The Financial Accounting Standards Board (“FASB”) recently announced an important Accounting Standards Update that affects all entities that issue equity-linked financial instruments with “down round” features. The Update simplifies the accounting for financial instruments with these features.
What is a Down Round?
A “down round” is a financing in which a company sells shares of its capital stock at a price per share that is less than the price per share it sold shares for in an earlier financing. Down round features are common in warrants, convertible preferred shares, and convertible debt instruments issued by private companies and development-stage public companies. Private company and other stakeholders expressed concern that current accounting guidance creates unnecessary cost and complexity for organizations that issue financial instruments with down round features.
The Accounting Standards Update (“ASU”) 2017-11 includes two parts.
First, it stipulates that the down round feature can no longer preclude an equity classification. Previously, the down round provision almost guaranteed derivative treatment for conversion features or standalone warrants and options. Furthermore, the amendment removes the requirement to record the derivative liability at fair value at each reporting period.
This change was based on feedback from stakeholders asserting that accounting for freestanding and embedded instruments with down round features as liabilities subject to fair value measurement on an ongoing basis creates a significant reporting burden. Stakeholders also indicated that this causes unnecessary income statement volatility associated with changes in value of an entity’s own share price. Moreover, stakeholders suggested that this accounting does not reflect the economics of the down round feature, which exists to protect certain investors from declines in the issuer’s share price under certain circumstances.
The second part of the update addresses the difficulty of navigating Topic 480, Distinguishing Liabilities from Equity. This difficulty was caused by extensive pending content in the FASB Accounting Standards Codification®. The pending content resulted from the indefinite deferral of accounting requirements related to mandatorily redeemable financial instruments of certain nonpublic entities and certain mandatorily redeemable noncontrolling interests.
For further guidance on understanding how your business will be affected by this update, please contact your Friedman advisor.
