Freestanding Warrants and Embedded Conversion Options
Complex Classification Rules Draw SEC Interest

By Robert A. Dyson

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Complex accounting rules address the measurement and classification of detachable (or freestanding) warrants, convertible debt, and convertible or redeemable preferred stock. Issuers ordinarily expect to account for common stock and warrants as equity, and account for debt as liabilities. Under certain circumstances, however, warrants and conversion provisions may be classified as liabilities, with changes in fair value recognized in net income each reporting period. Exhibit 1 illustrates a common equity transaction with the allocation of proceeds between the detachable warrants and equity based on their relative fair values.

The combination of complex rules and unresolved issues has created considerable uncertainty in measuring and classifying freestanding warrants, convertible debt, and convertible or redeemable preferred stock, particularly with SEC registrants. The SEC has provided guidance on this topic in its December 1, 2005, and November 30, 2006, editions of “Current Accounting and Disclosure Issues in the Division of Corporation Finance” and in various speeches by staff. The SEC also has required registrants to restate their financial statements to reflect its current interpretation of the existing literature.

The accounting of certain of these instruments is governed by SFAS 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity. This article addresses only those financial instruments with characteristics of both liabilities and equity, and that are indexed to or potentially settled in the reporting company’s stock.

Classification Based on SFASs 150 and 133

According to the 2005 and 2006 “Current SEC Issues,” companies should first determine whether their warrants, convertible preferred stock, and convertible debt are within the scope of SFAS 150, which requires financial instruments to be classified as liabilities if they have any of the following features:

• The issuer has an unconditional obligation to redeem the instruments by transferring assets at a specified or determinable date, or upon an event certain to occur.
• The issuer has an unconditional obligation to repurchase its equity shares and is required or may be required to settle such obligation by transferring assets when the holder exercises its right to demand repurchase. An example is a written put option on the issuer’s stock that is to be physically or net-cash settled (as defined below).
• The issuer has an unconditional obligation to issue a variable number of shares under certain circumstances. Exhibit 2 presents an example of this obligation.

FASB Staff Position (FSP) 150-3 defers indefinitely the effective date of SFAS 150 for mandatorily redeemable financial instruments (described in the second bullet above) that are issued by nonpublic companies. However, this deferral does not apply to public companies, defined as those that have or expect to issue publicly traded debt or stock; are required to file financial statements with the SEC; or provide financial statements for the purpose of issuing securities in the public market. Thus, companies that have filed registration statements which the SEC has not yet deemed effective are considered public companies that must apply all relevant provisions of SFAS 150.

If an instrument is not governed by SFAS 150, the entity should determine whether it meets the definition of a derivative under SFAS 133, Accounting for Derivative Instruments and Hedging Activities (paragraphs 6–9), and, if so, whether it meets any relevant scope exceptions.

Exhibit 3 presents the basic characteristics of derivatives. Derivatives are not considered equity and, accordingly, are classified as either assets or liabilities and measured at fair value. Except for certain instruments designated as hedges, changes in fair value are recognized as unrealized gains or losses each reporting period. Freestanding warrants are generally considered to be derivatives, and embedded conversion features may be classified as derivatives if they can theoretically be separated from the overall contract. As discussed below, certain contractual provisions that are not detachable from the financial instrument may be measured separately from the overall contract. Excluded from derivative accounting, however, are warrants that are both indexed to the reporting entity’s own stock and, if freestanding, would be classified in stockholders’ equity [as discussed in SFAS 133, paragraph 11(a)], and warrants whose terms are not consistent with the characteristics of derivatives, as discussed above. Warrants not considered derivatives must be evaluated under Emerging Issues Task Force (EITF) Issue 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock, to determine whether the instruments should be accounted for as equity or as liabilities.

Scope of EITF 00-19

EITF 00-19 is very complex because it incorporates the guidance of existing pronouncements while being continually subject to revision by new pronouncements and interpretations. It may require the separation of single financial instruments into components, each subject to different accounting rules. The first step in applying EITF 00-19’s provisions is to obtain a complete understanding of the relevant financial instruments.

