistributed earnings

[(10,000,000) / (10,000,000 + 6,000,000)] x 18,000,000 = $11,250,000

Per share amount:

$11,250,000 / 10,000,000 = $1.13 per share

To preferred:

[(“As converted” common shares) / (common shares outstanding + “as converted” shares of preferred)] x undistributed earnings

[(6,000,000) / (10,000,000 + 6,000,000)] x 18,000,000 = $6,750,000

(continued)

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Per share amount:

$6,750,000 / 2,000,000 = $3.38

Step 3: Allocate the total amount between distributed and undistributed earnings

Common Stock Preferred Stock Total

Distributed earnings $20,000,000 $12,000,000 $32,000,000Undistributed earnings 11,250,000 6,750,000 18,000,000Total $31,250,000 $18,750,000 $50,000,000

Step 4: Calculate basic earnings per share amounts

Note that the presentation of EPS is only required for each class of common stock and not for preferred stock or other participating securities. However, companies are not precluded from showing EPS for other participating securities.

Common Stock Preferred Stock

Distributed earnings $2.00 $6.00Undistributed earnings 1.13 3.38Total $3.13 $9.38

Example 4-6: Participating Securities with a Conversion Feature

Background/Facts:• Company A issued Series B convertible preferred stock.

• The provisions of the stock agreement allow the holder of the instrument to receive dividends paid and distributed to the holders of the common stock.

• Based upon the provisions set forth in the stock agreement, Company A determines that the Series B convertible preferred shares are participating securities.

Question:What method should Company A use to calculate basic EPS, the if-converted method or the two-class method?

Analysis/Conclusion: ASC 260-10-45-60A confirms that convertible participating securities must be included in basic EPS using the two-class method. The if-converted method should only be used for purposes of calculating diluted EPS if the effect is dilutive.

4.8.1 Adjustments to Exercise or Conversion Prices

Participation may not always involve the right to receive dividends in cash. For many equity-linked securities, dividends do not get paid to investors when declared on common stock. Instead, the conversion or exercise price of the security may be adjusted for dividends above a specified threshold to keep the investor whole. In some cases, those adjustments may constitute participation rights.

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4.8.1.1 Adjustments to Convertible Securities and Options

As stated in ASC 260-10-45-62, dividends transferred to an investor holding a convertible security in the form of a reduction of the conversion price or an increase in the conversion ratio of the security do not represent a participation right. This conclusion also applies to other optional securities on an issuer’s stock (e.g., options or warrants) if those securities provide for an adjustment to the exercise price that is tied to the declaration of dividends by the issuer. An adjustment to the conversion or strike price of an optional security represents a contingent transfer of value; the investor will only benefit from the adjustment if it converts or exercises the security and receives shares. The investor will not participate in dividends with common shareholders if the optional instrument expires without being converted or exercised.

An adjustment to a conversion price could however, create a contingent beneficial conversion feature. An issuer should assess whether an adjustment to the conversion price to compensate the holder for dividends creates a contingent beneficial conversion feature under the guidance in ASC 470-20-35-1 and FG section 3.5. If a dividend is declared and the conversion price is adjusted, there may be a charge to income available to common shareholders in the calculation of EPS because of a beneficial conversion feature.

If a convertible security has a mandatory conversion date and dividends or dividend equivalents are transferred to the investor in the form of a reduction of the conversion price or an increase in the conversion ratio of the security, then the instrument would be a participating security. In this case the transfer of value is not contingent on a decision to exercise.

4.8.1.2 Adjustments to Forward Contracts

Conversely, a provision that reduces the price paid in a forward sale contract on an issuer’s stock upon the declaration of a dividend does represent a participation right because it is a non-contingent transfer of value to the investor. In this case, the investor has a right to participate in the undistributed earnings of the issuer because a dividend declaration results in a transfer of value to the investor through a reduction in the forward purchase price per share. Because a forward contract must be settled and, therefore, the value transfer is not contingent—as opposed to a similar reduction in the exercise price of an option or warrant, which could expire unexercised—a forward contract with this type of provision is a participating security, regardless of whether a dividend is declared during the period the contract is outstanding.

4.8.1.3 Adjustments to Variable Share Forward Delivery Agreements

Variable share forward delivery agreements are typically components in mandatory units securities, such as ACES, PRIDES and DECS (FG section 9.3.2). In a variable share forward delivery agreement, the issuer sells its shares at a stated price, for example, for $50 per share in 3 years, with the number of shares to be issued dependent on the then current market price of the common stock. Typically, the investor is required to pay the stated price to the issuer at the settlement date. Economically, a variable share forward delivery agreement is a combination of a written call option and a purchased put option, each with different strike prices. For purposes of illustration, if after 3 years the stock price is:

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• Less than $50, the company will issue 1 share;

• Between $50 and $62.50, the company will issue a pro rata number of shares between 1 share and 0.8 share equal to a fixed dollar amount of $50;

• Greater than $62.50, the company will issue 0.8 shares.

The range between $50 and $62.50 is commonly referred to as the “dead zone.” If the issuer’s stock price at settlement falls within the dead zone, there is no transfer of value; the investor delivers $50 and the issuer delivers shares with a value equal to $50 based on the then current stock price.

Most variable share forward delivery agreements include an adjustment for dividends declared while the contract is outstanding as follows:

• The end points of the dead zone are adjusted downward.

• The number of shares delivered when the stock price at settlement is outside of the dead zone is also adjusted downward.

• There is no adjustment to the number of shares delivered when the stock price at settlement is within the dead zone.

As discussed above, an adjustment to an optional security, such as convertible debt or a warrant, is typically not considered a participation right whereas an adjustment to a forward sale contract where the holder will always receive the benefit of dividends if declared (i.e., there is always a transfer of value) is considered a participation right. The issuer of a variable share forward delivery agreement must determine whether any adjustment provisions included in its contract convey a contingent or a non-contingent transfer of value. Generally, a variable share forward delivery agreement is not considered a participating security provided:

• The agreement does not entitle the investor to participate in dividends if the final settlement is within the dead zone, and

• At issuance, it is at least reasonably possible that the final settlement of the contract will be at a price within the dead zone.

To determine whether it is reasonably possible for a particular variable share forward delivery agreement to settle at a price within the dead zone, an issuer may need to perform a quantitative evaluation that incorporates:

• The contractual terms of the agreement, including the method of adjusting for dividends and the maturity date,

• Volatility of the issuer’s stock,

• Historical and expected dividends, and

• How wide the dead zone is and whether the issuer’s stock price is inside or outside the dead zone at issuance.

This assessment must only be performed at issuance of the instrument; no subsequent evaluation need be performed.

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4.9 Share Lending Agreements

A convertible bond issuer may enter into a share lending agreement with an investment bank. A share lending agreement is intended to facilitate the ability of investors, primarily hedge funds, to borrow shares to hedge the conversion option in the convertible debt. Typically, they are executed in situations where the issuer’s stock is difficult or expensive to borrow in the conventional stock loan market.

The terms of a share lending arrangement typically require the issuer to issue shares to the investment bank in exchange for a small fee, generally equal to the par value of the common stock. Upon conversion or maturity of the convertible debt, the investment bank is required to return the loaned shares to the issuer. The shares issued are legally outstanding, entitled to vote and entitled to dividends, though under the terms of the arrangement the investment bank may agree to reimburse the issuer for dividends received and may agree to not vote on any matters submitted to a vote of the company’s shareholders.

See FG section 7.10.4 for a discussion of the recognition and measurement considerations of a share lending arrangement.

ASC 470-20-45-2A states that loaned shares are excluded from basic and diluted earnings per share unless default of the share lending arrangement occurs, at which time the loaned shares would be included in the basic and diluted EPS calculations. If dividends on the loaned shares are not reimbursed to the entity, any amounts, including contractual (accumulated) dividends and participation rights in undistributed earnings, attributable to the loaned shares would be deducted in computing income available to common shareholders, in a manner consistent with the two-class method (FG section 4.8).

Accounting for Modifications and Extinguishments / 5 - 1

Chapter 5: Accounting for Modifications and Extinguishments

5 - 2 / Accounting for Modifications and Extinguishments

5.1 Restructuring and Extinguishment

For a variety of reasons an issuer may modify the terms of an outstanding debt or equity security.

• A debt modification may be accounted for as (1) the extinguishment of the existing debt and the issuance of new debt or (2) a modification of the existing debt, depending on the extent of the changes.

• The accounting for the modification of an equity-classified instrument is typically dictated by the legal form of the transaction.

Alternatively, an issuer may decide to extinguish an instrument prior to its maturity. This may be done because of changes in interest rates or credit rating, changes in capital needs, or to mitigate the dilutive impact of the instrument, among other reasons. If a debt instrument is convertible, the issuer may instead decide to induce the investor to convert into equity by offering a cash or share “sweetener” for doing so, rather than extinguishing the instrument through the repayment of cash.

5.2 Analyzing a Debt Restructuring

A debt restructuring can be achieved in the following ways.

• Amending the terms or cash flows of an existing security.

• Exchanging existing debt for new debt with the same creditor.

• Repaying an existing debt obligation and contemporaneously issuing new debt with the same creditor. Although this is a legal extinguishment, the transaction must be analyzed under the relevant debt restructuring accounting guidance. See example 5-1.

The steps to determine the appropriate accounting treatment for a debt restructuring are illustrated in the following flowchart.

Analyzing a Debt Restructuring

Troubled Debt Restructuring? (FG section 5.3)

Debt Security/Term Loan or Line of Credit?

No

Line of CreditDebt Security orTerm Loan

Extinguishment or Modification?

Assess borrowing capacity

(FG section 5.5)

(FG section 5.4)

Accounting for Modifications and Extinguishments / 5 - 3

Example 5-1: Repayment of Debt Instrument with Contemporaneous Issuance of Debt

Background/Facts:• Company A has an outstanding loan (Loan 1) with Bank B with an unpaid balance

of $5 million.

• Company A pays Loan 1 in full.

• At the same time, Company A enters into a new loan agreement (Loan 2) with Bank B with a principal balance of $7.5 million.

Question:Should Company A assess the borrowing under Loan 2 as a restructuring of Loan 1?

Analysis/Conclusion:Yes, even though Loan 1 was legally extinguished, the transactions should be analyzed as a restructuring. Depending on several factors, this could result in accounting for the transaction as either (1) a troubled debt restructuring, (2) a modification of Loan 1, or (3) an extinguishment of Loan 1 and consummation of Loan 2.

5.3 Troubled Debt Restructurings (TDRs)

The first step in determining the appropriate accounting treatment for a debt restructuring is to assess whether it is a troubled debt restructuring (“TDR’’). A restructuring is a TDR if:

• The borrower is experiencing financial difficulties, and

• The lender grants a concession.

Both criteria are required to be met in order to have a TDR. ASC 470-60 requires both a qualitative and a quantitative analysis to determine whether the TDR criteria have been met.

A borrower that is experiencing financial difficulties should assess whether the lender has granted a concession in a debt restructuring, even if the restructuring results in the debt being fully satisfied with cash, other assets, or equity. See FG section 5.3.3.

In a restructuring in which the borrower grants an equity interest to the lender, the borrower should assess whether the equity grant triggers a change in control that requires push-down accounting to the reporting entity. For example, if a troubled debtor that is an SEC registrant settles its debt by giving a lender a 95 percent equity interest in the debtor, this could result in the new basis of the lender being pushed down to the debtor/reporting entity. This would result in a new basis of accounting for the reporting entity and business combination accounting guidance would be applied. In that case, the TDR may be recorded differently than described in this section.

5.3.1 Determining Whether the Borrower Is Experiencing Financial Difficulties

The first consideration in determining whether a borrower is experiencing financial difficulties is whether its creditworthiness has deteriorated since the debt was originally issued. As discussed in ASC 470-60-55-7, changes in an investment-grade credit rating are not considered a deterioration in creditworthiness for purposes

5 - 4 / Accounting for Modifications and Extinguishments

of this guidance. Conversely, a decline in credit rating from investment grade to noninvestment grade is considered a deterioration in the borrower’s creditworthiness.

If the creditworthiness of the borrower has deteriorated since the debt was originally issued, then the indicators of financial difficulty described in ASC 470-60-55-8 should be assessed. These indicators serve as examples of financial difficulty but are not all-inclusive; all aspects of the borrower’s current financial situation should be evaluated.

• The borrower is currently in default on its debt.

• The borrower has declared or is in the process of declaring bankruptcy.

• There is significant doubt as to whether the borrower will continue to be a going concern.

• The borrower’s securities have been, are in the process of, or are under threat of being delisted.

• Based on estimates and projections that only encompass the current business capabilities, the borrower forecasts that its entity-specific cash flows will be insufficient to service the debt (both interest and principal) in accordance with the contractual terms of the existing agreement through maturity.

• Absent the current modification, the borrower could not obtain funds from sources other than the existing creditors at an effective interest rate equal to the current market interest rate for similar debt for a non-troubled borrower.

Notwithstanding the above, the following factors, if both are present, provide determinative evidence that the borrower is not experiencing financial difficulties.

• The borrower is servicing its existing debt and can obtain funds to repay that debt from sources other than the existing creditors (without regard to the current restructuring) at an effective interest rate equal to the current market interest rate for a non-troubled borrower.

• The creditors agree to restructure the existing debt solely to reflect a decrease in current market interest rates for the borrower or positive changes in the creditworthiness of the borrower since the debt was originally issued.

5.3.2 Determining Whether the Creditor Has Granted a Concession

A concession is deemed to be granted if the effective borrowing rate on the restructured debt is less than the effective borrowing rate on the original debt. See Example 5-2 for a concession calculation. When performing a concession calculation, the following points should be considered:

• The carrying value of the original debt includes unamortized premium, discount, and issuance costs, and does not include hedging effects.

• If the debt has recently been restructured, the carrying value and effective interest rate of the debt immediately before the earlier restructuring should be used.

• If any sweeteners (e.g., preferred stock, warrants) are issued, their fair values should be included in day-one cash flows. If a previously issued sweetener is restructured, the change in fair value should be included in day-one cash flows.

• If the debt is settled through the transfer of assets or issuance of equity securities, the fair value of these instruments should be compared to the current carrying value of the debt.

Accounting for Modifications and Extinguishments / 5 - 5

5.3.3 Full Settlement of the Debt

A restructuring that results in the full settlement of the debt obligation should be accounted for in the same manner as a debt extinguishment (FG section 5.6). However, a borrower must determine whether the restructuring is a TDR even if it results in no remaining debt outstanding (i.e., the debt is fully satisfied with cash, other assets, or equity) as the borrower is required to disclose the fact that the debt was extinguished as the result of a TDR.

5.3.4 Modification of Terms

The recognition and measurement guidance for a modification of terms in a TDR varies based on whether the future undiscounted cash flows specified by the new terms are greater than or less than the carrying value of the debt. In calculating the future undiscounted cash flows specified by the new terms:

• All payments under the new terms should be included.

• Any contingent payments should be included without regard to the probability of those payments being made.

• If the number of future payment periods may vary because the debt is payable on demand, the estimate of future cash payments should be based on the maximum number of periods that could be required under the terms of the revised debt agreement.

Summary of Modification of Terms Accounting

If Future Undiscounted Cash Flows (Including All Contingent Payments) Are:

Gain Recognition and Interest Expense Impact

New Fees Paid to

Creditor

New Fees Paid to Third

Parties

Less than the net carrying value of the original debt

• A gain is recorded for the difference. If the debt holder is a related party, consider whether the gain should be recorded in equity (see FG section 5.3.6).

• The carrying value of the debt is adjusted to the future undiscounted cash flow amount.

• No interest expense is recorded going forward. Instead, each time a payment is made, the carrying value is reduced.

Reduce the recorded gain

Expense

Greater than the net carrying value of the original debt

• No gain is recorded.• A new effective interest rate

is established based on the carrying value of the debt and the revised cash flows.

Capitalize and amortize

Expense

If a TDR involves a combination of actions, such as a partial settlement of the debt and a modification of terms:

• The debtor should first reduce the carrying value of the debt by the fair value of the assets or equity interests transferred,

• Then apply the modification of terms guidance to determine the appropriate accounting.

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5.3.5 TDR of a Variable-Rate Instrument

When a restructured debt instrument has a variable interest rate, the guidance in ASC 470-60-35-11 indicates that the cash interest payments to be included in the TDR calculation should be based on the interest rate that was in effect at the time of the restructuring. If the cash flows from the principal repayments and interest payments determined based on the spot variable rate (e.g., LIBOR) at the date of restructuring are less than the carrying value of the debt, then a gain would be recorded on the date of the restructuring. Subsequently, all future principal and interest payments would be charged against the carrying value of the debt with no amounts being charged to interest expense.

However, subsequent to the restructuring, interest rates will change, resulting in cash flows differing from those used in the initial TDR calculation. The accounting treatment for changes in cash flows due to changes in interest rates depends on whether there is an increase or decrease from the spot interest rate used in the initial TDR accounting (the “threshold interest rate”).

We believe that upon an increase in interest rates, the borrower should record additional interest expense in the period that the expense was incurred. The additional interest expense is calculated by multiplying the difference between the current rate and the threshold rate by the current carrying value of the debt. ASC 470-60-35-11 indicates that the additional interest expense should be accounted for using a loss contingency model, which requires the borrower to record amounts that are probable and reasonably estimable. The amount of additional interest expense is both probable and reasonably estimable in the period in which an increase in interest rates occurs. That is, once the interest rate for a particular period is reset and that rate is above the threshold rate, a probable and estimable loss has been incurred equal to the interest payment to be made for that period. Accordingly, the additional interest expense is recorded in that period.

A decrease in interest rates could result in an additional restructuring gain due to lower forecasted payments than those used to calculate the originally recorded liability. Based on the guidance in ASC 470-60-35-11:

• Fluctuations in the effective interest rate after the TDR from changes in interest rates or other causes should be accounted for as changes in estimates in the periods the changes occur.

• However, the accounting for those fluctuations should not result in recognizing a gain on restructuring that may be offset by future cash payments. Rather, the carrying value of the restructured debt should remain unchanged, and future cash payments should reduce the debt balance until the point that any gain recognized cannot be offset by future cash payments.

In the case of a variable rate instrument, there is always a potential for future cash payments to offset the unrecorded gain generated by an interest rate decrease (the variable rate could increase in the future). Therefore, no gain is recognized until the entire debt balance is paid off and there are no future interest payments.

5.3.6 Restructuring of Debt by Existing Equity Holders

Parties that hold equity securities of the borrower (in addition to the restructured debt instrument) prior to a restructuring are considered related parties. If the borrower restructures its debt with these related parties, gain recognition may not be appropriate under ASC 470-50-40-2. Such a restructuring may be in essence

Accounting for Modifications and Extinguishments / 5 - 7

a capital transaction. If the lender/equity holder is restructuring its debt to protect its equity investment, then it is generally appropriate to account for the “gain” on restructuring as a capital contribution. This may be the case when the lender holds a significant amount of the borrower’s equity securities. In contrast, if the lender only holds a small amount of the borrower’s equity securities, gain recognition could be appropriate.

Example 5-2: Troubled Debt Restructuring

Background/Facts:• Company A has a term loan outstanding with one lender.

• Company A has (a) experienced a significant decline in sales, (b) defaulted on its interest payments, and (c) recently been delisted. The Company projects that it will not be able to make its future upcoming interest payments.

• On January 1, 2012, Company A negotiated a restructuring with its lender.

• Following is a summary of the terms of Company A’s original debt instrument and the terms added or modified during the restructuring. There are no contingent payments in the restructured debt obligation.

Terms of the Original Debt

Outstanding Balance $1,000,000Years 4 years, 6 monthsMaturity Date 6/30/2016Effective Interest Rate 6.00%Unamortized Discount $19,200Net Carrying Value $980,800Coupon 5.50%Interest Payments Annually in JunePrincipal Payment Balloon payment at maturity

Modifications

Lender Forgave $250,000Coupon Decreased To 3.00%Fair Value of Equity Granted to the Lender $ 50,000

Question:Is the restructuring of Company A’s debt considered a TDR?

Analysis/Conclusion:To determine whether the restructuring meets the qualifications for a TDR there are two questions to be answered:

1. Is Company A experiencing financial difficulties?

Yes, Company A is experiencing financial difficulties because it is in default on its debt, has had a significant decline in sales, and has been delisted.

(continued)

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2. Was Company A granted a concession by its lender?

To determine whether it was granted a concession, Company A must compare the effective interest rate of the restructured debt with the effective interest rate of the original debt. The effective interest rate of the restructured debt is calculated based on the guidance in ASC 470-60-55-10 through 55-14 as follows:

1/1/2012 6/30/2012 6/30/2013 6/30/2014 6/30/2015 6/30/2016 Total

Interest Payments $11,250 $22,500 $22,500 $22,500 $ 22,500 $101,250

Principal Payment 750,000 750,000

Equity Grant $50,000 Total Payments $50,000 $11,250 $22,500 $22,500 $22,500 $772,500 $851,250

Effective Interest Rate –1.50%1

Effective Interest Rate of Original Debt 6.00%1 The effective interest rate is determined by calculating the internal rate of return that is needed to

equate the total payments on the modified debt to the original net carrying value of $980,800. Since the effective interest rate of the restructured debt (–1.50%) is lower than the effective interest rate on the original debt (6.00%) the lender has granted a concession.

Based on the above, Company A is subject to the TDR model. This restructuring is a combination of types since it involves an equity issuance and a modification of terms. As such the TDR calculation is as follows:

Carrying value of the debt $980,800Less: fair value of the equity granted (50,000)Adjusted carrying value 930,800Less: future undiscounted cash flows (851,250)Gain $ 79,550

By reducing the debt balance by the fair value of the equity granted ($50,000), and recording the TDR gain ($79,550), the carrying value of the debt is adjusted to $851,250 (sum of the future undiscounted cash flows). Going forward, no interest expense is recognized and each time a payment is made the carrying value of the debt is reduced.

5.4 Modification vs. Extinguishment—Non-Revolving Debt Security or Term Loan

If a debt restructuring of non-convertible, non-revolving debt is not a TDR, the guidance in ASC 470-50-40 should be followed to determine if the restructuring is a modification or extinguishment. A debt modification can be achieved either by amending the terms of an existing security or by exchanging existing debt for new debt with the same creditor. The legal form of the transaction, whether a legal exchange or a legal amendment, is irrelevant for the purpose of determining whether an accounting extinguishment or modification has occurred (FG section 5.8 for discussion of modification of preferred stock). What is relevant is (1) whether the creditor remains the same and (2) whether the change in the debt terms is considered substantial.

Transactions involving the issuance of a new debt obligation to one creditor and the concurrent satisfaction of an existing debt obligation to another unrelated creditor

Accounting for Modifications and Extinguishments / 5 - 9

(i.e., when the debtor and creditor are not the same in both agreements) are always accounted for as an extinguishment of the existing debt and issuance of new debt.

The table below summarizes the accounting for a debt modification and extinguishment. More detailed guidance on the accounting for extinguishments is included in FG section 5.6.

Modification vs. Extinguishment

Type of Transaction

Gain/Loss Recognition and Interest Expense Impact

New Fees Paid to

Creditor

New Fees Paid to Third

Parties

Modification • No gain or loss is recorded.• A new effective interest rate is

established based on the carrying value of the debt and the revised cash flows.

Capitalize and amortize

Expense

Extinguishment • A gain or loss is recorded for the difference between the net carrying value of the original debt and the fair value of the new debt.

• Interest expense is recorded based on the effective interest rate of the new debt.

• See FG section 5.3.6 for a discussion of gain/loss treatment when the debt holders also hold equity securities of the borrower.

Expense Capitalize and amortize

5.4.1 Test to Determine Whether a Modification to Non-Revolving Debt Is Substantial

ASC 470-50-40-6 through 40-12 provide a test for determining whether cash flows have “substantially different terms” such that a debt instrument has been extinguished (rather than modified) for accounting purposes.

The terms of the new (or amended) debt instrument are substantially different from the original debt instrument if the present value of the cash flows under the amended or new debt is at least 10 percent different from the present value of the remaining cash flows under the original debt. To conduct this test, the issuer must compare:

• The present value of the cash flows of the original debt discounted at the effective interest rate of the original debt, with

• The present value of the cash flows of the new debt also discounted at the effective interest rate of the original debt.

If the present value of the two cash flow streams differs by 10 percent or more (in either direction), the debt instruments have substantially different terms and the original debt is considered extinguished. This is commonly referred to as the “10 percent test.”

Cash flows can be affected by changes in principal amounts, interest rates, or maturity. They can also be affected by fees exchanged between the debtor and creditor to effect changes in:

• Recourse or non-recourse features

• Priority of the obligation

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• Collateralization features (including changes in collateral)

• Debt covenants and/or waiver terms

• The guarantor (or elimination of the guarantor)

• Option features

ASC 470-50-40-12 provides specific guidance on performing the 10 percent test. Below are a few key takeaways from this guidance:

• When performing the 10 percent test, the cash flows of the new debt instrument should include all amounts paid by the debtor to the creditor (i.e., any fees paid to the lender in conjunction with the restructuring should be included in the cash flows of the new debt instrument) as a day-one cash flow.

• Third party fees should not be included in the cash flow analysis.

• If there is a variable interest rate in any of the debt instruments, the rate in effect at the time of the restructuring should be used.

• If any of the debt instruments are callable or puttable, then separate cash flow analyses should be performed assuming exercise and non-exercise of the put and call. The scenario that generates the smallest change should be used. See FG section 5.4.1.4 for further discussion of prepayment options.

• For debt that has been amended more than once in a one-year period, ASC 470-50-40-12(f) specifies that the debt terms that existed prior to the previous modification(s) should be used to apply the 10 percent test, if the modification(s) were deemed not to be substantially different. In other words, this is a “cumulative impact” assessment—when comparing the principal, interest, and creditor fee cash flows immediately before and after the current amendment, the terms that existed prior to the previous modification(s) should be used as opposed to the terms that existed immediately before the current amendment.

When applying the 10 percent test to a public debt issuance, the debt instrument is the individual security held by an investor and the creditor is the security holder. In an exchange or modification offer made to all investors, the 10 percent test is applied to those investors who agree to the exchange or modification; debt instruments held by investors who do not agree would not be affected.

ASC 470-50-40 does not apply when the debt instruments are sold directly from one investor to another investor in a market transaction, as the company has not engaged in an extinguishment or modification transaction (i.e., the ability of the investors to purchase and sell a public debt instrument does not impact the issuer’s accounting).

See FG section 5.7 for a discussion of restructuring of convertible debt instruments.

5.4.1.1 Loan Syndications and Participations

Many financing arrangements involve multiple lenders who are members of a loan syndicate or loan participation. The accounting for a loan syndication differs from that of a loan participation.

• In a loan syndication, each creditor is viewed as having its own loan with the borrower that is separate and distinct from the other creditors in the syndicate.

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• In a loan participation, the debt instrument is a contract between the debtor and the lead creditor. Participating creditors are not direct creditors, but rather have an interest represented by a certificate of participation.

Accordingly, the analysis of whether a restructuring of a loan syndication is a modification or extinguishment differs from the analysis a borrower would perform for a loan participation.

• In analyzing the restructuring of a loan syndication, the borrower must perform the 10 percent test separately with respect to each individual creditor participating in the syndication. We believe this approach should also apply to line-of-credit and revolving debt arrangements that are syndicated and are evaluated under ASC 470-50-40-21 (see FG section 5.5 for discussion relating to modifications to lines of credit).

• In analyzing the restructuring of a loan participation, the borrower must perform the 10 percent test with respect to the lead creditor. Similarly, for a line-of-credit and revolving debt arrangement structured as a participation the debtor would be required to apply the guidance in ASC 470-50-40-21 only to the lead creditor to determine if there has been a change in the borrowing capacity from the lead creditor (see FG section 5.5 for discussion relating to modifications to lines of credit).

The conclusions reached under the 10 percent test for each creditor in the term loan syndicate can be different (i.e., one creditor loan may be considered to be modified, while another may be considered extinguished). Similarly, under ASC 470-50-40-21, issuance costs may be written off for one member of the line-of-credit syndicate but not another.

If an exchange or modification offer is made to all members of the syndicate and only some of the creditors agree to the exchange or modification, the 10 percent test would be applied to debt instruments held by those creditors who agree to the exchange or modification. Debt instruments held by those creditors who do not agree to the exchange or modification would not be affected, unless their interests are paid off, in which case they would be accounted for as extinguishments.

If a new creditor enters the lending syndicate and provides a new term loan or access to a new line of credit, costs paid to creditors and third parties are treated as they would be for a new loan or line of credit from a new creditor; that is, deferred as debt issuance costs and amortized over the life of the new term loan or line of credit.

5.4.1.2 Third Party Intermediaries

A third party intermediary (e.g., an investment bank) may arrange a debt restructuring or exchange offer. For example:

• Company A has multiple bonds of a single bond offering outstanding. The bonds are held by a number of third-party investors.

• Bank B buys the bonds from the third-party investors.

• Bank B and Company A negotiate a restructuring (or exchange offer) of the bonds.

• Bank B sells the new bonds to third-party investors (who may, or may not, be the same as the investors in the original bonds).

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To determine the appropriate accounting treatment for a restructuring transaction arranged by a third-party intermediary, the company must first determine whether the intermediary is a principal to the transaction (i.e., arranging the debt restructuring on its own behalf) or the company’s agent (i.e., arranging the debt restructuring on behalf of the company or investors).

If the third-party intermediary is an agent, the company would look through the intermediary to determine whether the restructuring should be accounted for as an extinguishment or a modification.

• The company must first determine whether the investors after the restructuring are the same as the investors prior to the restructuring. If they are not, then the restructuring is accounted for as an extinguishment because the transaction does not involve the same creditor.

• If an investor holds the debt before and after the restructuring, the company should perform the 10 percent test based on the cash flows of the debt instruments held by those investors before and after the restructuring. The third-party intermediary is ignored for purposes of performing the 10 percent test.

If the third-party intermediary is considered a principal to the transaction, it is the investor. In this case, the company would perform the 10 percent test based on the cash flows of the debt held by the third-party intermediary before and after the restructuring.

Generally, if the intermediary is putting its own funds at risk and is subject to loss in the transaction, it is acting more like a principal. If it seeks to find other purchasers for the company’s debt and is compensated by a fee arrangement, it is acting more like an agent.

5.4.1.3 Consideration of Multiple Debt Instruments Held by One Lender

Oftentimes, a borrower may have several debt instruments outstanding with one lender. When performing the 10 percent test, we believe all of a lender’s debt instruments should be included in the 10 percent test. For example,

• A borrower has two debt instruments outstanding with one lender, Tranche A and Tranche B.

• The borrower (1) increases the principal balance of Tranche A and (2) pays off Tranche B.

Although there was a legal extinguishment of Tranche B, the borrower must perform the 10 percent test by (1) combining the cash flows of the original Tranche A and Tranche B debt instruments and (2) comparing those combined cash flows to the new cash flows of the restructured Tranche A. When discounting the cash flows of the restructured Tranche A, we believe a blended effective rate based on the original Tranche A and Tranche B should be used.

See FG section 5.4.1.9 for discussion of the concurrent modification of non-revolving (i.e., term debt) and revolving debt arrangements.

5.4.1.4 Prepayment Options

Oftentimes, debt agreements allow a borrower to prepay the debt prior to maturity, especially in variable rate debt instruments. A prepayment option is a call option

Accounting for Modifications and Extinguishments / 5 - 13

that gives the borrower the right to call the debt from the lender and pay the amount owed.

ASC 470-50-40-12(c) specifies that if either the new debt instrument or the original debt instrument is callable (by the issuer) or puttable (by the holder):

• The issuer should do separate cash flow analyses assuming exercise and non-exercise of the call or put at its earliest available date and for the stated call/put price (which may be par value or another amount).

• The cash flow test that generates the smaller change (exercise or non-exercise) should be used as the basis for determining whether the 10 percent threshold has been met.

• If a modification conclusion (e.g., change in cash flows is less than 10 percent) is reached in any scenario, then the analysis is complete and the restructuring is considered a modification.

If the prepayment option (or any put or call feature) is exercisable at any time, a borrower should assume it is exercised immediately on the date of amendment. This will usually result in the smallest change in cash flows. When including prepay ment options in the 10 percent test, it is not necessary to assess the ability of the borrower to prepay the debt. The 10 percent test considers all non-contingent contractual scenarios.

When applying the 10 percent test, it may also be appropriate to consider contingent prepayment options, such as a put option exercisable upon a change in control or upon completion of qualified financing. Determining whether a contingent prepayment option should be considered requires judgment based on the facts and circumstances at the modification date.

5.4.1.5 Non-cash Consideration

A debt restructuring may involve an issuance of non-cash consideration, such as warrants or preferred stock, to the lender. As stated in ASC 470-50-40-12(a), the cash flows of the new debt instrument include:

• All cash flows specified by the terms of the new debt instrument, plus

• Any amounts paid by the debtor to the creditor as part of the exchange or modification, less

• Any amounts received by the debtor from the creditor as part of the exchange or modification.

When the consideration to the creditor includes additional financial instruments, such as warrants or preferred stock, we believe the fair value of the instruments issued should be included as a day-one cash flow for purposes of the 10 percent test.

If the restructuring is considered a modification based on the 10 percent test, then any non-cash consideration should be capitalized similar to a cash fee paid to the lender. The capitalized amount, along with any existing unamortized debt discount or premium, should be amortized as an adjustment to interest expense over the remaining term of the modified debt instrument using the effective interest method.

If the restructuring is to be accounted for as a debt extinguishment, then the fair value of any non-cash consideration (e.g., fees paid to the creditor) is to be

5 - 14 / Accounting for Modifications and Extinguishments

associated with the extinguishment of the original debt instrument (i.e., treated as an amount paid to extinguish the debt) and included in determining the debt extinguishment gain or loss to be recognized.

If warrants or preferred stock are issued to third-party advisors rather than the lender, we believe the fair value of the warrants or preferred stock should be accounted for following the guidance in ASC 470-50-40-18 for third-party costs. The accounting for third-party costs depends upon whether there is an extinguishment or a modification.

5.4.1.6 Restructured Debt Is the Hedged Item in a Fair Value Hedge of Interest Rates

When performing the 10 percent test, the impact of the required amortization of basis adjustments due to the application of fair value hedge accounting should be ignored for the purposes of calculating the effective interest rate of the original debt instrument. The goal of the 10 percent test is to determine whether the terms of the relationship between the debtor and creditor pre- and post-exchange are substantially different. The fact that the debtor designated the debt as the hedged item in a fair value hedging relationship does not impact the relationship between the debtor and creditor.

If the exchange is considered a modification based on the 10 percent test, a new effective yield is to be determined based on the carrying value of the original debt instrument and the revised cash flows. ASC 815-25-35-8 states that the adjustment of the carrying value of a hedged asset or liability required by ASC 815-25-35-1(b) shall be accounted for in the same manner as other components of the carrying value of that asset or liability. Therefore, the basis adjustment becomes a part of the new effective yield computation that considers all of the cash flows over the remaining life of the new debt (i.e., the basis adjustment is amortized over the modified loan term).

If the exchange is an extinguishment, the debt is removed from the books, and a new debt instrument is recorded at fair value. As such, the existing hedging relationship is de-designated. If the interest rate swap is not terminated, the issuer could either (1) re-designate the swap in a hedging relationship of the new debt, if the requirements for hedge accounting are met or (2) record any future changes in the fair value of the swap in earnings.

5.4.1.7 Change in Currency of the Debt

If a debt instrument is modified such that the currency in which the debt is denominated changes, the change in currency should be included in the cash flows as part of the 10 percent test. To convert the cash flows on the new debt into the currency of the original debt, we believe there are two acceptable methods:

• Use the spot rate in effect at the debt exchange date.

• Use the forward rates corresponding to each cash flow (interest payment and principal) payment date.

5.4.1.8 Change in Principal

Application of the 10 percent test is a bit more complicated when there is a change in principal balance as a result of the restructuring. There are various methods of reflecting a change in principal in the 10 percent test that may be acceptable. In these circumstances, it is important to understand the terms of the instrument.

Accounting for Modifications and Extinguishments / 5 - 15

For financing arrangements that are contractually prepayable by the borrower, the following approach would be appropriate:

• The cash flows related to the lowest common principal balance (i.e., rollover money) between the original debt instrument and the new debt instrument are compared for purposes of the 10 percent test.

