Over the last three days, I went through the accounting definition of a derivative. If you have an agreement, or embedded feature within an agreement, that meets the definition, then derivative accounting has entered your life. Unless, of course, one of the scope exceptions applies! And there are many.
The vast majority of derivative accounting scope exceptions apply to specialized transactions and are designed to preclude the use of a specific aspect of derivative accounting…hedge accounting. Hedge accounting can allow part or all of changes in fair value (aka gain or loss) to stay on the balance sheet in the equity section known as “Other Comprehensive Income”. These gains and losses never hit the income statement and therefore do not affect earnings. You can sense the potential abuse this opens up from a dizzy height, so the FASB placed a lot of roadblocks in the way in the form of scope exceptions. And, on a less cynical note, there was also the idea derivative accounting would swamp a number of industries in which the purchasing and selling of contracts that meet the definition of a derivative is a common practice. These industries already have their own accounting practices and guidance and the FASB was not looking to make changes there when it issue derivative accounting guidance in its original form, FAS 133.
So I said that most of the scope exceptions apply to specialized transactions (and contracts). Here’s the list from ASC 815-10-15-13:
- Regular-way security trades
- Normal purchases and normal sales
- Certain insurance contracts
- Certain financial guarantee contracts
- Certain contracts that are not traded on an exchange
- Derivative instruments that impede sales accounting
- Investments in life insurance
- Certain investment contracts
- Certain loan commitments
- Certain interest-only strips and principal-only strips
- Certain contracts involving an entity’s own stock
- Residual value guarantees
- Registration payment arrangements
ASC 815-10-14 through 82 goes into each scope exception in detail. The language is not always easy to understand, but my fundamental view is that for the most part the nomenclature is very familiar to people who deal in these transactions and contracts routinely. There are some exceptions, of course, and that’s what I want to focus on here, with particular emphasis on the scope exception for certain contracts involving an entity’s own stock. My reason is very simple. While companies outside of specific industries are very unlikely to deal in transactions and contracts to which most of the scope exceptions apply, companies do raise capital all the time, and it very common for capital raising transactions to bump into the derivative accounting rules. So, I’ll dive right into that scope exception and then hit a few others that I think are important to the average company to be aware of.
Certain Contracts Involving an Entity’s Own Stock
Contracts involving an entity’s own stock include both freestanding contracts and so-called ‘equity-linked’ features embedded in otherwise non-equity contracts (like debt for example). This discussion applies equally to both. I’ve already written a post about freestanding instruments versus embedded features, so I’ll leave you to read that on your own.
This scope exception can be boiled down to meeting two basic criteria. If a contract, or an embedded feature, is excepted out of derivative accounting if it is both 1) indexed to the company’s own stock and 2) classified in equity. Simple enough, right? Well, yes, if you understand the rules. And there are lots and lots of rules applicable to these two simple criteria. Here we go.
Indexed to the entity’s own stock
To be considered indexed to the entity’s own stock, the contract, or embedded feature must pass a two-part test. The first questions is: Is the contract’s (or embedded feature’s) exercise contingent and, if so, is the contingency based on a) an observable market, other than the market for the entity’s own stock or b) an observable index, other than one measured solely by reference to the entity’s own operations. Let’s break this down.
Is exercise contingent? If not, then you can ignore the rest of question. If the equity-linked contract or feature is immediately exercisable or becomes exercisable based only on the passage of time, then this test is passed. If, however, exercise is contingent on some event or observable measure, then you have to evaluate that event or measurement. If the contingency is based on anything other than the entity itself…its stock price, its trading volume, its revenue, its number of employees, its net income, whatever…then it is not indexed to the company’s own stock. An index or market that includes the company does not count. Nor does an inflation index that includes the company’s industry. The contingency must be based on the company, and solely on the company. Period.
The second question in this two-part test is: Is the settlement amount equal to the difference between the fair value of a fixed number of the entity’s shares and a) a fixed monetary amount or b) a fixed amount of debt issued by the company? As opposed to the first question above, which in my mind is very objective and easily evaluated, this one is very tricky. The reason is that the settlement amount can get a bit complicated when provisions are added that affect the settlement amount. If any of these provisions are not, to use the FASB’s language, “…inputs to fair value” then this test can not be passed. What this requires, then, is some knowledge about what the inputs to fair value are. But, most accountants are not valuation experts, and most accountants who do some valuation work rely primarily on established, accepted valuation processes (like the Black-Scholes valuation model) without giving much thought to all the theory and concepts that went into heir development.