Many contracts governed by EITF 00-19 are attached to, or are provisions of, equity or debt instruments that are accounted for as separate contracts. For example, the common stock portion of equity units presented in Exhibit 1 should be accounted for as equity, whereas the warrants could be classified as either equity or a liability. A contract may specify the means of settlement or give either the issuing entity or counterparty a choice in the manner of settlement. The settlement methods are as follows:

• Physical settlement: The seller delivers the full stated number of shares and receives cash for the entire contract price.
• Net-share settlement: The entity incurring a loss delivers to the counterparty common stock with an aggregate fair value equal to that loss.
• Net-cash settlement: The entity incurring a loss delivers to the counterparty a cash payment equal to that loss. EITF 00-19 applies to the following financial instruments that are indexed to, and sometimes settled in, the issuer’s own stock:
• Certain freestanding derivative financial instruments, such as the warrants described in Exhibit 1. A freestanding contract is defined as a separate contract or part of a transaction that is legally detachable and separately exercisable and includes detachable warrants. EITF 00-19 does not apply to financial instruments with components that are not detachable but which otherwise meet the definition of an embedded derivative.
• Instruments classified as either permanent or temporary equity (as defined below) despite otherwise meeting the criteria of derivatives (which require classification as an asset or liability).
• Stock options issued to nonemployees who are vested. EITF 00-19 does not apply to options to nonemployees who are not vested, nor to any contracts, such as stock options, issued to compensated employees, vested or not.
• Security price guarantees or other financial instruments indexed to or otherwise based on the price of a reporting company’s stock issued in connection with a purchase business combination. However, EITF 00-19 applies only if those instruments are accounted for as contingent consideration meeting the criteria in EITF 97-8, Accounting for Contingent Consideration Issued in a Purchase Business Combination, for recording as part of the cost of the business acquired.

Many of the financial instruments specifically excluded from EITF 00-19’s scope are addressed by other pronouncements. For example, EITF 00-19 does not apply to contracts that are indexed to and settled in the stock issued by a consolidated subsidiary; these are governed by EITF 00-6, Accounting for Freestanding Derivative Financial Instruments Indexed to, and Potentially Settled in, the Stock of a Consolidated Subsidiary.

EITF 00-19 also provides a scope exception for conventional convertible debt. Conventional convertible debt requires the holder to realize the value of the conversion feature by exercising that feature and, at the company’s option, receiving the entire proceeds in a fixed number of shares or an equivalent amount of cash. Thus, any contract, including convertible debt, that permits the settlement of a liability with a variable number of shares, similar to the instrument described in Exhibit 2, is not deemed conventional convertible debt. According to EITF 05-2, The Meaning of “Conventional Convertible Debt Instrument” in Issue No. 00-19, instruments are considered conventional if the ability to exercise the option is based on the passage of time or a contingent event. Convertible debt with certain antidilution features designed to maintain the value of the conversion option in the event of an equity restructuring may be deemed conventional convertible debt, despite the possibility that a variable number of shares may be issued. Such restructuring may include stock dividends, stock splits, spinoffs, rights offerings, or other recapitalizations.

Basic Concepts of EITF 00-19

EITF 00-19 requires that all contracts initially be measured at fair value and classified based on the required or assumed settlement method. In general, EITF 00-19 requires contracts that require net-cash settlement to be initially classified as either assets or liabilities, and contracts that require settlement in shares to be classified as equity instruments. Contracts providing the issuing entity with a choice of settling in either shares or cash are classified as equity because the settlement is assumed to be in shares, while contracts providing the counterparty with a choice of settling in shares or cash are classified as assets or liabilities because the settlement is assumed to be in cash. Equity contracts are classified as either permanent equity or temporary equity.

EITF 00-19 incorporates the concepts of “permanent” and “temporary” equity presented in EITF Topic D-98, Classification and Measurement of Redeemable Securities. Topic D-98 differentiates between conventional equity capital, where the security requires the delivery of shares as part of a physical or net-share settlement (permanent equity) and securities with certain contingent cash redemption features imposed by the counterparty (temporary equity). Although SFAS 150 requires many securities once considered temporary equity to be classified as liabilities, Topic D-98 provides detailed guidance on securities not covered by that statement. Temporary equity, often called “mezzanine items,” includes securities with conditional cash redemption features that may arise upon the occurrence of events not solely within the issuer’s control (as opposed to unconditional obligations required by SFAS 150).

The measurement of equity should follow a two-step process, because some contracts may include provisions that bifurcate the security into permanent and temporary equity. All equity contracts should initially be measured at fair value. This includes contracts where the issuing entity has a choice in settling the contract with stock or cash. Any cash redemption amount should be reclassified as temporary equity. Subsequent changes in fair value of both permanent and temporary equity are not recognized as long as the contracts continue to be classified as equity. As discussed below, these contracts must meet additional requirements to be classified as equity.