• Any principal in excess of the rollover money is treated as a new, separate debt issuance.

• Any decrease in principal is treated as a partial extinguishment of debt.

Under this approach, unamortized debt issuance costs and new fees associated with the restructuring are generally accounted for as follows.

Money ClassificationUnamortized

Debt Issue CostsNew

Creditor FeesNew Third Party Fees

Principal increase with an existing lender

N/A Capitalize allocated portion

Capitalize allocated portion

Partial principal pay-down made to existing lender

Expense allocated portion

Expense allocated portion

Expense allocated portion

Rollover Money—Modification Continue to amortize

Capitalize Expense

Rollover Money—Extinguishment Expense Expense Capitalize

For financing arrangements that are not contractually prepayable by the borrower, the following method would be appropriate:

• The cash flows of the original debt instrument are compared to the cash flows based on the repayment schedule of the new debt instrument.

• An increase in principal is treated as a day-one cash inflow in the cash flows of the new debt instrument.

• A decrease in principal is treated as a day-one cash outflow in the cash flows of the new debt instrument.

Under this approach, the debt instrument is viewed as a single unit of account, therefore the unamortized debt issuance costs and new fees associated with the restructuring may be accounted for as follows.

Money ClassificationUnamortized

Debt Issue CostsNew

Creditor FeesNew Third Party Fees

Modification Continue to amortize

Capitalize Expense

Extinguishment Expense Expense Capitalize

However, when a transaction accounted for as a modification involves a significant decrease in principal, we believe it is appropriate to expense unamortized debt issuance costs and new creditor fees. A company following this method, should adopt an accounting policy to determine how to address unamortized fees when there is a significant decrease in principal. One policy is to follow the fee guidance in the first method described in this section.

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5.4.1.9 Modification of Instruments Held by Multiple Lenders

In practice, debtors may have both non-revolving (i.e., term debt) and revolving-debt arrangements that are concurrently modified. When legal exchanges and amendments of debt affect non-revolving and revolving debt simultaneously, companies should allocate the new fees paid to the creditor and new third-party costs to the individual instruments using a reasonable, rational, and supportable approach. New costs paid to creditors and third parties in connection with a legal exchange or amendment should also be allocated to the new instruments and then further allocated to each creditor. Once these various costs have been allocated to the creditor level, the analysis of each creditor may be completed and a determination made as to (1) whether the exchange or amendment of the non-revolving debt is considered a modification or extinguishment under ASC 470-50-40 and (2) the appropriate accounting for the revolving instrument under ASC 470-50-40-21.

Example 5-3: Restructuring of Syndicated Term Loan Facility

Background/Facts:• Company A has a syndicated term loan facility.

• Given the decline in interest rates and the Company’s improved credit rating, the Company wishes to take advantage of the opportunity to lower its borrowing costs so it enters into an agreement to restructure the syndicated facility.

• The restructuring transaction (1) increases the total amount of money borrowed, (2) extends the term of the facility, and (3) lowers the interest rate on the facility.

• All fees paid during the restructuring were paid to secure the new debt instrument; there were no fees incurred to exit the original pre-payable debt instrument.

• The existing loans of the facility are prepayable in whole or in part at any time.

The following table summarizes the terms of the original syndicated facility and the new syndicated facility at the restructuring date.

Original Syndicated Facility

New Syndicated Facility

Principal Balance $52,000,000 $100,000,000

Coupon (paid annually) 5.5% 5.0%

Effective Interest Rate 6.0% 5.9%

Original Term 10 years 5 years

Remaining Term 3 years 5 years

Unamortized Debt Issuance Costs $ 695,000 —

New Creditor Fees — $ 4,000,000

New Third-Party Fees — $ 1,000,000

Analysis/Conclusion:Step 1: Compare lender balances

All lenders in both the original and new debt agreements must be compared to determine common lenders to both agreements. Then, the classification of the principal balances for common lenders must be determined. The principal balances could be classified as (1) rollover money, (2) new money, or (3) partial extinguishment.

(continued)

Accounting for Modifications and Extinguishments / 5 - 17

Summary of Loan Balances

Bank

Balance of Original

SyndicationBalance of New

Syndication Change Classification

A $ 5,000,000 $ 5,000,000 — Rollover moneyB $20,000,000 $ 30,000,000 $ 10,000,000 Rollover and new moneyC — $ 60,000,000 $ 60,000,000 New moneyD $12,000,000 $ 5,000,000 $ (7,000,000) Rollover and partial

extinguishment

E $15,000,000 — $(15,000,000) ExtinguishmentTotal $52,000,000 $100,000,000

Step 2: Allocate costs

Unamortized debt issuance costs relating to the original syndicated facility are allocated to each bank on a pro-rata basis. One method that may be used to allocate the costs based on the percentage of the loan balance that was (1) rolled over to the new facility and (2) paid down (if applicable) is illustrated below.

Allocation of Unamortized Issuance Costs

Bank

Balance of Original

Syndication

Percentage of Original

Syndication

Allocation of Unamortized

Issuance Costs

Allocated to

Rollover Paydown

A $ 5,000,000 9.6% $ 67,000 $ 67,000 —B $ 20,000,000 38.5% $268,000 $268,000 —C — — — — —D $ 12,000,000 23.1% $160,000 $ 67,000 $ 93,000E $ 15,000,000 28.8% $200,000 — $200,000

$ 52,000,000 100% $695,000 $402,000 $293,000

New fees paid to creditors and to third parties are allocated to each bank in the new syndicated facility on a pro-rata basis. Since all of the fees paid are associated with the issuance of the new instrument, no amounts are allocated to the pay-off amounts.

Allocation of New Creditor Fees

BankBalance of New

Syndication

Percentage of New

Syndication

Allocation of New

Creditor Fees

Allocated to

Rollover New Money

A $ 5,000,000 5.0% $ 200,000 $ 200,000 —B $ 30,000,000 30.0% $1,200,000 $ 800,000 $ 400,000C $ 60,000,000 60.0% $2,400,000 — $2,400,000D $ 5,000,000 5.0% $ 200,000 $ 200,000 —E — — — — —

$100,000,000 100% $4,000,000 $1,200,000 $2,800,000

(continued)

5 - 18 / Accounting for Modifications and Extinguishments

Allocation of New Third-Party Fees

BankBalance of New

Syndication

Percentage of New

Syndication

Allocation of New

Third-Party Fees

Allocated to

Rollover New Money

A $ 5,000,000 5.0% $ 50,000 $ 50,000 —B $ 30,000,000 30.0% $ 300,000 $ 200,000 $ 100,000C $ 60,000,000 60.0% $ 600,000 — $ 600,000D $ 5,000,000 5.0% $ 50,000 $ 50,000 —E — — — — —

$100,000,000 100% $1,000,000 $ 300,000 $ 700,000

Step 3: Perform the 10 percent test:

• The 10 percent test is performed for those creditors who were in the facility before and after the debt restructuring.

• Calculate the present value of the future cash flows of the original facility (e.g., the contractual principal and interest payments) using the effective interest rate of the original facility at the date of the modification.

• Calculate the present value of the new facility (e.g., contractual principal and interest payments, as well as the fees allocated to the creditor) using the effective interest rate in effect for the original facility on the date of the modification.

• Calculate the difference between the present values.

• The results using the net method are summarized in the table below.

Summary of 10 Percent Test

Bank

Present Value of the Lowest Common Principal Amount

of Original Debt1

Present Value of Rollover Money2 (Including

Creditor Fees)

Difference in Present Value of Rollover Money

A $ 4,989,000 $ 5,067,000 2.70%B $19,958,000 $20,265,000 2.70%D $ 4,989,000 $ 5,067,000 2.70%

1 This amount is calculated by scheduling out the cash flows of the original instrument and discounting at the effective interest rate of 6%.

2 This amount is calculated by scheduling out the cash flows of the new instrument based on its new coupon and term and discounting at the original effective interest rate of 6%. The creditor fees allocated to the rollover money are also included as a day one cash flow.

Step 4: Determine if modification or extinguishment and account for the fees:

• Determine whether the new term loan syndicated facility is a modification or an extinguishment for each bank.

• Determine the appropriate accounting treatment and dollar amounts of (1) unamortized debt issuance costs, (2) new fees paid to creditors, and (3) new fees paid to third parties.

(continued)

Accounting for Modifications and Extinguishments / 5 - 19

Summary of Fee Accounting3

BankModification or

Extinguishment? Treatment

Unamortized Debt Issuance

CostsNew

Creditor FeesNew Third-Party Fees

A Modification Expense — — $ 50,000Capitalize — $ 200,000 —Continue

to Amortize $ 67,000 — —B New Money and

Modification Expense — — $ 200,000Capitalize — $1,200,000 $ 100,000Continue

to Amortize $268,000 — —C New Money Expense — — —

Capitalize — $2,400,000 $ 600,000Continue

to Amortize — — —D Modification and

Partial Pay Down Expense $ 93,000 — $ 50,000Capitalize — $ 200,000 —Continue

to Amortize $ 67,000 — —E Extinguishment Expense $200,000 — —

Capitalize — — —Continue

to Amortize — — —$695,000 $4,000,000 $1,000,000

3 See FG sections 5.4 and 5.4.1.8 for a discussion of the accounting for unamortized debt issuance costs, creditor fees and third-party fees.

5.5 Modifications to and Payoffs of Line-of-Credit or Revolving-Debt Arrangements

A line-of-credit or revolving-debt arrangement is an agreement that provides the borrower with the ability to:

• Borrow money at different points in time, up to a specified maximum amount,

• Repay portions of previous borrowings, and

• Reborrow under the same contract.

Line-of-credit and revolving-debt arrangements may include both amounts drawn by the borrower (a debt instrument) and a commitment by the lender to make additional amounts available to the borrower under predefined terms (a loan commitment). In most situations, the borrower incurs costs to establish a line-of-credit or revolving-debt arrangement, and some or all of the costs are deferred and amortized over the term of the arrangement.

If a restructuring of a line-of-credit or revolving-debt arrangement is not a troubled debt restructuring, the guidance in ASC 470-50-40-21(c) provides a framework for determining how to account for unamortized debt issue costs and new fees.

The debtor should compare the borrowing capacity under the original arrangement (the product of the remaining term and the maximum available credit under the

5 - 20 / Accounting for Modifications and Extinguishments

arrangement) to the borrowing capacity of the new or modified arrangement (rather than the outstanding principal amount as is done for non-revolving debt) with the same creditor. In other words, on a lender by lender basis, perform the following analysis:

• If the borrowing capacity of the new arrangement is greater than or equal to the borrowing capacity of the original arrangement, then any unamortized debt issue costs, any new fees paid to the creditor, and any new third-party costs incurred should be associated with the new arrangement (that is, deferred and amortized over the term of the new arrangement).

• If the borrowing capacity of the new arrangement is less than the borrowing capacity of the original arrangement, then any new fees paid to the creditor and any new third-party costs incurred should be associated with the new arrangement (that is, deferred and amortized over the term of the new arrangement). However, any unamortized debt issue costs relating to the original arrangement at the time of the change should be immediately written off in proportion to the decrease in borrowing capacity of the original arrangement. The unamortized debt issue costs relating to the original arrangement that remain after the proportional write off should be amortized over the term of the new arrangement.

If a lender exits the line of credit completely, then all unamortized costs should be written off.

Example 5-4: Accounting for Unamortized Costs and New Fees in Revolving-Debt Arrangement

Background/Facts:Terms of original revolving arrangement:

• Five year term (three years remaining)

• $10 million commitment amount

• Unamortized debt issuance costs at the restructuring date: $200,000

Terms of new revolving arrangement:

• Four year term

• $5 million commitment amount

• New third party fees: $10,000

• New creditor fees: $20,000

Questions/Conclusions:1. What is the borrowing capacity of both the original and the new arrangements?

Original borrowing capacity: $30 million ($10 million commitment amount x 3-year remaining term)

New borrowing capacity: $20 million ($5 million commitment amount x 4-year remaining term)

(continued)

Accounting for Modifications and Extinguishments / 5 - 21

2. Is there an adjustment required to the unamortized costs? If so, what is the adjustment?

Yes. The borrowing capacity decreased by $10 million or 33% percent ($10 million/$30 million). Therefore, 33% ($66,000) of the unamortized costs should be expensed in the current period. The remaining unamortized debt issuance costs should be amortized over the term of the new arrangement.

3. How should the new fees be recorded?

Both the creditor fees and third-party fees should be capitalized and amortized over four years, which is the term of the new arrangement.

5.6 Debt Extinguishment Accounting

Debt extinguishment accounting is required when a company:

• Restructures a debt instrument in a manner that causes it to trigger extinguishment accounting based on the 10 percent test, or

• Reacquires its debt for cash, other assets, or equity.

When debt extinguishment accounting is required, the company will generally record a gain or loss on extinguishment in earnings. ASC 470-50-40-2 addresses how a gain or loss on debt extinguishment should be measured. It requires that the issuer recognize currently in income the difference between the reacquisition price and the net carrying amount of the original debt.

Reacquisition price is defined in the ASC Master Glossary to include the amount paid on extinguishment, including a call premium, miscellaneous costs of reacquisition, and the fair value of any assets transferred or equity securities issued. Accordingly, reacquisition price would include fees (which may include non-cash fees) paid by the debtor to the creditor in connection with the extinguishment.

Net carrying amount is defined in the ASC Master Glossary to include unamortized debt issuance costs and any unamortized debt discount or premium related to the extinguished debt including:

• Unamortized discounts from a derivative that required separation,

• An unamortized beneficial conversion feature (BCF), and

• A discount from allocation of a portion of the investment proceeds to warrants sold with the debt (FG section 3.4).

Thus, the difference between (1) the net carrying value of the debt plus any separated derivative and (2) the reacquisition price is recorded as an extinguishment gain or loss. If there is a BCF in the debt, the BCF must be recognized as part of the extinguishment accounting.

See FG section 5.3.6 for a discussion of debt extinguishment gain/loss treatment when the debt holders are also equity holders of the debtor’s company.

In a restructuring accounted for as an extinguishment, the new debt instrument would be recorded at fair value.

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5.6.1 Classification of Gain or Loss on Debt Extinguishments

ASC 470-50-45-1 indicates that gains and losses from extinguishment of debt that are unusual in nature are not precluded from being classified as extraordinary items. Nevertheless, the FASB has observed that debt extinguishment transactions “would seldom, if ever, result in extraordinary classification of the resulting gains and losses.” Accordingly, gains and losses on debt extinguishment, including troubled debt restructurings, are rarely classified as extraordinary items.

There is no specific SEC guidance regarding the classification of a debt extinguish-ment gain or loss. ASC 470-50-40-2 requires an extinguishment gain or loss to be identified as a separate item.

• One method of accounting for the extinguishment gain or loss is to present the amount as a separate line item on the income statement, typically within non-operating income.

• Another acceptable method is to report the extinguishment gain or loss in interest expense with disclosure of the components of the gain or loss in the footnotes to the financial statements. If this approach is taken the company should also disclose this treatment in the accounting policies footnote to provide full transparency and clarity in the financial statements.

5.6.2 Debt Extinguishment as a Subsequent Event

An extinguishment occurring subsequent to the end of the fiscal year but prior to the issuance of the financial statements should be accounted for as a non-recognized subsequent event, which is not recorded in the financial statements. The SEC staff has indicated that it will object to recognition of a gain or loss from a debt extinguishment in a period other than the period in which the debt is considered extinguished. This includes circumstances in which extinguishment of a debt obligation occurs subsequent to a period end, but prior to issuance of the financial statements, or in which a registrant announces prior to the end of a period its intention to call debt for redemption in a subsequent period.

If the gain or loss from a planned extinguishment would be material, disclosure regarding a planned extinguishment and its likely effects is required in notes to the financial statements and in MD&A. For periods preceding the actual extinguishment, interest expense and other carrying costs, as well as debt issuance costs and debt discount or premium should continue to be accounted for pursuant to the terms of the debt instrument and the life assumed when the obligation was initially recorded.

5.7 Restructuring of Convertible Debt Instruments

For convertible debt, the test to determine whether the cash flows are substantially different for the purpose of determining whether a debt modification or extinguishment has occurred is more complicated. ASC 470-50-40-12(g) prescribes a two-step approach for determining whether a convertible debt restructuring should be accounted for as a modification or extinguishment.

ASC 470-50-40-10 does not address legal modifications or exchanges of debt instruments in which the embedded conversion option is separated and accounted for as a derivative under ASC 815 prior to modification, subsequent to modification, or both. The accounting for these transactions depends on the specific facts and circumstances.

Accounting for Modifications and Extinguishments / 5 - 23

Step 1:

Change in cash flows: Perform the 10 percent test discussed in FG section 5.4.1. The 10 percent test should not include any changes in fair value of the embedded conversion option.

If there is an extinguishment under Step 1, there is no need to conduct the additional tests in Step 2. However, if under Step 1 there is not an extinguishment, proceed to the tests in Step 2 to determine if extinguishment accounting is required.

Step 2:

Change in fair value of the embedded conversion option: If the change in the fair value of the embedded conversion option is greater than 10 percent of the carrying value of the original debt instrument immediately before the restructuring, account for the restructuring as an extinguishment. The fair value of the embedded conversion option is generally calculated using an option pricing model, such as the Black-Scholes-Merton model, based on the terms of the embedded conversion option and inputs such as market interest rates, the company’s stock price, the volatility of the company’s stock price, and the expected dividend yield on the company’s stock.

Addition or removal of an embedded conversion option: If the restructuring added or removed a substantive conversion option from the original debt instrument, the restructuring would automatically be accounted for as an extinguishment.

If the test in either Step 1 or Step 2 is met, the restructuring of the debt instrument should be accounted for as an extinguishment.

As noted in Step 1, the change in the fair value of an embedded conversion option resulting from a convertible debt restructuring should not be included in the 10 percent test. Further, Step 2 must be performed if the 10 percent test in Step 1 does not result in a conclusion that extinguishment accounting is required. Thus, if a convertible debt restructuring produces a change in cash flows that is less than 10 percent under Step 1 and the change in the fair value of an embedded conversion option is less than 10 percent under Step 2, then even if in the aggregate the changes exceed 10 percent of the original carrying value of the convertible debt instrument, extinguishment accounting is not required (assuming the second condition in Step 2 is not met).

See FG section 7.7 for a discussion of convertible debt extinguishment accounting.

See FG section 7.4.5 for a discussion of derecognition (including extinguishment) of convertible debt with a cash conversion feature. If a restructuring requires the application of extinguishment accounting and the new instrument does not require or permit cash settlement upon conversion, the new instrument would no longer be subject to the guidance for convertible debt with a cash conversion feature discussed in FG 7.4.

5.7.1 Convertible Debt Modification Accounting

When convertible debt is modified in a transaction that is not accounted for as an extinguishment, an increase in the fair value of the embedded, unseparated conversion option (calculated as the difference between the fair value of the embedded conversion option immediately before and after the modification or

5 - 24 / Accounting for Modifications and Extinguishments

exchange) should reduce the carrying value of the debt instrument (increasing debt discount or reducing debt premium) with a corresponding increase in additional paid-in capital. This additional discount would be amortized over the remaining term of the debt. However, a decrease in the fair value of an embedded conversion option resulting from a restructuring should not be recognized.

An issuer should not recognize a BCF or reassess an existing BCF upon a restructuring that is not accounted for as an extinguishment.

5.7.2 Convertible Debt with Cash Conversion Feature Modification Accounting

When convertible debt with a cash conversion feature is modified in a transaction that is not accounted for as an extinguishment, a new effective interest rate should be determined to amortize the remaining debt discount. If the modification affects the embedded conversion option so that it no longer requires or permits cash settlement, the liability and equity components should continue to be accounted for separately.

5.8 Modification vs. Extinguishment—Preferred Stock

The guidance in ASC 470-50 only addresses the accounting for debt modifications that involve a change in cash flows. There is no comparable guidance for evaluating and accounting for preferred stock modifications. In addition, many preferred stock modifications do not involve changes in cash flows, but may result in a significant change to the fair value of the security, such as a change in the liquidation preference order/priority, voting rights, or conversion ratio. As such, the accounting for preferred stock modifications depends on the facts and circumstances of each transaction, including the nature of, and reasons for, the modification.

5.8.1 Preferred Stock Modifications

Some legal modifications of preferred stock only involve the holders of different classes of preferred stock and do not impact common shareholders. For example, when a modification to outstanding preferred stock is made concurrent with the sale of new preferred stock, the existing preferred stockholders may make concessions regarding their rights in order to attract the new capital. The new preferred stock-holders may insist on such concessions as a condition of their investment to avoid immediate dilution of their investment upon closing. Based on an evaluation of fair value of the securities before and after the modification, such concessions by the existing preferred stockholders may represent a transfer of value from the existing preferred stockholders to the new preferred stockholders.

Transfers of value between different classes of preferred stockholders are generally not recorded by the company. However, these transactions are often very complex and should be carefully considered to determine the appropriate accounting. In some cases, additional consideration may be conveyed to the original preferred stockholders for agreeing to consent to the transaction (consent fee), which may need to be recognized as a charge to retained earnings and earnings per share (EPS).

Other preferred stock modifications may involve a transfer of value between preferred stockholders and common stockholders. In such cases, we believe it is generally appropriate to account for the modification based on the guidance in ASC 718-20-35-3 for modifications to stock compensation arrangements classified as equity. Accordingly, for these modifications, any change in value resulting from the

Accounting for Modifications and Extinguishments / 5 - 25

modification (computed as the difference between the fair value of the security with the new terms and the fair value of the security with the original terms, measured on the modification date) should be included in earnings available to common shareholders (used to calculate basic and diluted EPS) as an effective dividend to (from) preferred stockholders. This is similar to the EPS treatment for extinguishment gains (losses) on preferred stock in ASC 260-10-S99-2.

5.8.2 Preferred Stock Extinguishment Accounting

When preferred stock is legally extinguished (e.g., by exchanging Series A preferred stock for Series B preferred stock), the guidance in ASC 260-10-S99-2 applies (i.e., extinguishment accounting applies). Accordingly, in a legal extinguishment of preferred stock, companies should calculate the difference between (1) the fair value of the consideration transferred (Series B) to the holders of the Series A preferred stock and (2) the carrying value of the securities surrendered (Series A).

• If the fair value of the consideration transferred is greater than the carrying value of the securities surrendered (1) retained earnings should be reduced by the difference (in the absence of retained earnings, additional paid-in capital should be reduced) and (2) earnings available to common shareholders (used to calculate basic and diluted EPS) should be reduced by the difference.

• If the fair value of the consideration transferred is less than the carrying value of the securities surrendered, the difference should be credited to retained earnings and added to earnings available to common shareholders.

The accounting for extinguishments and modifications of preferred stock classified as liabilities under the guidance in ASC 480 is the same as that for other debt instruments. See the debt extinguishment discussion in FG section 5.6.

5.8.2.1 Extinguishment of Convertible Preferred Stock with a BCF

If an entity redeems a convertible preferred security with a beneficial conversion feature (BCF), the excess of (a) the fair value of the consideration transferred to the holders of the convertible preferred security over (b) the carrying value of the convertible preferred security on the issuer’s balance sheet plus (c) the amount previously recognized for the BCF, should be subtracted from net earnings to arrive at earnings available to common shareholders (used to calculate basic and diluted EPS). Similarly, if (a) the fair value of the consideration transferred to the holders is less than the sum of (b) the carrying value of the convertible preferred security on the issuer’s balance sheet, and (c) the amount previously recognized for the BCF, the difference should be added to earnings available to common shareholders.

5.9 Modification of Warrants Classified as Equity

Warrants to acquire common stock or preferred stock may be modified through an amendment. The reasons for a modification vary. Some modifications involve the reduction of the warrant exercise price to induce exercise and thus raise new capital. Other warrant modifications may be made in connection with modifications to preferred stock as discussed in FG section 5.8.1. Depending on the nature of, and reason for, the modification, there may be a need for a charge to earnings or retained earnings and EPS.

5 - 26 / Accounting for Modifications and Extinguishments

5.10 How PwC Can Help

Our debt restructuring consultants and Assurance professionals frequently advise companies regarding the interpretation and application of the accounting rules for debt restructurings, including:

• Whether a debt restructuring should be accounted for as a modification, an extinguishment, or a troubled debt restructuring.

• Identification of restructuring costs and whether those costs should be capitalized or expensed.

• Appropriate classification of restructured debt.

• Appropriate disclosures.

If you have questions regarding the accounting for debt restructurings or would like help in assessing the impact a debt restructuring has on your company’s financial statements, please contact your PwC engagement partner or one of the subject matter experts listed in the contacts section at the end of this Guide.

Debt / 6 - 1

Chapter 6: Debt

6 - 2 / Debt

6.1 Debt Instrument Overview

Entities issue debt for a number of reasons, including obtaining funding for:

• Day-to-day operations,

• Acquisitions and capital investments,

• Satisfying maturing debt,

• Share buybacks, and

• Pension plan contributions.

There are many types of debt instruments and agreements, each of which may contain features that require consideration in determining the appropriate accounting treatment. This chapter discusses a number of these features and discusses the potential accounting implications of each. See FG section 3.1 for a discussion of puts and calls embedded in debt instruments.

6.2 Balance Sheet Classification—Current vs. Non-Current

The ASC Master Glossary defines current liabilities as:

Obligations whose liquidation is reasonably expected to require the use of existing resources properly classifiable as current assets, or the creation of other current liabilities (emphasis added).

The principal guidance for determining the balance sheet classification of liabilities is contained in ASC 210-10-45-5 through 45-12. Under that guidance, current liabilities include:

• Short-term debt expected to be liquidated within one year (or operating cycle, if longer).

• Current maturities of long-term obligations.

• Obligations that, by their terms, are due on demand or will be due on demand within one year (or the operating cycle, if longer) from the balance sheet date, even if liquidation is not expected within that period.

• Long-term obligations that are (or will be) puttable by the creditor either because (a) the debtor’s violation of a provision of the debt agreement at the balance sheet date makes the obligation puttable or (b) the violation, if not cured within a specified grace period, will make the obligation puttable. When (1) cure of the violation is not expected within the grace period, resulting in the debt becoming puttable, (2) no waiver of the puttable debt will be granted, and (3) the company does not meet the conditions under ASC 470-10-45-13 through 45-20 for refinancing the short-term debt on a long-term basis (FG section 6.2.1).

• Contingently convertible debt with a cash conversion feature (FG section 7.4) for which (1) the issuer is required to or has asserted that it will settle the par or accreted value of the bond in cash upon conversion and (2) the contingency has been met at the reporting date.

Debt / 6 - 3

Example 6-1: Long-Term Loan Payable Upon Demand

Background/Facts:Company A has entered into a long-term loan agreement with Bank B that includes a provision allowing Bank B to demand full payment of the loan at any time.

Question:Should the loan be classified as non-current in the financial statements of Company A?

Analysis/Conclusion:No. Based on the guidance in ASC 470-10-45-9 and 45-10, loan amounts that have long-term maturities but enable the lender to demand payment at any time should be classified as current liabilities. Demand (or puttable) obligations are considered current liabilities as the timing of payment is controlled by the lender.

Example 6-2: Demand Provision vs. Subjective Acceleration Clause

Background/Facts: • As of December 31, 2013, Company A has two outstanding loans, Loan X and

Loan Y. Both loans have a stated maturity date beyond December 31, 2014 (one year from the balance sheet date).

• Loan X contains a demand provision that allows the lender to put the debt to Company A at any time.

• Loan Y contains a subjective acceleration clause (SAC) that would allow the lender to put the debt to Company A if Company A fails to maintain satisfactory operations or if a material adverse change in Company A’s financial condition occurs.

• The lender historically has not accelerated due dates of loans containing similar clauses and the financial condition of Company A is strong.

Question: How should Company A classify Loan X and Loan Y on its balance sheet as of December 31, 2013?

Analysis/Conclusion:Loan X, which contains a demand provision, should be classified as current.

Loan Y, which contains a SAC, should be classified as non-current.

A demand provision differs from a SAC in a long-term debt agreement, as discussed in ASC 470-10-45-2. A demand provision requires current liability classification even if liquidation is not expected within the period. A SAC does not require disclosure or classification of the debt as current if the likelihood of acceleration of the due date (the lender’s exercise of the SAC) is remote.

6 - 4 / Debt

Example 6-3: Impact of an Approved Debt Repayment Plan

Background/Facts:• On December 31, 2012, Company A had an outstanding debt instrument with a

maturity date of March 31, 2017, which the company classified as non-current.

• Prior to December 31, 2012, Company A announced a debt repayment plan, which was approved by its Board of Directors.

• Under the debt repayment plan, redemption is scheduled to occur in Q1 2013, subsequent to the release of the 2012 annual report on Form 10-K. The debt would not otherwise require repayment until its scheduled maturity date in 2017.

Question:How should Company A classify this debt instrument as of December 31, 2012?

Analysis/Conclusions:The redemption plan is not an irrevocable commitment to redeem the debt as of year-end and Company A’s announcement of the plan prior to the balance sheet date does not create a legally binding obligation to redeem the debt. Company A should continue to classify the debt in accordance with the original terms of the debt agreement, which would result in a non-current classification at December 31, 2012.

6.2.1 Short-Term Debt Refinanced on a Long-Term Basis After the Balance Sheet Date

ASC 470-10-45-14 allows short-term obligations to be reclassified as non-current at the balance sheet date if the borrower has the intent to refinance the short-term obligation on a long-term basis and its intent is supported by an ability to consummate the refinancing demonstrated in one of the following two ways:

1. Before that balance sheet is issued a long-term obligation or equity securities are issued that replace the short-term debt.

2. Before the balance sheet is issued, the borrower has entered into a financing agreement to refinance the short-term obligation on a long-term basis on terms that are readily determinable and all the following conditions are met:

a. The new financing agreement does not expire within one year from the balance-sheet date.

b. The debt that will be issued is not cancelable by the lender (and obligations incurred under the agreement are not puttable during that period) except for violation of a provision with which compliance is objectively determinable or measurable.

c. No violation of any provision of the financing agreement exists at the balance-sheet date and no available information indicates that a violation has occurred thereafter but prior to the issuance of the balance sheet.

d. If a violation of the financing agreement exists, a waiver has been obtained.

e. The lender or the prospective lender or investor is expected to be financially capable of honoring the financing agreement.

Debt / 6 - 5

If the financing agreement discussed in (2) has a subjective termination clause rather than an objective termination clause, the short-term debt will not be considered refinanced on a long-term basis. See FG section 6.2.1.1 for discussion of subjective acceleration clauses.

Example 6-4: Impact of Parent Guarantee

Background/Facts:• Company A has a short-term obligation to an unaffiliated third party that the

company intends to refinance on a long-term basis with a guarantee provided by its parent.

• The parent owns 100 percent of the company’s voting stock.

Question:Can Company A classify the short-term obligation as non-current since it has the intent to refinance the debt and a parent guarantee to support its ability to consummate the refinancing?

Analysis/Conclusion:No. Company A may classify a short-term obligation as non-current only if the conditions in ASC 470-10-45-14 (FG section 6.2.1) are met. One requirement, discussed in ASC 470-10-45-14(b)(1), is:

The agreement does not expire within one year from the date of the entity’s balance sheet and during that period the agreement is not cancelable by the lender or the prospective lender or investor (and obligations incurred under the agreement are not callable during that period) except for violation of a provision with which compliance is objectively determinable or measurable.

Although, Company A has demonstrated its intent to refinance the short-term obligation on a long-term basis by acquiring the long-term guarantee from its parent, the parent owns 100 percent of the company and thus, controls both the parties to the agreement and can cancel the guarantee at any time. Since there is no deterrent to prevent the parent from cancelling the guarantee, it is discretionary. As a result, the guarantee fails the provisions of ASC 470-10-45-14(b)(1).

6.2.1.1 Subjective Acceleration Clauses

Many long-term financing agreements contain clauses that allow the lender to refuse to lend if the borrower experiences an adverse change. These are often referred to as Subjective Acceleration Clauses (SAC), Material Adverse Change (MAC), or Material Adverse Effect (MAE) clauses.

A long-term financing arrangement that contains these clauses can be called at the discretion of the lender. Thus, such clauses prevent the reclassification of short-term obligations from current to non-current. This prohibition is due to the subjective nature of these clauses, which may be interpreted differently by the parties to the financing agreement. The fact that the lender can refuse to allow the company to refinance its short-term obligations undermines the company’s assertion that it has the ability to refinance the current obligation into long-term, non-current debt.

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6.2.1.2 Insufficient Refinancing and Fluctuating Balances

To meet the requirements for non-current classification based on refinancing, the amount of the short-term obligation to be refinanced cannot exceed the estimated minimum amount expected to be available under the long-term financing agreement. For financing agreements that specify objective criteria (e.g., inventory levels) that the borrower must maintain or achieve to ensure adequate borrowing capacity, the company should evaluate whether it will continue to meet the provisions set forth in the financing agreement.

When the provisions of the financing agreement call for the attainment of specified operating results, levels of financial position, or another measurement that exceeds those previously attained, classification as non-current is permissible only if it is reasonable to expect that the specified requirements can be achieved such that long-term borrowings (or successive short-term borrowings for an uninterrupted period under a financing agreement, as described in FG section 6.2.1.3) will be available to refinance the short-term debt outstanding at the balance sheet date on a long-term basis. Meeting this test requires a high degree of assurance.

Example 6-5: Refinancing Subject to Working Capital Requirement

Background/Facts:In January 2013, Lender A agrees to extend Company B’s loan, which is due on June 30, 2013, by one year. The extension requires that Company B maintain a specified level of working capital during the six months ending June 30, 2013.

Question:How should the loan be classified in the December 31, 2012, financial statements of Company B?

Analysis/Conclusion:It would be appropriate to reclassify the short-term debt as non-current at December 31, 2012, if the specified working capital level had been reached at December 31, 2012, and it is reasonable to expect that the working capital level will be maintained through June 30, 2013.

6.2.1.3 Refinancing with Successive Short-Term Borrowings

A short-term obligation that will be refinanced with successive short-term obligations may be classified as non-current as long as the cumulative period covered by the financing agreement is uninterrupted and extends beyond one year. This would include short-term borrowings under revolving credit agreements that permit either continuous replacement with successive short-term borrowings for more than a year or conversion to term loans extending beyond a year at the company’s option. These should be classified as non-current if the borrower intends to utilize those provisions and meets the criteria for refinancing the short-term debt on a long-term basis.

The rollover provisions must be included in the terms of the debt obligation; classification as non-current cannot be based solely on management’s intent. For example, short-term debt in the form of commercial paper must be supported by a contractually long-term financing arrangement, such as a revolving credit agreement with sufficient unused borrowing capacity to support the ability to refinance the

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commercial paper. Any SACs, MACs or MAEs in the refinancing agreements would cause the company to fail to meet the requirements to assert its ability to refinance its short-term debt on a long-term basis.

6.2.2 Revolving-Debt Arrangements

Revolving-debt arrangements with a contractual term beyond one year may require the execution of a note for each borrowing under the arrangement. While the credit arrangement may permit long-term borrowings, the underlying notes may be for a shorter term, possibly less than one year. When individual notes are issued, the debt should be classified based upon the term of each individual note, not based on the expiration date of the credit agreement, unless the conditions for non-current classification based on a refinancing are met (FG section 6.2.1).

Other revolving-debt arrangements may have a feature that gives the debtor the option to select between two different types of borrowings, each with potentially different terms. For example, a borrower may be able to choose between:

• A long-term, dollar-denominated loan having a maturity date consistent with the expiration date of the revolving debt arrangement and carries a rate of LIBOR, or

• A dollar-denominated loan with a maximum maturity of ninety days that carries a rate based on Euribor.

In such cases, the Euribor debt would require current classification unless (1) the conditions are met for refinancing the short-term debt on a long-term basis (FG section 6.2.1) or (2) the Euribor debt automatically converts at its maturity date, without any further actions, into the LIBOR debt with a long-term maturity date.