My rule of thumb in applying this test is to take a hard look at any provision that affects the settlement amount. If the settlement calculation is not a straightforward price times quantity calculation, I dig in. These types of provisions tend to remove the equity-like risks and characteristics of the settlement amount and that is exactly what the FASB is after with this test. Great in concept, but very difficult to apply. Gratefully, the FASB provides a list (ASC 815-40-15-7E) of the most common inputs to fair value. This is not a complete list, but it’s pretty good and better than nothing:
- Strike price of the instrument or feature
- Term or duration
- Expected dividends or other dilutive activities
- Stock margin costs
- Interest rates
- Stock price volatility
- The entity’s credit spread over benchmark interest rate(s)
- The ability to maintain a standard hedge in the underlying stock
Some of these will be recognizable as inputs to the Black-Scholes option value model. Others, such as the credit spread over a benchmark rate, may not be as obvious. The last item in the list, the ability to maintain a standard hedge, is baked into the Black-Scholes model as a core assumption and basically means that it is possible to eliminate price risk by hold a long position in the stock and a short position in the option. Fortunately, in practice the primary provisions that run afoul of the fair value input test are either price adjustments based on contingent events (regardless of whether a contingent event is based solely on the company’s operations) or leverage features that are pegged to one or more fair value inputs.
The big one, though, is what is known as a “down-round price protection”. This is a very common provision in conversion options and warrant agreements and is designed to give today’s investor the economic benefit of a subsequent financing that is at an effective price that lower than the price the investor paid today. For example, if the company issues a warrant with a strike price of $1.00 today and then issues a warrant at some point in the future with a lower strike, say $.75, then the earlier warrant’s strike will be adjusted downward by some percentage of the strike price difference. This is often called a “ratchet” adjustment since the adjustment is only down, never up. A “half-ratchet” gives the investor 50% of the strike difference while a full ratchet provides 100% of the price difference. It’s also interesting that this adjustment is often referred to as “anti-dilution”. The traditional concept of anti-dilution is that the adjustment does not improve the investor’s position; rather, the adjustment serves only to maintain the economic value of his or her holding. The traditional anti-dilution adjustment is for events like stock dividends and stock splits and is designed to offset effect of the event. A ratchet actually improves the holder’s position relative to other holders of equity that do not also enjoy the adjustment.
Any price adjustment that is not purely anti-dilutive as that term is traditionally used violates this test and the contract or embedded feature can not be considered indexed to the company’s own stock.
One other significant point to make here. The probability of any of these provisions occurring nor which party, the company of the holder, controls control the event(s) has no bearing on the analysis. The only test is whether one or more of the violating provisions is present in the agreement.
Classified in Equity
If, and only if, the contract or embedded feature is considered indexed to the entity’s own stock, the next step is to evaluate whether it meets the conditions necessary for equity classification. The equity classification analysis is aimed entirely at the form of settlement of the contract or feature. Specifically, if it is possible that the contract will be net cash settled, regardless of how remote that possibility is, then equity classification is prohibited. Let me note here that conventional convertible debt is specifically excepted out of the equity classification requirements.
The FASB uses a control model to evaluate the possibility of net cash settlement. Here is the basic model:
1. If the contract or embedded feature REQUIRES net cash settlement, then equity classification is prohibited.
2. If the contact or embedded feature REQUIRES net cash settlement upon occurrence of one or more contingent events, then equity classification is prohibited unless the company controls the occurrence of the contingent event(s). Certain events are clearly outside the company’s control, such as governmental approvals, weather events, geological events, and market indexes reaching specified levels, to name just a few. Other events are not so obvious, such as sales of assets, tender offers and other capital events that can may be controlled by shareholders, or even the holder of the instrument you are evaluating. These situations require a very good understanding of shareholder rights and powers as well as state law. Evaluating these types of events will usually require input from the company’s legal counsel.
3. If the contract REQUIRES share settlement, the equity classification is permitted so long as all other conditions for equity classification are met. I’ll get into those conditions below.
