Is it Equity, Debt, or Some of Each?

Investor financing for today’s tech companies is complex, different terms in convertible debt, warrants and preferred stock can result in surprising and difficult accounting treatments. At a recent Public Company Accounting Oversight Board (PCAOB) workshop, both SEC and PCAOB representatives emphasized the risk of financial statement misstatements due to complexities in equity vs. liability determination issues. The complexity is due in part to the intricacy of today’s financial instruments, and compounded by US GAAP standards. This subject is addressed in three different Financial Accounting Standard Board (FASB) ASC topics; ASC 480 “Distinguishing Liabilities from Equity,” ASC 470-20 “Debt with Conversion and Other Options” and ASC 815 “Derivatives and Hedging,” which collectively span around 400 pages. Analyzing the proper accounting treatment for complex financial instruments includes referring to all three aforementioned ASC topics.

How about a few examples?

Normally detachable “plain vanilla” warrants, warrants that do not have any put provisions or down round protections, will be considered equity on the balance sheet. However, warrants that have certain down round protection, where the strike price reduces if the underlying stock is issued at a lower price, will be considered liabilities. In other situations, if the stock underlying the warrant is puttable back to the issuer at the option of the holder, the warrant is considered a liability. Even a plain vanilla warrant can be a liability if there are not enough authorized shares. Are you beginning to scratch your head? Furthermore, freestanding warrants can be the most simple of the complex financial instruments used to analyze for proper GAAP treatment.

Additional pitfalls hover with convertible debt, convertible preferred stock and convertible debt issued with warrants. For example, typical convertible debt, debt where the conversion price is equal to or greater than the value of the underlying stock when the debt is issued and where there are no down round protections, is generally considered as one instrument treated as a liability on the balance sheet with no ongoing fair value issues. However, the same convertible debt if issued with detachable “plain vanilla” warrants in one transaction will require the proceeds received with the issuance to be allocated between the debt liability and the warrants equity. Furthermore, the value assigned to the warrants is considered a discount with the debt and amortized to interest expense over the debt term. Wait, it could get worse. Depending on the relationship of the conversion price to the value of the underlying stock, and the calculation of the “adjusted” conversion price, it could give rise to a Beneficial Conversion Feature (BCF). The BCF gives rise to additional debt discount to be amortized to interest expense.

What about some preferred stock complexities?

Normally, “plain vanilla” convertible preferred stock, preferred stock without redemption features and down round protection is classified as equity on the balance sheet. Public company convertible preferred stock that is not redeemable, but has down round protection will likely be treated as one instrument in equity. However, if the preferred stock were redeemable, the conversion feature would be considered a derivative liability and the issuance proceeds would need to be allocated between the preferred stock and the conversion feature, which would be considered a derivative liability. The fair value of the derivative liability would need to be adjusted on each balance sheet date with any adjustments flowing through the income statement. Keep in mind that the result could even be different in this case if a private company issues the preferred stock.

Other complexities can result from additional terms in the financial instruments. There is not an easy set of rules or simple flow chart to get one to the correct accounting conclusion. Read the financial instruments carefully and the terms analyzed against the GAAP literature.

 
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