Settlement alternatives, and the party that controls the settlement alternatives, figure significantly in determining the accounting treatment of an equity-linked freestanding or an embedded derivative. The pre-Codification guidance was contained primarily within EITF-0019, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock. The Codification guidance is buried within ASC 815 (primarily ASC 815-40). While the accounting guidance assumes cash settlement if the counterparty has the choice of settlement, and share settlement if the issuer controls the choice, these assumptions can be overcome based on the substance of the transaction.
You’ll recall that once you have a derivative, whether freestanding or embedded, the only way out of fair value accounting is to meet the conditions for one of the remaining scope exceptions. One of those exceptions is if the instrument (or embedded) is both indexed to the company’s own stock and classified in equity. To be indexed to the company’s own stock is a two-part test. Once passed, you move on to determining classification based on its settlement terms.
If net cash settlement is required under the contract terms, then equity classification is prohibited. If physical or net share settlement is required, then equity classification is required as long as all other conditions for equity classification are met. The list of conditions is lengthy. These are two most straight-forward settlement provisions to evaluate. Things get stickier when one of the parties has a choice of settlement alternatives.
Let’s look at the the counterparty first. In most cases, the assumption of net cash settlement prevails and equity classification is prohibited.The only way to overcome this assumption is to have settlement alternatives that have different economic values. In other words, if the value of share settlement is greater than net cash settlement, then it is possible to argue that the counterparty will choose share settlement because of this value difference. However, the value difference needs to be significant enough to cover transaction costs of converting the shares to cash and the potential impact selling the shares may have on the value of the stock. Additionally, if there is a history of cash settlement, then there is no point making this value difference argument. The past net cash settlements will trump the value difference. Personally, I think this position is nearly impossible to sustain since the first time the counterparty chooses net cash settlement taints every settlement that follows. Net cash settlement must be assumed. I have only rarely seen a counterparty choose share settlement in lieu of net, and I have not not seen this position successfully supported.
If the company has the choice of net cash settlement or share settlement, share settlement is assumed and equity classification is permitted as long as all other conditions are met. Again, this is a lengthy list and the Equity-Linked Transactions decision analysis tool goes through each condition. But, there conditions are not the only potential problem. There may be other contracts with the counterparty that cause problems. For example, if the counterparty holds a put on all shares issued to him/her by the company and the put price is in the money (i.e., greater than the fair value of the stock), then the transaction is effectively a debt issuance. Equity classification is prohibited.