6.2.3 Commercial Paper

When the interest rate payable by a company on commercial paper is lower than the rate on long-term borrowings, a company may borrow funds by issuing commercial paper (which has maturities of 30, 60, or 90 days) and use the proceeds to repay borrowings under long-term revolving-debt arrangements. When the interest rate on the commercial paper exceeds the rate under the long-term revolving-debt arrangements, the company will borrow under the long-term revolving-debt arrangements and pay off the short-term commercial paper. Companies can reclassify their commercial paper as non-current, provided the requirements for refinancing the short-term commercial paper debt on a long-term basis (FG section 6.2.1) are met and appropriate disclosures are made in the notes to the financial statements.

Repayments of commercial paper using working capital after the balance sheet date followed by a borrowing under a long-term revolving-debt arrangement to replenish the working capital prior to the financial statement issuance date do not meet the intent requirement for refinancing a short-term borrowing on a long-term basis (FG section 6.2.1). The commercial paper should be classified as current.

Subject to meeting the conditions for refinancing a short-term borrowing on a long-term basis, the amount of the commercial paper to be presented as non-current at the balance sheet date should not exceed the estimated minimum amount expected to be available under the revolving-debt arrangement.

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Example 6-6: Reclassification of Commercial Paper to Non-Current

Background/Facts:• Company A has $100 million outstanding in commercial paper at the reporting

date.

• Company A has a long-term revolving-debt arrangement that will allow it to borrow up to $80 million. Company A projects that the full $80 million under the long-term revolving-debt arrangement will be available during the next year.

• The long-term revolving-debt arrangement contains no SAC, MAC, or MAE clauses with respect to future borrowings.

• The company has represented its intent to use the long-term revolving-debt arrangement to repay $50 million of the commercial paper at maturity in 30 days.

Question:Would it be appropriate for Company A to reclassify $50 million of the $100 million of commercial paper to non-current as of the balance sheet date?

Analysis/Conclusion:Yes, because the company will use long-term funding to achieve this outcome. If the company used its working capital to pay the $50 million of commercial paper at maturity and subsequently borrowed $50 million under the long-term revolving-debt arrangement, reclassification of the $50 million of commercial paper at the balance sheet date to non-current would be inappropriate as it used its working capital for repayment.

6.2.4 Liquidity Facility Arrangements for Variable Rate Demand Obligations

A Variable Rate Demand Obligation (VRDO) is a debt instrument, typically a bond, that the investor can put (or demand repayment). This feature gives the investor the ability to redeem the investment on short notice (usually 7 days) by putting the debt to the issuer’s remarketing agent. Upon an investor’s exercise of a put, the remarketing agent will resell the debt to another investor to obtain the funds to honor the put (i.e., to repay the investor). If the remarketing agent fails to sell the debt (referred to as a “failed remarketing”), the funds to pay the investor who exercised the put will often be obtained through a liquidity facility issued by a financial institution. Liquidity facilities typically take the form of a standby or direct-pay letter of credit, line of credit, or standby bond purchase agreement.

ASC 470-10-55-7 through 55-9 addresses these instruments and states that the presence of a “best-efforts” remarketing agreement (typical for VRDO issuances) should not be considered when evaluating whether the VRDO should be classified as current or non-current. A company must assume that a put will occur and unless the VRDO issuer has the ability and intent to refinance the debt on a long-term basis (FG section 6.2.1), VRDOs should be classified as a current liability. If a liquidity facility provides the issuer with the ability to refinance, issuers should evaluate the terms of their liquidity agreements in light of the requirements for refinancing a short-term borrowing on a long-term basis (FG section 6.2.1) for attributes that might impact balance sheet classification of the debt, including:

• Expiration date of the commitment. A liquidity facility for the VRDOs must be effective for at least one year past the balance sheet date. VRDOs supported by liquidity agreements that expire within one year of the balance sheet must be classified as current.

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• Covenant violations. Violations of covenants set forth in the liquidity agreements could cause termination of the agreement or demand for immediate repayment of any draws. There should be no violation of any provision in the financing agreement at the balance sheet date and no available information that indicates that a violation occurred after the balance sheet date but prior to the issuance of the financial statements. A covenant violation occurring prior to or after the balance sheet date requires a waiver to be obtained to achieve non-current classification. The form and content of the waiver needs to ensure that the waiver is in force for at least 12 months and is not subject to termination beyond those conditions set forth in the original agreement. See FG section 6.2.5 for further discussion of covenant violations.

• SAC, MAC, or similar clauses. The existence of subjective clauses that provide the lender with the ability to demand repayment based on subjective (rather than objective) criteria will typically preclude classification of the VRDOs as non-current.

• Repayment terms. The repayment terms of the liquidity facility will impact the determination of amounts due within one year of the balance sheet date (and thus the amount of the VRDOs that must be classified as a current liability). Some liquidity facilities have repayment terms that are installment-based and others require a balloon payment at the facility’s expiration date.

• Ability to cancel. The lender should not have the ability to cancel the credit facility within one year from the balance sheet date except for violations of the terms of the agreement (including failure to meet a condition, or breach or violation of a provision, such as a restrictive covenant, representation, or warranty) that can be objectively measured.

During the financial crisis, the demand for and cost of liquidity facilities increased significantly. As a result, organizations are evaluating alternative liquidity facilities to provide back-up funding in the event that VRDOs are put. These liquidity facilities require an organization to ensure that it has sufficient cash or funds available in the event puts occur. The absence of a third-party liquidity provider to refinance the debt on a long-term basis generally will result in classification of the VRDOs as a current liability.

6.2.5 Covenant Violations

Many debt agreements contain covenants that the borrower must adhere to throughout the life of the agreement. The terms of the covenants are negotiated between the borrower and the lender and may vary from agreement to agreement. Financial ratio covenants, which require the borrower to maintain various financial ratios, are included in nearly every debt agreement.

A breach of a covenant triggers an event of default. An event of default may lead to an increase in the interest rate and a potential demand for repayment (i.e., the debt becomes due).

Long-term obligations that are, or will be, puttable by the lender are required to be classified as current liabilities. A long-term obligation could be puttable by the lender because:

• The borrower has violated a covenant in the debt agreement, which makes the obligation puttable by the lender.

• The violation, if not cured within a specified grace period, will make the obligation puttable by the lender.

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Under ASC 470-10-45-11, these puttable1 obligations must be classified as current unless:

• The creditor has waived the right to demand repayment for more than a year (or an operating cycle, if longer) from the balance sheet date. If the obligation is puttable because of violations of certain provisions of the debt agreement, the creditor needs to waive its right with regard only to those violations.

• The creditor has subsequently lost the right to demand repayment for more than a year (or an operating cycle, if longer) from the balance sheet date. For example, the debtor has cured the violation after the balance sheet date and the obligation is not puttable at the time the financial statements are issued.

• For obligations containing a grace period within which the debtor may cure the violation, it is probable that the violation will be cured within that period, thus preventing the obligation from becoming puttable.

ASC 470-10-55-2 through 55-6 specifies additional guidance when there has been a covenant violation at the balance sheet date that has been subsequently waived (for a period greater than one year) and there are the same or more restrictive covenants at subsequent compliance measurement dates within the next year. Classification of such an obligation as a current liability at the balance sheet date is not required if:

• The debtor has cured the violation after the balance sheet date within the specified grace period such that the debt is not puttable at the financial statement issuance date.

• The obligation is not puttable at the time the financial statements are issued due to receipt of a waiver from the creditor in which the creditor has given up its right (arising from the covenant violation) to demand repayment for more than one year from the balance sheet date and the borrower has determined that it is not probable that violation of the same or more restrictive covenants will occur at subsequent compliance measurement dates within the next year that will make the debt puttable.

• The short-term obligation meets the requirements for refinancing on a long-term basis (FG section 6.2.1).

Example 6-7: Violation of a Provision in the Debt Agreement

Background/Facts:• Company A is a publicly-traded enterprise, with its stock traded on the NASDAQ

Stock Exchange (the “Stock Exchange”).

• At December 31, 2012, Company A has an outstanding bond with a maturity date of December 31, 2015. The bond indenture contains a feature that allows investors to put the bonds to Company A upon the occurrence of a “fundamental change.” One of the events defined as a fundamental change is the Company losing approval for trading on the Stock Exchange (referred to as delisting).

1 ASC 470-10-45-11 refers to debt that is callable by the lender. We have referred to these instruments as puttable because debt that is callable by the lender is the same as puttable debt (i.e., the lender may require the issuer to repay the debt prior to its contractual maturity date).

(continued)

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• On December 15, 2012, Company A failed to meet the requirements of a NASDAQ Rule that requires a minimum market value of securities. The Stock Exchange notified the Company that its stock would be delisted within forty-five business days (i.e., in February 2013) unless the Company obtained a waiver of the violation from the Stock Exchange.

• It is not probable that the Company will be able to cure the violation during the period between the notification date and the delisting date.

Question:How should Company A account for the bond in the December 31, 2012, financial statements?

Analysis/Conclusion:The Company should classify the bond as a current liability on the balance sheet reporting date.

The condition prompting the delisting was present as of the balance sheet date and therefore is considered a violation as of December 31, 2012.

6.2.5.1 Payments Made to Effect a Change in Debt Covenants or a Waiver of a Covenant Violation

A payment (of cash or other instruments) made to a lender to effect a waiver of a covenant violation is considered a modification of the terms of the debt instrument. When such a payment is made, the issuer should analyze the modification using the debt restructuring guidance discussed in FG section 5.4.1.

6.2.6 Effect of Subjective Acceleration Clauses on the Classification of Long-Term Debt

A long-term obligation that contains a subjective acceleration clause (SAC) is not required to be classified as a current liability so long as acceleration of the due date is judged as remote. However, if the company’s circumstances are such that acceleration of the due date is probable (for example, there are recurring losses or liquidity problems), long-term debt subject to a SAC should be classified as a current liability. If acceleration of the due date is judged reasonably possible, disclosure of the existence of a SAC clause is generally sufficient.

This guidance differs from the requirement to reclassify short-term obligations at the balance sheet date to non-current and the prohibition of replacement long-term borrowing and financing agreements from being cancellable by the lender based upon a subjective acceleration clause. The requirement to reclassify short-term obligations at the balance sheet date to non-current represents a higher standard for a financing agreement than is required for long-term debt obligations that have a SAC. As noted in ASC 470-10-55-1, this different standard reflects the fact that in the case of long-term debt, the lender has already loaned money on a long-term basis and the continuation of non-current classification requires a judgment about the likelihood of acceleration of the due date caused by an exercise of the SAC by the lender.

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6.2.6.1 Balance Sheet Classification of Borrowings Outstanding under Revolving Credit Agreements That Include both a Subjective Acceleration Clause and a Lock-Box Arrangement

Borrowings that are legally long-term under a revolving credit agreement must be classified as current if they include:

• A Subjective Acceleration Clause (SAC), Material Adverse Change clause (MAC), or Material Adverse Effect clause (MAE), and

• A requirement to maintain a lock-box arrangement (or a sweep feature or other creditor arrangements), whereby remittances from the borrower’s customers must reduce the revolving debt outstanding.

Such lock-box arrangements require that working capital be used to reduce the debt outstanding and thus current classification of the debt is required even though the revolving credit agreement may have a long-term contractual maturity. However, as discussed in FG section 6.2.1.3, short-term borrowings under revolving credit agreements that permit either continuous replacement with successive short-term borrowings for more than a year or conversion to term loans extending beyond a year at the company’s option should be classified as non-current if the borrower intends to utilize those provisions and meets the criteria for refinancing the short-term debt on a long-term basis (FG section 6.2.1). Consequently, the removal of a SAC, MAC, or MAE would permit a revolving line of credit with a lock-box arrangement to be classified as non-current provided it meets the requirements for refinancing with successive short-term borrowings discussed in FG section 6.2.1.3. The lock-box arrangement does not in and of itself require current classification of the debt.

Borrowings outstanding under a revolving credit agreement that includes both a SAC and a requirement to maintain a “springing” lock-box, whereby remittances from the borrower’s customers are not forwarded to the lender to reduce the debt outstanding until and unless an event of default occurs, are non-current obligations, because the remittances do not automatically reduce the debt outstanding without another event occurring. In this circumstance, the effect of the SAC on classification of this long-term debt should be determined based on the guidance described in FG section 6.2.6.

6.3 Classification of Liabilities as “Trade Accounts Payable” or “Other Liabilities/Bank Debt” in a Structured Payable Transaction

For a variety of reasons, a company may establish a payment program with a financial institution (e.g., a bank) whereby the bank will make payments to vendors on behalf of the company. This could be done as part of a cash management service offering of a bank, to take advantage of discounts offered by vendors as incentives for making early payments, or to provide vendors the opportunity to sell their receivables to a financial institution (which typically results in better payment terms for the company).

For example, such an arrangement may involve:

• Company A and Bank B approach certain of the Company’s vendors regarding entering into a new payment program.

• Under the payment program, the Bank pays the vendors directly.

• Company A is then obligated to pay the Bank an agreed upon amount.

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• Once a vendor’s receivable has been selected for the program, further adjustments (e.g., product returns) are not permitted. As such, any future adjustments would be negotiated between the Company and the vendor.

The balance sheet classification of the resulting payable depends on the economic substance of the arrangement. If the arrangement is similar to a factoring arrangement and the legal classification of the payable remains that of a trade payable, it would be classified as such. If the arrangement is substantively a refinancing of the trade payables with the bank, it should be classified as debt or other liabilities. If the arrangement results in balance sheet classification as debt or other liabilities, it would impact the classification of the payments in the company’s statement of cash flows as they would now be considered a financing activity used to pay off a vendor payable (an operating activity).

Guidance relevant to making this determination is limited. Some arrangements may appear to be structured transactions to avoid classifying the arrangement as a borrowing. The SEC Staff2 has stated that an entity must thoroughly analyze all the facts and circumstances specific to the individual transaction to ensure that the accounting for the transaction reflects the substance of the transaction. The following are among the factors that an entity should consider in this analysis:

• The roles and responsibilities of each party (a tri-party agreement may indicate a refinancing of the payable),

• Whether the program is offered to a wide range of vendors and whether vendor participation in the program is voluntary,

• Impact of the transaction on other contractual arrangements,

• Whether default on payment to the bank under such an arrangement would trigger a cross default (other than a general debt obligation cross-default),

• Whether there would be an automatic drawdown on the company’s line of credit with the bank upon a failure to pay on a payable,

• Any fees, interest, commissions, rebates or discounts,

• Any extended deadlines for paying third parties,

• Whether the terms of the payable to the bank are those typical of a trade payable, and

• Whether the payable continues to meet the UCC definition of a trade payable.

6.4 Payment in Kind

Some debt agreements provide that interest accrued must be paid in kind (PIK) with the same instruments as those in the original issuance. With PIK debt, cash interest is deferred, generally at the issuer’s option, until some later date. Unlike zero-coupon bonds, which simply accrete interest from a discounted amount up to par, the interest rate on PIK debt is paid out over time with issuances of the same security.

Some agreements allow for interest to be paid in another series of preferred stock or debt. Other agreements provide that accumulated undeclared dividends or unpaid interest can be paid in additional shares of common stock upon the holder’s conversion of the preferred stock or debt. Some provide both a PIK feature and a conversion feature for the accumulated dividends or unpaid interest.

2 Discussed in speech at 2004 AICPA National Conference in Current SEC and PCAOB Developments.

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PIK notes are separate loan commitments from the original debt issuance because each time the interest payment comes due and the issuer elects to pay with PIK notes, the lender is issuing the company a separate debt instrument. These types of loan commitments (for the interest) may meet the definition of a derivative.

A scope exception from derivative accounting exists for borrower loan commitments per ASC 815-10-15-13(i). Specifically, the guidance states that a potential borrower’s ability to borrow is not subject to the requirements of ASC 815, and there is no requirement for the borrower to separately account for these commitments.

6.4.1 Classification of Accrued Interest Payable Settlable with Paid-in-Kind (PIK) Notes

The terms of debt instruments may permit the issuer to satisfy accrued interest on the debt with additional PIK notes having identical terms (maturity date, interest rate, etc.) as the original debt. In such cases, the original debt is referred to as PIK notes. Typically, the interest may be paid either in cash or additional (PIK) notes, at the issuer’s discretion. If the issuer intends on paying the interest with additional notes, the balance sheet classification of the accrued interest payable should be based on the maturity date of the additional notes expected to be issued.

Example 6-8: Accrued Interest Settlable in PIK Notes

Background/Facts:• In October 2013, Company A issued floating-rate senior PIK notes that are due on

September 30, 2018.

• The notes have semi-annual interest payments payable in the form of cash or additional PIK notes at Company A’s option.

• Company A intends on paying the interest in the form of additional PIK notes. The maturity date of the PIK notes delivered to settle the interest payments is the same as the original note.

Question:How should Company A classify the accrued interest on the notes as of December 31, 2013?

Analysis/Conclusion:At December 31, 2013, Company A should classify the accrued interest as non-current liabilities since it has both the intent and ability to refinance the short-term liability (accrued interest) on a long-term basis.

The issuance of the original PIK notes demonstrates Company A’s ability to consummate a refinancing of the interest on a long-term basis, with terms that are readily determinable and meet all of the following conditions:

1. Does not expire within one year from the Company’s balance sheet.

2. The agreement (i.e., the right to satisfy interest with long-term PIK notes) is not cancellable by the lender.

3. The PIK notes issued under the agreement are not puttable, except for violations for which compliance is objectively measurable.

(continued)

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4. No violation of any provision in the financing agreement exists at the balance sheet date.

5. There is no available information that indicates that a violation has occurred after the balance sheet date and prior to the issuance of the financial statements, which would prevent the issuer from having the right to satisfy the interest with long-term PIK notes; for example, there is no covenant violation of the original PIK notes that would:

— Accelerate their due date and the due date of any additional PIK notes that might be used to satisfy the interest, or

— Prevent the issuer from electing to pay the interest in PIK notes while there is a covenant violation of the original PIK notes.

6. The lender entered into the financing agreement permitting interest to be refinanced with PIK notes.

7. The company is expected to be financially capable of honoring the agreement.

6.5 Guarantees on Debt

Under ASC 460, guarantees of a third-party’s indebtedness and indirect guarantees of the indebtedness of others (when the creditor has only an indirect claim against the guarantor) are to be recorded by the guarantor as a liability at fair value. The following guarantees are excluded from the initial recognition and measurement provisions of ASC 460-10-15-4:

• A guarantee between a parent and its subsidiaries.

• Guarantees between corporations under common control.

• A parent’s guarantee of its subsidiary’s debt to a third party.

• A subsidiary’s guarantee of the debt owed to a third party by either its parent or another subsidiary of that parent.

See ASC 460-10-25-1 for additional arrangements that are excluded from its initial recognition and measurement requirements.

ASC 460-10-50 requires disclosures by guarantors, including guarantees that are excluded from the initial recognition and measurement provisions of ASC 460. Disclosures related to intercompany guarantees are only required in the separate financial statements of the issuer of the guarantees. See ASC 460-10-15-7 for additional arrangements that are excluded from all of its requirements (i.e., initial recognition, measurement, and disclosure).

Although not within the scope of ASC 460, a company should consider disclosing guarantees of its indebtedness by principal shareholders or other related parties to inform the reader that the company may not be able to obtain financing without the guarantees of others.

Per ASC 825-10-25-13, the issuer of a liability with an inseparable third-party credit enhancement shall not include the effect of (benefit of) the credit enhancement in the fair value measurement of the liability. In determining the fair value of debt with a third-party guarantee, the issuer would consider its own credit standing and not that of the third-party guarantor.

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Certain guarantee contracts may meet the definition of a derivative in ASC 815-10-15-83, which would require the guarantee contracts to be reported at fair value with changes in fair value recorded in earnings.

ASC 815-10-15-58 provides a scope exception from derivative accounting treatment for certain financial guarantee contracts that meet all of the following conditions:

a. The guarantee provides for payments to be made solely to reimburse the guaranteed party for failure of the debtor to satisfy its required payment obligations under a non-derivative contract, at:

1. Prespecified payment dates,

2. Accelerated payment dates as a result of the occurrence of an event of default (as defined in the financial obligation covered by the guarantee contract), or

3. An accelerated payment date due to a notice of acceleration made to the debtor by the creditor.

b. Payment under the financial guarantee contract is made only if the debtor’s obligation to make payments as a result of conditions as described in (a) is past due.

c. The guaranteed party is exposed to the risk of nonpayment both at inception of the financial guarantee contract and throughout its term through direct legal ownership of the guaranteed obligation or through a back-to-back arrangement with another party that is required by the back-to-back arrangement to maintain direct ownership of the guaranteed obligation.

Financial guarantee contracts are subject to ASC 815 if they do not meet all three of the above conditions. For example, some contracts require payments to be made in response to changes in another underlying, such as a decrease in a specified debtor’s creditworthiness.

6.6 Contingent Interest on Debt

Some debt securities pay additional interest only when certain conditions exist. For example, the amount of interest to be paid may be based on company stock price, company credit rating, or the amount of dividends declared on the company’s common stock.

In other scenarios, the payment of additional interest may be contingent on the occurrence of certain events. For example, additional interest could be paid to investors upon a change in tax law (e.g., withholding or deduction) that increases the tax obligation of certain investors. In such cases, the issuer will often pay additional amounts so that the payments received by the investors after such withholding or deduction will equal the amounts they would have received in the absence of such withholding or deduction.

A contingent interest feature that meets the definition of a derivative would be considered clearly and closely related to a debt host when indexed solely to interest rates and credit risk. Many contingent interest features in debt instruments are not considered clearly and closely related to the debt host, thus are separated and accounted for as derivatives. Although the contingent interest might not be material to an issuer’s financial statements initially (e.g., due to a low probability of the condition or event occurring that would require such additional payments), the issuer should monitor and periodically assess its materiality.

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Certain contingent obligations to pay additional interest may meet the definition of a registration payment arrangement within the scope of ASC 825-20. The scope of the guidance includes arrangements requiring payment of an increased interest rate on debt instruments as a consequence of not obtaining a listing on a stock exchange. In these circumstances, the contingent obligation to pay additional interest should be recognized and measured separately in accordance with ASC 450-20-25 (and not ASC 815). See FG section 3.8 for further discussion of registration payment arrangements.

The determination of the likelihood of paying contingent interest must be consistent for book and tax purposes. That is, if the issuer determines that the value of the contingent interest is not material because the likelihood of payment is remote, then the same assertion should be used when determining if the interest is deductible for tax purposes. One should question any conclusion that payment of such feature is remote for book purposes but reasonably possible or probable for tax purposes.

6.7 Joint and Several Liability

Under joint and several liability, the total amount of an obligation is enforceable against any of the parties to the arrangement. For example, under joint and several liability in a lending arrangement, the lender can demand payment in accordance with the terms of the arrangement, for the total amount of the obligation from any of the obligors or any combination of the obligors. The obligors cannot refuse to perform on the basis that they individually only borrowed a portion of the total, nor that other parties are also obligated to perform. However, the paying obligor may be able to pursue the other obligors for repayment, depending on the agreement amongst the co-obligors and the laws covering the arrangement.

Joint and several liabilities can exist between entities that are under common control. Entities that are under common control may be jointly and severally liable for the obligations of the parent, or a sister company that is under common control. For instance, multiple subsidiaries may participate in a financing arrangement in which each subsidiary borrows a specified amount, but are jointly and severally liable for repayment of the total debt incurred by the group. Joint and several liability arrangements can also exist between unrelated parties. For instance, several unrelated entities may be jointly and severally liable as a result of a legal settlement.

ASU 2013-04, which has been codified into ASC 405, addresses issues related to the recognition, measurement, and disclosure of obligations resulting from joint and several liability arrangements for which the total amount under the arrangement is fixed at the reporting date. ASU 2013-04 does not address obligations resulting from joint and several liability arrangements that are specifically addressed within existing U.S. GAAP guidance, such as asset retirement and environmental obligations, contingencies, compensation retirement benefits, and taxes.

The standard is effective for public companies for fiscal years and interim periods within those fiscal years beginning after December 15, 2013. Non-public companies will adopt the standard for fiscal years ending after December 15, 2014, and interim and annual periods thereafter. Early application is permitted.

The FASB adopted ASU 2013-04 in order to address the diversity in practice related to the accounting for joint and several liabilities. Previously, some entities followed the guidance in ASC 405-20 and recorded the full liability, while other entities considered the guidance in ASC 450-20 and ASC 410-30 and recorded its estimated portion of the total obligation subject to joint and several liability.

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6.7.1 Scope

ASU 2013-04 applies to obligations resulting from joint and several liability arrangements for which the total amount under the arrangement is fixed at the reporting date, except for obligations accounted for under:

• Asset retirement and environmental obligations accounted for under ASC 410;

• Contingencies accounted for under ASC 450;

• Guarantees accounted for under ASC 460;

• Compensation retirement benefits accounted for under ASC 715; and

• Income taxes accounted for under ASC 740.

When assessing whether obligations are potentially within the scope of ASU 2013-04, companies must carefully assess their agreements and ensure that all features within the agreements are understood. Contractual features that may appear to result in an agreement having joint and several liability may be a guarantee. For instance, in an arrangement where two unrelated companies form a joint venture, the joint venture may obtain financing from a bank. If the bank is required to demand repayment from the company formed in the joint venture first, and only upon non-performance by the joint venture can the bank demand repayment from the two entities that formed the joint venture, then the two companies may not have a joint and several liability, instead, the companies may have a guarantee that is required to be accounted for under ASC 460.

In order for the total amount of an obligation to be considered fixed at the reporting date, ASC 405-40-15-1 states that there can be no measurement uncertainty at the reporting date relating to the total amount under the arrangement. However, the total amount under the arrangement could be subject to change, and still be subject to ASU 2013-04. This would only occur in situations where the total amount under the arrangement subsequently changed due to factors that are unrelated to measurement uncertainty. For instance, a company may be jointly and severally liable for an amount borrowed under a line of credit. At the reporting date, this amount is fixed, however, in subsequent periods additional amounts could be borrowed under the line of credit. Another example would relate to floating rate debt. At the reporting period, the amount is fixed, and thus would be subject to ASU 2013-04; however, in subsequent periods the interest rate may change.

Example 6-9: Contingency vs. Joint and Several

Background/Facts:• Company D and Company E are companies that jointly marketed a product.

• A lawsuit is brought against Company D and Company E claiming that the product posed a threat to the public. Under government laws and regulations for the product, Company D and Company E are jointly and severally liable.

• The litigation is still ongoing however; both companies believe that a loss is probable and could be reasonably estimated.

Question:Should Company D and Company E apply ASU 2013-04?

(continued)

Debt / 6 - 19

Analysis/Conclusion:No. As the litigation is still ongoing the amount of the loss is not fixed at the reporting date, Company D and Company E are outside of the scope of ASU 2013-04 and should apply ASC 450-20, Contingencies—Loss Contingencies.

Example 6-10: Judicial Ruling

Background/Facts:• This example is based on the same information and assumptions used in Example

6-9.

• The case is now completed, and a judicial ruling has been given.

• The defendants will each be required to pay an amount under the lawsuit but will be joint and several for the total amount.

Question:Should Company D and Company E apply ASU 2013-04?

Analysis/Conclusion:Yes, the amount has become fixed at the reporting date and Company D and Company E have an obligation under a joint and several liability arrangement. Therefore, they would be within the scope of ASU 2013-04. Each company would be required to record a liability equal to the amount that it agreed to pay, as well as its best estimate for any additional amount it expects to pay.

6.7.2 Recognition

Obligations resulting from joint and several liability arrangements are to be measured as the sum of the following: (a) the amount the reporting company agreed to pay with its co-obligors and (b) any additional amount the reporting company expects to pay on behalf of its co-obligors. The corresponding entry or entries (i.e., cash, an expense, a receivable, an equity transaction, and/or another account) will depend on the specific facts and circumstances of the transaction.

In assessing the amount a company expects to pay, a company would not apply a probability weighted threshold to record any additional liability (i.e., a company would not follow a more-likely-than-not threshold). A company is required to record their best estimate which is the single most-likely amount in a range of possible estimated amounts. Therefore, if a company develops a range of amounts that they could be required to pay, and one number in the range is better than the others, than that amount should be recorded. To the extent that no amount within the range is a better estimate than any other amount, then ASC 405-40-30-1 requires the company to record the minimum amount in the range.

As the measurement guidance requires that a company record the sum of the amount that it has agreed to pay, and what it expects to pay, a company could not avoid the recognition of its portion of the joint and several liability because the company does not believe it is going to be able to pay.

Companies are required to use the guidance above to measure both the initial liability, as well as the liability in subsequent periods.

6 - 20 / Debt

6.7.2.1 Recoveries

Under a joint and several arrangement the party to the transaction that is asked to pay the entire obligation may be able to demand repayment in full from the co-obligors. If one or more of the co-obligors are required to repay an amount in excess of the amount they agreed to repay with their co-obligors, they may be able to record a recovery for the amount due to them from the other co-obligors. ASU 2013-04 does not provide specific guidance with respect to recording recoveries under a joint and several liability arrangement. A company must consider the facts and circumstances of each joint and several liability arrangement to determine if a recovery should be recorded. Depending on the facts and circumstances of a transaction, a company could have a receivable or a gain contingency.

Determining whether a company has a receivable or a gain contingency will require the use of judgment. If the company has a contractual right to demand repayment from the other co-obligors, then recording a receivable may be appropriate if the company has been asked to contribute more than what it originally agreed to. If the company records a receivable, it would also be required to assess the receivable for impairment. If the company does not have a contractual right to demand repayment from the other co-obligors, then the recovery may be considered a gain contingency. For instance, if the company does not have a contractual right to demand repayment, but intends on suing the co-obligors then the recovery may be viewed as a gain contingency. Companies should also consider the nature of transactions between entities under common control, as these transactions may be capital in nature. For instance, if one of the sister companies pays the obligation in full and the parent company directs the company to forgive the debt for the other co-obligors, then a capital distribution may have taken place. Refer to ARM 5520.25 “Advances to, and Receivables from, Shareholders,” for additional considerations around related party transactions.

Example 6-11: Recording Receivables

Background/Facts:• Company Q and Company R are each wholly own subsidiaries of Parent

Company.

• Company Q raises $50 million in debt, and uses $25 million for its corporate purposes, and provides $25 million in proceeds to Company R for its corporate purposes. Both Company Q and Company R are jointly and severally obligated for the full amount of the debt.

• They have agreed internally through a written agreement to repay the proceeds on their respective proceeds as allocated day one, and which enables each company to obtain recovery from the other should they be asked to pay a greater amount.

• The bank demands repayment in full on the debt from Company Q, because Company R is experiencing financial difficulty.

Question:Can Company Q record a receivable for the $25 million from Company R?

(continued)

Debt / 6 - 21

Analysis/Conclusion:Yes. Company Q and Company R have a legally enforceable arrangement which indicates that each party is responsible for repaying the amount each party borrowed under the arrangement. Therefore, Company Q should record a receivable for $25 million. However, Company Q must assess the receivable for impairment and may need to recognize an allowance for the amount considered uncollectible.

Example 6-12: Capital Transactions

Background/Facts:• This example is based on the same information and assumptions used in Example

6-11.

• However, Company R is not experiencing financial difficulty but the Parent Company has decided that Company R will not repay the $25 million that it owes to Company Q.

Question:Can Company Q record a receivable for the $25 million from Company R?

Analysis/Conclusion:No. The parent company’s decision to override the terms of the agreement providing for Company R to repay Company Q is effectively a transfer of capital between the subsidiaries. Accordingly, Company Q should record the transaction as a distribution of capital.

6.7.3 Disclosures

A company is required to disclose for each liability or each group of similar liabilities:

• The nature of the arrangement, including how the liability arose, the relationship with other co-obligors, and the terms and conditions of the arrangement.

• The total amount outstanding under the arrangement, which cannot be reduced by the effect of any amounts that may be recoverable from other co-obligors.

• The carrying amount, if any, for a company’s liability and the carrying amount of a receivable recognized, if any.

• The nature of any recourse provision that would enable recovery from other companies of the amounts paid, including any limitations on the amounts that might be recovered.

• In the period the liability is initially recognized and measured or in a period the measurement changes significantly, the corresponding entry and where it was recorded in the financial statements.

While not addressed in the ASU, if a company discounts its liabilities, then companies are encouraged to disclose the undiscounted amount of the liability, as well as the discount rate used.

6 - 22 / Debt

6.7.4 Transition

The standard is effective for public companies for fiscal years and interim periods within those fiscal years beginning after December 15, 2013, and non-public companies will adopt the standard for fiscal years ending after December 15, 2014, and interim and annual periods thereafter. ASC 405-40-65-1 provides specific transition guidance for companies adopting the standard. The standard calls for a modified retrospective transition. Therefore, a company would only apply this standard to those obligations that existed at the beginning of a company’s fiscal year of adoption. In order to record the liability for these arrangements in the comparative periods presented in the initial year of adoption, a company may use hindsight, and is required to disclose that fact. The use of hindsight would allow a company to recognize, measure, and disclose obligations resulting from joint and several liability arrangements in comparative periods using information available at adoption, rather than requiring a company to make judgments about what information it had in each of the prior periods to measure the obligation. If a company had an obligation that existed in a comparative period, but it was extinguished prior to the beginning of the fiscal year the entity adopts ASU 2013-04, then a company would not adjust its previous accounting for the obligation.

6.8 How PwC Can Help

Our capital market transaction consultants and Assurance professionals frequently advise companies regarding the interpretation and application of the accounting literature to debt instruments, including:

• Classification of debt instruments as current or non-current.

• Classification (i.e., trade account payable or other bank debt) of a structured vendor payable transaction.

• Whether embedded components such as put and call options (discussed in Chapter 3) should be separated and recorded at fair value with changes in fair value recorded in earnings.

• Guarantees on debt.

• Appropriate disclosure items.

If you have questions regarding the accounting for a debt instrument or would like help in assessing the impact a debt issuance would have on your company’s financial statements, please contact your PwC engagement partner or one of the subject matter experts listed in the contacts section at the end of this Guide.

Convertible Debt / 7 - 1

Chapter 7: Convertible Debt

7 - 2 / Convertible Debt

7.1 Analysis of Convertible Debt

Convertible debt is a debt instrument (typically a bond) that the investor can either:

• Hold until maturity and redeem for par value, or

• Exercise the conversion option and receive an amount equal to (1) a fixed number of shares multiplied by (2) the issuer’s stock price at the date of conversion.

If the conversion option is in the money, the investor would exercise the option and take the shares, which are worth more than the par value of the debt. However, the investor should only exercise the conversion option when it’s in the money at (or close to) the bond’s maturity date. Exercising the conversion option at an earlier date causes the investor to forfeit the time value of the conversion option. Rather than early exercising a conversion option, investors looking to exit a bond typically sell the bond to another investor who will pay for both the intrinsic (in the money) and time values.

If the issuer’s stock price does not reach a level where the conversion option is in the money, the investor would not exercise its option, the debt will mature, and the investor will receive the par value.

One of the key benefits to issuers of convertible debt is the relatively low cash coupon (due to the value of the conversion option) when compared to similar non-convertible debt. The interest deducted for tax purposes, however, may be significantly higher through the use of a contingent interest feature (FG section 7.9) or a call option overlay (FG section 7.10.3). In deciding whether to issue convertible debt, a company must weigh these benefits with the risk of diluting shareholders’ equity through the issuance of equity at the specified conversion price.

Many convertible debt instruments contain a number of complicated provisions—such as puts and calls, contingent conversion options, and contingent interest provisions—that must be analyzed to determine whether the features need to be accounted for separately.

One of the first decisions an issuer of convertible debt makes in determining the structure of the debt it will issue is the settlement method upon conversion. There are two primary methods of settling a debt upon conversion (1) entirely in shares or (2) in some combination of cash and shares. An issuer must weigh cash management, dilution, and earnings per share considerations, among others, when deciding on a settlement feature. See FG section 7.4 for a discussion of convertible debt with cash conversion features.

The following flowchart lays out a framework for navigating the many standards that must be applied to determine the appropriate accounting treatment by the issuer of a convertible debt instrument.

See FG section 4.3.1 for a discussion of the EPS treatment of share-settled convertible debt. See FG section 4.6 for a discussion of the EPS considerations for convertible debt with a cash conversion feature.

Convertible Debt / 7 - 3

Analysis of Convertible Debt

Should the embedded conversionoption be separately accounted for

pursuant to the guidance in ASC 815?1

(FG section 7.2)

Does the instrument contain acash conversion feature

(as defined in FG section 7.4)?

