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Amendment Is Approved for Simplification of Down-Round Accounting

The FASB agreed to finalize an update to GAAP that is intended to make the accounting easier for companies that attract investors by issuing warrants with embedded down-round options. The options are often used to protect early-stage investors in private companies from investment losses during later funding rounds.

A divided FASB on May 10, 2017, agreed to finalize an update to GAAP that is intended to make the accounting easier for companies that attract investors by issuing warrants with embedded down-round options.

Down-round options lower the exercise price for a stock option or other type of equity instrument if the company’s value declines. The options are often used to protect early-stage investors in private companies from investment losses during later funding rounds.

The amendments the FASB approved will let businesses ignore the existence of a down-round feature in a financial instrument when deciding whether to classify the instrument as a liability or equity. Under current GAAP, instruments with the provisions typically are classified as liabilities, even if the protection feature is never exercised.

If the protection feature gets triggered, the effect would not have to be recorded on the balance sheet or income statement, but in earnings per share. The change would apply to freestanding warrants and to businesses that are within the scope of FASB ASC 260, Earnings Per Share, as well as businesses that are not required to provide earnings per share but voluntarily choose to do so, the FASB agreed on May 10.

The effort — which was supposed to be a relatively straightforward solution — has been a hard slog for the FASB, with several back-and-forth discussions about whether the planned fix would help financial professionals or the startup businesses that typically use the options.

The planned update stems from the December 2016 Proposed Accounting Standards Update (ASU) No. 2016-370, Distinguishing Liabilities From Equity (Topic 480): I. Accounting for Certain Financial Instruments With Down Round Features II. Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests With a Scope Exception.

Current GAAP prohibits certain instruments with down-round features from being indexed to a company’s own stock, which means they must be classified as a liability, and not equity, under Subtopic 815-40, Derivatives and Hedging—Contracts in Entity’s Own Equity. Critics have said the presence of a down-round feature should not automatically require instruments to be classified as liabilities.

The amendments in Proposed ASU No. 2016-370 let businesses ignore the existence of a down-round feature when determining whether an instrument should be classified as a liability or equity, but it would have required recognition of the feature once it is triggered.

But consensus on the proposal was tough to find. The comments submitted in response to Proposed ASU No. 2016-370 were mixed, and some financial professionals wanted the FASB to consider more extensive improvements to the liability and equity guidance in U.S. GAAP and asked that it not add another rule to the already complex guidance. Others, including the FASB’s Private Company Council (PCC), questioned whether the proposed change would truly simplify accounting.

FASB members Christine Botosan, Harold Schroeder, and Marc Siegel voted against the final amendment.

Botosan agreed that the accounting for down-round options needed to be simplified, but she did not think the changes based on Proposed ASU No. 2016-370 were a simplification. In her view, by letting companies ignore the effects of a down-round trigger, the FASB was letting them ignore economic events.

“I’m frankly really glad I don’t have to teach this to anyone because I don’t know how I’d explain this,” said Botosan. Before she joined the FASB in July 2016, she was an accounting professor at David Eccles School of Business at the University of Utah.

FASB member Lawrence Smith countered that the current accounting was equally hard to explain. The existing standard requires businesses to record a counterintuitive charge through the income statement when the value of their stock rises, and a gain when their shares decline.

“When the stock market is going up, and these things are recorded under current GAAP as liabilities, and you have a charge to earnings to reflect that change, how do you explain that?” Smith said. He said he was in favor of the planned update not for conceptual reasons, but for “practicalities.”

The FASB plans to publish the update to U.S. GAAP in the third quarter of this year and have it become effective for public companies for fiscal years beginning after December 15, 2018, including quarterly periods within that fiscal year. All other organizations must follow it for annual reports after December 15, 2019, and quarterly periods after December 15, 2020. The FASB said it is permitting adoption of the changes ahead of the effective date.

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