In early December 2016, the Financial Accounting Standards Board (“FASB”) issued a proposal that could make the accounting for instruments with down-round price protection features less complicated. Over the years I’ve had many clients come to me because they issued convertible debt or warrants that they thought would be recorded in equity only to find out they required liability classification at fair value. One of the culprits which often caused them to fail the criteria to be recorded in equity was down-round price protection, otherwise known as “full-ratchet anti-dilution” protection.
An instrument with down-round protection requires the Company to lower the strike price on the instrument if they issue securities at a lower price in the future. Investors often want this type of language in their agreements to help protect them from dilution if a subsequent investor is offered a better conversion or exercise price. Depending on wording in the agreement, the down-round feature could compensate the holder for more than the dilution they actually suffer, or even if an event is non-dilutive. Consequently, instruments with down-round protection generally don’t meet the criteria in Accounting Standards Codification 815 Derivatives and Hedging to be considered indexed to the Company’s own stock. This has historically meant that the entire instrument or the conversion option would require liability or asset classification at fair value and re-measurement each reporting period.
Companies complained that this accounting resulted in high cost and added complexity because it required recurring fair value measurements. It also led to greater volatility in the income statement due to changes in the fair value of the Company’s stock. To help reduce these complexities, the FASB recently issued a proposal which may help simplify the accounting. Rather than considering the down-round feature when determining whether an instrument meets the criteria to be considered indexed to the Company’s own stock, companies would only recognize the effect of the down-round feature if it is triggered in the future.
The proposal would require the following accounting if the down-round protection was triggered:
- Instruments recorded in equity: The value of the down-round feature would be recognized as a dividend in equity
- Instruments recorded as liabilities: The value of the down-round feature would be recognized through a charge to net income
If the proposal is approved, changes would be recorded on the effective date as an adjustment to the opening balance of retained earnings. Prior periods would not be affected. Any comments on the proposed accounting changes are due to the FASB by February 6, 2017.
If approved, this proposal may help simplify the accounting for financial instruments with down-round price protection. Remember the “devil is in the details” so companies shouldn’t just assume that this proposal will let them record all their warrants and conversion features as equity. Keep in mind that there are other common provisions, such as cash redemption requirements or variable conversion rates, which could still cause the warrant or conversion option to require liability classification.