(FG section 7.4)

Account for conversion optionseparately, initially record at fairvalue with changes in fair value

recorded in earnings.

Does the instrument contain abeneficial conversion feature (BCF)?

(FG section 7.3)

Account for the instrument as aliability in its entirety.

Separate the instrument into debtand equity components following therespective allocation guidance for a

BCF or cash conversion feature.

(FG sections 7.8 through 7.10)

Evaluate other embedded components—such as put options, call options, contentengent interest—to determine whether they require separate accounting

as derivatives (see FG section 7.8 through 7.10).

No

NoYesYes

YesNo

1 Note that the analysis used to determine whether to separate an embedded conversion option differs for “conventional” convertible debt versus “non conventional” convertible debt.

7 - 4 / Convertible Debt

Methods of Separating Convertible Debt

Method When Applied Description of Methodology Result

Derivative Separation

If the embedded conversion option must be separated and accounted for under the guidance in ASC 815

• Determine the fair value of the embedded conversion option

• Record the conversion option at fair value and reduce the debt liability by an equivalent amount

• Carry the conversion option as a liability at fair value with changes in fair value recorded in earnings

• Amortize the discount on the debt liability to interest expense over the life of the bond

• Debt liability carried at accreted value

• Separate derivative liability recorded at fair value with changes in fair value recorded in earnings

Cash Conversion Option Separation

If the bond must be separated into debt and equity components under the guidance in ASC 470-20

• Determine the fair value of the debt liability by determining the fair value of an equivalent debt instrument without a conversion option

• Record the debt liability at fair value as calculated above

• The difference between the proceeds received and the debt liability is recorded in additional paid-in capital

• No subsequent remeasurement of the amount recorded in equity

• Amortize the discount on the debt liability to interest expense over the expected life of the bond

• Debt liability carried at accreted value

• Equity is not subsequently remeasured

BCF Separation

If a BCF must be separated under the guidance in ASC 470-20

• Determine the BCF amount based on the in-the-money amount of the conversion option

• Record the BCF in additional paid-in capital and record a discount on the debt liability by a corresponding amount

• No subsequent remeasurement of the amount recorded in equity

• Amortize the discount on the debt liability to interest expense over the life of the bond

• Debt liability carried at accreted value

• Equity is not subsequently remeasured

Convertible Debt / 7 - 5

7.2 Embedded Conversion Options

The first step in determining the appropriate accounting for a convertible debt instrument is to determine whether the embedded conversion option must be separated and accounted for as a derivative. ASC 815-15-25-1 requires embedded derivatives to be accounted for separately if all of the following criteria are met:

a. The economic characteristics and risks of the embedded derivative are not “clearly and closely related” to the economic characteristics and risks of the host contract.

A conversion option embedded in a debt instrument allows the investor to convert the debt into an equity classified security (common or preferred stock) of the issuer. Such an equity-linked feature would not be considered clearly and closely related to a debt host instrument. See FG section 2.3.1.2.

b. The hybrid instrument is not measured at fair value with changes in fair value reported in earnings.

Convertible debt instruments that are bifurcated into a debt and an equity component based on the guidance in ASC 470-20, such as debt with (1) a cash conversion feature (FG section 7.4) or (2) a beneficial conversion feature (FG section 7.3), are not eligible for the fair value option under ASC 825 based on the guidance in ASC 825-10-15-5(f). All other convertible debt instruments may be carried at fair value by the issuer, although this is typically not the case.

If an issuer carries a convertible debt instrument at fair value with changes in fair value recorded in earnings, evaluation of the embedded conversion option and other embedded features to determine whether they require separation is not required.

c. A separate instrument with the same terms as the embedded derivative would be a derivative instrument subject to the requirements of ASC 815.

As discussed in FG section 2.3, to determine whether a conversion option would be accounted for as a derivative under the guidance in ASC 815, an issuer should consider the following:

• Does the conversion option meet the definition of a derivative?

— If the equity securities underlying the embedded conversion option are readily convertible to cash, such as publicly traded common shares, the embedded conversion option meets the definition of a derivative.

— If the equity securities underlying the conversion option are not readily convertible to cash, the embedded conversion option may not meet the definition of a derivative. See FG section 2.3.2.

• Does the conversion option qualify for the scope exception for certain contracts involving an issuer’s own equity in ASC 815-10-15-74?

See FG section 2.3.3 for a discussion of the scope exception for certain contracts involving an issuer’s own equity. See FG section 2.5.2.2 for a discussion of the application of the requirements for equity classification to convertible debt instruments.

Many convertible debt instruments have several embedded conversion options that are interrelated. If after performing the accounting analysis of one conversion option, it is determined that it must be separated because it does not qualify for the scope exception for certain contracts involving an issuer’s own equity in ASC 815-10-15-74

7 - 6 / Convertible Debt

(FG section 2.3.3), then all of the conversion options should be separated and accounted for as a single derivative at fair value with changes in fair value recorded in earnings.

7.2.1 Contingent Conversion Option

A conversion option contingency may determine whether the investor has the right to convert the debt instrument into equity (e.g., if the company has a successful IPO, the investor may convert; if the company does not have a successful IPO, the bond is not convertible). More commonly, a conversion option contingency merely impacts when an investor can exercise its conversion option.

Without a conversion contingency, we would expect that a bond with a cash conversion feature (FG section 7.4) would be classified as a current liability (because it can be converted at any time); with a conversion contingency a bond with a cash conversion feature should be classified as a non-current liability provided the contingency has not been resolved and there is sufficient time to maturity. Once the contingency has been resolved or the time to maturity would require current liability classification, the bond should be classified as a current liability.

There are two broad categories of conversion option contingencies:

• Contingencies tied to an event or index other than the issuer’s stock price, and

• Contingencies tied to the issuer’s stock price.

7.2.1.1 Contingency Based on an Event or Index Other Than the Issuer’s Stock Price

There may be many reasons for an issuer to include a contingency tied to something other than its stock price in a conversion option. For example, a bond may be convertible only upon the successful completion of an IPO because the issuer does not want to issue equity unless the IPO occurs.

In evaluating whether a contingent conversion option should be separated and accounted for as a derivative, careful consideration should be given to the impact of the contingency on the determination of whether the option is considered indexed to the company’s own stock. To qualify for the scope exception for certain contracts involving an issuer’s own equity in ASC 815-10-15-74, the conversion option must (1) be indexed to the company’s own stock and (2) meet the requirements for equity classification. Contingent conversion options that require the satisfaction of a contingency based on something other than the issuer’s stock price would be considered indexed to the company’s own stock only if the contingency is based on something other than an observable market or index. See FG section 2.3.3 for a discussion of the scope exception for certain contracts involving an issuer’s own equity. See FG section 2.5.1 for a discussion of the requirements to be considered indexed to a company’s own stock.

If the instrument’s conversion is based on achieving a substantive contingency based on an event or index other than the issuer’s stock price, the instrument would not be included in diluted EPS until the non-market based contingency has been met, provided the instrument is not convertible unless the contingency occurs.

Convertible Debt / 7 - 7

7.2.1.2 Contingency Based on Issuer’s Stock Price

Contingent conversion options are the norm in debt instruments that contain a cash conversion feature (FG section 7.4). Contingent conversion options tied to the issuer’s stock price typically allow the investor to exercise its conversion option only once the price of the common stock has met or exceeded a predetermined threshold for a certain period of time. They are included to provide the issuer some protection against an unanticipated use of cash upon an early conversion by prohibiting conversion unless the specified stock price has been achieved. Most stock price contingencies only impact the timing of when the investor can exercise its conversion option, as they generally expire shortly before the maturity date of the bond. At that time, the investor is allowed to exercise its conversion option prior to maturity even if the stock price contingency has not been satisfied.

If the only conversion option contingency is related to the issuer’s stock price, the option would generally be considered indexed to the company’s own stock (FG section 2.5.1). Provided the requirements for equity classification in ASC 815-40-25 (FG section 2.5.2) are met, such a contingent conversion option would typically meet the requirements for the scope exception for certain contracts involving an issuer’s own equity in ASC 815-10-15-74 and would not have to be separated and accounted for as a derivative. See FG section 2.3 for a discussion on the analysis of an embedded equity-linked feature. See FG section 2.3.3 for a discussion of the scope exception for certain contracts involving an issuer’s own equity.

ASC 260-10-45-44 requires contingently convertible instruments that are tied to the issuer’s stock price to be treated in the same manner as other convertible securities and included in diluted EPS, if the effect is dilutive, regardless of whether the stock price contingency has been met. Depending on the terms of the security, it could be included in diluted EPS using either the if-converted method (FG section 4.3) or a method that approximates the treasury stock method in the case of a convertible bond with a cash conversion feature (FG section 4.6).

Example 7-1: Classification of Debt with a Contingent Conversion Option

Background/Facts:• On January 1, 2011, Company A issued a convertible bond with a conversion price

of $120. Upon conversion the bond will be settled in (1) cash up to the par value of the bond and (2) net shares for any additional value resulting from the conversion option. Company A concluded that the bond must be bifurcated into its debt and equity components pursuant to the guidance in ASC 470-20 (FG section 7.4).

• The bond has a maturity date of December 31, 2015, and is convertible by the investor:

— Prior to September 30, 2015, only if Company A’s share price trades at or above a price of $130 for 45 days of the preceding quarter.

— After September 30, 2015, at any time.

• During Q2 2012 Company A’s stock price traded above a price of $130 for more than 45 days, which allowed investors to exercise their conversion option in Q3 2012.

• In Q3 2012 Company A’s stock price traded below a price of $130 for the entire quarter such that the stock price contingency was no longer met and, beginning in Q4 2012, investors could no longer exercise their conversion option.

(continued)

7 - 8 / Convertible Debt

Question:Should the convertible bond be classified as a current or non-current liability in Company A’s financial statements as of (a) June 30, 2012, and (b) September 30, 2012?

Analysis/Conclusion:Upon conversion, Company A will deliver cash (and shares) to settle the convertible bond. Therefore, Company A should classify the convertible bond as a current liability in any period in which investors could exercise their conversion option within the 12 months following the reporting period.

Company A should classify the convertible bond as follows:

June 30, 2012 Current liability. In Q2 2012 Company A’s stock price traded at a level that allowed investors to exercise their conversion option for the period July 1–September 30, 2012.

September 30, 2012 Non-current liability. In Q3 Company A’s stock price traded at a level that would not allow investors to exercise their conversion option for the period October 1–December 31, 2012. It is unknown whether the stock price contingency will be met, allowing investors to convert, at a future date.

Furthermore, in periods that Company A could be required to deliver cash to settle the bond, it should reclassify an amount from permanent equity to mezzanine (temporary) equity equal to the difference between:

• The amount of cash deliverable upon conversion (typically par value of the bond), and

• The carrying value of the bond liability.

See FG section 7.4.3 for a discussion of mezzanine equity classification of the equity component of a convertible bond with a cash conversion feature.

7.2.2 Adjustment to Shares Delivered Upon Conversion in the Event of a Fundamental Change (Make-Whole Table)

Many convertible debt instruments provide for an adjustment to the number of shares deliverable upon conversion in the event of a fundamental change. This provision is included to compensate the investor for the lost option time value and forgone interest payments upon an unanticipated fundamental change, such as a change in control or significant change in the Board of Directors’ membership. Typically, the adjustment to the number of shares is included in a matrix of issuer stock price and time to maturity. The number of shares to be received upon conversion decreases as (1) stock price increases and (2) time to maturity decreases. However, because option time value is not linear, neither is the adjustment.

To determine whether a conversion option subject to adjustment in the event of a fundamental change should be separated and accounted for as a derivative, the issuer should consider whether it qualifies for the scope exception for certain contracts involving an issuer’s own equity in ASC 815-10-15-74. To qualify for this scope exception the conversion option must (1) be indexed to the company’s own stock and (2) meet the requirements for equity classification. See FG section 2.3 for a discussion on the analysis of an embedded equity-linked feature. See FG section 2.3.3 for a discussion of the scope exception for certain contracts involving an issuer’s own equity.

Convertible Debt / 7 - 9

As discussed in FG section 2.5.1.2, to be considered indexed to the company’s own stock any adjustments to the settlement amount should be based on variables that are standard inputs to the value of a “fixed-for-fixed” forward or option on equity shares. These variables include items such as the term of the instrument, expected dividends, stock borrow costs, interest rates, stock price volatility, and the ability to maintain a standard hedge position. Generally, a make-whole table used to calculate the adjustment of the number of shares delivered upon conversion in the event of a fundamental change has two inputs: (1) stock price and (2) time to maturity. As discussed in the example in ASC 815-40-55-45 and 55-46, these inputs are standard inputs to the value of a “fixed-for-fixed” forward or option on equity shares. Therefore, such an adjustment to the number of shares deliverable upon conversion in the event of a fundamental change would not impact the conclusion that the feature is considered indexed to the company’s own stock.

In addition, make-whole tables typically include a cap on the number of shares the issuer could be required to deliver upon conversion, which addresses one of the requirements for equity classification in ASC 815-40-25. Provided the remaining requirements for equity classification in ASC 815-40-25 are met, a provision that adjusts the number of shares delivered upon conversion in the event of a fundamental change typically would not cause the conversion option to be separated and accounted for as a derivative.

7.2.3 Conversion Option Upon Trading Price Condition (Parity Provision)

Many convertible debt instruments with a contingent conversion option contain a provision that permits the investor to exercise the conversion option if the bond is trading at a specified percentage, for example 98 percent of the parity value of the underlying shares (referred to as a “parity provision”). This provision is typically included to provide protection to the investor by allowing conversion in a scenario when they may want to convert, but would be unable to do so under a contingent conversion option.

Theoretically, a convertible bond should always be worth more than the underlying shares because a convertible bond provides a floor on the value to be received (absent an issuer credit event, the investor will receive at least the par value of the bond at maturity) as well as coupon payments over the life of the bond. A parity provision is likely to only be triggered in periods of extreme market disruption or in issuer specific situations, such as a significant change in the availability of the issuer’s shares in the stock loan market.

To determine whether a conversion option with a parity provision should be separated and accounted for as a derivative, the issuer should consider whether it qualifies for the scope exception for certain contracts involving an issuer’s own equity in ASC 815-10-15-74. To qualify for the own equity scope exception, the conversion option must (1) be indexed to the company’s own stock and (2) meet the requirements for equity classification. The example in ASC 815-40-55-45 and 55-46 concludes that a parity provision is considered indexed to the company’s own stock. Thus, provided the requirements for equity classification in ASC 815-40-25 are met, a parity provision typically would not cause the conversion option to have to be separated and accounted for as a derivative. See FG section 2.3 for a discussion on the analysis of an embedded equity-linked feature. See FG section 2.3.3 for a discussion of the scope exception for certain contracts involving an issuer’s own equity.

7 - 10 / Convertible Debt

7.3 Beneficial Conversion Feature (BCF)

The beneficial conversion feature (BCF) rules apply only to convertible instruments (1) whose embedded conversion option is not required to be separated under ASC 815 (FG section 7.2) and (2) that do not contain a cash conversion feature that must be separately reported under ASC 470-20 (FG section 7.4).

A BCF exists if the conversion option is in the money at the commitment date (i.e., when the conversion price of the convertible debt instrument is less than the fair value of the instrument into which it is convertible). The BCF is determined using a conversion ratio based on the book value allocated to the convertible instrument (e.g., considering allocations to detachable warrants). Similarly, a contingent BCF may occur if at some date in the future, the conversion option is adjusted to a price that is less than the issuer’s stock price at the commitment date.

Convertible debt instruments with a beneficial conversion feature that are bifurcated into a debt and equity component subject to the guidance in ASC 470-20 are not eligible for the fair value option under ASC 825 based on the guidance in ASC 825-10-15-5(f).

See FG section 3.5 for a further discussion of BCFs.

7.4 Cash Conversion Feature (previously FSP APB 14-1)

In traditional, share settled convertible debt, no cash is received upon conversion. If the investor exercises its conversion option, the full number of shares underlying the bond is received. In contrast, a convertible bond with a cash conversion feature allows the issuer to settle its obligation upon conversion, in whole or in part, in a combination of cash or stock either mandatorily or at the issuer’s option.

ASC 470-20 requires special accounting for convertible debt instruments with a cash conversion feature, unless the embedded conversion option must be separated and accounted for as a derivative (FG section 7.2).

We believe that the scoping language for the cash conversion subsections of ASC 470-20 is intentionally broad. Any instrument with the possibility of partial cash settlement, even for a small portion of the total conversion value and regardless of intent to cash settle, should be accounted for using this guidance.

However, the scope of the cash conversion subsections of ASC 470-20 excludes:

• Convertible preferred shares classified as equity or temporary equity (see FG section 8.4).

• Convertible debt that requires or permits settlement in cash or other assets upon conversion only when shareholders would receive the same form of consideration in exchange for their shares (e.g., due to a change in control).

• Convertible debt instruments where consideration is required in cash only for a fractional share upon conversion.

The guidance in ASC 470-20 does apply to convertible preferred shares that are classified as liabilities for financial reporting purposes. For example, convertible preferred stock with a stated redemption date that requires settlement of the par amount of the instrument in cash is within the scope of ASC 470-20.

Convertible Debt / 7 - 11

Typically, a convertible debt instrument with a cash conversion feature takes one of three forms:

• The issuer may at its option satisfy the entire obligation in either cash or stock (Instrument B).

• The issuer must settle the par (or accreted) value of the obligation in cash and the conversion spread in either cash or stock (Instrument C).

• The issuer may settle the entire obligation in any combination of cash or stock (Instrument X).

7.4.1 Recognition and Measurement

If convertible debt with a cash conversion feature contains an embedded derivative other than the embedded conversion option (e.g., a change in control put option), that embedded derivative should be evaluated under the guidance in ASC 815 to determine whether it should be accounted for separately before the guidance in ASC 470-20 (discussed in this section) is applied. Therefore, when evaluating whether an embedded put or call option should be accounted for separately from the host debt instrument, the discount created by separating the conversion option under the guidance in ASC 470-20 would not be considered. See FG section 7.8 for a discussion of embedded put and call options and FG section 7.9 for a discussion of contingent interest.

Provided the embedded conversion option does not have to be separated and accounted for as a derivative (FG section 7.2), convertible debt instruments within the scope of ASC 470-20 should be bifurcated into a liability component and the embedded conversion option (i.e., the equity component) in a manner that reflects the interest cost at the rate of similar nonconvertible debt. This is done by:

• Determining the carrying amount of the liability component based on the fair value of a similar debt instrument excluding the embedded conversion option. Typically, an income valuation approach, or a present value calculation, is used to calculate the fair value of the debt liability. To perform this calculation the issuer should determine (1) the expected life of the liability (FG section 7.4.1.1) and (2) the borrowing rate of a nonconvertible debt instrument (FG section 7.4.1.2).

• Recognizing the embedded conversion option in equity by ascribing the difference between the proceeds and the fair value of the debt liability to additional paid in capital (APIC).

• Reporting the difference between the principal amount of the debt and the amount of the proceeds allocated to the liability component as a debt discount, which is subsequently amortized to interest expense over the instrument’s expected life using the interest method (FG section 7.4.1.3).

Convertible debt instruments with a cash conversion feature that are bifurcated into a debt and equity component subject to the guidance in ASC 470-20 are not eligible for the fair value option under ASC 825, based on the guidance in ASC 825-10-15-5(f).

The equity component should not be remeasured, provided that the conversion option continues to meet the requirements for equity classification in ASC 815-40. If the conversion option subsequently fails to meet the requirements for equity classification and is reclassified as a liability, the difference between the amount recognized in equity and the fair value of the embedded conversion option at the reclassification date should be accounted for as an adjustment to equity.

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Periodic reported interest expense for convertible debt with a cash conversion feature includes (1) the instrument’s coupon and (2) the current period’s amortization of the debt discount. Therefore, the accounting interest expense will be higher than the cash coupon on the convertible debt. See FG section 7.4.1.3 for a discussion of amortization of the debt discount.

See FG section 7.4.4 for a discussion of earnings per share.

7.4.1.1 Determining the Expected Life

In determining the expected life of the debt liability for purposes of the fair value measurement described in FG section 7.4.1, only substantive embedded features, other than the embedded conversion option, should be considered. The determination of whether an embedded feature is nonsubstantive should be based on the probability, at the instrument’s issuance date, of the feature being exercised. This should be considered in the context of the instrument in its entirety, including the embedded conversion option.

An issuer should consider the impact of any prepayment features, such as puts and calls, on the expected life of the debt liability. One way to do this is to use a valuation approach that considers all of the features of the convertible debt liability, including the conversion option. Although this method is likely to reflect the commercial substance and economics of the debt instrument, it may not be consistent with the requirements in ASC 470-20. The method of determining the expected life of a debt liability with puts and calls described in ASC 470-20 is to consider whether it would be rational to exercise a call (or for the investor to exercise a put) if it were embedded in a nonconvertible debt with the same terms as the convertible debt being evaluated. The hypothetical nonconvertible debt instrument is an instrument that (1) pays the same coupon rate as the convertible debt instrument and (2) was issued at a discount to par value, to compensate for the low coupon rate when compared to nonconvertible debt rates.

When considering puts and calls embedded in debt instruments:

• An issuer would generally not call a nonconvertible debt instrument with a low coupon rate. Therefore, a bond with an issuer call option would generally have an expected life equal to its contractual life.

• Conversely, an investor would generally put a nonconvertible debt instrument with a low coupon as soon as possible. Therefore, generally for such an instrument it is probable that an investor put option will be exercised. In this case, the bond has an expected life from the period from issuance to the first put date.

• A bond that has an issuer call and an investor put option at the same date generally has an expected life equal to the period from issuance to the simultaneous put/call date.

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Summary of Likely Impact of Puts and Calls on Estimated Life

Description Likely Estimated Life

Matures in 10 years Issuer call in 5 years Investor put in 5 years

5 years

Matures in 10 years Issuer call in 5 years Investor put in 7 years

7 years

Matures in 10 years Issuer call in 7 years Investor put in 5 years

5 years

Matures in 10 years No issuer call Investor put in 5 years

5 years

Matures in 10 years Issuer call in 5 years No investor put

10 years

The expected life is not reassessed in subsequent reporting periods unless the instrument is modified.

Example 7-2: Impact of Change of Control Put on Expected Life

Background/Facts:• Company A issues a convertible bond that may be settled upon conversion in

any combination of cash or shares at the Company’s option and concludes that the bond must be bifurcated into a debt and equity component pursuant to the guidance in ASC 470-20.

• The bond contains a feature that allows the investors to put the bond to Company A at the bond’s par value upon a fundamental change, in this case a change in control. This feature is frequently referred to as a “change-in-control” put. See FG section 7.8.2.

• Company A determines that the investor’s put option should not be separated and accounted for as a derivative (FG section 7.8).

Question:Should the inclusion of the put option exercisable upon a fundamental change be taken into account in determining the expected life of the convertible bond for purposes of determining the fair value of the debt liability?

Analysis/Conclusion:Company A must assess whether the change in control put is a substantive feature at the bond’s issuance date. If, at issuance of the bond, it is probable that an event that would trigger the change in control put will not occur, the change in control put would likely be deemed nonsubstantive and disregarded for purposes of determining the expected life.

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7.4.1.2 Determining the Nonconvertible Debt Rate

In determining the nonconvertible debt rate for purposes of the fair value measurement described in FG section 7.4.1, an issuer should consider:

• The interest rate on its own nonconvertible debt. If that debt is similar to the convertible debt being evaluated, in terms of issuance date and seniority, it may be appropriate to use the interest rate on its own nonconvertible debt without making any adjustments to it. If there are differences in seniority, issuance date, or tenor, an issuer should consider these differences in determining the nonconvertible debt rate.

• Market rates for nonconvertible debt instruments with terms similar to the convertible debt being evaluated that have been issued by companies with similar credit quality.

• The use of a valuation specialist. This is especially true for high-yield issuers who may not have sufficient market data regarding nonconvertible debt rates available due to low credit quality.

Example 7-3: Using a Purchased Call Option to Determine the Nonconvertible Debt Rate

Background/Facts:• Company A issues a convertible bond that may be settled upon conversion in

any combination of cash or shares at the Company’s option and concludes that the bond must be bifurcated into its debt and equity components pursuant to the guidance in ASC 470-20.

• Concurrent with the issuance of the convertible bond, Company A enters into a call option overlay transaction on its own stock with Bank Z (FG section 7.10.3) in which the Company (1) purchases a call option on its own shares from Bank Z that mirrors the strike price and terms of the conversion option embedded in the convertible bond and (2) sells a call option on its own shares to Bank Z at a higher strike price.

• Company A decides to determine the borrowing rate of a nonconvertible debt instrument by determining the difference between (1) the proceeds received upon issuance of the convertible bond and (2) the amount paid to Bank Z for the purchased call option. The Company believes this is the most reliable method of determining the nonconvertible debt rate because it would be based on input from market-based transactions.

Question:Is the methodology to be used by Company A acceptable to determine the borrowing rate of a nonconvertible debt instrument?

Analysis/Conclusion:Probably not. The call option purchased from Bank Z will not have the same value as the call option embedded in Company A’s convertible debt due to:

• Inefficiencies in the convertible debt market, which cause a conversion option embedded in a bond to generally be worth less than a similar freestanding option.

• Differences in counterparty credit risk.

Therefore, using the value of the purchased call option as a proxy for the value of the embedded conversion option, without adjustment, is generally not appropriate.

Convertible Debt / 7 - 15

7.4.1.3 Amortization of Debt Discount

The debt discount created by bifurcating a convertible bond within the scope of ASC 470-20 into its debt and equity components should be amortized using the interest method. The amortization period should be the expected life of a similar nonconvertible liability (considering the effects of any embedded features other than the conversion option, such as prepayment options). If an issuer uses an income valuation approach, or a valuation technique that is consistent with that approach, to measure the fair value of the liability component at initial recognition, the time period used as the expected life should also be used to amortize the discount. The amortization period is not reassessed in subsequent reporting periods unless the instrument is modified.

7.4.2 Tax Accounting Considerations

The application of the guidance in ASC 470-20 will result in a basis difference associated with the liability component that represents a temporary difference under ASC 740. The basis difference is the difference between:

• The carrying value of the debt liability under the provisions of ASC 470-20, and

• The convertible debt instrument’s tax basis (which would generally be its original issue price adjusted for any original issue discount or premium).

The initial recognition of the deferred taxes associated with this basis difference should be recorded as a deferred tax liability with an adjustment to additional paid in capital. In subsequent periods, the deferred tax liability is reduced and a deferred tax benefit will be recognized in earnings as the debt discount is amortized to pre-tax income. Consequently, the total income tax benefit in subsequent periods would include the current tax effect of deducting interest (to the extent permitted under the tax law) and the deferred tax benefit from the reversal of a portion of the deferred tax liability.

The taxable temporary difference associated with the debt discount on a bond with a cash conversion feature may constitute a source of future taxable income under ASC 740-10-30-18. Depending on reversal patterns, this taxable temporary difference should be considered in assessing the future realization of existing deferred tax assets.

The guidance in ASC 470-20 applies to certain convertible preferred shares that are mandatorily redeemable. For example, convertible preferred stock with a stated redemption date that requires settlement of the par amount of the instrument in cash is within the scope of ASC 470-20. For tax purposes, however, the instrument may be considered equity. In that case, the instrument may not result in a tax liability in the event it is redeemed for the book carrying amount, nor would it provide tax deductions for accrued interest (which may constitute dividends for tax purposes). Consequently, deferred taxes would not be recognized because the instrument’s carrying value (or book basis) is expected to reverse without tax consequence.

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Example 7-4: Application of ASC 470-20 to a Convertible Bond with a Cash Conversion Feature

Background/Facts:• Company A issues a convertible bond that will be settled upon conversion by

delivering (1) cash up to the principal amount of the bond and (2) net shares equal to any value due to the conversion option being in the money. Company A concludes that the bond must be bifurcated into its debt and equity components pursuant to the guidance in ASC 470-20.

• Company A’s stock price is $85 at the date the bond is issued.

• The convertible bond has the following terms:

Principal Amount $100 million issued in $1000 bonds

Coupon Rate 2.00%

Years to Maturity 7 years

Issuer Call Option 2 years and thereafter

Investor Put Option 5 years and thereafter

Conversion Price $100

Conversion Terms Investors can convert in any quarter following a quarter in which Company A’s stock price traded at or above $110 for at least 45 days

Conversion Settlement Upon conversion, investors will receive per $1000 bond (1) $1000 in cash and (2) net shares equal to any value due to the conversion option being in the money

• Company A determines that a nonconvertible debt instrument with the same terms would have an expected life of 5 years because its bond is puttable by investors beginning in year 5.

• Based on its analysis of 5 year nonconvertible debt with similar terms issued by companies with similar credit quality, Company A determines the coupon rate for a nonconvertible debt instrument with the same terms to be 8.00 percent.

• Using a present value calculation, Company A determines the initial carrying value of the debt to be $76 million. The embedded conversion option is $24 million; the difference between the $100 million proceeds and $76 million debt liability.

• Company A calculates deferred taxes associated with bifurcating the bond into its debt and equity components as the product of (1) the debt liability discount ($24 million) and (2) Company A’s effective tax rate of 40 percent, resulting in a deferred tax liability of $9.6 million.

• Company A develops the following schedule of balances and accretion using the beginning debt liability balance calculated using an income valuation approach and the interest method of amortization.

(In millions) Year 1 Year 2 Year 3 Year 4 Year 5

Balance at Beginning of Period

$76.0 $80.1 $84.5 $89.3 $ 94.4

Amortization of Discount 4.1 4.4 4.8 5.1 5.6Balance at End of Period $80.1 $84.5 $89.3 $94.4 $100.0

(continued)

Convertible Debt / 7 - 17

Question:What are the journal entries recorded by Company A (1) upon issuance of its convertible bond and (2) during Year 1?

Analysis/Conclusion:At issuance of the convertible bond:(Amounts in millions)

1. Dr Cash $100.0Dr Debt discount 24.0Dr Additional paid-in capital 9.6

Cr Debt $100.0Cr Additional paid-in capital 24.0Cr Deferred tax liability 9.6

To recognize (a) the receipt of cash, (b) bifurcation of the convertible bond into its debt liability and residual equity components and (c) creation of the deferred tax liability associated with that bifurcation.

During Year 1:(Amounts in millions)

2. Dr Interest expense $ 6.1Cr Cash $ 2.0Cr Debt discount 4.1

To recognize (a) the payment of the 2.0 percent cash coupon and (b) amortization of the debt discount using the interest method.

(Amounts in millions)

Dr Deferred tax liability $ 1.6Cr Deferred tax benefit (P/L) $ 1.6

To recognize the reduction of the deferred tax liability as the debt liability discount is amortized.

Example 7-5: Change in the Expected Life of a Convertible Bond

Background/Facts:• This example is based on the same information and assumptions used in Example

7-4.

• Company A determined the expected life of the bond to be 5 years based on the inclusion of an investor put option exercisable beginning in year 5. The Company used that 5 year life to determine the borrowing rate of a nonconvertible debt instrument and as the amortization period. At the end of 5 years the debt discount has been fully amortized such that the convertible bond is recorded on Company A’s books at its par value.

• At the end of 5 years, the bond is neither called by Company A nor converted or put by investors.

(continued)

7 - 18 / Convertible Debt

Question:How should Company A record interest expense on the convertible bond in Year 6 and beyond?

Analysis/Conclusion:Once the debt discount recorded at issuance has been fully amortized, Company A would record only the convertible coupon paid in cash (2.00 percent) as interest expense. ASC 470-20 does not permit adjustments to the amortization period or expected life of a convertible debt instrument after issuance.

7.4.3 Mezzanine (Temporary) Equity Classification

An embedded conversion option that is accounted for separately in equity under the guidance in ASC 470-20 may be required to be classified as mezzanine equity in periods in which the debt is currently convertible or redeemable.

• Debt is currently convertible if the investor is able to exercise its conversion option. For contingently convertible debt, this would typically be the period after the contingency has been met. For debt without a conversion contingency, the debt may be convertible at any time.

• Debt is currently redeemable if (1) the investor holds a put option that is currently exercisable or (2) the bond matures in the current period.

The amount required to be classified in mezzanine equity when a debt instrument with a cash conversion feature is currently convertible depends on the terms of the debt instrument (see FG section 7.4 for a description of each instrument).

• Instruments B and X—Mezzanine equity classification is not required because, upon conversion, the issuer has the option to settle both the bond principal and the conversion option value in shares.

• Instrument C—The difference between (1) the amount of cash deliverable upon conversion (i.e., par value of the debt) and (2) the carrying value of the debt component should be classified as mezzanine equity.

The amount required to be classified in mezzanine equity when a debt instrument with a cash conversion feature is currently redeemable is equal to the difference between (1) the redemption amount and (2) the carrying value of the debt component.

See FG section 3.6 for a further discussion of mezzanine equity classification.

7.4.4 Earnings per Share

Most convertible bonds with a cash conversion feature are included in diluted EPS using a method similar to the treasury stock method, which is illustrated in ASC 260-10-55-84 through 55-84B. Under this method:

• There is no adjustment for the cash-settled portion of the instrument; interest expense (including the accretion of the discount created by separating the equity component at issuance) remains in income available to common shareholders, or the numerator of diluted EPS.

Convertible Debt / 7 - 19

• The number of shares included in the denominator of diluted EPS is calculated by dividing the conversion spread value by the average share price during the reporting period. The conversion spread value is the value that would be delivered to investors based on the terms of the bond, at the assumed conversion date.

However, the issuer of a debt instrument that may settle in any combination of cash or stock at the issuer’s option (Instrument X bond) should consider the guidance on instruments settlable in cash or shares (FG section 4.5).

• If the issuer has a stated policy to settle or a past practice of settling, upon conversion, (1) the par (or accreted) value of the obligation in cash and (2) the value of the conversion spread in shares, diluted EPS should be calculated using the method described above.

• If the issuer does not have a stated policy to settle, upon conversion, the par (or accreted) value of the obligation in cash, or has a past practice of settling similar instruments entirely in shares, the issuer may need to include the debt instrument in diluted EPS using the if-converted method (FG section 4.3).

7.4.5 Derecognition (Conversion or Extinguishment)

The accounting for the derecognition of a convertible bond with a cash conversion feature is the same whether the bond is (1) extinguished/repurchased or (2) converted. In either case, the issuer should allocate the fair value of the consideration transferred (cash or shares) and any transaction costs incurred between (1) the debt component—to reflect the extinguishment of the debt and (2) the equity component—to reflect the reacquisition of the embedded conversion option.

• The issuer should first calculate the fair value of the debt immediately prior to it’s derecognition. This is generally done by re-calculating the carrying value of the bond using an updated remaining expected life of the debt instrument and updated nonconvertible debt rate assumption. This is the amount used to account for the extinguishment of the debt.

— A gain or loss on extinguishment equal to the difference between the consideration allocated to the liability component and the carrying value of the liability component, including any unamortized debt discount or issuance costs, is recorded in earnings.

• The remainder of the consideration is allocated to the reacquisition of the embedded conversion option (equity component).

• If any other stated or unstated rights and privileges exist, a portion of the consideration should be allocated to those rights and privileges and accounted for according to other applicable accounting guidance.

Transaction costs incurred with third parties (other than the investors) that directly relate to the settlement of the instrument should be allocated to the debt component by calculating the ratio of the fair value of the debt to the total fair value of consideration delivered and multiplying it by the total transaction costs. The remainder of the transaction costs are allocated to the reacquisition of the equity component.

7 - 20 / Convertible Debt

Example 7-6: Early Conversion of a Convertible Bond with a Cash Conversion Feature

Background/Facts:• This example is based on the same information and assumptions used in Example

7-4.

• At the end of Year 3, Company A’s stock price is $150.

• Company A decides to exercise its call option. Once the bond is called by Company A, investors have the ability to either (1) convert the bond and receive cash and shares with a value equal to $1500, which reflects the value of the conversion option, or (2) choose not to convert and receive $1000 upon settlement of the call option. Investors decide to convert their bonds.

• Upon conversion, Company A settles the bonds by issuing $100 million in cash and $50 million in common shares.

• The remaining original expected life of a nonconvertible debt instrument is 2 years.

• Based on its analysis of 5 year nonconvertible debt with 2 years left to maturity with similar terms issued by companies with similar credit quality, Company A determines the coupon rate for a nonconvertible debt instrument with the same terms to be 6.00 percent.

