The FASB on May 3, 2021, published a narrowly tailored accounting standard that makes it easier to report about written call options such as warrants that remain equity classified after a modification or exchange.
The standard provides a principles-based framework for determining whether an issuer should recognize a modification or exchange of the warrant as an adjustment to equity or as an expense.
The guidance was developed to eliminate reporting differences among entities that stemmed from the lack of explicit accounting rules in U.S. GAAP. Differences range from an immediate charge to earnings or an equity adjustment to no impact on earnings or equity.
Both public and private companies are required to apply the provisions prospectively to fiscal years after December 15, 2021, and interim periods within, the board said. The guidance however can be applied earlier including in an interim period. If adopted in an interim period, it should be applied as of the beginning of the fiscal year that includes that interim period.
The rules come at a time when the SEC has been scrutinizing the way special purpose acquisition companies (SPACs) have been accounting for warrants, and therefore would prove useful to those entities, accountants said.
“With so many SPACs having to restate over recent SEC views on the accounting for warrants, I could see where some of these SPACs would want to amend their warrants today to avoid SEC scrutiny when they eventually file for the de-SPAC transaction,” Scott Ehrlich, President of Mind the GAAP, LLC, said. “So, in short, I could see a lot more warrant modifications in the next three to six months,” he said.
A SPAC is a shell corporation without performance history or revenue that is formed for the sole purpose of raising capital through an initial public offering (IPO) to then acquire a target business.
Warrants are frequently used by SPACs, which typically issue them with common stock in their IPOs. A warrant is a written call option under which the counterparty has the right, but not the obligation, to purchase a specified quantity or amount of common stock from the issuing entity at a specified price, according to a FASB analysis.
Historically, a number of SPACs classified warrants as part of equity. However, the SEC in April – citing U.S. GAAP – said warrants with certain features probably would be more rightly classified as a liability.
The new accounting rules would also be significant to thinly capitalized technology start-ups or research and development (R&D) companies in the pharmaceutical industry. Issuance and modification of warrants in conjunction with raising capital is also common among those companies, many of which are in pre-revenue or growth stages and therefore depend on investors to fund their operations.
Among reasons issuers typically modify outstanding warrants, the most prevalent is to raise cash and capital.
Nitty Gritty of the Rules
The new standard was issued as Accounting Standard Update (ASU) No. 2021-04, Earnings Per Share (Topic 260), Debt— Modifications and Extinguishments (Subtopic 470-50), Compensation—Stock Compensation (Topic 718), and Derivatives and Hedging— Contracts in Entity’s Own Equity (Subtopic 815-40) Issuer’s Accounting for Certain Modifications or Exchanges of Freestanding Equity-Classified Written Call Options a consensus of the Emerging Issues Task Force.
When applying the new rules, treat a modification of the terms or conditions or an exchange of “a freestanding equity-classified written call option that remains equity classified” as an exchange of the original instrument for a new instrument, according to a text of the standard.
To measure the effect of the modification or exchange, an entity has to consider whether it is part of or directly related to a modification or an exchange of an existing debt instrument or line-of-credit or revolving-debt arrangements. In that case, measure it as “the difference between the fair value of the modified or exchanged written call option and the fair value of that written call option immediately before it is modified or exchanged.”
Measure all other modifications or exchanges, as the excess, if any, “of the fair value of the modified or exchanged written call option over the fair value of that written call option immediately before it is modified or exchanged,” the guidance states.
The effect of the changes should be recognized on the basis of the substance of the transaction, in the same manner as if cash had been paid as consideration.
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