By Denise Lugo
Early-staged companies should get a consistent way to report modifications to all freestanding equity-classified derivative instruments, an area lacking uniformity in GAAP, according to the FASB’s Emerging Issues Task Force (EITF).
The EITF on September 3, 2020, said the FASB should propose that companies apply a principles-based framework to determine the appropriate accounting treatment based on the economic substance of the modification of those items.
A company would account for or recognize the modification based on whether it is to a financing transaction to raise equity, to raise or modify debt, compensation for goods or services, or other modifications.
To transition the rules, companies would be able to choose between prospective and full retrospective application, the task force agreed. Companies would not be required to provide additional transition disclosures beyond those required in Topic 250, Accounting Changes and Error Corrections.
The issue is relevant to warrants, other options, and forwards that remain classified in equity after a modification is made. These are instruments under which an investor has the right to purchase a specific amount of common stock from an issuer at a specified price.
The topic is common among technology startups or research and development entities in the pharmaceutical sector which are not yet able to generate enough revenue or cash flow to fund their ongoing operation, EITF discussions indicated. The issuance or modifications to warrants is therefore common among those types of companies, which do so to attract more investments as part of their negotiations with investors.
Task Force Went Broader Than Asked
The EITF’s decision morphed from its discussions on Issue No. 19-C, Warrant Modifications: Issuers’ Accounting for Modifications of Equity Classified Freestanding Call Options That Are Not within the Scope of Topic 718, Compensation—Stock Compensation, or Topic 815, Derivatives and Hedging.
Task force members decided to broaden the scope of the issue, stating that doing less would create differences in accounting for very similar contracts.
“Right now we have the scope defined as equity classified freestanding call options. What we see in practice though is there are other equity classified derivatives that are very similar to written call options like forward sales,” said Paul Beswick, a former SEC chief accountant, and current partner at Ernst & Young LLP. “The fact is you look at referring guidance, the guidance isn’t related to warrants, it’s actually broader to equity classified contracts. And so I was just wondering why we would create diversity amongst what seemed to be very similar contracts,” he said.
No Explicit GAAP on Topic
The FASB added the project to the EITF’s agenda after companies said there is a lack of explicit guidance in the GAAP codification on accounting for modifications of equity-classified warrants that remain equity classified after modification.
Companies have been analogizing to various guidance in the GAAP codification and certain SEC guidance, according to a board handout. For example: when the modification is executed in conjunction with raising equity some companies refer to guidance in Topic 718, Compensation—Stock Compensation, for modification of equity classified stock options, which requires recognition of value transferred as compensation cost (that is, effect on earnings), or guidance in Subtopic 470-20, Debt with Conversion and Other Options, regarding conversion of a convertible debt instrument to equity pursuant to an inducement offer, which requires immediate recognition of value transferred via the inducement offer as an expense (that is, effect on earnings). SEC staff announcements and speeches are also analogized to.
Analogizing to codification and SEC guidance has resulted in different views about how to account for those types of modifications, the handout states.
The topic still has to be discussed by the FASB.
This article originally appeared in the September 8, 2020 edition of Accounting & Compliance Alert, available on Checkpoint.
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