• Using a present value calculation, Company A determines the fair value of the debt to be $92.7 million.

• Company A allocates the $150.0 million consideration transferred to investors as follows (1) $92.7 million to extinguish the debt and (2) $57.3 million to the embedded conversion option.

• A loss on extinguishment of $3.4 million is determined by calculating the difference between (1) the fair value of the bond prior to conversion—$92.7 million and (2) the carrying value of the bond at the end of year 3—$89.3 million (see table in Example 7-4).

• A deferred income tax benefit related to the loss on extinguishment of $1.4 million ($3.4 million x 40% tax rate) is also recorded.

• The remaining deferred tax liability at the end of year 3 is $4.3 million.

• The difference between the deferred tax liability and deferred income tax benefit resulting from the loss on extinguishment is recognized in additional paid in capital.

Question:How should Company A record the early conversion by investors?

Analysis/Conclusion:(Amounts in millions)

Dr Debt $100.0Dr Additional paid-in capital 57.3Dr Loss on extinguishment 3.4Dr Deferred tax liability 4.3

Cr Debt discount $ 10.7Cr Cash 100.0Cr Deferred income tax benefit 1.4Cr Common stock 50.0Cr Additional paid-in capital 2.9

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7.5 Conversion into Equity

The conversion into common or preferred stock is not an extinguishment if it represents the exercise of a conversion right that was included in the original terms of the instrument.

• In a conversion of a convertible bond pursuant to original conversion terms, the debt is settled in exchange for equity and no gain or loss is recognized on conversion.

• The exchange of common or preferred stock for debt that does not contain a conversion right in its original terms is an extinguishment. Such an exchange may also be considered a troubled debt restructuring. See discussion of Troubled Debt Restructurings in FG section 5.3.

Example 7-7: Conversion of Instrument Upon Issuer’s Exercise of Call Option

Background/Facts:• Company A issued a bond with an embedded conversion option that investors

can exercise in any quarter following a quarter in which Company A’s stock price traded at or above $110 for at least 45 days.

• The bond also contains a call option that allows Company A to call the bond 2 years after issuance and anytime thereafter. Upon Company A’s exercise of its call option, investors have the right to exercise their conversion option even if the stock price contingency has not been met.

• Company A calls the bond at a time when the investors cannot otherwise exercise their conversion option because the contingency has not been met.

Question:Is the settlement of the bond considered a conversion or an extinguishment?

Analysis/Conclusion:It depends on whether the conversion option was substantive at the date the bond was issued. If the conversion option was considered substantive as of the date of issuance, settlement of the bond would be accounted for as a conversion. If the bond did not contain a substantive conversion option as of its issuance date, the settlement should be accounted for as a debt extinguishment.

A substantive conversion option is one that is at least reasonably possible of being exercisable in the future absent the issuer’s exercise of a call option. For purposes of determining whether it is reasonably possible that the conversion option will be exercised, an assessment of the holder’s intent is not necessary. The assessment of whether the conversion feature is substantive should be based on assumptions, considerations, and marketplace information available as of the issuance date.

An instrument that has no conversion option other than upon the issuer exercising its call option does not have a substantive conversion option. ASC 470-20-40-9 contains a list (not intended to be all-inclusive) of additional factors that may be helpful in assessing whether a conversion option is substantive (that is, whether it is at least reasonably possible that the conversion option will be exercised in the future).

7 - 22 / Convertible Debt

Example 7-8: Conversion of Bond with a Separated Conversion Option

Background/Facts:• Company A issues a 5-year convertible bond that allows bondholders to exercise

a conversion option over a 3-year period beginning three months after issuance.

• The embedded conversion option was separated from the debt host upon issuance pursuant to ASC 815. Accordingly, the proceeds from issuance were allocated to the derivative and debt host, both of which are liabilities.

• In subsequent periods, the debt host is accreted using the interest method over the term of the debt, and the derivative is remeasured at fair value with changes in fair value recorded in earnings.

• Prior to the expiration of the conversion option, the bondholders exercise the conversion option.

Question:How should Company A account for the conversion?

Analysis/Conclusion:It should be accounted for as an extinguishment (FG section 7.7.1). ASC 470-50-40-5 and ASC 470-50-15-3(a) exclude the use of extinguishment accounting for conversions that represent the exercise of the conversion right contained in the terms of debt at issuance. This exclusion is based on the concept that the debt and the conversion option are inseparable from each other. The exclusion does not apply when the conversion option is separated at the time the debt is issued; thus extinguishment accounting should be applied. See FG section 7.7.1 for a discussion of extinguishment accounting for a convertible debt instrument with a separated conversion option.

7.5.1 Conversion Prior to Full Accretion of BCF Discount

When an instrument with a beneficial conversion feature (BCF) (FG section 7.3) is converted prior to the full accretion of the discount created by the BCF, ASC 470-20-40-1 requires the unamortized BCF amount to be recorded immediately as interest expense.

The amount of BCF amortized could exceed the amount the holder realizes upon conversion. This could occur when a debt instrument incorporates a multiple-step discount to the stock price at the commitment date, such as a 15 percent discount to the commitment date stock price if the debt is converted after 6 months, and a 35 percent discount to the commitment date stock price if the debt is converted after 1 year. Based on the guidance in ASC 470-20-30-7, the issuer of such a debt instrument would record a BCF based on the most beneficial terms to the investor (35 percent discount to the commitment date stock price), provided there are no contingencies other than the passage of time, and would amortize that BCF. If the investor converts the debt instrument at a point in time when the less beneficial conversion price (15 percent discount to the commitment date stock price) is in effect, the previously recognized BCF amortization would not be reversed.

Convertible Debt / 7 - 23

7.6 Induced Conversion

An induced conversion is a transaction in which the issuer induces conversion of the debt by offering (or agreeing to issue) additional securities or other consideration (“sweeteners”) to investors. Induced conversions are transactions that both:

• Change the conversion privileges if the investor exercises during a limited period of time, and

• Include all equity securities issuable pursuant to conversion privileges included in the original terms, regardless of which party initiates the offer or whether the offer relates to all holders.

ASC 470-20-40-14 clarifies that the induced conversion guidance should be applied to an exchange of convertible debt for equity securities (or a combination of equity securities and other consideration) whether or not the exchange involves a legal exercise of the conversion option in the debt.

ASC 470-20-40-13 through 40-17 require recognition of an expense (which consequently impacts EPS) equal to the fair value of the securities or other consideration issued to induce conversion in excess of the fair value of securities issuable pursuant to the original conversion terms. The expense may not be reported as an extraordinary item. Repurchases that are not induced conversions are extinguishments (FG section 7.7). These two accounting methods can produce significantly different results depending on the market value of the securities issued.

Example 7-9: Limited Period of Time

Background/Facts:Induced conversions are transactions that both:

• Change the conversion privileges if the investor exercises during a limited period of time, and

• Include all equity securities issuable pursuant to conversion privileges included in the original terms, regardless of which party initiates the offer or whether the offer relates to all holders.

Question:What is a “limited period of time”?

Analysis/Conclusion:As noted in ASC 470-20-40-13, the FASB deliberately did not state a specific time period because to do so would be arbitrary. We believe that when evaluating the effective time period of a change in conversion privileges, the issuer’s intent in offering the sweetener must be to induce prompt conversion of the convertible debt. When this assessment is made, the inducement period should be considered in relation to the period in which the debt is convertible without the sweetener.

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Example 7-10: Offer to Convert Initiated by the Investor

Background/Facts:• Company A issues a convertible instrument to investors.

• One of the investors offers to surrender the instrument in exchange for more shares of stock than the investor is entitled to under the original conversion terms. The offer is valid for a limited period of time.

• Company A agrees to the offer.

Question:Should Company A account for the transaction as an induced conversion or as an extinguishment?

Analysis/Conclusion:Company A should account for the transaction as an induced conversion. The SEC staff has indicated a preference for inducement accounting in such circumstances, noting that the party who makes the offer should not affect the accounting. Thus, inducement accounting is not affected by which party makes the offer.

This guidance applies to both convertible debt and convertible preferred stock. See FG 7.6.1 for a discussion of induced conversions of convertible debt with a cash conversion feature.

Example 7-11: Reduction in Shares Issued Upon Conversion

Background/Facts:• Company A issues a convertible instrument to investors.

• Company A extends an offer to investors, for a limited period of time, to allow investors to tender their convertible instruments in exchange for cash and shares. The total value of consideration that could be received would be greater than the value of the shares that the investor is entitled to under the original conversion terms.

• The number of shares the investor would receive is less than the number of shares that the investor is entitled to under the original conversion terms. This shortfall is made up for with cash.

Question:Should Company A account for the transaction as an induced conversion or as an extinguishment?

Analysis/Conclusion:Company A should account for the transaction as an extinguishment. ASC 470-20-40-13(b) requires that all equity securities issuable pursuant to conversion privileges included in the terms of the debt at issuance should be issued if the conversion is to qualify for inducement accounting. If fewer shares are issued, this condition is not met and extinguishment accounting is required.

This guidance applies to both convertible debt and convertible preferred stock. See FG 7.6.1 for a discussion of induced conversions of convertible debt with a cash conversion feature.

Convertible Debt / 7 - 25

7.6.1 Induced Conversion of Convertible Debt with a Cash Conversion Feature

The guidance for determining whether the issuer of convertible debt with a cash conversion feature has induced conversion differs from the guidance for convertible debt without a cash conversion feature and preferred stock. As discussed in ASC 470-20-40-26, if convertible debt with a cash conversion option is amended to induce early conversion, the issuer should apply the inducement accounting described below. However, if the issuer merely offers investors additional consideration if they exercise their conversion option during a specified period of time (without amending the terms of the instrument), that would be accounted for using the derecognition guidance discussed in FG section 7.4.5.

Upon an induced conversion of convertible debt with a cash conversion feature, the issuer

• Recognizes an inducement charge equal to the difference between (1) the fair value of the consideration delivered to the investor and (2) the fair value of the consideration issuable under the original conversion terms.

• Allocates the fair value of the consideration issuable under the original conversion terms to the debt and equity components as described in FG section 7.4.5.

7.7 Convertible Debt Extinguishment Accounting

The accounting for an extinguishment of share-settled convertible debt is similar to the accounting for nonconvertible debt. A gain or loss on extinguishment equal to the difference between (1) the reacquisition price and (2) the net carrying amount of the original debt is recorded. See FG section 5.6 for a discussion of debt extinguishment accounting.

Debt extinguishment accounting may also be applied if an issuer restructures share-settled convertible debt in a manner that triggers extinguishment accounting. See FG section 5.7 for a discussion of the restructuring of convertible debt instruments.

See FG section 7.4.5 for a discussion of extinguishment accounting for convertible debt with a cash conversion feature.

7.7.1 Extinguishment Accounting—Bifurcated Conversion Option

When a conversion feature has been separated from a convertible debt host contract and accounted for as a liability, there is no equity conversion feature remaining in the debt for accounting purposes. Therefore, while there may be a legal conversion of the debt, for accounting purposes we believe that both liabilities (i.e., the debt host and the separated derivative liability) are subject to extinguishment accounting because they are being surrendered in exchange for common shares. As such, a gain or loss upon extinguishment of the two liabilities equal to the difference between the recorded value of the liabilities and the fair value of the common stock issued to extinguish them should be recorded.

To account for the conversion of convertible debt securities when the conversion option has been separated and accounted for as a liability, perform the following steps:

• Update the valuation of the separated derivative to the date of legal conversion.

• Adjust the carrying value of the host debt instrument to reflect accretion of any premium or discount on the host debt instrument up to the date of legal conversion.

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• Amortize debt issue costs to the date of legal conversion.

• Ensure that the book basis of the host debt instrument reflects all components of book value, including the unamortized portion of any premiums or discounts on the debt host recorded as an adjustment to the debt host and any unamortized debt issue costs recorded as deferred charges. These items collectively represent the net carrying amount of the debt host used to measure the extinguishment gain or loss. See ASC 470-50-40-1 through 40-3.

• Calculate the difference between the reacquisition price and net carrying amount of the debt by comparing the fair value of the shares issued upon conversion to the updated net carrying values of the sum of the separated embedded derivative liability and the debt host. Record any difference as an extinguishment gain or loss in earnings.

7.7.2 Extinguishment Accounting—Beneficial Conversion Feature (BCF)

Upon the redemption of convertible debt with a BCF, ASC 470-20-40-3 requires the issuer to allocate the reacquisition price to the extinguishment of BCF and the debt. Upon the extinguishment of convertible debt with a BCF, the issuer:

• Calculates the intrinsic value (i.e., in-the-money amount) of the conversion feature at the extinguishment date and allocates that amount of the reacquisition price to the redemption of the BCF.

• Allocates the remainder of the reacquisition price to the extinguishment of the debt.

• Redeems the BCF through a debit to additional paid-in capital.

• Records a gain or loss on debt extinguishment by comparing the reacquisition price allocated to the debt with the net carrying value of the debt. See FG section 5.6 for a discussion of debt extinguishment accounting.

7.8 Put and Call Options Embedded in Convertible Debt

An issuer should evaluate put and call options embedded in a convertible debt instrument under the guidance in ASC 815-15-25-42 and ASC 815-15-25-26 to determine whether they should be separated and accounted for as derivatives at fair value. See FG section 3.1 for a discussion of puts and calls embedded in debt instruments.

As discussed in FG section 7.4.1, if a convertible debt instrument with a cash conversion feature contains a put or call option, it should be evaluated under the guidance in ASC 815 to determine whether it should be accounted for separately before the guidance in ASC 470-20, discussed in that section, is applied.

7.8.1 Put Options

Some convertible debt instruments, particularly long-dated instruments, contain a put option that allows investors to redeem the bond, typically at par value, either continuously or at discrete dates after a specified point in time.

An issuer should evaluate a put option embedded in a convertible debt instrument under the guidance in ASC 815-15-25-42 and ASC 815-15-25-26 to determine whether it should be separated and accounted for as a derivative at fair value. Even a put at par value may be required to be separated if the debt instrument was not issued at par value. See FG section 3.1 for a discussion of puts and calls embedded in debt instruments.

Convertible Debt / 7 - 27

7.8.2 Put Upon a Fundamental Change (Change in Control Put)

Many convertible debt instruments contain a contingently exercisable put option that allows the investor to put the bond, typically at par, upon a fundamental change, such as a change in control. A put upon a fundamental change is included as a form of investor protection that allows the investor the ability to dispose of the instrument in circumstances when they may not want to continue to hold it.

Example 7-12: Fundamental Change Put at Higher of Par or Conversion Value

Background/Facts:Company A issues a convertible bond with a provision that allows the investor to put the bond, at par value, upon a fundamental change. The terms of this provision require Company A to deliver cash equal to the greater of the (1) par value of the bond or (2) the converted value of the bond.

Question:Should the option to put the bond upon a fundamental change be separated from the convertible bond?

Analysis/Conclusion:Possibly. The put option at par value needs to be evaluated to determine whether it should be separated (FG section 3.2). Often it will not be separated.

However, the embedded conversion option should be separated. The term used to describe an option or right in a bond is irrelevant; an issuer should look to the economic substance of the right that has been conveyed. The put option upon a fundamental change is really two options (1) a put option at par value and (2) a contingently exercisable conversion option, which must be settled in cash.

A conversion option that must be settled in cash in circumstances beyond the issuer’s control does not meet the requirements for equity classification in ASC 815-40-25 and is not eligible for the scope exception for certain contracts involving an issuer’s own stock in ASC 815-10-15-74. Although the cash settlement provision is only included in the conversion option exercisable upon a fundamental change, all of the conversion options, including the base conversion option that requires share settlement, are interrelated. For that reason, they should be evaluated in combination and if one fails to qualify for the ASC 815-10-15-74 scope exception, they should be separated and valued as a group. Therefore, the entire conversion option should be separated and carried at fair value with changes in fair value recorded in earnings.

7.8.3 Issuer Call Options

Many convertible debt instruments contain a call option that allows the issuer to redeem the bond, typically at par value, either continuously or at discrete dates. Typically, the investor will have the right to exercise its conversion option (even a contingent conversion option for which the contingency has not been met) upon the issuer’s exercise of its call option. An issuer typically will call a convertible bond to force the investor to exercise its conversion option. For example, the issuer of a convertible bond that is sufficiently in the money such that conversion at maturity is relatively certain may decide to force the investor to exercise its conversion option to stop the interest payments on the bond.

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An issuer should evaluate a call option embedded in a convertible debt instrument under the guidance in ASC 815-15-25-42 and ASC 815-15-25-26 to determine whether it should be separated and accounted for as a derivative at fair value. See FG section 3.1 for a discussion of puts and calls embedded in debt instruments.

7.9 Contingent Interest

A contingent interest feature requires additional interest to be paid only when certain conditions exist. Typically, contingent interest features are included for tax purposes to allow the issuer to deduct interest expense in excess of the cash coupon paid, although the extra deductions are subject to recapture. In addition, contingent interest can deter investors from exercising their put or conversion option. Prior to conversion (or extinguishment) the issuer would continue to deduct interest expense in excess of the cash coupon paid.

A contingent interest provision in convertible debt typically requires the payment of additional interest if the instrument’s average trading price is at a specified level above or below par value. For example, contingent interest in the amount of 25bp multiplied by the instrument’s trading price will be paid if the average trading price is above $120. Many contingent interest features become effective only after a simultaneous put/call date.

A contingent interest feature that meets the definition of a derivative would be considered clearly and closely related to a debt host when indexed solely to interest rates and credit risk. However, the trading price of a convertible debt instrument is a function of more than just interest rates and credit risk due to the embedded conversion option. As a result, contingent interest features in convertible debt instruments that are indexed to the instrument’s trading price are generally not considered clearly and closely related to the debt host and are separated and accounted for as a derivative. The issuer should monitor the value of the contingent interest feature and periodically assess its materiality. Many contingent interest features are not material to the issuer’s financial statements initially. This is more likely to be the case for a contingent interest feature in an instrument that is callable and puttable before the contingent interest feature is effective. A contingent interest feature in an instrument that is not puttable is more likely to have material value.

The determination of the likelihood of paying contingent interest must be consistent for book and tax purposes. That is, if the issuer determines that the value of the contingent interest is not material because the likelihood of payment is remote, then the same assertion should be used when determining if the interest is deductible for tax purposes. One should question any conclusion that payment of such feature is remote for book purposes but reasonably possible or probable for tax purposes.

7.10 Instruments Executed in Conjunction with a Convertible Bond

An issuer may execute a number of agreements in connection with the issuance of a convertible bond. In the following sections we describe some of the more common agreements. There are several reasons an issuer may choose to enter into these agreements, however the majority are executed to achieve better pricing for the convertible bond.

7.10.1 Detachable Warrants

An issuer, typically a high-yield issuer, may bundle convertible debt with detachable warrants and issue the combined instrument as a unit. When an instrument is issued

Convertible Debt / 7 - 29

in a bundled transaction with warrants, the sales proceeds should be allocated between the base instrument and the warrants. The allocation of proceeds depends on the accounting classification of the separate warrant as equity or liability:

• If the warrants are classified as equity, then such allocation is made based upon the relative fair values of the base instrument and of the warrants following the guidance in ASC 470-20-25-2.

• If the warrants are classified as a liability, then the sales proceeds are first allocated to the warrant based on the warrant’s full fair value (not relative fair value) and the residual amount of the sales proceeds is allocated to the base security.

If the convertible bond is subject to the beneficial conversion feature (BCF) guidance in ASC 470-20 the sales proceeds allocated to the convertible instrument is divided by the contractual number of conversion shares to determine the accounting conversion price per common share (also called the effective conversion price), which is used to measure the BCF. See FG section 3.5 for a discussion of BCFs.

7.10.2 Greenshoe (Overallotment Option)

A greenshoe is a freestanding agreement between an issuer and an underwriter that allows the underwriter to call additional convertible debt instruments to “upsize” the amount of securities issued. For example, a 20 percent greenshoe on a $100 million convertible debt offering allows the underwriter to require the issuer to issue an additional $20 million of debt at par value. The term “greenshoe” comes from the name of the company (Green Shoe Manufacturing, which later became Stride Rite Corporation) that first used such an agreement with its underwriter.

Prior to the issuance of a convertible debt instrument, an underwriter will take orders from investors. The underwriter will then allocate the base amount plus any greenshoe amount to the investors. The amount allocated to investors in excess of the base amount is called an overallotment. One way an underwriter may fill an overallotment is by exercising the greenshoe. Another way is by buying the newly issued convertible debt in the open market. An underwriter will rarely exercise its option if the debt is trading below par value. Instead, the underwriter will buy the debt in the open market, and in doing so create additional demand, which should increase the price of the newly issued convertible debt.

There are several types of greenshoes, the most common being an overallotment option. An overallotment option allows the underwriter to call additional debt from the issuer only to fill overallotments. The underwriter cannot exercise an overallotment option and hold or sell the convertible debt for its own account. Other types of greenshoes allow the underwriter full discretion over the convertible debt received by exercising their option.

A greenshoe on a publicly traded debt instrument generally will meet the definition of a derivative. However, since it is an option to call a debt instrument (not the underlying equity) it is not eligible for the scope exception for certain contracts involving an issuer’s own equity in ASC 815-10-15-74. As a result, a greenshoe on public debt is generally accounted for as a derivative at fair value. Greenshoes are generally short-dated and, as such, may not have a value material to the issuer’s financial statements; accordingly, the issuer should determine the value and assess its materiality to determine how to proceed.

A greenshoe on a privately placed debt instrument may not meet the definition of a derivative if the debt is not readily convertible to cash (FG section 2.3.2.1). In that

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case, the greenshoe on privately placed debt would not be separately accounted for as a derivative. Rather, there would be no accounting until any additional debt instruments are issued under the greenshoe.

In addition, the commitment date used to measure any beneficial conversion feature (BCF) in convertible debt issued due to the exercise of a greenshoe is the date the underwriter exercises the greenshoe. Prior to then, there is no commitment on the part of the underwriter to purchase the debt from the issuer. It is possible for convertible debt which was initially priced out of the money on the original commitment date (i.e., the closing date when cash and the debt are exchanged) to become in the money (resulting in a BCF charge for the debt issued due to the exercise of the greenshoe) if the stock price appreciates between the two closing dates. See FG sections 7.3 and 3.5 for further discussion of BCFs.

7.10.3 Call Option Overlay (Call Spread, Capped Call)

A call option overlay (call spread, capped call) is a transaction executed between a convertible bond issuer and an investment bank. They are more commonly executed in connection with a convertible bond with a cash conversion option, but may also be executed in connection with a share-settled bond. In a call option overlay, the issuer buys a call option from the investment bank that mirrors the conversion option embedded in the convertible bond, effectively “hedging” or canceling the embedded conversion option. The issuer pays a premium to the investment bank to buy this option. The issuer then sells a call option to the investment bank, almost always at a higher strike price than the embedded conversion option and purchased call option, effectively raising the strike price of the convertible bond transaction. If the strike price of the sold call option is higher than the strike price of the purchased call option, the issuer will receive a lower premium from the investment bank for selling this option.

The primary reasons an issuer may execute a call option overlay transaction are (1) to receive additional tax benefits and (2) to synthetically raise the strike price on the convertible bond, which diminishes the likelihood the issuer will have to issue shares, to a level that would not price efficiently in the convertible bond market. See FG section 7.10.3.2 for a discussion of the tax considerations.

A call option overlay may be executed as two separate call option transactions—this is referred to as a call spread—or it can be executed as a single integrated transaction—this is referred to as a capped call. The issuer must weigh credit, tax, and EPS considerations in determining whether to execute a call spread or a capped call.

A call spread and a capped call are accounted for separately from the convertible bond with which they are issued or associated with. A call spread is accounted for as two transactions (1) a purchased call option on the company’s own stock and (2) a written call option on the company’s own stock at a higher strike price, whereas a capped call is accounted for as a single transaction. See FG section 2.5 for a discussion of the analysis of freestanding equity-linked instruments. See FG section 7.10.3.1 for a discussion of the EPS treatment, which is different for a call spread and a capped call.

7.10.3.1 Earnings per Share

A call option overlay is included in diluted EPS based on the form of the transaction. A capped call generally is not include in diluted EPS because it is anti-dilutive. In a

Convertible Debt / 7 - 31

call spread, however, the purchased call is not include in diluted EPS because it is anti-dilutive, but the sold call is included in diluted EPS. This can create so called “double dilution” from the convertible bond and the sold call, if the issuer’s stock price increases to a level above the strike price on the sold call.

7.10.3.2 Tax Considerations

An issuer can receive additional tax deductions for a call option overlay, if it meets certain requirements and properly elects to integrate the call option overlay with the convertible bond, pursuant to applicable Treasury regulations. The specific tax requirements to achieve integration are quite detailed. Typically, issuers pursuing this strategy will execute two separate call options in a call spread transaction, and will only elect to integrate the purchased call, so that they can deduct the premium paid over the term of the convertible bond. Under this approach, the premium received for issuing the higher strike call option is not integrated—nor is it included in taxable income. In order for this strategy to work, the two call options must be truly separate for tax purposes, which typically requires certain conditions, including staggered maturity dates, to be met. This aspect of the tax analysis can also be quite detailed. (If the two options are not separate for tax purposes—e.g., a capped call is executed—the issuer can only obtain a tax deduction for the net premium paid.)

A deferred tax asset equal to the additional tax deductions that will be taken over the life of the transaction should be recorded with an offsetting entry to additional paid in capital.

7.10.4 Share Lending Agreement

Less commonly, a convertible bond issuer may enter into a share lending agreement with an investment bank. A share lending agreement is intended to facilitate the ability of investors, primarily hedge funds, to borrow shares to hedge the conversion option in the convertible bond. Typically they are executed in situations where the issuer’s stock is difficult or expensive to borrow in the conventional stock borrow market.

The terms of a share lending arrangement typically require the issuer to issue (loan) shares to the investment bank in exchange for a small fee, generally equal to the par value of the common stock. Upon conversion or maturity of the convertible debt, the investment bank is required to return the loaned shares to the issuer. The shares issued are legally outstanding, entitled to vote, and entitled to dividends, although under the terms of the arrangement the investment bank may agree to reimburse the issuer for dividends received and may agree to not vote on any matters submitted to a vote of the company’s shareholders.

Under ASC 470-20-25-20A, the fair value of the share lending arrangement should be recorded at inception as a debt issuance cost with the offset to equity. The debt issuance cost should be amortized to interest expense over the life of the debt, increasing the overall “implied” cost of the convertible debt arrangement.

7.10.4.1 Earnings per Share

ASC 470-20-45-2A states that loaned shares are excluded from basic and diluted earnings per share unless default of the share-lending arrangement occurs, at which time the loaned shares would be included in the basic and diluted EPS calculations. If dividends on the loaned shares are not reimbursed to the entity, any amounts, including contractual (accumulated) dividends and participation rights

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in undistributed earnings, attributable to the loaned shares should be deducted in computing income available to common shareholders, in a manner consistent with the two-class method in paragraph ASC 260-10-45-60B.

7.11 How PwC Can Help

Our capital market transaction consultants and Assurance professionals frequently advise companies regarding the interpretation and application of the accounting literature to convertible debt, including:

• Whether the embedded conversion option, or other features embedded within the convertible debt, should be separated and recorded at fair value with changes in fair value recorded in earnings.

• Whether convertible debt should be bifurcated based on the guidance for convertible debt with cash conversion options in ASC 470-20. When a convertible debt instrument does need to be bifurcated, providing advice regarding performing the calculation, and inputs to the calculation, of the amounts recorded as debt and equity.

• The appropriate accounting treatment for greenshoes (or over-allotment options), detachable warrants, call option overlays and other transactions executed in connection with convertible debt.

• Earnings per share impacts.

• Appropriate disclosure items.

If you have questions regarding the accounting for convertible debt or would like help in assessing the impact a convertible debt issuance would have on your company’s financial statements, please contact your PwC engagement partner or one of the subject matter experts listed in the contacts section at the end of this Guide.

Preferred Stock / 8 - 1

Chapter 8: Preferred Stock

8 - 2 / Preferred Stock

8.1 Characteristics of Preferred Stock

Preferred stock (also called preferred shares or preference shares) is a class of ownership in a company that is senior to common stock and subordinate to debt.

The following features are associated with preferred stock:

• In the event of liquidation, preferred stockholders have a priority claim on a company’s assets over common stockholders, and a subordinate claim to bondholders and other creditors.

• May be voting or non-voting; some preferred shares may have voting rights for certain extraordinary events (e.g., take-over of the company, issuance of new shares).

• Generally receives dividends before common stockholders. The dividend is usually fixed and may be cumulative or non-cumulative. Dividends typically must be declared by the board of directors to be distributable.

• May be entitled to receive additional dividends in conjunction with dividends paid to common shareholders (“participating preferred stock”).

• May be perpetual, mandatorily redeemable on a certain redemption date, or contingently redeemable either upon occurrence of a certain event or at a point in time.

• Can be callable at the option of the issuer after a certain period (e.g., 5 years) or upon extraordinary events (e.g., tax law change, rating agency or capital treatment events).

• May contain other features, such as put options, exchange rights, increasing dividends, and conversion options.

In practice, the terms of preferred stock issues can vary widely. A company may issue several series of preferred stock with different features and different priorities as to dividends or assets in case of liquidation. Depending on its terms, preferred stock may be considered a hybrid instrument with characteristics of both equity and debt.

From the issuer’s perspective, preferred stock is a more expensive form of financing than debt. The incremental cost comes with some advantages. The issuer may achieve better credit ratings than with “straight” debt, and the issuance of preferred stock does not affect control held by the common shareholders (due to the absence or limitation of voting rights). Dividends may be deferred without credit downgrade, as opposed to interest on a debt instrument. Preferred stock may also be used to prevent hostile takeovers by adding a conversion feature, or a feature calling for forced redemption at a high liquidation value, upon a change in control. One of the main disadvantages of preferred stock for issuers is that dividends are paid from after-tax profits (i.e., they are not tax deductible).

From the investor’s perspective, dividends on preferred stock are generally higher than the interest paid on debt with similar terms due to preferred stock’s lower seniority claim on assets in case of liquidation. Preferred securities are generally higher risk than debt securities due to their lower seniority claim in bankruptcy and, in some cases the lack of a maturity date, which extends the potential term of the investment. In addition, absent a conversion option, preferred securities have a

Preferred Stock / 8 - 3

lower potential for market price increases, which may make them less attractive than common stock. The tax treatment to investors differs for an individual and a corporation. Specifically, a corporate investor is taxed at a lower rate than an individual.

8.2 Analysis of Preferred Stock

Classify as a liability

Evaluate conversion options (see FG section 8.4.3) and other embedded derivatives to determine whether they should be accounted for separately. (see Chapter 3 –

Guide to Accounting for Derivative Instruments and Hedging Activities – 2012 edition)

Yes

No

Classify as mezzanine equity

Classify as permanent equity

Yes No

Based on an evaluation of the redemption and conversion features, is the instrument a

liability under ASC 480?

(FG sections 8.3 and 8.4)

Analyze if mezzanine equity classification is required under

ASC 480-10-S99

(FG sections 8.3 and 8.4)

8.3 Redemption Features in Preferred Stock

The first step in determining the accounting treatment of preferred stock is to determine whether the preferred stock must be accounted for as a liability under ASC 480 (see FG section 2.4). If the preferred shares are not convertible, their redemption features should be analyzed under ASC 480. Mandatorily redeemable preferred stock that is not convertible is classified as a liability under ASC 480. Refer to FG section 8.4.2 for a discussion of mandatorily redeemable convertible preferred stock.

If the issuer concludes that the preferred stock should not be accounted for as a liability under ASC 480, it should be accounted for as equity. The issuer should then determine whether to present the preferred shares as permanent or mezzanine equity.

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For SEC registrants, ASC 480-10-S99 requires preferred securities redeemable for cash or other assets to be classified outside of permanent equity (in the “mezzanine” equity or “temporary” equity section) if their redemption is:

• At a fixed or determinable price on a fixed or determinable date.1

• At the option of the holder.

• Based upon the occurrence of an event that is not solely within the control of the issuer.

Although the SEC’s guidance is aimed at public entities, we believe that the mezzanine equity presentation is preferable for a non-public entity’s preferred securities that meet these criteria.

Various redemption features and their impact on the classification of preferred stock as a liability, mezzanine, or permanent equity are summarized in the table below and discussed in more detail in FG sections 8.3.1 through 8.3.3.

Preferred Stock Redemption Features

Type of Redemption Feature Liability or EquityMezzanine or

Permanent Equity

Mandatory Redemption Liability Not ApplicableContingent Redemption Equity Mezzanine

No Redemption (i.e., perpetual preferred stock) Equity Permanent

8.3.1 Mandatorily Redeemable Preferred Stock

ASC 480 defines a mandatorily redeemable financial instrument as an instrument that is issued in the form of shares and embodies an unconditional obligation for the issuer to redeem the instrument on a specified or determinable date (or dates) or upon an event that is certain to occur.

Common examples of mandatorily redeemable preferred stock include:

• Preferred stock (non-convertible, or convertible, if conversion option is not substantive) that must be redeemed on a specified date.

• Preferred stock held by an employee that must be redeemed in the event of the employee’s death or termination of employment.

• Preferred stock that is redeemable subject to an “adequate liquidity” clause or a term-extension option. A liquidity provision may affect the timing of the unconditional requirement for redemption but does not eliminate the redemption requirement.

Mandatorily redeemable preferred stock that is not convertible is classified as a liability under ASC 480. Refer to FG section 8.4.2 for a discussion of mandatorily redeemable convertible preferred stock.

The definition of “mandatorily redeemable” specifically excludes instruments that are redeemable only upon the liquidation or termination of the reporting entity. For example, if the reporting entity (such as a trust or partnership) has a finite life (e.g., 25 years) and is to be liquidated at the end of its term, its equity securities are not

1 Preferred stock with a redemption at a fixed or determinable date can be classified as equity if it has a substantive conversion option (see FG section 8.4).

Preferred Stock / 8 - 5

considered mandatorily redeemable simply because they are redeemed when the entity is liquidated.

Example 8-1: Preferred Stock Redeemable Upon Liquidation of an Entity or Death/Termination of a Partner

Background/Facts:A partnership issues two series of preferred stock with the following redemption provisions:

• Series A is redeemable upon liquidation of the partnership. The partnership has a life of 25 years.

• Series B is redeemable upon the death or termination of the partner holding the shares.

Question:Are the Series A and Series B shares mandatorily redeemable, requiring liability classification under ASC 480?

Analysis/Conclusion:Series A: No, the definition of mandatorily redeemable specifically excludes instruments that are redeemable only upon the liquidation or termination of the reporting entity. Assuming Series A does not have any other features that would require liability classification, it is classified as equity as it is only redeemable upon liquidation of the partnership.

Series B: No, the partnership is a limited life partnership with a life of 25 years. The redemption event (death or termination of the partner) is not certain to occur within the life of the partnership. Assuming Series B does not have any other features that would require liability classification, it is classified as equity as it is contingently redeemable.

If, however the life of the partnership were 100 years 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.

Example 8-2: Redemption of Preferred Shares Funded by Insurance

Background/Facts:A partnership with a life of 100 years issues Series B preferred shares which are redeemable upon the death or termination of the partner holding the shares.

The partnership classifies the shares as a liability because (as discussed in Example 8-1) the shares are considered mandatorily redeemable as the redemption is based on an event (death or termination of the partner within 100 years) that is certain to occur.

The partnership purchases life insurance policies to cover the cost of the redemption of the Series B shares upon the death of the partner holding the shares.

Question:Does the purchase of life insurance to cover the cost of redemption affect the classification of the Series B preferred shares?

(continued)

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Analysis/Conclusion:No. ASC 480-10-55-64 clarifies that an insurance contract that funds the redemption of shares does not affect the shares’ classification as a liability.

ASC 480 and SEC guidance differ on this matter. The SEC Staff’s training manual includes a provision that allows registrants to report as permanent equity instruments that are mandatorily redeemable upon the death of the holder if the registrant has purchased life insurance to fund the entire cost of the redemption. However, the FASB believes that the shares are liabilities regardless of the issuer’s ability to fund their redemption through insurance proceeds. Therefore, an issuer must classify as a liability any preferred shares that are a liability within the scope of ASC 480, regardless of the effects of an insurance policy. Issuers can only consider the effects of an insurance policy for redeemable securities that are not liabilities within the scope of ASC 480 (i.e., convertible, redeemable preferred shares).