4. If the contract provides the HOLDER with the choice of either net cash settlement or share settlement, then net cash settlement is assumed and equity classification is prohibited. This assumption is rarely overcome by facts and circumstances. There would have to be a significantly greater economic value from share settlement over net cash settlement, after factoring in costs and other factors to convert the shares to cash, for this assumption to be reversed.
5. If the contract provides the COMPANY with the choice of either net cash settlement or share settlement, then share settlement is assumed and equity classification is permitted so long as all other conditions for equity classification are met.
Additional conditions for equity classification
The additional conditions for equity classification is not a particularly long list, but the explanation of certain of the conditions is lengthy. I’ll provide the list here and go into the details of each condition in a separate post. The conditions are:
- Except in certain specific circumstances, the company must be able to settle the contract or embedded feature in unregistered shares.
- The company must have sufficient authorized and unissued shares available to settle the contract after considering all other commitments that may require the issuance of shares during the period that the contract or embedded feature is outstanding.
- The contract or embedded feature must contain an explicit limit on the number of shares issuable on share settlement.
- The company can not be required by the contract or embedded feature to make a cash payment to the holder in settlement of the contract or embedded feature if the company fails to make timely filings with the SEC.
- The company can not be required to make a cash payment (a so-called “make whole” or “top off” payment) to the holder if the shares delivered in share settlement and subsequently sold by the holder do not provide sufficient proceeds to cover the amount due.
- If the contract provides for net cash settlement, then such net cash settlement can only occur in circumstances in which the holders of the underlying stock would also receive a cash payment in exchange for their shares.
- There must be no provisions in the contract that provide rights to the holder that are greater than that of the stock underlying the contract.
- There must be no requirement to post collateral as credit support for the contract or embedded feature.
If all of these conditions are met, the equity classification is permitted. Please note, however, that this evaluation is not a one-time process. These conditions must be evaluated at each balance sheet date. If one or more of the conditions is not met, then equity classification is no longer permitted and the contract or embedded feature no longer qualifies for this scope exception.
Oddly enough, if the contract is not indexed to the company’s own stock and not eligible for equity classification, and therefore subject to derivative accounting, there is still one more possible scope exception, at least from an income statement perspective. This one, however, is not available to an embedded feature.
You’ll recall that there are two parts to derivative accounting, hedge accounting and non-hedge accounting. Contracts involving an entity’s own stock are not typically thought of in the context of a hedge; however, the ASC specifically notes that an equity-linked contract may indeed be a hedge and qualify for hedge accounting. If the criteria for hedge accounting are met, then the derivative contract is still subject to derivative accounting, but part or all of the changes in fair value (i.e., gains and losses) can be classified in the Other Comprehensive Income section of the equity section. That leaves the fair value swings on the balance sheet and out of your income statement. Nice!
BUT, please have a look the hedge accounting criteria. They are strict and the hedging strategy must be formally documented in advance of entering the hedge transaction. You can’t declare your contract a hedge after the fact. In other words, qualifying for hedge accounting is a practical impossibility without having entered into the contract for the express purpose of hedging.
Embedded Feature that is Clearly and Closely Related to the Host Contract
This scope exception applies only to an embedded derivative feature and would actually come ahead of the ‘own stock’ analysis above. This exception looks at the risks and characteristic of the embedded derivative feature and those of the host contract, and, if clearly and closely related to each other, then the feature does not need to be bifurcated from the host contract. My post on the clearly and closely related scope exception goes into the details.
Yes, leases are indeed exempt from hedge accounting. However, embedded features within a lease are NOT exempt. If you have a lease with payments terms that are tied to the company’s stock, a stock market index, weather or geological events, interest rates or any other observable event, you need to evaluate that feature as a possible embedded derivative. The feature would have certain scope exceptions available, of course, including the possibility that the feature is clearly and closely related to the host contract…the lease.
Registration Payment Arrangements
This one brings up a lot of questions. Registration payment arrangements are accounted for as contingencies. That’s clear and I’ve already written a post on subject. The confusion comes up around why this is even mentioned as a scope exception. Well, the reason is actually simple. When the derivative accounting guidance was first issued and applied to equity-linked transactions, registration rights agreements, which contained provisions that often met all of the criteria of a derivative, were producing a long list of derivatives that companies had to bifurcate and account for separately. The FASB determined that this was not the intent of the derivative accounting guidance which was instead focused on the specific financial instruments. The EITF quickly addressed this in an EITF issue. It now falls under the contingency guidance.