FASB Issues Guidance Towards the Simplification of Instruments with Down Round Features

In an effort to reduce complexities and ease costs related to certain financial instruments with characteristics of both liabilities and equity, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2017-11, Part I. Accounting for Certain Financial Instruments With Down Round Features and Part 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.

Part I of ASU 2017-11

Part I of ASU 2017-11 affects companies that issue financial instruments that include down round provisions, which are commonly found in warrants, convertible preferred shares, and convertible debt. A financial instrument’s down round provision is triggered when the issuer subsequently issues shares at a per-share price below the strike price of the financial instrument. Alternatively, this feature can be triggered by the subsequent issuance of convertible financial instruments with a lower strike price than the down round instrument. Such down round provisions serve to protect investors from the decline in the issuer’s share price, which could ultimately dilute their ownership position in a company.

Part I of ASU 2017-11 simplifies the classification of these types of equity-linked instruments with down round provisions and no longer requires the freestanding equity-linked instrument to be measured at fair value. Prior to a company adopting this ASU, an equity-linked financial instrument with a down round provision is not considered to be indexed to the company’s own stock and often results in liability classification for a warrant or in bifurcation of a conversion option. Furthermore, it must be measured at fair value at the end of each reporting period, with changes in the fair value from one reporting period to the next flowing through earnings.

After a company adopts this ASU, if a down round provision of an equity-linked freestanding instrument is triggered (i.e., the strike price of a financial instrument is reduced), the company would not have to record the effect on the balance sheet or income statement, but rather, in earnings per share. The effect is treated and recorded as a dividend; thus, a reduction of income available to common shareholders in basic earnings per share. Convertible instruments with embedded conversion options, such as convertible notes payable with down round provisions, still need to be assessed for beneficial conversion features in accordance with Accounting Standards Codification (“ASC”) 470-20.

Example – Warrants with a Down Round Provision
On March 1, 20X7, Company A issues warrants to Investor X to acquire A’s common shares for $5.00 per share. The terms specify that if Company A issues common shares or warrants with a lower exercise price per share, the exercise price of Investor X’s warrants will be adjusted to that exercise price (down round feature). Company A performs an analysis and determines the issued warrants contain a down round provision that is indexed to its own stock. As a result, Company A will classify the warrants in equity in accordance with ASC 815-40-15.

On April 1, 20X7, Company A issues warrants to Investor Z to acquire A’s common shares for $3.00 per share. Since the warrants issued to Investor Z have a lower price per share than the warrants issued to Investor X, the down round provision is triggered and the exercise price of the warrants held by Investor X are adjusted to $3.00.

On April 1, 20X7, Company A compares the fair value of the warrants (without the down round provision) with an exercise price of $5.00 per share and the fair value of the warrants (without the down round provision) with an exercise price of $3.00 per share. Company A determines the value transferred to Investor X when the exercise price of the warrants decreased from $5.00 to $3.00. This adjustment is treated as a decrease in retained earnings and an increase to the carrying value of the warrants in additional paid-in capital (as a deemed dividend). Subsequently, this decrease in retained earnings causes a decrease in the income available to common shareholders in the basic EPS computation. For diluted EPS, Company A applies the treasury stock method for the warrants and adds back the computed adjustment to income available to common shareholders.

Other Key Takeaways

• Once it is determined that a down round provision has been triggered and a company records the deemed dividend, this financial instrument is no longer subsequently re-measured at fair value at the end of each reporting period.
• A down round provision may be triggered multiple times, and the deemed dividend is then calculated in the same manner for each occurrence.
• Certain requirements of ASU 2017-11 only apply to companies that present earnings per share. Private companies that do not disclose earnings per share still need to determine appropriate classification of financial instruments with down round provisions; however, they do not need to recognize the impact of a down round provision that is triggered.

Disclosure Requirements

When a down round provision is triggered and the financial statements reflect the effect of the down round provision, the following must be disclosed in the financial statements:

• The fact that a down round provision has been triggered.
• The value (i.e., deemed dividend) of the effect of the related triggered down round provision.

Part II of ASU 2017-11

FASB ASC 480 contains extensive pending content due to the indefinite deferral of accounting requirements about mandatorily redeemable financial instruments of certain nonpublic entities and certain mandatorily redeemable non-controlling interests. Part II of ASU 2017-11 replaces that indefinite deferral with a scope exception. This was done to improve the readability of the FASB ASC and reduce the complexity associated with navigating the guidance in FASB ASC 480. These Part II amendments do not have an accounting effect.

Effective Dates and Transition Considerations

The effective dates of ASU 2017-11 can be found below, with early adoption permitted. A company must elect either a full or modified retrospective approach in the period of adoption.

Modified retrospective approach – more common

A company would recognize the cumulative effect of the change as an adjustment to beginning retained earnings in the year of adoption.

Full retrospective approach – less common

A company would apply the amendments retrospectively for each prior period presented in the financial statements, consistent with the guidance set forth in ASC 250-10-45-5 through 45-10.