8.3.2 Contingently Redeemable Preferred Stock

The classification of contingently redeemable preferred securities as equity or a liability is based on an evaluation of their features. A contingently redeemable security with substantive conditions for redemption is not considered mandatorily redeemable. For example, the following instruments are not considered mandatorily redeemable:

• Preferred stock where the holder has the option to redeem (e.g., preferred stock with put options or “puttable” stock). In this case, the holder may or may not exercise the option.

• Preferred stock that is redeemable only if there is a change in control or successful initial public offering.

Contingently redeemable securities that contain redemption provisions that (1) are not substantive or (2) affect the timing of the redemption, but do not remove the redemption requirement, such as an adequate liquidity clause or term-extending option, are considered mandatorily redeemable and classified as a liability under the guidance in ASC 480.

The existence of a contractual redemption provision results in mezzanine equity classification if the redemption is contingent upon the occurrence of a future event that is outside of the issuer’s control. A probability assessment that a redemption event’s occurrence is remote cannot overcome the requirement for mezzanine equity classification.

The SEC Staff has indicated (in ASC 480-10-S99-3A f.) that it believes ordinary liquidation events, which involve the redemption and liquidation of all equity securities, should not result in a security being classified as mezzanine equity.

Example 8-3: Reassessment of Contingently Redeemable Instruments

Background/Facts:Company A issues Series C perpetual preferred shares that are callable anytime after year 5 and mandatorily redeemable only upon a change in control of Company A.

(continued)

Preferred Stock / 8 - 7

Question:Must Company A continually reassess whether the Series C preferred shares are contingently redeemable (i.e., classified as equity) or mandatorily redeemable (i.e., classified as a liability)?

Analysis/Conclusion:Yes. ASC 480 requires an issuer to assess whether an instrument is mandatorily redeemable at each reporting period. A contingently redeemable financial instrument should be reclassified as a liability when the contingent event has occurred or becomes certain to occur, thus making the instrument unconditionally redeemable.

The Series C preferred shares would initially be classified as equity because redemption is not unconditional. The occurrence of a change in control event would require the Series C shares to be reclassified as a liability.

The reclassification is recorded at the instrument’s fair value as a debit to equity and a credit to liability without any impact on earnings. The difference between the fair value of the redeemable preferred stock and the carrying value prior to becoming unconditionally redeemable should be subtracted from (or added to) net income to arrive at earnings available to common shareholders used in computing basic and diluted EPS (ASC 260-10-S99).

8.3.3 Perpetual Preferred Stock (No Redemption)

Perpetual preferred stock, by its legal terms, has no contractual redemption provisions. Absent any conversion or exchange provisions, perpetual preferred stock would not be classified as a liability under ASC 480.

However, if the perpetual preferred stockholders control the board (or could control the board as a result of events outside the company’s control, such as a debt default) and the instrument contains a call option exercisable at the company’s discretion, the shares would be considered to have a redemption feature. The SEC Staff believes preferred stock with these attributes contains a substantive redemption feature allowing the preferred stockholders to force the company to redeem their preferred stock for cash. This would require mezzanine equity classification despite the absence of a contractual redemption right.

Example 8-4: Perpetual Preferred Stock with Liquidated Damages

Background/Facts:Company B issues perpetual preferred shares. The shares provide for liquidated damages in the event Company B is not able to register the preferred shares within 90 days of issuance, an event that is outside the control of Company B.

Question:Must the preferred shares be classified as mezzanine equity because Company B can be required to pay liquidated damages on the preferred shares upon an event outside its control?

Analysis/Conclusion:No, a liquidated damage right is not a legal redemption right and payment of such damages does not result in a legal redemption or settlement of the security. The

(continued)

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payment of liquidated damages also does not affect any other rights associated with the security (e.g., voting rights, conversion rights, etc).

If a security is not otherwise required to be classified as mezzanine equity, the SEC Staff has generally not required mezzanine equity classification solely as a result of a liquidated damage clause.

Example 8-5: Increasing Rate Perpetual Preferred Stock

Background/Facts:Company A issues perpetual preferred stock for which it received proceeds equal to the par value of the security. The preferred stock pays an at-market dividend rate of 6 percent for the first 5 years and a dividend rate of 25 percent thereafter.

The preferred shares contain a call option that allows Company A to call the preferred shares at par value at the end of year 5 before the dividend rate steps up.

Questions:Are the preferred shares considered perpetual even though Company A would be economically compelled to call the shares to avoid paying a very high, off-market dividend rate?

How would Company A accrue the dividends on the increasing rate preferred stock?

Analysis/Conclusion:Yes, the shares are perpetual. The shares are not redeemable even if Company A may be economically compelled to redeem an increasing-rate preferred share. Further, if a security is not otherwise required to be classified as mezzanine equity, the SEC Staff has generally not required mezzanine equity classification solely as a result of an increasing-rate dividend feature since the preferred stockholder cannot force the company to redeem the security.

Dividends on increasing rate preferred stock are accrued based on the payment schedule in the guidance in ASC 505-10-S99-7. Therefore, Company A would accrue 6% per share for the first 5 years and 25 percent thereafter until it calls the preferred stock and retires it.

If an increasing rate preferred stock has a variable dividend, computation of the dividend should be based on the value of the applicable index at the date of issuance and should not be affected by subsequent changes in the index until those changes are effective.

8.4 Conversion Features in Preferred Stock

From the investor’s perspective, one of the main disadvantages of preferred stock compared to common stock is its limited potential to benefit from increases in the enterprise value of the issuer. While higher (or lower) earnings expectations lead to increases (or decreases) in the fair value of common stock, the fair value of preferred stock is largely unaffected by the company’s performance unless the preferred stock has a conversion feature.

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A conversion feature that allows the holder to convert preferred stock into common is a mechanism that may be used to eliminate this disadvantage of owning preferred shares and generally reduces the stated dividend on preferred stock issuances.

When the accounting conversion price of a convertible preferred stock is less than the market price for the equity into which the instrument is convertible, a beneficial conversion feature (BCF) likely exists. See FG section 3.5 for discussion of BCFs.

Convertible preferred stock requires liability classification under ASC 480 if it results in an obligation to issue a variable number of shares with a monetary value based solely or predominantly on a fixed monetary amount known at inception.

The table below summarizes the impact of various conversion features on the classification of preferred stock as a liability, mezzanine, or permanent equity. It is important to note that after the analysis of the impact of the conversion features on the classification of the preferred stock, the issuer must also assess the appropriate accounting for the embedded conversion feature (see FG section 8.4.3).

Mezzanine or Permanent Equity

Conversion Feature Liability or Equity Mandatory Conversion

Redeemable or Convertible at the Option of

the Holder

Fixed number of shares

Equity Permanent Mezzanine

Fixed or variable number of shares depending on the common stock’s market value

Fact dependent Mezzanine if there is no cap on the number of shares

Mezzanine if there is no cap on the number of shares

Variable number of shares equal to a fixed monetary amount

Liability N/A N/A

8.4.1 Non-Redeemable Preferred Stock Convertible into a Fixed or Variable Number of Shares

The guidance in ASC 480 requires issuers to classify preferred shares that, upon conversion, will result in the delivery of a variable number of shares that have a value solely or predominantly based on a fixed monetary amount. This determination is made upon issuance of the shares and is not reassessed.

Consider the following examples of convertible preferred stock:

• Series A: automatically converts into a fixed number of common shares on a specified date.

Series A is outside the scope of ASC 480. Although the issuer is obligated to deliver shares, the share amount is fixed. Series A should be classified as permanent equity as it is mandatorily convertible into common shares.

• Series B: automatically converts into a variable number of common shares with a monetary value equal to the par amount (or stated value) of the preferred shares. The number of shares that the company will issue is based on the par value of the

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preferred stock divided by the market price of the common stock on the specified conversion date.

Series B is within the scope of ASC 480. The Series B shares convert into a variable number of shares and the monetary value of the obligation is based solely on a fixed monetary amount (par value of the Series B preferred) known at inception. Series B should be classified as a liability.

• Series C: automatically converts on a specified date and the number of shares to be issued depends on the then-current market price of the common stock as follows:

— If the market price of the common stock is less than $50, the company will issue 1 share.

— If the market price of the common stock is between $50 and $62.50, the company will issue a pro rata number of shares between 1 share and 0.8 share.

— If the market price of the common stock is greater than $62.50, the company will issue 0.8 shares.

Series C is more difficult to analyze under ASC 480. Under the terms described above:

— The issuer is obligated to issue a fixed number of shares if the stock price is below $50 (i.e., 1 share) or above $62.50 (i.e., 0.8 shares).

— If the stock price is between $50 and $62.50 the issuer is obligated to issue a variable number of shares with a value of $50 (i.e., a pro rata number between 1 share and 0.8 shares). Thus, if the stock price is within the range of $50 and $62.50, the holder will receive a variable number of shares with a fixed monetary value (i.e., $50).

The obligation to issue a variable number of shares for a fixed monetary amount known at inception is only one of the three possible scenarios. Therefore, the issuer must evaluate whether the obligation to issue a variable number of shares is for a predominantly fixed amount known at inception. The determination of predominance depends on the facts and circumstances of each issuance, and should involve consideration of:

— The volatility of the company’s stock,

— The stock price at issuance, and

— The range of the stock price at which the company will issue a variable number of shares for a fixed monetary amount.

If the company determines that the monetary value of the obligation is based predominantly on a fixed monetary amount known at inception, ASC 480 requires liability classification of the instrument.

8.4.2 Redeemable Convertible Preferred Stock

Mandatorily redeemable preferred stock, convertible at the option of the investor into the issuer’s equity prior to its redemption date, is outside the scope of ASC 480 and should be classified as equity. In such cases, the redemption is not certain to occur since the conversion option could be exercised prior to the redemption

Preferred Stock / 8 - 11

date. However, the instrument requires mezzanine classification as the conversion is outside the issuer’s control. Consider the following example:

An issuer issues Series D preferred stock that is convertible into a fixed number of shares and can be:

• Redeemed any time after the fifth anniversary, or

• Converted into common stock by the holder any time before the first redemption date.

In this example, the Series D preferred stock should be classified as mezzanine equity securities because the cash redemption feature is outside of the issuer’s control (i.e., the preferred shareholders can force cash redemption).

8.4.3 Analysis of the Conversion Option

Upon determination of the instrument’s classification, the issuer should determine whether the conversion option should be separated from the host and accounted for at fair value.

The first step in the embedded derivative analysis is to determine whether the host is more akin to debt or equity. For a hybrid instrument issued in the form of a share, the SEC Staff clarified that the classification of preferred stock as mezzanine equity is not in and of itself determinative of whether the nature of the host is debt or equity. The evaluation of the nature of the host should take into consideration the economic characteristics and risks, based on stated and implied features (ASC 815-10-S99-3).

In remarks at the 2006 AICPA National Conference on Current SEC and PCAOB Developments, the SEC Staff noted that there are certain attributes that the Staff believes should be analyzed to determine the nature of the host. These attributes include (but should not be limited to):

• Redemption provisions in the instrument,

• The nature of the returns (stated rate or participating),

• Mandatory or discretionary returns,

• Voting rights,

• Collateral requirements,

• Whether the preferred stockholders participate in the residual,

• Whether they have a preference in liquidation, and

• Whether the preferred stockholders have creditor rights (i.e., the right to force bankruptcy).

One of these factors standing alone would not be determinative of the nature of the host, and therefore judgment is required in making the host determination.

If a hybrid instrument is determined to be akin to equity, the equity conversion option is not separated because it is considered clearly and closely related to the preferred stock. See FG section 7.1 for a discussion of convertible debt including convertible preferred stock determined to be akin to debt.

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8.5 Preferred Stock Exchangeable into Debt

Some freestanding preferred stock contains a provision that requires a mandatory exchange into debt on a stated date. This feature allows the issuer to “swap” after-tax dividends for tax deductible interest payments. Such instruments are classified as liabilities under ASC 480.

However, 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. The investor could convert the preferred stock into common stock prior to the mandatory exchange date. The instrument would require presentation as mezzanine equity because it embodies an obligation to redeem for a fixed or determinable amount that is outside of the issuer’s control.

8.6 Participation Rights

One of the main disadvantages of preferred stock compared to common stock is its limited potential to benefit from increases in earnings. Participation rights entitle the holder to receive additional income in conjunction with dividends paid to common stockholders. Participation rights are a feature that may be used to reduce the dividend on preferred stock issuances.

If a preferred share is determined to be more akin to equity than debt, a participation right is considered clearly and closely related to the host equity instrument. If the preferred stock is more akin to debt, the participation right should be analyzed to determine if it represents an embedded derivative requiring separate accounting at fair value under ASC 815 (see Chapter 3—Guide to Accounting for Derivative Instruments and Hedging Activities—2012 edition). See FG section 8.4.3 for a discussion of attributes that should be considered in determining whether preferred stock is more akin to equity or debt.

In addition, participation rights generally require the issuer to include the instrument in earnings per share using the two-class method of calculating EPS. See FG section 4.8 for a discussion of participating securities and the two-class method of calculating EPS.

8.7 Put and Call Options Embedded in Preferred Stock

Due to the higher cost of issuing preferred stock, these instruments are often callable after a certain period (e.g., after five years). Put options provide investors liquidity and protection upon the occurrence of specified events. For example, a put option exercisable upon a fundamental change may be included to give investors the ability to exit the investment in circumstances in which they may not want to continue to hold it.

Call and put options may affect the mezzanine classification of the instrument. For example, call options would trigger mezzanine classification if the preferred shareholders control or could control the board. Put options would trigger mezzanine classification if they give the holder the right to require redemption unconditionally, or upon the occurrence of an event that is not solely within the control of the issuer.

The issuer should also consider whether any call or put options embedded in a preferred stock host should be separated and accounted for under the guidance in ASC 815. See FG section 3.3 for a discussion of calls and puts embedded in equity instruments.

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8.8 Tranched Preferred Stock

Tranched preferred stock issuances have become increasingly popular, particularly in the technology and biotechnology sectors and with start-up companies. A tranched preferred stock issuance is one in which preferred stock is issued with a simultaneous contractual commitment, which either (1) requires the company to issue additional series at a future date or upon occurrence of a specified milestone or (2) gives investors the option to require the company to issue additional series at a future date or upon occurrence of a specified milestone.

From the investor’s perspective, tranched financing defers cash funding. Milestones align the commitment of funds to the company’s performance. From the issuer’s perspective, tranched preferred stock reduces fundraising efforts and funding risk if the milestones are achieved.

The issuer must determine whether the right (or commitment) to issue preferred stock in the future (collectively, the right to issue shares) is a freestanding instrument or a component embedded in the initial issuance.

As discussed in FG section 2.2, ASC Master Glossary defines a freestanding financial instrument as:

A financial instrument that meets either of the following conditions:

a. It is entered into separately and apart from any of the entity’s other financial instruments or equity transactions.

b. It is entered into in conjunction with some other transaction and is legally detachable and separately exercisable.

Since the right to issue shares is typically entered into in connection with the issuance of the first tranche of preferred stock an issuer typically considers the provisions in (b) above.

• Are the first tranche of preferred stock and the right to issue shares legally detachable?

• Are the first tranche of preferred stock and the right to issue shares separately exercisable?

FeatureFreestanding

IndicatorsEmbedded Indicators

Can the investor separate its originally issued preferred shares from any newly issued shares? Yes No

Do the originally issued shares remain outstanding when the right to issue shares is exercised? Yes No

8.8.1 Right to Issues Shares Is a Freestanding Instrument

If the right to issue shares is a freestanding instrument, the issuer must first determine the appropriate classification of that freestanding right. The classification affects the methodology for allocating the proceeds to the originally issued preferred stock and the right to issue shares.

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The right to issue shares should first be evaluated under the analysis for certain freestanding instruments (ASC 480) in FG section 2.4 and then using the model for freestanding equity-linked instruments in FG section 2.5.

• If it is determined that the right to issue shares should be classified as equity, the proceeds from the original issuance should be allocated to the originally issued preferred stock and the right to issue shares using the relative fair value method. There is no subsequent remeasurement of that right to issue shares if it is classified as equity.

• If it is determined that the right to issue shares should be classified as an asset or liability, the proceeds from the original issuance should be first allocated to that right at fair value, with any remainder allocated to the originally issued preferred shares. The right to issue shares would be subsequently recorded at fair value with changes in fair value recorded in earnings.

The allocation of value to the right to issue shares will create a discount from the par value of the originally issued preferred shares. Any discount may have to be accreted. See subsequent measurement discussion in FG section 8.9.2.

8.8.2 Right to Issue Shares Is an Embedded Feature

If the right to issue shares is an embedded feature, it should be evaluated to determine whether it should be separated and accounted for at fair value with changes in fair value recorded in earnings using the model for embedded equity-linked components in FG section 2.3.

If an embedded right to issue shares must be separated, a discount from the par value in the originally issued preferred shares will be created. Any discount may have to be accreted. See subsequent measurement discussion in FG section 8.9.2.

8.9 Preferred Stock Measurement

8.9.1 Initial Measurement

Upon issuance, preferred shares are generally recorded at fair value. If the preferred shares are issued in conjunction with other securities, such as warrants, and the other securities meet the requirements for equity classification, the sales proceeds from the issuance should be allocated to each security based on their relative fair values. If the preferred shares are issued in conjunction with other securities, such as warrants, which are classified as liabilities, then the proceeds are first allocated to the warrants liability based on its full fair value and the remaining proceeds are allocated to the preferred security classified in equity.

8.9.2 Subsequent Measurement

A discount may arise upon issurance of preferred stock when it is issued:

• On a stand-alone basis with a fair value less than its redemption value.

• In a bundled transaction with warrants, in which the proceeds are allocated between the preferred stock and the warrants.

Preferred stock recorded as equity at a value less than its redemption value should be accreted to its redemption value if the redemption is not solely at the issuer’s option. Accretion of preferred stock is recorded as a deemed dividend, which

Preferred Stock / 8 - 15

reduces retained earnings and earnings available to common shareholders in calculating basic and diluted EPS.

• If the security has a stated redemption date, the preferred stock should be accreted over the period from issuance to the redemption date.

• In the case of preferred stock that is puttable by the investor, the instrument should be recorded at redemption value at each put date. Any discount from the redemption value would be recognized over the period from issuance to the first put date.

• If a preferred stock instrument is redeemable only at the option of the issuer, the discount from the redemption value is not accreted. The difference between issuance and redemption value is recognized as a one-time dividend upon redemption of the instrument.

For mandatorily redeemable instruments classified as liabilities within the scope of ASC 480, the subsequent measurement should be recognized in one of two ways:

• If both (a) the amount that is to be paid and (b) the settlement date are fixed, the instrument should be subsequently measured at the present value of the amount that is to be paid on the settlement date, with interest cost accruing based on the rate implicit at the inception of the instrument.

Mandatorily redeemable instruments should be recorded at the redemption amount at the redemption date. Therefore, the stated dividend rate on mandatorily redeemable instruments with cumulative dividends should generally be accrued even if the dividend is not declared, as the cumulative dividends are generally included in the redemption amount. This accounting is consistent with the guidance in ASC 480-10-S99-2, which requires accretion or adjustment to the mandatory redemption amount over the period that begins on the issuance date and ends on the redemption date.

• If either the amount that is to be paid or the settlement date varies as a result of specified conditions, the subsequent measurement of the instrument should be based on the amount of cash that would have been paid under the conditions specified in the contract if a settlement had occurred on the reporting date.

• If the amount to be paid to settle the liability varies, the amortization amount should be adjusted such that the liability will reach the amount to be paid on the settlement date.

• If the settlement date varies, the amortization amount and period should be adjusted to reflect that change.

Changes in the value of the instrument since the previous reporting date should be recognized as interest expense.

Other instruments classified as liabilities under ASC 480 should be recorded at fair value with changes in fair value recorded in earnings, unless ASC 480 or other accounting guidance specifies another measurement method.

8.10 Preferred Stock Dividends

Non-cumulative dividends on preferred stock, do not accrue to the preferred shareholders until declared by the directors. They should be recorded only once declared. The terms of a preferred stock contract may require the payment of periodic dividends with or without declaration by the board of directors. In this case

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it is appropriate to record the dividend when payment is due as the issuer is legally obligated to pay the dividend regardless of whether there has been a declaration by the board. Noncumulative dividends do not add to the liquidation value of the preferred stock.

Cumulative dividends on preferred stock accrue either due to the passage of time or occurrence of an event (e.g., the attainment of cash flow goals, attainment of profitability levels, etc.). If the holders of cumulative preferred stock do not receive a dividend (the Board does not declare a dividend), then the undeclared dividend for that period is accumulated. However, as discussed below, an entry is not necessarily recorded in the financial statements. The issuer is obligated to pay any accumulated undeclared dividends (as well as any declared but unpaid dividends) at the time of liquidation of the company. In addition, in some cases, cumulative undeclared dividends may be payable upon a holder’s earlier redemption of the preferred stock or upon a contractually required redemption (such as upon a change in control of the company) of the preferred stock.

Declared dividends should be charged to retained earnings and reported as dividends payable. Undeclared dividends on cumulative preferred stock should be accrued when earned (payment is due) only if declaration by the board of directors is not required. Otherwise, cumulative dividends should be recorded when declared.

Issuers should assess the computation of earnings per share independently from their accounting for cumulative preferred stock. In most cases, a company’s earnings per share computations must reflect accrued undeclared dividends related to cumulative preferred stock.

8.11 Conversion into Equity

The conversion of an instrument into common or preferred stock is not an extinguishment if it represents the exercise of a conversion right that was included in the original terms of the instrument. In a conversion of convertible preferred stock pursuant to original conversion terms, the stock is extinguished in exchange for equity with no impact on retained earnings or EPS.

However, the exchange of common or preferred stock for preferred stock that does not contain a conversion right in its original terms is considered an extinguishment (see FG section 8.12).

8.11.1 Conversion Prior to Full Accretion of a Beneficial Conversion Feature (BCF) Discount

When an instrument with a beneficial conversion feature (BCF) is converted prior to the full accretion of the discount created by the BCF, ASC 470-20-40-1 requires the unamortized BCF amount to be recorded immediately. In the case of preferred stock conversions, this amount is recorded as a deemed dividend charged to retained earnings. The guidance also requires any other unamortized discounts at the conversion date to be written off to expense.

The amount of BCF amortized could exceed the amount the holder realizes upon conversion. This could occur when an instrument incorporates a multiple-step discount to the stock price at the commitment date, such as a 15 percent discount to the commitment date stock price if the instrument is converted after 6 months, and a 35 percent discount to the commitment date stock price if the instrument is converted after 1 year. Based on the guidance in ASC 470-20-30-7, the issuer of such

Preferred Stock / 8 - 17

an instrument would record a BCF based on the most beneficial terms to the investor (35 percent discount to the commitment date stock price), provided there are no contingencies other than the passage of time. If the investor converts the instrument at a point in time when the less beneficial conversion price (15 percent discount to the commitment date stock price) is in effect, the previously recognized BCF amortization would not be reversed.

Example 8-6: Treatment of Unallocated BCF Upon Conversion

Background/Facts:• On January 2, 2012, Company A sold 1,000 shares of Series A Convertible

Preferred Stock for $10,000. The Series A shares have a stated value of $10/share and a five year stated life.

• The conversion price is initially $10, subject to adjustment upon the occurrence of anti-dilution events. Company A concludes that the embedded conversion features does not require separate accounting as a derivative under ASC 815.

• The market price of common stock at the commitment date (determined to be January 2, 2012) was $13/share; therefore of the $10,000 of sales proceeds received for the 1,000 shares of Series A Convertible Preferred Stock, $3,000 was allocated to additional paid-in capital at issuance for the BCF embedded in the preferred stock.

• The preferred stock was converted two years after its issuance. At the conversion date, Company A had $1,800 of unamortized BCF recorded in additional paid-in capital.

Question:How is the unamortized discount on the preferred stock accounted for upon conversion?

Analysis/Conclusion:ASC 470 requires that unamortized BCF discounts be expensed at the conversion date. Since the preferred stock was converted prior to the stated redemption date, the remaining unamortized discount is required to be immediately charged to retained earnings as a dividend on the conversion date.

8.11.2 Induced Conversion

An induced conversion is a transaction in which the issuer induces conversion of a convertible instrument by offering additional securities or other consideration (“sweeteners”) to the convertible security holders. Induced conversions are transactions that:

• Change the conversion privileges if the investor exercised during a limited period of time, and

• Include all equity securities issuable pursuant to conversion privileges included in the original terms, regardless of which party initiates the offer or whether the offer relates to all holders.

ASC 260-10-S99-2 addresses the accounting for induced conversions of preferred stock. Inducement accounting applies to conversions of convertible preferred stock regardless of whether the “offer” for consideration in excess of the original conversion terms is made by the preferred holder rather than the issuer.

8 - 18 / Preferred Stock

For an induced conversion of preferred stock, the fair value of the inducement is a charge to retained earnings with an offsetting credit to the inducement consideration as appropriate (e.g., cash, common stock, etc.). The fair value of the inducement is also reflected in earnings per share. In addition, if such preferred stock was reported as mezzanine equity, the amount in mezzanine equity is transferred to permanent equity (common stock) upon conversion.

8.12 Preferred Stock Extinguishment Accounting

When preferred stock is extinguished, the issuer records a preferred stock dividend equal to the difference between (1) the fair value of the consideration transferred to the holders of the preferred stock and (2) the carrying amount of the securities surrendered. The preferred stock dividend could be either an increase to or a reduction of earnings available to common shareholders, which is used to calculate both basic and diluted EPS. See FG section 5.8.1 for a discussion of preferred stock modification.

The accounting for extinguishments and modifications of preferred stock classified as liabilities under the guidance in ASC 480 is the same as that for other debt instruments. See the debt extinguishment discussion in FG section 5.6.

8.12.1 Extinguishment of Convertible Preferred Stock with a BCF

When a convertible preferred stock is redeemed, the investor does not realize the value of the BCF; a BCF arises only from a conversion. Therefore, upon the redemption of preferred stock with a BCF, the BCF amount allocated to additional paid-in capital at issuance is reversed (debit to equity) which impacts the amounts recognized in equity and earnings available to common shareholders (i.e., the EPS numerator). Upon the extinguishment of a convertible preferred stock with a BCF, the issuer:

• Redeems the BCF through a debit to additional paid-in capital equal to the amount originally allocated to additional paid-in capital for the BCF,

• Records a reduction in earnings available to common shareholders to the extent (a) the fair value of the consideration transferred to the holders of the convertible preferred security is greater than (b) the carrying amount of the convertible preferred security in the issuer’s balance sheet plus (c) the amount previously recognized for the beneficial conversion option, and

• Records an increase in earnings available to common shareholders to the extent (a) the fair value of the consideration transferred to the holders of the convertible preferred security is less than (b) the carrying amount of the convertible preferred security in the issuer’s balance sheet plus (c) the amount previously recognized for the BCF.

8.13 How PwC Can Help

Our capital market transaction consultants and Assurance professionals frequently advise companies regarding the interpretation and application of the accounting literature to preferred stock, including:

• Classification (i.e., liability, mezzanine equity or permanent equity) of preferred stock transactions, including advice regarding the analyses needed to determine the appropriate classification (e.g., analysis of whether a transaction is predominantly indexed to a fixed monetary amount).

Preferred Stock / 8 - 19

• Whether embedded components should be separated and recorded at fair value with changes in fair value recorded in earnings.

• Earnings per share impacts.

• Appropriate disclosure items.

If you have questions regarding the accounting for preferred stock or would like help in assessing the impact a preferred stock issuance would have on your company’s financial statements, please contact your PwC engagement partner or one of the subject matter experts listed in the contacts section at the end of this Guide.

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Chapter 9: Share Issuance Contracts

9 - 2 / Share Issuance Contracts

9.1 Summary of Share Issuance Contracts

In this chapter we describe contracts under which a company sells its own shares for future delivery using a derivative instrument. These instruments include forward contracts to sell a company’s own shares, purchased puts, written warrants (call options), and variable share forward delivery agreements (components of a mandatory units structure). Such contracts can either require the company to issue the shares, or give the company or the investor the option to sell or buy the shares, respectively. The following table summarizes the contracts discussed in this chapter.

Summary of Share Issuance Contracts

Contract Summary of TermsMandatory or Optional

Settlement1

Forward Sale Issuer agrees to sell a fixed number of shares to an investor on a specified date in the future, typically at a fixed price2

Mandatory

Purchased Put Option Issuer can sell a fixed number of shares to an investor on a specified date or dates in the future or upon the occurrence of an event, typically at a fixed price2

Issuer’s Option

Warrant/Written Call Option Investor can buy a fixed number of shares on a specified date or dates in the future or upon the occurrence of an event, typically at a fixed price2

Investor’s Option

Variable Share Forward Delivery Agreement

Issuer agrees to sell a variable number of shares, based on the issuer’s stock price or some other variable, to an investor at a fixed price2 on a specified date in the future

Mandatory

1 Settlement may involve “gross physical settlement” where the full number of shares underlying the contract and exercise prices are exchanged or “net settlement” where the unrealized gain or loss on the contract is settled by the payment of cash or shares.

2 Fixed price agreements typically have provisions where the price may change upon the occurrence of specific events.

9.2 Forward Sale Contract, Purchased Put Option, and Written Call Option (Warrant) on a Company’s Own Stock

A forward sale contract on a company’s own stock is a derivative instrument that obligates the holder to buy a specified number of the company’s shares at a specified date and price. In contrast, purchased puts and written calls on a company’s own stock are derivative instruments that provide the company (or holder), with the right, not the obligation, to sell (or acquire), the company’s shares by a certain date and at a specified price. The company receives a premium from the holder when it writes a call option on its own stock, and pays a premium to purchase a put on its own stock. Forward contracts effectively fix the price an investor will pay for the company’s stock. A call option allows the investor to benefit from favorable share price movements since whether and when to buy the stock is a choice the investor makes based on the market price of the stock. These instruments can be combined with other instruments and structured to include many different types of features, such as contingencies, which could benefit the company or be used to attract investors.

Share Issuance Contracts / 9 - 3

The first step in determining the appropriate accounting treatment for a freestanding instrument involving an issuer’s own shares is to assess whether the instrument is within the scope of ASC 480 (see FG section 2.4). A physically settled forward sale contract whereby the issuer delivers a fixed number of its shares for a fixed amount of cash would typically be excluded from the scope of ASC 480, and therefore would not be recorded as a liability under that guidance. Similarly, a freestanding written call option and a purchased put option on a company’s own shares would typically be excluded from ASC 480. However, the terms of each instrument should be analyzed carefully. The following instruments would be classified as a liability within the scope of ASC 480:

• A forward contract to sell a variable number of the issuer’s own shares for a fixed monetary amount (see FG section 9.3.2),

• A forward contract to sell redeemable preferred shares, since the instrument may require settlement by the transfer of assets if the underlying preferred stock is redeemed (see FG section 9.2.1), and

• Warrants (written call options) to sell redeemable shares, since the instrument may obligate the issuer to transfer assets, albeit it is a conditional obligation (see FG section 9.2.1).

If the instrument is not within the scope of ASC 480, the next step is to determine whether it should be classified as (a) equity or (b) a liability (or asset) measured at fair value with changes in value recorded in earnings. See FG section 2.5 for the analysis of freestanding equity-linked instruments.

9.2.1 Instruments on Redeemable Shares

Under ASC 480, freestanding financial instruments that at inception embody an obligation to repurchase the issuer’s equity shares and that require or may require the issuer to settle by transferring assets are required to be classified as liabilities. Examples include forward purchase contracts, written put options, and other similar instruments (but not outstanding equity shares).

A mandatorily redeemable financial instrument is classified as a liability within the scope of ASC 480. It is an instrument issued in the form of equity that requires the issuer to redeem it by transferring assets at a specified or determinable date, or upon an event that is certain to occur (other than liquidation or termination of the reporting entity).

ASC 480-10-55-33 clarifies that all freestanding warrants (and other similar instruments) to acquire shares are liabilities if the underlying shares are either puttable by the holder or mandatorily redeemable. This is because they embody an obligation by the issuer to repurchase its own shares, and may require a transfer of assets. Liability classification is required regardless of the timing of the redemption or the redemption price.

ASC 480-10-25-9 states that the obligation for the issuer to transfer assets includes both conditional and unconditional obligations. Thus, even if the obligation (due to the redemption feature embedded in the shares) is conditional, the presence of any contingencies that may need to be met that would require the issuer to transfer assets is irrelevant in determining the applicability of ASC 480. Probability is therefore not a relevant consideration. See FG section 2.4.2 for guidance on the measurement of these instruments.

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Example 9-1: Warrant on Puttable Shares

Background/Facts:On July 1, 2011, Company A issued warrants on puttable shares, whereby upon exercise of the warrant, the holder receives shares of common stock that have an embedded put right. The put right gives the holder the right to put the shares received to Company A for cash. Each warrant is exercisable at a strike price of $50 per share until July 1, 2013. Once the warrants are exercised, the shares may be put to the issuer at their current market value for a two-year period from exercise of the warrant.

Question:How should Company A classify the warrants upon issuance?

Analysis/Conclusion:The warrants are within the scope of ASC 480 and should be classified as a liability. They should be recorded at fair value with changes in fair value recorded in earnings.

The warrants contain a conditional obligation to transfer assets—if the holder exercises the warrant, receives the shares, and exercises the put option embedded in the shares, the issuer must pay cash. ASC 480-10-25-9 includes both conditional and unconditional obligations in determining the appropriate classification of such instruments. The conditions leading to the transfer of assets is irrelevant in the analysis of whether the warrants are within the scope of ASC 480.

Moreover, the classification of the underlying shares (which ordinarily would be temporary equity, once issued) is not considered in determining the classification of the warrants. Instead, the existence of the put feature in the shares, which allows the holder to compel the issuer to redeem the shares for cash, is the driver in determining the classification of the warrants.

9.2.2 Prepaid Forward Sale of a Company’s Own Shares

A prepaid forward contract to sell a company’s own shares is an instrument in which the company receives cash (or other assets) at inception of the contract to issue either a fixed or variable number of its equity shares at a future date. A forward sale contract can be fully prepaid (i.e., the investor delivers substantially all of the consideration at inception of the contract) or partially prepaid (i.e., the investor delivers some of the consideration at inception of the contract and the remainder of the consideration during the life or at maturity of the contract).

In determining the appropriate accounting for a prepaid forward sale of a company’s own shares, the issuer must first consider whether the contract is fully or partially prepaid as the application of the accounting literature differs. Generally, a prepaid forward contract would be considered:

• Fully prepaid if the investor delivers consideration equal to or greater than 90 percent of the forward purchase price at inception of the contract, and

• Partially prepaid if the investor delivers consideration less than 90 percent of the forward purchase price at inception of the contract.

Forward contracts on a company’s own shares should be included in diluted EPS using the treasury stock method (see FG section 4.4). For a fully prepaid forward sale

Share Issuance Contracts / 9 - 5

contract, there are no proceeds received upon exercise or settlement of the contract (the proceeds are paid at inception). This results in incremental shares that are included in diluted EPS equal to the full number of shares issuable under the forward contract.

In addition, if the prepaid forward contract is to issue a fixed number of shares it is generally appropriate to show the shares as outstanding for basic EPS purposes. The number of shares to be issued is known and they are issuable for no additional consideration.

9.2.2.1 Fully Prepaid Forward Sale of a Company’s Own Shares

A fully prepaid forward sale contract is a hybrid instrument comprising (1) a debt host instrument and (2) an embedded forward sale contract. As discussed in FG section 2.1, embedded features are not within the scope of ASC 480. Therefore, the issuer would apply the guidance in ASC 480 (see FG section 2.4) to determine whether the contract as a whole meets the requirements for liability classification, but would not separately analyze the embedded forward sale contract using the guidance in ASC 480. Generally, a fully prepaid forward sale of a company’s own shares would not be a liability under the guidance in ASC 480.

If the prepaid forward sale contract is not within the scope of ASC 480, the guidance in FG section 2.3 should be applied to determine whether the embedded forward sale contract (1) meets the own equity scope exception in ASC 815-10-15-74, and thus should not be separated or (2) should be separated and accounted for at fair value with changes in fair value recorded in earnings.

