Accounting Changes Coming for Some Warrants, Convertibles

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By Denise Lugo

Dec. 8 — Private companies and development-stage public companies would get some relief from burdensome and complex rules for certain equity-linked financial instruments, according to a Financial Accounting Standards Board proposal.

FASB issued the proposal Dec. 7 to provide a simpler method for accounting for equity-linked financial instruments with “down round” features, a common reference to a round of financing in which investors purchase stock from a company at a lower valuation than the valuation placed on the company’s stock by earlier investors.

Down round features are most common in warrants, convertible debt or preferred stock. Under current rules, the existence of the down round results in derivative accounting, which requires marking them to fair value each reporting period. Under the proposed model, the down round is only valued when it is triggered, so the valuation exercise isn’t required to be performed on a recurring basis.

New Model

Under the proposed changes, a company would exclude the down round feature from the assessment of whether the instrument is indexed to the company’s own stock. When the down round feature is triggered, its effects would be recognized as follows:

• for a financial instrument classified as equity, recognize the value of the effect of the down round feature in equity as a dividend;

• for a financial instrument classified as a liquidity, recognize the value of the effect of the down round feature through a charge to net income.

Moreover—or those instruments with down round features that have been triggered—a company would disclose that the feature was triggered, the value of the effect of the down round feature being triggered and the financial statement line item in which that effect is recorded.

Eliminates Cost, Complexity

Under current rules, a down round feature would generally trigger fair value measurement for warrants and embedded conversion options with a debt host, assuming the underlying shares are readily convertible to cash or the contract provides for a net settlement.

Some companies have said fair value measurement on an ongoing basis creates a significant reporting burden and unnecessary income statement volatility associated with the changes in value of a company’s own share price.

Moreover, many private company practitioners have said they had to hire third-party valuation experts to determine the fair value of the down round feature because of the complexity in applying the guidance.

Companies have until Feb. 6 to comment on the proposed changes, which affect ASC 480.

To contact the reporter on this story: Denise Lugo in New York at dlugo@bna.com

To contact the editor responsible for this story: S. Ali Sartipzadeh at asartipzadeh@bna.com

For More Information

FASB’s proposal for simplifying down round features of financial instruments is at http://src.bna.com/kDb.

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