9.2.2.2 Partially Prepaid Forward Sale of a Company’s Own Shares

A partially prepaid forward sale contract is a freestanding instrument that must be evaluated to determine whether it is a liability within the scope of ASC 480. Therefore, the issuer would analyze the contract using the guidance in ASC 480 (see FG section 2.4). Generally, a partially prepaid forward sale of a company’s own shares would not be a liability under the guidance in ASC 480.

If the prepaid forward contract is not within the scope of ASC 480, the guidance in FG section 2.5 should be applied to determine whether it should be classified as (a) equity or (b) a liability measured at fair value with changes in fair value recorded in earnings.

9.3 Units Structures

Units structures are bundled instruments that typically involve debt securities that are issued along with a share issuance derivative contract, such as a detachable written call option or a forward sale on a variable number of shares (see FG section 9.3.2). In units structures, companies issue separate instruments together in a single transaction to meet its financing objectives, meet its investors’ objectives, or for tax purposes. This section discusses two main types of units structures: (a) debt issued with detachable warrant, and (b) mandatory units.

9.3.1 Debt Issued with Detachable Warrants

Debt is commonly issued with detachable warrants that allow the investor to purchase shares of the company at a fixed price. Issuing warrants along with the debt in a bundled transaction results in a lower interest rate on the debt, since

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the investor is also receiving an option to participate in the economic rewards (with limited downside risks) of being an equity holder. Because the warrants are detachable and may be sold or exercised independently of holding the debt, they are considered freestanding (see FG section 2.2).

The appropriate accounting treatment for the issued warrants is determined by whether they are classified as (a) equity or (b) a liability (see FG section 2.5). If the warrants are classified as equity, proceeds are allocated to the warrants on a relative fair value basis and they are not remeasured subsequently; in contrast, if they are accounted for as liabilities, they are recorded at fair value with changes in fair value recorded in earnings.

Whether the warrant is accounted for as equity or a liability also impacts the initial measurement of the issued debt. As discussed in FG section 3.4, if the warrants are classified as a liability, the sales proceeds received from the issuance of the bundled transaction are first allocated to the warrants based on their full fair value, and the residual amount of the sales proceeds is allocated to the debt security. In contrast, if the warrants are classified as equity, the allocation is made based on the relative fair values of the debt security and the warrants. The determination of the initial carrying amount of the debt security is important because it will determine the appropriate discount to record on the debt, which is accreted through interest expense up to its par amount using the effective interest method. The degree of the discount may also impact the evaluation of other features of the debt such as embedded derivatives.

9.3.1.1 Repurchase of Debt with Detachable Warrants

When an issuer extinguishes debt with detachable warrants, such as through an open market repurchase of the securities, it must allocate the repurchase price (cash and fair value of the common stock) to the debt security and the warrants using a relative fair value allocation.

• The portion of the repurchase price attributable to the debt security is used to calculate any gain or loss on debt extinguishment. A gain on extinguishment is recognized in earnings if the amount allocated to the debt is less than the carrying value. See FG section 5.6 for further discussion of debt extinguishment accounting.

• The portion of the repurchase price attributable to the warrant(s) 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.

9.3.2 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, a mandatory unit consists of a bundled transaction comprising both (a) term debt with a remarketing feature and (b) a detachable forward purchase contract that obligates the holder to purchase shares of the company’s common stock at a specified time and at a specified price before the maturity of the debt. The number of shares to be received by the holder is based on the market price of the issuer’s stock on the settlement date of the contract (“variable share forward delivery agreement”).

Share Issuance Contracts / 9 - 7

Typically the terms of the debt issued as part of a mandatory units structure include:

• The debt has a stated principal amount equal to the settlement price of the variable share forward delivery agreement and is pledged to secure the holder’s obligation to pay the settlement/exercise price of the variable share forward delivery agreement.

• The debt has a fixed maturity (generally, five years) with a “remarketing” (described below) that occurs in proximity to the maturity date of the variable share forward delivery agreement (generally, three years).

• The interest rate is a fixed rate for the period from issuance to the remarketing date.

• If the remarketing is successful, the debt is sold to new investors at the market rate for debt with the remaining term to maturity (generally, two years). The debt must be sold for an amount at least equal to the settlement price of the variable share forward delivery agreement. If the remarketing does not result in a successful sale of the term debt at the minimum required price (failed remarketing), then the term debt would be delivered to the issuer. This deliverance would be considered satisfaction of the settlement price under the variable share forward delivery agreement. Generally, the interest rate an issuer will pay upon remarketing is not capped, 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:

If the stock price is: The company issues:

Less than $50 1 shareBetween $50 and $62.50 A pro rata number of shares between 1 share and 0.8

equal to a fixed dollar amount of $50Greater than $62.50 0.8 shares

The price paid by the investor is $50.

As such, the variable share forward delivery agreement is an instrument that comprises three features:

• A purchased put on the company’s own shares (a put on one share with an exercise price of $50),

• A written call option on the company’s own shares (a call on 0.8 shares with an exercise price of $62.50), and

• An agreement to issue the company’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 entered into separately and is legally detachable from the issued debt, it is considered a freestanding instrument and accounted for separately from the debt. Refer to FG section 2.2 for additional discussion on the analysis of whether an instrument is considered freestanding or embedded.

The variable share forward delivery agreement must then be analyzed to determine whether it should be classified as a liability per ASC 480-10-25-14(a). Under that guidance, an instrument to deliver a variable number of shares is classified as a liability if, at inception of the contract, the monetary value of the obligation is based solely or predominantly on a fixed monetary amount known at inception. In this

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example, the company only issues a variable number of shares for a fixed monetary amount if the share price is between $50 and $62.50. An assessment therefore must be made to determine whether the possibility of settling within that range is “predominant.” Judgment may be required; factors to consider include the following:

• The volatility of the company’s stock,

• The stock price at issuance, and

• The range of the stock price at which the company will issue a variable number of shares for a fixed monetary amount.

If the variable share forward delivery agreement is not within the scope of ASC 480, the next step is to determine whether it should be classified as (a) equity or (b) a liability (or asset) measured at fair value with changes in value recorded in earnings (see FG section 2.5).

9.3.2.1 Contract Payments Paid by the Issuer

Typically, the investor in a mandatory units structure receives quarterly payments comprising both (a) interest on the debt 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 paid on a net purchased put on the company’s own stock. Rather than paying the premium upfront to the investor, the issuer pays the premium over time in the form of these contract payments.

Assuming the forward contract will be treated as an equity instrument, the issuer should account for the obligation to make the contract payments as a liability measured at the present value of the payments over the life of the variable share forward delivery agreement. The liability is subsequently accreted using the effective interest method over the life of the variable share forward delivery agreement.

Example 9-2: Accounting for Mandatory Units

Background/Facts:Company A issues 10 mandatory units to investors. Each mandatory unit has a stated par value of $1,000 and consists of the following:

• A five-year debt security of Company A with an initial rate of 4.5 percent, paid quarterly, for the first thirty-three months. At the end of thirty-three months, the debt security will be remarketed and the interest rate will reset to the market rate demanded by investors for the remaining life of the debt.

• A three-year variable share forward delivery agreement under which at maturity, each investor will pay Company A $1,000 and get a variable number of shares depending on Company A’s stock price at the maturity date, as summarized below:

If the stock price is: The company issues:

Less than $50 20 sharesBetween $50 and $62.50 A pro rata number of shares equal

to a fixed dollar amount of $1,000Greater than $62.50 16 shares

(continued)

Share Issuance Contracts / 9 - 9

• Company A will pay a 1.00 percent per annum contract payment on the variable share forward delivery agreement.

• Company A’s common stock has a $1.00 par value.

Company A determines that the debt and the variable share forward delivery agreement should be accounted for separately. In addition, Company A concludes that the variable share forward delivery agreement should be accounted for as an equity instrument (see FG sections 2.4 and 2.5).

Upon remarketing, the interest rate on the debt resets to 3.8%. At settlement of the variable share forward delivery agreement, Company’s A stock price is $65.00.

Question:What are the journal entries to record (1) issuance of the mandatory units, (2) periodic entries over the life of the instrument, (3) the debt remarketing, (4) maturity of the variable share forward delivery agreement, and (5) maturity of the issued debt?

Analysis/Conclusion:1. Issuance of the mandatory units. Record (a) cash proceeds from the issuance

of 10 mandatory units, (b) the issued debt, (c) the contract payments at their present value based on the company’s three year financing rate, and (d) the fair value of the variable share forward delivery agreement to equity.

Dr Cash $10,000Dr Equity—APIC $ 275

Cr Debt (Note payable) $10,000Cr Debt (Contract payments) $ 275

Note: Since the forward contract is deemed to be a freestanding instrument and classified within equity, proceeds received ($10,000) are allocated to the debt and equity instruments on a relative fair value basis. In this case, the fair value of the forward contract is $0. However, a financing of $275 is imputed based upon the present value of the contract payments discounted at the company’s three year financing rate. These contract payments are treated as a corresponding reduction of equity as premiums on purchased options on a company’s own stock and therefore classified in stockholder’s equity.

2. Periodic entries over the life of the instrument. Record (a) quarterly interest expense of $112.50 ($10,000 x 4.5% x 1/4), and (b) cash paid under the contract obligation along with interest expense using the effective interest method.

a. Dr Interest expense $112.50Cr Cash $112.50

b. Dr Debt (Contract payment) $ 23Dr Interest expense $ 2

Cr Cash $ 25

3. Upon debt remarketing. Record quarterly interest expense of $95 ($10,000 x 3.8% x 1/4) upon remarketing for the remaining life of the instrument.

Dr Interest expense $ 95Cr Cash $ 95

(continued)

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4. Upon maturity of the variable share forward delivery agreement. Record (a) the issuance of shares at par value (10 units x 16 shares per unit x $1.00 par value = $160) and (b) proceeds received upon settlement of the variable share forward delivery agreement.

a. Dr Cash $10,000Cr Equity—Par Value $ 160Cr Equity—APIC $ 9,840

5. Upon maturity of the issued debt. Record cash paid upon redemption of the notes.

a. Dr Debt (Note payable) $10,000Cr Cash $10,000

9.3.2.2 Repurchase of Mandatory Units

When an issuer extinguishes mandatory units, such as through an open market repurchase of the securities, 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 9-2:

• 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 an asset 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 would be a liability to the issuer.

The contract payment liability discussed in FG section 9.3.2.1 constitutes 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 accounting for a repurchase of mandatory units is the same as the accounting for debt with detachable warrants. The repurchase price (cash and fair value of the common stock) is allocated to the debt security and components of the 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 and (2) the carrying value is recognized in earnings. See FG section 5.6 for further discussion of debt extinguishment accounting.

• The portion of the repurchase price attributable to the 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 issuer should take into consideration the fact that the investors are relieving themselves of a liability. 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 variable share forward delivery

Share Issuance Contracts / 9 - 11

agreement and (2) the carrying value of the debt. See FG section 5.6 for further discussion of debt extinguishment accounting.

• The portion of the repurchase price attributable to the variable share forward delivery agreement (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.

9.3.3 EPS Considerations

The diluted EPS treatment of a units structure depends on whether the debt can be tendered to satisfy the investor’s payment of the exercise price for the share issuance derivative.

ASC 260-10-55-9 specifies that instruments that require or permit the tendering of debt in satisfaction of the exercise price should be included in diluted EPS by assuming (1) the share issuance is exercised and (2) the debt is tendered.1 This method results in EPS dilution similar to the use of the if-converted method (see FG section 4.3).

If the debt 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 a reduction of earnings available to common shareholders, and

• The share issuance derivative is included as a potentially issuable common share using the treasury stock method (see FG section 4.4)

Typically, the base security in the units offering will be remarketed at some point prior, but close, to the maturity of the share issuance contract. For example, the debt security may have a five year life, with a remarketing after 2.75 years, and the share issuance contract will mature at the end of 3 years. Most securities allow the investor to use the debt to satisfy the exercise price of the share issuance derivative in the event of a failed remarketing.

Thus, in determining the method for including a units structure in diluted EPS, an issuer must consider whether the debt can be used to satisfy the exercise price (1) unconditionally or (2) upon a failed remarketing. If the debt is usable only upon a failed remarketing, then provided a successful remarketing is probable of occurring, use of the treasury stock method is generally appropriate.

9.4 How PwC Can Help

Our capital market transaction consultants and Assurance professionals frequently advise companies regarding the interpretation and application of the accounting rules for share issuance transactions, including:

• Classification (i.e., liability or equity) of share issuance transactions, including advice regarding the analyses needed to determine the appropriate classification (e.g., analysis of whether a transaction is predominantly indexed to a fixed monetary amount).

1 Interest (net of tax) on any debt assumed to be tendered is added back as an adjustment to the numerator of the diluted EPS calculation.

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• Earnings per share impacts.

• Appropriate disclosure items.

If you have questions regarding the accounting for share issuance transactions or would like help in assessing the impact a share issuance transaction could have on your company’s financial statements, please contact your PwC engagement partner or one of the subject matter experts listed in the contacts section at the end of this Guide.

Derivative Share Repurchase Contracts / 10 - 1

Chapter 10: Derivative Share Repurchase Contracts

10 - 2 / Derivative Share Repurchase Contracts

10.1 Summary of Share Repurchase Contracts

In a share repurchase (or stock buyback) a company distributes cash to existing shareholders to reacquire a portion of the company’s outstanding stock. The company can retire the reacquired shares or hold them as treasury stock. Share repurchases:

• Reduce cash,

• Reduce equity, and

• Reduce the number of common shares outstanding, which generally increases earnings per share.

There are many ways to execute a share repurchase, such as:

• An open market repurchase program, which involves an issuer simply purchasing shares in the market along with all other prospective buyers and sellers.

• Privately negotiated stock repurchases with individual shareholders.

• Derivative share repurchase contracts such as (1) a forward repurchase, (2) a written put option, or (3) an accelerated stock repurchase (ASR) program.

This chapter discusses the recognition and measurement of derivative share repurchase contracts. The following table summarizes, at a high level, the instruments discussed in this chapter.

Summary of Share Repurchase Contracts

Contract Summary of TermsMandatory or Optional

Share Repurchase

Forward Repurchase Company agrees to purchase shares, in exchange for cash, on a specified date in the future.

Mandatory

Written Put Option Company must buy shares at a fixed price if its stock price falls below a specified level.

Counterparty’s Option

Prepaid Written Put Option Company pays cash at inception of the contract. At maturity:• If the stock price is above a

specified level the company will receive a fixed amount of cash or a variable number of shares with a monetary value equal to the fixed cash amount.

• If the stock price is below the specified level it will receive a fixed number of shares.

Counterparty’s Option

Accelerated Stock Repurchase (ASR)

Company pays cash at inception and receives shares. The final purchase price is determined by an average market price over the life of the contract. The difference between the initial and final purchase price can be settled in cash or shares at the company’s option.

Mandatory

Derivative Share Repurchase Contracts / 10 - 3

10.2 Forward Repurchase of a Company’s Own Stock

A forward repurchase contract on a company’s own stock obligates the company to buy its own shares at a future date. Generally, forward contracts on a company’s own stock are physically settled (the company receives the shares and pays the price agreed with the counterparty) as this form of settlement allows the company to achieve the objective of buying its own shares. See FG section 10.2.1 for a discussion of the accounting for a physically settled forward repurchase contract.

Forward repurchase contracts can also be settled net in cash (the party with a loss delivers to the party with a gain a cash payment equal to the gain and no shares are exchanged) or settled net in the company’s shares (the party with a loss delivers to the party with a gain shares with a current fair value equal to the gain). However, these settlement options are typically not used when the company’s objective is to reacquire its shares, since the company would not receive shares under either of these settlement options and could be required to issue shares. See FG section 10.2.2 for a discussion of the accounting for a net cash or net share settled repurchase contract.

10.2.1 Physically Settled Forward Repurchase

Physically settled forward repurchase contracts, in which an issuer will repurchase a fixed number of its shares in exchange for cash, should initially be measured at the fair value of the shares at the contract’s inception (the spot price of the shares at that date), adjusted for any unstated rights or privileges. At the inception of a physically settled forward repurchase contract, the issuer should reduce equity and recognize a liability for the fair value of the shares. Essentially these contracts are accounted for as financed purchases of treasury stock.

The subsequent measurement of a physically settled forward repurchase contract depends on whether the amount to be paid and the settlement date are fixed or can vary.

If both (a) the amount to be paid and (b) the settlement date are fixed, the liability should be accreted to the amount to be paid on the settlement date. Interest cost should accrue based on the implicit interest rate at inception of the instrument (generally the difference between the spot price at the inception of the contract and the contractually agreed upon forward price).

If either (a) the amount to be paid or (b) the settlement date varies based upon specified conditions, ASC 480-10-35-3 requires the instrument to be subsequently measured at the amount of cash that would have been paid under the conditions specified in the contract if a settlement had occurred on the reporting date.

• If the amount to be paid to settle the liability varies, the amortization amount should be adjusted such that the liability will reach the amount to be paid on the settlement date.

• If the settlement date varies, the amortization amount and period should be adjusted to reflect that change.

Changes in the value of the instrument since the previous reporting date should be recognized as interest expense.

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Example 10-1: Physically Settled Forward Repurchase

Background/Facts:On July 1, 2011, Company A enters into a forward repurchase contract with Bank B. Under the terms of the forward contract Company A is obligated to purchase 1,000 shares of its own stock at a price of $125 per share on June 30, 2012. Company A’s stock price is $122.50 on July 1, 2011; therefore, there is a 2.00 percent financing cost associated with this forward contract.

Question:What are the journal entries to record (1) commencement of the forward contract, (2) periodic interest over the life of the contract, and (3) maturity of the forward contract?

Analysis/Conclusion:1. Commencement of the forward contract. Record a reduction in equity equal

to the fair value of the shares (spot price) and a corresponding liability for the obligation to deliver cash under the forward contract.

Dr Equity1 $122,500Cr Forward contract liability $122,500

2. Periodic interest over the life of the contract. Record interest expense for the 2.0 percent implicit financing cost in the forward contract using the effective interest method.

Dr Interest expense $ 2,500Cr Forward contract liability $ 2,500

3. Maturity of the forward contract. Record the payment of cash to settle the forward contract liability and reclassify the equity entry from APIC to treasury stock to reflect the share delivery.

Dr Forward contract liability $125,000Cr Cash $125,000

Dr Treasury stock $122,500Cr Equity1 $122,500

1 This can either be a separate line item within shareholder’s equity or included in additional paid-in capital (APIC). If it is included in APIC, the company should disclose that fact in the financial statement footnotes and separately identify amounts in the statement of changes in shareholder’s equity.

10.2.1.1 Earnings per Share Considerations

The shares underlying a physically settled forward repurchase contract should be treated as treasury stock for purposes of calculating both basic and diluted EPS.

Any contractual dividends or participation rights attributable to shares to be repurchased (that have not been recognized as interest costs in accordance with ASC 480) should be deducted in computing income available to common shareholders, consistent with the two-class method of calculating EPS set forth in ASC 260-10-45-59A through 45-60B. See FG section 4.8 for a discussion of participating securities and the two-class method of calculating EPS.

Derivative Share Repurchase Contracts / 10 - 5

10.2.2 Net Cash or Net Share Settled Forward Repurchase

A forward repurchase contract that permits or requires net cash or net share settlement (as opposed to a forward repurchase contract that only permits physical settlement as discussed in FG section 10.2.1) is classified as a liability (or asset) and measured initially and subsequently at fair value with changes in fair value recorded in earnings. Classification as an asset or liability depends on the fair value of the contract at the reporting date.

Such forward contracts are within the scope of ASC 480, which requires that a company classify the following freestanding financial instruments as liabilities (or in some cases, assets):

• Obligations that require or may require repurchase of the issuer’s equity shares by transferring assets (e.g., written put options and forward purchase contracts [unless they can only be settled physically as discussed in FG section 10.2.1]), and

• Certain obligations where at inception the monetary value of the obligation is based solely or predominantly on variations inversely related to changes in the fair value of the issuer’s equity shares, for example, a written put that could be net share settled.

See FG section 2.4 for further discussion of ASC 480.

10.3 Written Put Option on Own Shares

When a company writes a put option on its own shares, it agrees to buy the shares from a counterparty, generally in exchange for cash, when its share price falls below a specified price. In return, the counterparty pays the company a premium for entering into the written put option. Generally, a put option has a strike price below the share price at inception (i.e., it is out-of-the-money). A written put option can be either a postpaid contract or a prepaid contract, as described below.

Postpaid

• The company pays cash equal to the put strike price x the number of shares when and if the counterparty exercises the put option.

• The counterparty pays the company the put premium either (1) at inception, (2) over the life of the put option, or (3) upon exercise or maturity of the option.

Prepaid

• The company pays cash generally equal to the strike price x the number of shares at inception.

• If the company’s share price is below the put strike price upon exercise, the counterparty will deliver a fixed number of shares to the company. Generally the strike price is adjusted from the at-market price to incorporate the payment of (a) interest on the cash prepayment and (b) a put premium to the company from the counterparty.

• If the company’s share price is above the put strike price upon exercise, the counterparty will deliver a cash payment to the company equal to (a) the amount paid by the company at inception, plus (b) interest on the cash prepayment, plus (c) the put premium.

10 - 6 / Derivative Share Repurchase Contracts

10.3.1 Postpaid Written Put Option

A postpaid written put option is generally settled (if exercised) in one of three ways:

• Physical settlement—the company delivers cash equal to the put strike price x the number of shares underlying the put option and receives the shares in return.

• Cash settlement—the company delivers cash equal to (1) the difference between the company’s share price upon exercise of the put option and the put’s strike price, multiplied by (2) the number of shares underlying the option.

• Net share settlement—the company delivers a variable number of shares with a then current value equal to the cash settlement value.

Regardless of the form of settlement, a postpaid written put option is classified as a liability measured initially and subsequently at fair value with changes in fair value recorded in earnings because it is a liability within the scope of ASC 480. Fair value accounting is required even if the postpaid written put option does not meet the definition of a derivative instrument in ASC 815. ASC 480 requires that a company classify certain freestanding financial instruments as liabilities (or in some cases, assets):

• Obligations that require or may require repurchase of the issuer’s equity shares by transferring assets (e.g., written put options and forward purchase contracts [unless they can only be settled physically as discussed in FG section 10.2.1]), and

• Certain obligations where at inception the monetary value of the obligation is based solely or predominantly on variations inversely related to changes in the fair value of the issuer’s equity shares, for example a written put that could be net share settled.

See FG section 2.4 for further discussion of ASC 480.

In determining how to include a postpaid written put option in diluted EPS, an issuer must determine whether cash or share settlement of the put option should be assumed. See the discussion of instruments settlable in cash or shares in FG section 4.5.

• If the written put option is assumed to be settled in cash, there are no adjustments to the numerator (i.e., the change in fair value recorded in earnings remains in the numerator) or denominator of the diluted EPS calculation as compared to the basic EPS calculation.

• If the written put option is assumed to be settled in shares, the following adjustments are made to the basic EPS calculation when calculating diluted EPS, if the effect is dilutive (1) the change in fair value recorded in earnings is reversed from the numerator and (2) the shares issuable under the written put option (calculated by applying the reverse treasury stock method described in ASC 260-10-45-35 through 45-36) are included in the denominator.

10.3.2 Prepaid Written Put Option

Generally, a prepaid written put option is not a liability within the scope of ASC 480. To settle a fully prepaid written put option, a company is not obligated to deliver any value (cash, other assets, or shares); the company made its cash payment at inception of the put option. If the company has no further obligation to pay cash (or other assets) in the future under any circumstances, a prepaid written put option is outside the scope of ASC 480. Further, since ASC 480 does not apply to embedded

Derivative Share Repurchase Contracts / 10 - 7

components, a company should not separately analyze the written put option embedded in a prepaid written put option agreement using the guidance in ASC 480.

If a prepaid written put option is not within the scope of ASC 480, the next step is to determine whether it should be classified as (a) equity or (b) an asset measured at fair value with changes in fair value recorded in earnings. See FG section 2.5 for the analysis of a freestanding equity linked instrument.

A prepaid written put option is anti-dilutive and, as such, is not included in the calculation of diluted EPS (see FG section 4.2).

10.4 Accelerated Share Repurchase (ASR) Programs

An accelerated share repurchase (ASR) program is a transaction executed by a company with an investment bank counterparty that allows the company to buy a large number of shares immediately at a purchase price determined by an average market price over a period of time. The average market price is generally the volume weighted average price (VWAP), which is an objectively determinable market price. One of the primary objectives of an ASR is to enable the company to execute a large treasury stock purchase immediately, while paying a purchase price that mirrors the price achieved by a longer-term repurchase program in the open market.

In its most basic form, an ASR program comprises the following two transactions:

• A treasury stock purchase in which the company buys a fixed number of shares and pays the investment bank counterparty the spot share price at the date of the repurchase, and

• A forward contract under which the company either receives or delivers cash or shares (generally at the company’s option) at the specified maturity date of the forward contract. The company receives value (equal to the difference between the VWAP over the term of the contract and the spot share price multiplied by the number of shares purchased) from the bank if the VWAP is less than the spot share price paid at inception, and delivers value to the bank if the VWAP is greater than the spot share price paid at inception.

However, many ASR programs executed today have terms that vary from this basic transaction (e.g., many ASRs have a variable maturity date, rather than a fixed maturity date) and include additional features (such as a cap or collar) that are quite common but may complicate the accounting analysis that must be performed. The terms or features that may vary among ASR transactions include:

• Fixed Dollar or Fixed Share

— In a fixed dollar ASR the proceeds paid by the company are fixed and the number of shares received varies based on the VWAP.

— In a fixed share ASR the number of shares purchased is fixed and the amount paid for those shares varies based on the VWAP.

• Variable Maturity or Fixed Maturity

— In a variable maturity ASR, the investment bank has the option to choose the maturity date of the ASR, subject to a minimum and maximum maturity. The investment bank pays a premium (which generally takes the form of a discount on the share repurchase price) for this option.

— A fixed maturity ASR has a stated maturity date.

10 - 8 / Derivative Share Repurchase Contracts

• Uncollared, Capped, or Collared

— In an uncollared ASR the company participates in all changes in VWAP over the term of the ASR.

— In a capped ASR the company participates in changes in VWAP subject to a cap, which limits the price the company will pay to repurchase the shares. A cap protects the company from paying a price for its shares above what it believes to be reasonable. The company pays the investment bank a premium for this protection.

— In a collared ASR the company participates in changes in VWAP subject to a cap and a floor. The cap protects the company from paying a price for its shares above what it believes to be reasonable and the floor limits the benefit the company receives from a declining share price. The company receives a payment from the investment bank counterparty for selling the floor which can partially or fully offset the premium paid for the cap.

• Share Holdback

— In an effort to avoid legal and EPS complications that arise when a company delivers shares upon settlement of the forward contract, many companies elect to receive fewer shares than they are entitled to at contract inception. In some cases, the company may receive staggered partial share deliveries over the term of the forward contract. The partial delivery of shares reduces the likelihood of the company being required to deliver shares back to the bank to settle the forward contract.

Despite these alternatives, all ASR transactions follow the same basic framework, depicted below.

Illustration of ASR Mechanics

Trade Date

Company

Bank

StockLender

StockMarket

shares $

shares1

2 3 forward contract

cashcollateral

� At trade date, the investment bank borrows the company’s shares from the stock lenders (parties independent of the company) at the spot price. Often the investment bank will provide cash collateral to the stock lenders, who are typically institutional investors.

� The company makes a cash payment to the investment bank and all or a portion of the borrowed shares are delivered to the company (by the investment bank).

� The company agrees to a future settlement based on a VWAP. This is also known as the forward contract (or make-up contract) of the ASR program.

Derivative Share Repurchase Contracts / 10 - 9

Averaging or Repurchase Period

Company

Bank

StockLender

StockMarket

shares

45

shares$cashcollateral

� During the repurchase period, the investment bank purchases shares in the open market on a daily basis on behalf of the company.

The shares are returned to the stock lenders to settle the bank’s share borrowings.

� The length of the repurchase period varies depending on the size of the treasury share purchase relative to the average trading volume of the company’s shares. As discussed above, the investment bank may be able to change this period.

Maturity and Settlement Date

6

Company

Bank

StockLender

StockMarket

forwardcontract

� At the settlement date (or maturity) the company will settle the forward contract based on the terms of the contract.

Generally, if the VWAP during the averaging period is less than the company’s stock price at trade date, the company will have paid a lower price for its shares through the ASR than it would have in a spot repurchase at trade date. If the VWAP during the averaging period is higher than the company’s stock price at trade date, the company will have paid a higher price for its shares through the ASR than it would have in a spot repurchase at the trade date. Note that practically, a company could not execute a spot repurchase of the number of shares underlying most ASR programs without significantly affecting its share price. Economically the company has paid VWAP for its share repurchase.

10.4.1 Recognition and Measurement

ASR programs are generally accounted for as two separate transactions:

• A treasury stock transaction recorded on the date the initial shares are received, and

• A contract on a company’s own stock (i.e., the forward contract).

The treasury stock transaction should be recorded based upon the fair value (spot price) of the shares delivered.

The forward contract must first be assessed to determine whether it meets the requirements for equity classification. If not, it would be classified as a liability reported at fair value with changes in fair value recorded in earnings. As discussed in FG section 2.1, the first step in analyzing a freestanding equity linked instrument is to determine whether it is within the scope of ASC 480. Provided the forward contract is classified as equity it should be recorded in APIC at its fair value.

10 - 10 / Derivative Share Repurchase Contracts

The accounting treatment upon settlement of an ASR depends on whether the ASR is settled in cash or shares.

• When an ASR is settled in cash, either by the company or the investment bank, the cash payment should be recorded in APIC because it is a payment to settle an equity classified contract.

• When an ASR is settled by a cash payment from the company to the investment bank, the full cash payment should be recorded as a reduction of equity (debit APIC / credit cash).

• When an ASR is settled by a cash payment from the investment bank to the company, the full cash payment should be recorded as an increase to equity (debit cash / credit APIC).

Similarly, when an ASR is settled in shares, either by the company or the investment bank, the share issuance should be recorded in APIC, at the then-current fair value, because they are issued (or relieved) to settle an equity classified contract.

• When an ASR is settled by the company issuing new shares to the investment bank, the shares should be recorded at the then-current fair value, with an offsetting entry to APIC (debit APIC – forward contract / credit common stock / credit APIC). When an ASR is settled by the company issuing treasury shares to the investment bank, the guidance for the reissuance of treasury share should be applied.

• When an ASR is settled by the investment bank delivering additional shares to the company the shares should be recorded in treasury stock at the then-current fair value (debit APIC / credit treasury stock). Alternatively, some view the delivery of additional shares from the investment bank to the company as part of the initial treasury stock transaction. Thus, in practice, some companies record the shares in treasury stock at a value equal to the amount initially recorded in APIC for the forward contract (debit APIC / credit treasury stock). Under this method treasury stock is recorded at the amount of consideration paid for the ASR.

If neither the company nor the investment bank owe value, there should be no accounting entry. The fair value of the equity classified forward should remain in APIC. However, if the forward was initially recorded in a memo account (APIC – equity forward) it should be reclassified to the general APIC account.

10.4.1.1 Application of ASC 480

As previously noted, ASC 480 requires certain contracts on a company’s own stock to be classified as a liability (or in some cases, an asset) at fair value with changes in fair value recorded in earnings. Instruments included in the scope of ASC 480 include:

1. Obligations that require or may require repurchase of the issuer’s equity shares by transferring assets (e.g., written put options and forward purchase contracts [unless they can only be settled physically as discussed in FG section 10.2.1]), and

2. Certain obligations where at inception the monetary value of the obligation is based solely or predominantly on:

a. A fixed monetary amount known at inception, for example, a payable settlable with a variable number of the issuer’s equity shares,

Derivative Share Repurchase Contracts / 10 - 11

b. Variations inversely related to changes in the fair value of the issuer’s equity shares, for example, a written put that could be net share settled.

Typically, an ASR transaction does not require the company to transfer cash or other assets to settle the contract (however, cash is paid at inception of the transaction). Most ASR transactions allow the company to settle the forward contract in cash or shares at the company’s option. If the company has the option to deliver shares, then the contract does not meet the requirements in (1) above for inclusion in the scope of ASC 480.

A company must also assess whether the forward contract embodies an obligation that may require it to issue a variable number of shares. If there is no requirement for the company to deliver value to the investment bank counterparty in any circumstance, then the forward contract would not meet the requirements in (2) above for inclusion in ASC 480. However, this is generally not the case.

More often, the forward contract will contain provisions that could require the company to deliver a variable number of shares. In that case, the company must determine, at inception, whether the monetary value of the number of shares to be delivered at settlement is based predominantly on (a) a fixed monetary amount or (b) variations inversely related to changes in the fair value of the issuer’s equity shares.

In the basic ASR transaction described in FG section 10.4, a company could be required to deliver a variable number of shares at maturity of the forward contract. In such a transaction, the monetary value received or delivered is equal to the difference between (a) the VWAP over the term of the contract and the spot share price multiplied by (b) the number of shares purchased at inception. Since the monetary value changes as the VWAP changes, it is not predominantly based on a fixed monetary amount. In addition, the company could be required to deliver value as the price of its shares (i.e., VWAP) increases and could receive value as the price of its shares decreases; therefore, the monetary value would not be based on variations inversely related to changes in the fair value of the company’s equity shares.

The monetary value of an ASR transaction that incorporates various alternatives to the basic structure may be more complicated to determine. Frequently, a quantitative analysis of the possible settlement outcomes should be performed to determine how the monetary value is affected by the terms of the transaction. A quantitative analysis may take into account factors such as:

• Terms of the contract, including the number of shares delivered at inception of the transaction,

• The company’s stock price at trade date,

• The volatility of the company’s stock price, and

• The probability of any cap or floor on the forward contract being reached.

10.4.1.2 Analysis of Freestanding Equity-Linked Instrument

If the instrument is not within the scope of ASC 480, the next step is to determine whether it should be classified as (a) equity or (b) a liability (or asset) measured at fair value with changes in fair value recorded in earnings. See FG section 2.5 for the analysis of freestanding equity linked instruments.

10 - 12 / Derivative Share Repurchase Contracts

Example 10-2: Fixed Dollar Accelerated Share Repurchase Program

Background/Facts:On September 30, 2011, when the Company’s stock price is $125 per share, Company A enters into an accelerated share repurchase (ASR) program with the following terms:

• The ASR is a fixed dollar program in which Company A will deliver $10 million to Bank B on September 30, 2011, to repurchase a variable number of shares.

• The variable number of shares will be determined by dividing the $10 million contract amount by the VWAP observed during the term of the ASR contract.

• Bank B delivers 76,000 shares to Company A on September 30, 2011.

• Company A is not obligated to deliver any cash to Bank B after the initial cash delivery of $10 million.

• The ASR has a variable maturity, at Bank B’s option, with a minimum maturity of 3 months (12/31/11) and a maximum maturity of 6 months (3/31/12).

Company A analyzes the ASR contract and determines that:

• It is not a liability within the scope of ASC 480 since:

— there is no obligation to deliver cash after inception of the transaction, and

— based on a quantitative analysis, the monetary value of the forward contract is not predominantly based on (1) a fixed monetary amount or (2) variations inversely related to Company A’s stock price

• It meets the requirements for equity classification (see FG section 2.5)

Company A determines that the ASR should be accounted for as (1) a treasury stock transaction for the initial delivery of shares and (2) a freestanding forward contract on its own stock, which is classified as an equity instrument.

Bank B does not exercise its variable maturity option and the contract continues for the maximum term, maturing at 3/31/12. The VWAP over the term of the contract is $117.00, thus upon maturity Company A receives an additional 9,470 shares ([$10 million ÷ $117 = 85,470] less 76,000 initial share delivery).

The company’s share price at the maturity date of the ASR is $110 per share.

Question:What are the journal entries to record the (1) commencement and (2) settlement of the ASR transaction?

(continued)

Derivative Share Repurchase Contracts / 10 - 13

Analysis/Conclusion:1. Commencement of the ASR transaction. Record the cash payment, increase in

treasury stock and fair value of the forward contract.

Dr Treasury stock $9,500,000Dr Equity—APIC 500,000

Cr Cash $10,000,000

2. Settlement of the ASR transaction. Record the shares received as treasury stock with an offsetting entry to APIC.

Dr Treasury stock $1,041,700Cr Equity—APIC $1,041,700

10.4.2 Earnings per Share Considerations

ASR programs are included in EPS as two separate transactions:

• A treasury stock transaction recorded on the date the shares are received, and

• A freestanding derivative on a company’s own stock (i.e., the forward contract).

The treasury stock transaction reduces the weighted average shares outstanding, used to calculate both basic and diluted EPS, as of the date the shares are received by the company.

The freestanding derivative on the company’s own stock is generally included in diluted EPS using the treasury stock method (see FG section 4.4); however, the issuer should consider (1) the terms of the specific ASR program and (2) their company specific facts and circumstances to determine the appropriate EPS treatment.

10.4.2.1 Settlement in Cash or Shares

Most ASR contracts give the company the option to elect to receive, or pay, any value owed under the ASR contract at maturity in cash or shares. If a company has established a pattern of settling ASR contracts in cash, the use of the treasury stock method may not be appropriate. Rather, the company may be required to include the ASR in diluted EPS as though it were accounted for as an asset or liability (with fair value changes recorded in earnings available to common shareholders). See FG section 4.5 for a discussion of instruments settlable in cash or shares.

10.4.2.2 Anti-Dilution

In addition, a company must determine whether an ASR contract is anti-dilutive (see FG section 4.2) at the end of each reporting period. Most capped and collared ASR contracts are structured so that the issuer will receive additional shares at maturity; typically the issuer has to deliver shares under a capped or collared ASR only when specified events occur. In addition, in many ASR programs that are not capped or collared, the investment bank counterparty will under deliver shares at inception, such that it is expected the issuer will receive shares at maturity of the ASR, rather than issue them. In both of these fact patterns, the ASR contracts are likely to be anti-dilutive, and excluded from the calculation of diluted EPS.

10 - 14 / Derivative Share Repurchase Contracts

10.5 How PwC Can Help

Our capital market transaction consultants and Assurance professionals frequently advise companies regarding the interpretation and application of the accounting rules for share repurchase transactions, including:

• Appropriate classification (i.e., liability or equity) of share repurchase transactions, including advice regarding the analyses needed to determine the appropriate classification (e.g., analysis of whether a transaction is predominantly indexed to a fixed monetary amount).

• Earnings per share impacts.

• Appropriate disclosure items.

If you have questions regarding the accounting for share repurchase transactions or would like help in assessing the impact a share repurchase transaction has on your company’s financial statements, please contact your PwC engagement partner or one of the subject matter experts listed in the contacts section at the end of this Guide.

Noncontrolling Interest as a Source of Financing / 11 - 1

Chapter 11: Noncontrolling Interest as a Source of Financing

11 - 2 / Noncontrolling Interest as a Source of Financing

11.1 Overview of Noncontrolling Interests

When a parent company owns only a portion of the equity of a controlled subsidiary a noncontrolling interest (NCI) is created. For example, a NCI is recorded in a parent company’s financial statements in the following cases:

• A parent company acquires a controlling interest but does not acquire all of the common or preferred stock of a consolidated subsidiary.

• A parent is required to consolidate an entity in which it has little or no equity interest (e.g., pursuant to the variable interest model under ASC 810).

• A parent sells a portion of the common stock it holds in a subsidiary.

• A subsidiary issues preferred stock, classified as equity or temporary equity to a third party.

• A parent issues options to employees or third parties based on a subsidiary’s shares (or a subsidiary issues options on its own shares).

In some cases, a parent may not own all of a subsidiary’s equity for strategic reasons. In other cases, the creation of a NCI may be driven by tax or legal requirements. Alternatively, a NCI may serve as a source of financing. For example, an acquiring company may choose to buy a controlling interest in a target company and leave the remainder of the equity outstanding.

A company that acquires a controlling, but not wholly-owned, interest in a subsidiary typically wants the ability to obtain the remainder of the subsidiary’s shares; a forward or option contract executed with the NCI holder will give it the ability to do so. Alternatively, a seller may want to retain an equity interest in the company it is selling to participate in the results of its ongoing performance. Since these shares are typically not marketable, a NCI holder may execute an agreement (i.e., forward or option contract) to provide liquidity for its interests. Agreements with the NCI holder may be executed between (1) the parent and the NCI holder or (2) the subsidiary and the NCI holder.

A NCI does not result when a third-party investor holds an instrument that is classified as a liability. Therefore, if an investor holds preferred stock in a subsidiary that is classified as a liability under ASC 480 (see FG section 2.4), there is no NCI related to that preferred stock recorded in the parent company’s financial statements. See FG section 8.2 for a discussion of the classification of preferred stock. The same is true for instruments indexed to a subsidiary’s shares issued to investors; if those instruments do not meet the requirements for equity classification, they do not create a NCI. See FG section 2.1 for the analysis of equity-linked instruments.

This chapter does not address all aspects of accounting for NCI. Many NCI-related issues, such as changes in a parent’s ownership interest in a subsidiary, attribution of net income, and intercompany eliminations, are addressed in PwC’s A Global Guide to Accounting for Business Combinations and Noncontrolling Interests—2012.

11.2 Analysis of Instruments Indexed to a Subsidiary’s Shares Executed with NCI Holders

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) based on the guidance in ASC 815-40-15-5C. This is the case whether an instrument that is executed with a NCI holder is entered into by the parent

Noncontrolling Interest as a Source of Financing / 11 - 3

or by the subsidiary. Therefore, the analysis to determine the appropriate accounting treatment for an instrument issued by a parent indexed to the stock of a consolidated subsidiary is similar to the analysis to determine the accounting treatment for an equity-linked instrument on a company’s own stock (see FG section 2.1).

Analysis of Instruments Indexed to a Subsidiary’s Shares Executed with NCI Holders

Freestanding

Embedded

Is the instrument (or embeddedcomponent) freestanding or

embedded in the NCI?(FG section 11.2.1)

Accounting treatmentdetermined using Analysis of

Embedded Equity-LinkedComponents

(FG section 2.3)Consider impact of the

embedded component on theclassification of NCI shares

(FG section 11.2.3)

Is the instrument within the scope of ASC 480?(FG section 2.4.1)

Apply the recognition and measurement guidance in ASC 480

(FG section 2.4.2)Consider impact of the instrument on the classification of NCI shares

(FG section 11.2.2)

Accounting treatmentdetermined using Analysis of a

Freestanding Equity-LinkedInstrument

(FG section 2.5)Consider impact

of the instrument on theclassification of NCI shares

(FG section 11.2.2)

Yes No

11.2.1 Freestanding vs. Embedded

The first question that should be answered to determine the appropriate accounting treatment of an instrument indexed to a subsidiary’s shares executed with a NCI holder is whether the instrument is freestanding or embedded in the NCI. As discussed in FG section 2.2, ASC Master Glossary defines a freestanding financial instrument as:

A financial instrument that meets either of the following conditions:

a. It is entered into separately and apart from any of the entity’s other financial instruments or equity transactions.

b. It is entered into in conjunction with some other transaction and is legally detachable and separately exercisable.

11.2.1.1 Separately and Apart

Factors to consider in determining whether an instrument is entered into separately and apart from the transaction that created the NCI, include:

11 - 4 / Noncontrolling Interest as a Source of Financing

• Whether the counterparty to the instrument is unrelated to the NCI holder—a counterparty that is unrelated to the NCI holder would indicate that the instrument was entered into separately and apart from the NCI.

• When the counterparty to the instrument is the NCI holder (1) whether the instrument is documented separately from the transaction that gave rise to the NCI and (2) the length of time between the creation of the NCI and the execution of the instrument—execution with the NCI holder may occur separately and apart from the NCI if the instrument is separately documented (and there is no linkage between to the two instruments) and there is a reasonable period of time between the transaction that created the NCI and the execution of the instrument.

11.2.1.2 Legally Detachable and Separately Exercisable

Oftentimes an instrument indexed to a subsidiary’s shares will be executed in connection with the transaction that created the NCI. Thus, in determining whether the instrument is freestanding or embedded, the analysis generally hinges on whether the instrument is legally detachable and separately exercisable. The table below highlights indicators and considerations when determining whether an instrument is legally detachable and separately exercisable from a NCI.

Indicator Indicates Freestanding Indicates Embedded Considerations

Transferability of either (1) the shares that represent the NCI or (2) the instrument

Shareholder and/or purchase agreements do not limit the transfer of either instrument (i.e., the instrument can be transferred while the underlying shares are retained)

Shareholder and/or purchase agreements do limit the transfer of either instrument (i.e., the instrument cannot be transferred without the underlying shares)

Significant indicator if separately transferable; however, not a significant indicator if shares/instrument cannot be separately transferred as stapled/attached securities can still be freestanding

Continued existence of the NCI after the instrument is settled

Instrument can be settled while the NCI remains outstanding

Once the instrument is settled, the NCI is subject to redemption or is no longer outstanding

Significant indicator

Settlement Instrument can be or is required to be net settled

Instrument can only be settled on a gross physical basis

Significant indicator

Counterparty If the parent is the counterparty, then the instrument could be viewed as attached to the NCI

If the subsidiary is the counterparty, then the equity comprising the NCI and the instrument are with the same counterparty

Not a significant indicator as from a consolidated perspective, a subsidiary’s equity is also a parent’s equity

Specific shares The shares that represent the NCI to be delivered upon settlement of the instrument are not specifically identified

The shares that represent the NCI to be delivered upon settlement of the instrument are specifically identified

If the shares issued by the subsidiary are not publicly traded, this indicator is less significant because it is not possible for the NCI holder to obtain the issuer’s shares in the open market

Noncontrolling Interest as a Source of Financing / 11 - 5

Example 11-1: Analysis of Put Right

Background/Facts:Parent Company A acquires 80 percent of the common shares of Subsidiary B from Company Z. Company Z retains the remaining common shares (20 percent) in Subsidiary B.

As part of the acquisition, Parent Company A and Company Z enter into an agreement that allows Company Z to put its equity interest in Subsidiary B, in its entirety, to Parent Company A at a fixed price on a specified date. The put option is non-transferrable and terminates if Company Z sells its Subsidiary B shares to a third party.

Question:Is Company Z’s put option freestanding from or embedded in the NCI recorded in Parent Company A’s financial statements?

Analysis/Conclusion:The put option is embedded in the NCI recorded in Parent Company A’s financial statements because it does not meet either of the conditions of a freestanding financial instrument.

• The put option was executed as part of the acquisition, therefore it was not entered into separately and apart from the transaction that created the NCI.

• The put option is not legally detachable and separately exercisable as it is non-transferrable and terminates if Company Z sells its shares.

11.2.2 Accounting for a Freestanding Instrument Executed with NCI Holders

A freestanding instrument should be accounted for on a separate basis. The appropriate accounting treatment will be determined by the type of instrument and its terms. The issuer should also consider what impact, if any, the freestanding instrument has on the parent company’s accounting for the NCI. In many cases, the NCI continues to be reported in the parent company’s financial statements based on the contractual terms of the shares that represent the NCI. In other cases, the NCI is recharacterized as a liability even though the instrument indexed to the subsidiary’s shares is considered freestanding from the NCI.

The table below summarizes the parent company’s accounting treatment for (1) various instruments indexed to a subsidiary’s shares and (2) NCI.

11 - 6 / Noncontrolling Interest as a Source of Financing

Freestanding Derivative on NCI Shares

Accounting for the Instrument(s) Accounting for NCI

Written put option See FG section 10.3 for a discussion of the accounting treatment of a written put option.Generally, a written put option is recorded at fair value with changes in fair value recorded in earnings based on the guidance in ASC 480.

Recorded as a separate component of equity.

Purchased call option

See FG section 2.5 for the analysis of a freestanding equity-linked instrument.

Recorded as a separate component of equity.

Forward purchase See FG section 10.2 for a discussion of the accounting treatment of a forward purchase contract.

Since it is certain that the parent will purchase the remaining shares, the NCI is recharacterized as a liability.

Collar See FG section 2.4 for the analysis of certain freestanding instruments.Generally, a collar is recorded at fair value with changes in fair value recorded in earnings based on the guidance in ASC 480.

Recorded as a separate component of equity.

Freestanding written put and purchased call

See FG section 11.2.2.1 for a discussion of when written put options and purchased call options should be combined. Generally, a written put option and purchased call option are accounted for separately.A written put option is recorded at fair value with changes in fair value recorded in earnings based on the guidance in ASC 480 (see FG section 10.3).A purchased call option is generally accounted for as an equity contract. See FG section 2.5 for the analysis of a freestanding equity-linked instrument.

Recorded as a separate component of equity.

11.2.2.1 Combination of Written Put and Purchased Call Options

A written put option and a purchased call option with the same strike price and exercise dates are economically equivalent to a forward purchase contract. The accounting treatment of both (1) the instrument and (2) the corresponding NCI differ based on whether the options are accounted for separately (i.e., as a written put option and a purchased call option) or in combination (i.e., as a forward purchase contract). Thus, a parent company should determine whether a written put option and purchased call option that are freestanding from a NCI are also freestanding from each other. See FG section 2.2 for guidance on determining whether instruments are freestanding.

Noncontrolling Interest as a Source of Financing / 11 - 7

If the written put option and purchased call option were issued as a single instrument (freestanding from the NCI), the combined instrument is recorded as an asset or liability at fair value with changes in fair value recorded in earnings based on the guidance in ASC 480 (see FG section 2.4).

As discussed in ASC 480-10-25-15, a freestanding written put option that is accounted for as a liability within the scope of ASC 480 should not be combined with a freestanding purchased call option that is outside the scope of ASC 480. A written put option is recorded as a liability at fair value with changes in fair value recorded in earnings based on the guidance in ASC 480 (see FG section 2.4). A purchased call option may be recorded as (1) equity, which is not remeasured, or (2) an asset recorded at fair value with changes in fair value recorded in earnings (see FG section 2.5).

11.2.3 Accounting for an Instrument Embedded in a NCI

Once the parent company determines that an instrument is embedded in a NCI, it should assess whether the agreement meets the requirements to be accounted for separately from the host NCI. See FG section 2.3 for the analysis of embedded equity-linked components. Frequently, embedded components in a NCI are not required to be accounted for as derivatives and thus are not accounted for separately.

If a parent company determines that an embedded component should not be accounted for separately, it should assess whether the embedded component has an impact on the classification of the NCI shares. The table below summarizes the potential effect that various embedded components may have on the classification of NCI shares.

Embedded Component Impact on Accounting for NCI

Written put option An embedded written put option may affect the classification of the NCI shares as mezzanine or permanent equity. See FG section 11.3.

Purchased call option

Typically would not affect the classification of the NCI shares.

Forward purchase A forward contract embedded in a NCI results in mandatorily redeemable NCI shares. See FG section 8.3.1 for a discussion of mandatorily redeemable shares.The parent company should (1) eliminate the NCI shares from equity and (2) record mandatorily redeemable shares as a liability.

Collar The impact of a collar is generally determined by the terms of the options. See written put option and purchase call option discussion above.

Written put and purchased call with the same fixed strike price and exercise date

Based on the guidance in ASC 480-10-55-59 and 55-60, the written put option and purchased call option should be viewed on a combined basis with the NCI and accounted for as a financing of the parent’s purchase of the NCI.The parent consolidates 100 percent of the subsidiary. The derivative is recorded as a liability and accreted, through interest expense, to the strike price over the period until settlement.As discussed in ASC 480-10-55-62, this treatment would also apply if the exercise prices of the written put option and purchase call option were not identical as long as they are not significantly different.

Written put and purchased call with floating strike prices

A NCI with an embedded put and call with a floating strike price is not considered a mandatorily redeemable instrument under ASC 480. This is because the fair value of the shares at the exercise date could be equal to the strike price; in that situation, the embedded put and call may not be exercised. This makes the NCI shares contingently redeemable rather than mandatorily redeemable. See FG section 8.3.2 for a discussion of contingently redeemable securities.

11 - 8 / Noncontrolling Interest as a Source of Financing

11.3 Redeemable NCI

A redeemable NCI results when (1) an embedded put option is not separated from its host NCI or (2) when the subsidiary’s shares are redeemable.

For SEC registrants, ASC 480-10-S99 requires equity securities redeemable for cash or other assets to be classified outside of permanent equity (in the “mezzanine” equity or “temporary” equity section) if their redemption is:

• At a fixed or determinable price on a fixed or determinable date.1

• At the option of the holder.

• Based upon the occurrence of an event that is not solely within the control of the issuer.

Although the SEC’s guidance applies to public entities, we believe that the mezzanine equity presentation is preferable for a non-public entity’s equity securities that meet any one of these criteria.

11.3.1 Initial Measurement

Upon issuance, redeemable equity securities are generally recorded at fair value. If the securities are issued in conjunction with other securities, such as debt or equity instruments, the sales proceeds from the issuance should be allocated to each security based on their relative fair values.

11.3.2 Subsequent Measurement

The objective in accounting for redeemable equity securities subsequent to issuance is to report the securities at their redemption value no later than the date they become redeemable by the holder.

A discount may arise from a redeemable equity security when it is issued:

• On a stand-alone basis with a fair value less than its redemption value.

• In conjunction with other securities, and the proceeds are allocated between the redeemable equity security and the other securities issued.

A redeemable equity security recorded at a value less than its redemption value should be accreted to its redemption value in some cases. Accretion of a redeemable equity security is recorded as a deemed dividend, which reduces retained earnings and earnings available to common shareholders in calculating basic and diluted EPS.

• If the equity security is currently redeemable (e.g., at the option of the holder), it should be adjusted to its maximum redemption amount as of each reporting period.

1 Preferred stock with redemption at a fixed or determinable date can be classified as equity if it has a substantive conversion option (see FG section 8.4).

Noncontrolling Interest as a Source of Financing / 11 - 9

• If the equity security is not currently redeemable and it is probable the instrument will become redeemable, then it should be either (i) accreted to its redemption value over the period from the date of issuance to the earliest redemption date or (ii) recognized immediately at its redemption value.

• If the equity security is not currently redeemable (e.g., the contingency that triggers the holder’s redemption right has not been met) and it is not probable that it will become redeemable, subsequent adjustment is not necessary until redemption is probable. The parent company should disclose why redemption of the equity security is not probable.

A reduction in the carrying value of a redeemable equity security is appropriate only to the extent the carrying value had previously been increased. Thus, if the redemption price of an instrument decreases, it should not be adjusted below its initial carrying value. An exception to this rule exists for redeemable securities that participate in the earnings of the subsidiary. In that case, the adjustment to the carrying value is determined after the attribution of net income or loss of the subsidiary pursuant to the consolidation procedures in ASC 810.

Example 11-2: Adjustment to the Carrying Value of Redeemable Equity Securities

Background/Facts:• Parent Company A acquires 80 percent of the common shares of Subsidiary B

from Company Z. Company Z retains the remaining common shares (20 percent) in Subsidiary B. As part of the acquisition, Parent Company A and Company Z enter into an agreement that allows Company Z to put its equity interest in Subsidiary B, in its entirety, to Parent Company A for $100 million.

• The fair value of the NCI at the acquisition date is $100 million.

• Parent Company A concludes that the put option is embedded in the NCI (i.e., it is a puttable NCI). As a result, the NCI is accounted for at fair value as mezzanine equity because the interest is redeemable at the option of the minority shareholder.

• The put option is immediately exercisable.

• At the end of the first year, Subsidiary B records a net loss of $50 million. The amount of the net loss attributable to the NCI shares is $50 million x 20% = $10 million.

• The redemption value of $100 million does not change as a result of Subsidiary B generating a net loss.

Question:How should Parent Company A account for the $10 million net loss attributable to the NCI shares?

Analysis/Conclusion:Since the redemption value of the NCI remains unchanged, the $10 million net loss attributable to the NCI shares should be recorded to retained earnings as a deemed dividend to the NCI holder. The dividend is deducted from earnings available to common shareholders in calculating Parent Company A’s basic and diluted earnings per share.

11 - 10 / Noncontrolling Interest as a Source of Financing

11.4 How PwC Can Help

Our capital market transaction consultants and Assurance professionals frequently advise companies regarding the interpretation and application of the accounting rules for noncontrolling interests and instruments indexed to noncontrolling interests, including:

• Classification (i.e., liability or equity) and measurement of noncontrolling interests.

• Whether embedded components should be separated and accounted for at fair value with changes in fair value recorded in earnings.

• Earnings per share impacts.

• Appropriate disclosure items.

If you have questions regarding the accounting for noncontrolling interests or instruments indexed to noncontrolling interests, please contact your PwC engagement partner or one of the subject matter experts listed in the contacts section at the end of this Guide.

Technical References and Abbreviations / A - 1

Appendix A: Technical References and Abbreviations

A - 2 / Technical References and Abbreviations

Appendix A: Technical References and Abbreviations

The following table should be used as a reference for the abbreviations utilized throughout the Guide:

Abbreviations Technical References

ASC 210 Accounting Standards Codification 210, Balance Sheet

ASC 260 Accounting Standards Codification 260, Earnings Per Share

ASC 450 Accounting Standards Codification 450, Contingencies

ASC 460 Accounting Standards Codification 460, Guarantees

ASC 470 Accounting Standards Codification 470, Debt

ASC 480 Accounting Standards Codification 480, Distinguishing Liabilities from Equity

ASC 505 Accounting Standards Codification 505, Equity

ASC 740 Accounting Standards Codification 740, Income Taxes

ASC 810 Accounting Standards Codification 810, Consolidation

ASC 815 Accounting Standards Codification 815, Derivatives and Hedging

ASC 825 Accounting Standards Codification 825, Financial Instruments

ASC 835 Accounting Standards Codification 835, Interest

EITF 00-19 (ASC 815-40-25)

EITF Issue No. 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock

EITF 07-5 (ASC 815-40-15)

EITF Issue No. 07-5, Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock

FSP APB 14-1 (ASC 470-20)

FASB Staff Position No. APB 14-1, Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement)

IAS 32 International Accounting Standard No. 32, Financial Instruments: Presentation

IAS 39 International Accounting Standard No. 39, Financial Instruments: Recognition and Measurement

Technical References and Abbreviations / A - 3

Abbreviations Other References

AICPA American Institute of Certified Public Accountants

ASC Accounting Standards Codification

ASR Accelerated Share Repurchase

BCF Beneficial Conversion Feature

EITF Emerging Issues Task Force

EPS Earnings per Share

FASB or Board Financial Accounting Standards Board

FG Guide to Accounting for Financing Transactions: What You Need to Know about Debt, Equity and the Instruments in Between

GAAP Generally Accepted Accounting Principals

IFRS International Financial Reporting Stanards

LOC Line of Credit

MAC / MAE Material Adverse Change / Material Adverse Effect

MD&A Management’s Discussion and Analysis

NYSE New York Stock Exchange

SAB Staff Accounting Bulletin

SAC Subjective Acceleration Clause

SEC Securities and Exchange Commission

US United States

TDR Troubled Debt Restructuring

VRDO Variable Rate Demand Obligation

Definition of Key Terms / B - 1

Appendix B: Definition of Key Terms

Accelerated Share Repurchase (ASR)

A transaction executed by a company with a bank counterparty that allows the company to buy a large number of shares immediately at a purchase price determined by an average market price over a subsequent period of time. One of the primary objectives of an ASR is to enable the company to execute a large treasury stock purchase immediately, while paying a purchase price that mirrors the price achieved by a longer-term repurchase program in the open market.

Beneficial Conversion Feature

A non-detachable conversion feature that is in the money at the commitment date.

Call Option If a company buys a call option on its own equity, the call option provides the company with the right but not the obligation, to buy a specified quantity of its shares from the counterparty (call option seller) to the contract at a fixed price for a given period.

If a company sells a call option on its own equity, the call option obligates the company to sell a specified quantity of its shares to the counterparty (call option buyer) to the contract at a fixed price for a given period. A warrant is economically equivalent to a sold call option.

A call option embedded in a debt instrument provides the issuer (borrower) with the right to repay its debt on demand prior to the stated maturity date.

Call Option Overlay (Call Spread or Capped Call)

A transaction between a convertible bond issuer and a bank whereby the issuer purchases a call option from the bank which mirrors the conversion option embedded in the issuer’s convertible bond, effectively “hedging,” or canceling, the embedded conversion option. The issuer then sells a call option to the bank, almost always at a higher strike price than the embedded conversion option and purchased call option, effectively raising the strike price of the convertible bond transaction.

A call option overlay may be executed as two separate call option transactions (a “call spread”) or it can be executed as a single integrated transaction (a “capped call”).

Change-in-control Put A contingently exercisable put option embedded in a debt instrument that provides the holder with the right to put the debt back to the issuer upon the occurrence of a fundamental change in the issuing entity (such as a change in control).

B - 2 / Definition of Key Terms

Definition of Key Terms / B - 3

Contingently Convertible Instrument

An instrument that has an embedded conversion option that is exercisable only upon the satisfaction of a contingency.

Convertible Debt A debt security that provides the holder with the option to exchange the debt security for a specified number of the issuer’s equity securities.

Convertible Preferred Stock

A preferred security that provides the holder with the option to exchange the security for a specified number of a different class of the issuer’s equity shares.

Current Liability An obligation whose liquidation is reasonably expected to require the use of existing resources properly classifiable as a current asset, or the creation of another current liability.

Derivative Instrument A financial instrument that meets the definition of a derivative in ASC 815-10-15-83.

Detachable Warrant A detachable warrant is one that is originally issued in conjunction with another security (often debt) that may be exercised or traded separately following the issue date.

Embedded Derivative Implicit or explicit terms that affect some or all of the cash flows or the value of other exchanges required by a contract in a manner similar to a derivative instrument.

Equity-linked Instrument

A hybrid instrument that contains an embedded component linked to the equity of the issuer. The investor’s return is dependent upon the performance of the underlying equity to which the instrument is linked. Including equity-linked component in a financing transaction frequently enables companies to lower cash interest costs. A convertible debt instrument is an example of an equity-linked instrument.

Factoring Arrangement

An agreement under which a party sells or assigns its accounts receivable to another party (the “factor”) in exchange for a cash advance. The factor acquires the rights to the accounts receivable as well as assumes the associated credit risk (without recourse to the seller). The factor typically charges interest on the advance as well as a commission. The price paid for the receivables is discounted from their face amount to account for interest, commissions and the likelihood of uncollectibility.

Forward Contract An agreement obligating two parties to buy or sell a specified quantity of an underlying security at a specified future date and price.

B - 4 / Definition of Key Terms

Freestanding Financial Instrument

A financial instrument that either (a) is entered into separately and apart from any of the entity’s other financial instruments or equity transactions or (b) is entered into in conjunction with some other transaction and is legally detachable and separately exercisable.

Greenshoe or Overallotment Option

A freestanding agreement between an issuer and an underwriter which allows the underwriter to call additional securities to “upsize” the amount of securities issued (i.e., a 20 percent greenshoe on a $100 million convertible debt offering allows the underwriter to require the issuer to issue an additional $20 million of debt at par value).

Host Instrument The non-derivative component of a hybrid instrument which “hosts” an embedded derivative feature.

Induced Conversion A transaction in which the issuer induces conversion of a convertible instrument by offering additional securities or other consideration (“sweeteners”) to investors.

Interest Method The method used to arrive at a periodic interest cost (including amortization) that will represent a level effective rate on the sum of the face amount of the debt and (plus or minus) the unamortized premium or discount and expense at the beginning of each period.

Line-of-Credit (or Revolving Debt) Arrangement

A line-of-credit or revolving debt arrangement is an agreement that provides the borrower with the option to make multiple borrowings up to a specified maximum amount, to repay portions of previous borrowings, and to then reborrow under the same contract. Line-of-credit and revolving debt arrangements may include both amounts drawn by the debtor (a debt instrument) and a commitment by the creditor to make additional amounts available to the debtor under predefined terms (a loan commitment).

Loan Participation A transaction in which a single lender makes a large loan to a borrower and subsequently transfers undivided interests in the loan to groups of banks or other entities.

Loan Syndication A transaction in which several lenders share in lending to a single borrower. Each lender loans a specific amount to the borrower and has the right to repayment from the borrower. It is common for groups of lenders to jointly fund those loans when the amount borrowed is greater than any one lender is willing to lend.

Definition of Key Terms / B - 5

Lock-box Arrangement

An arrangement with a lender whereby the borrower’s customers are required to remit payments directly to the lender and amounts received are applied to reduce the debt outstanding. A lock-box arrangement refers to any situation in which the borrower does not have the ability to avoid using working capital to repay the amounts outstanding. That is, the contractual provisions of a loan arrangement require that, in the ordinary course of business and without another event occurring, the cash receipts of a debtor are used to repay the existing obligation.

Mandatory Units An equity-linked financial product, often marketed under different proprietary names by different financial institutions (e.g., ACES, PRIDES, or DECS), which consist of a bundled transaction comprising both (a) term debt with a remarketing feature and (b) a detachable variable share forward delivery agreement.

Net Cash Settlement A form of settling a financial instrument under which the entity with a loss delivers to the entity with a gain cash equal to the gain.

Net Share Settlement A form of settling a financial instrument under which the entity with a loss delivers to the entity with a gain shares of stock with a current fair value equal to the gain.

Noncontrolling Interest

The portion of equity (net assets) in a subsidiary not attributable, directly or indirectly, to a parent; noncontrolling interest is sometimes called a minority interest.

Non-revolving Debt Arrangements (Term Debt)

Unlike a line-of-credit or revolving-debt arrangement, a non-revolving debt arrangement (or term debt) is a credit agreement that provides the borrower with a fixed repayment plan within which further credit is not extended as payments are made.

Participation Right A contractual right of a security holder to receive dividends or returns from the security issuer’s profits, cash flows, or returns on investment.

Payment-in-Kind A bond in which the issuer has the option at each interest payment date of making interest payments in cash or in additional debt securities. Those additional debt securities are referred to as baby or bunny bonds. Baby bonds generally have the same terms, including maturity dates and interest rates, as the original bonds (parent payment-in-kind bonds). Interest on baby bonds may also be paid in cash or in additional like-kind debt securities at the option of the issuer.

B - 6 / Definition of Key Terms

Physical Settlement A form of settling a financial instrument under which (a) the party designated in the contract as the buyer delivers the full stated amount of cash or other financial instruments to the seller and (b) the seller delivers the full stated number of shares of stock or other financial instruments or nonfinancial instruments to the buyer.

Preferred Stock An equity security that has preferential rights compared to common stock.

Prepayment Option A call option embedded in a debt instrument.

Put Option If a company buys a put option on its own equity, the put option provides the company with the right but not the obligation, to sell a specified quantity of its shares to the counterparty (put option seller) to the contract at a fixed price for a given period.

If a company sells a put option on its own equity, the put option obligates the company to buy a specified quantity of its shares from the counterparty (put option buyer) to the contract at a fixed price for a given period.

A put option embedded in a debt instrument provides the investor (lender) with the right to demand repayment prior to the stated maturity date.

Subjective Acceleration Clause (SAC)

A subjective acceleration clause is a provision in a debt agreement that states that the creditor may accelerate the scheduled maturities of the obligation under conditions that are not objectively determinable (for example, if the debtor fails to maintain satisfactory operations or if a material adverse change occurs).

Troubled Debt Restructuring (TDR)

A restructuring in which the creditor, for economic or legal reasons related to the debtor’s financial difficulties, grants a concession to the debtor that it would not otherwise consider.

Units Structure A bundled instrument that typically involves debt securities that are issued along with a share issuance derivative contract, such as a detachable warrant or a variable share forward delivery agreement.

Definition of Key Terms / B - 7

Variable Rate Demand Obligation (VRDO)

A debt instrument, typically a bond, that the investor can put. Upon an investor’s exercise of a put, a remarketing agent will resell the debt to another investor to obtain the funds to honor the put (i.e., to repay the investor). If the remarketing agent fails to sell the debt (referred to as a “failed remarketing”), the funds to pay the investor who exercised the put will often be obtained through a liquidity facility issued by a financial institution.

Variable Share Forward Delivery Agreements

In a variable share forward delivery agreement, the issuer sells shares of its common stock at a stated price with the number of shares to be issued dependent upon the then current market price of the common stock, subject to a minimum and maximum number of shares. Typically, the investor is required to pay the stated price to the issuer at the settlement date. Economically, a variable share forward delivery agreement is a combination of a written call option and a purchased put option, each with different strike prices.

Refer to FG section 9.3.2 for further detail, including an illustrative example.

Warrant A written call option on the issuer’s own common or preferred equity shares.

Summary of Changes from 2012 Edition / C - 1

Appendix C:Summary of Changes from 2012 Edition

C - 2 / Summary of Changes from 2012 Edition

Appendix C: Summary of Changes from 2012 Edition

The 2013 edition of the PricewaterhouseCoopers (PwC), Guide to Accounting for Financing Transactions: What You Need to Know about Debt, Equity and the Instruments in Between, has been updated as of May 15, 2013 to include additional authoritative and interpretive guidance not included in the 2012 edition. This appendix includes a summary of the noteworthy revisions to this guide.

Noteworthy Revisions

Chapter 2: Analysis of Equity-Linked Instruments

• Section 2.2 was updated to clarify the framework used to determine whether a component is freestanding or embedded in a host instrument.

• Section 2.6 was added to provide guidance on accounting for instruments classified as equity.

• Section 2.7 was added to provide guidance on financial statement disclosure of equity-linked instruments.

Chapter 5: Accounting for Modifications and Extinguishments

• Section 5.7.2 was added to provide additional guidance on the accounting for a modification of convertible debt with a cash conversion feature.

Chapter 6: Debt

• Section 6.7 was added to include a discussion of ASU 2013-04, Obligations Resulting from Joint and Several Liability Arrangements for Which the Total Amount of the Obligation Is Fixed at the Reporting Date (a consensus of the FASB Emerging Issues Task Force).

Chapter 7: Convertible Debt

• Sections 7.7.2 was added to provide guidance on extinguishment accounting for a convertible debt instruments with a beneficial conversion feature.

Chapter 10: Derivative Share Repurchase Contracts

• Section 10.4.1 was updated to provide additional guidance on the accounting for the settlement of an Accelerated Share Repurchase program.

Acknowledgments

The Guide to Accounting for Financing Transactions: What You Need to Know about Debt, Equity and the Instruments in Between (2012) represents the efforts and ideas of many individuals within PricewaterhouseCoopers LLP, including the members of PwC’s National Professional Services Group and various subject matter experts.

The teams of PwC professionals that contributed to the content and review of this Guide are listed by topic below.

Topic Team Members

Core Team John Bishop Ken Dakdduk Nora Joyce

Analyzing Puts, Calls and Other Features and Arrangements

Greg McGahan Maria Constantinou Krystyna Niemiec

Earnings per Share Jay Seliber John F. Horan III

Accounting for Modifications and Extinguishments Jay Seliber Maria Constantinou Suzanne Stephani

Debt Dave Lukach Chad Soares Nick Milone

Convertible Debt Greg McGahan John Toriello

Preferred Stock Heather Horn John F. Horan III Monica Rebreanu

Share Issuance Contracts Frederick (Chip) Currie Kristin Orrell

Derivative Share Repurchase Contracts Frederick (Chip) Currie Chris Rhodes

Noncontrolling Interest as a Source of Financing Pam Yanakopulos John Liang

Contacts

PwC professionals have years of experience advising clients on the transactions discussed in this Guide. The sections entitled How PwC Can Help at the end of many chapters list some of the many areas in which PwC can provide advice. If you would like to discuss one of the topics covered in this Guide, please contact your PwC engagement partner or one of the PwC partners listed below.

Dave Lukach Partner, Financial Instruments, Structured Products and Real Estate Group Phone: 1-646-471-3150 Email: david.m.lukach@us.pwc.com

Fred Elmy Partner, Financial Instruments, Structured Products and Real Estate Group Phone: 1-646-471-2830 Email: frederick.j.elmy@us.pwc.com

Chris Rhodes Partner, Capital Markets and Accounting Advisory Services Phone: 1-646-471-5860 Email: chris.rhodes@us.pwc.com

Pam Yanakopulos Partner, Capital Markets and Accounting Advisory Services Phone: 1-312-298-3798 Email: pamela.yanakopulos@us.pwc.com

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