All other contracts should be classified as either assets or liabilities, and initially measured at fair value, with any changes in fair value reported in earnings and disclosed in the financial statements. The contracts include all those requiring the issuing entity to pay cash upon the demand of the holder. If contracts classified as assets or liabilities are ultimately settled in shares, any resulting gains and losses should be included in earnings.

Both the 2005 and 2006 “Current SEC Issues” emphasize that the classification of warrants as liabilities is based on the contract’s provisions. The agreement may require the warrants to be settled in cash if certain events occur, such as if the registrant is delisted from its primary stock exchange, or if a required registration is not declared effective by the specified date. The key point is that the mere existence of such a provision, not the probability of its occurrence, is sufficient to classify the warrants as a liability.

EITF 00-19 requires the entity to reassess the classification of a contract at each balance sheet date. For public companies, this would be each quarter. If the classification changes as a result of an event during the reporting period, the entity should reclassify the contract as of the date of that event. There is no limit on the number of times a contract may be reclassified.

As part of the periodic reassessment, changes in the classification from equity to assets/liabilities or vice versa require the contract to be measured at a new fair value. If a contract is reclassified from permanent or temporary equity to an asset or a liability, the company should, as of the reclassification date, record the change from the existing carrying value to the new fair value as an adjustment to stockholders’ equity. If the contract permits partial net-share settlement and the entire amount cannot be classified as permanent equity, EITF 00-19 permits partial reclassification of permanent equity to temporary equity, assets, or liability. If a contract is reclassified from an asset/liability to equity, the previously recognized gains or losses reflecting changes in fair value should not be reversed. Exhibit 5 and Exhibit 6 present examples of such reclassifications.

Additional Considerations to Classify Contracts as Equity

EITF 00-19 classifies certain financial instruments as assets/liabilities if specific criteria are not met, regardless of the expected ultimate settlement. In other words, even if the company expects to settle in stock, a net-cash settlement (an asset/liability classification) is presumed if certain conditions are not met. An important element in determining the classification of these contracts as either equity or assets/liabilities is the degree of control entities have in settling the contract with stock. Any provision that could require net-cash settlement (as opposed to a conditional requirement, or the issuer’s option to pay cash) generally precludes accounting for a contract as equity. In order to avoid the possibility (as opposed to probability) of a net-cash settlement, all of the following conditions must be met for a contract to be classified as equity:

The contract permits the company to settle in unregistered shares. EITF 00-19 assumes net-cash settlement if the contract requires physical or net-share settlement by delivery of only registered shares. This assumption is based on the belief that the entity may be required to net-cash settle the contract because it does not control the events or actions necessary to deliver registered shares, and it is unlikely that nonperformance would be an acceptable alternative. This condition is met by contract provisions permitting the settlement in unregistered shares, giving a public company control in settling the contract by issuing equity. Currently, equity classification of contracts requiring delivery of only registered shares is permitted when common stock delivered at settlement is registered as of the inception of the transaction and there are no further timely filing or registration requirements. As of this writing, however, the SEC is considering interpretations that could modify this rule.

A requirement for the entity to make its “best efforts” to register shares may meet this condition, however, as long the company can settle the obligation with unregistered shares and as long as the contract explicitly asserts that cash settlement is not required. Otherwise, promises of registering the shares or filing a registration statement in the future do not meet this condition; EITF 00-19 asserts that the SEC’s declaring a registration statement effective is not within the control of the entity. Consequently, the contract must be classified as an asset or a liability. Only when a registration of the stock is declared effective may a contract be classified as equity. Exhibit 6 presents an example of this condition.

Certain rules govern when a company attempts to settle the contract with registered shares and the registration fails, such as the withdrawal of a registration filed with the SEC. Contracts should be classified as equity if a failed registration does not preclude delivery of unregistered shares, if net-share settlement by delivery of unregistered shares is permitted, and if the other conditions in EITF 00-19 are met. In these circumstances, delivery of unregistered shares in a private placement to the counterparty may be within the control of a company if a failed registration has occurred six months or more prior to the classification date. If the failed registration occurred less than six months prior to the classification date, the entity must make a legal determination of whether it can settle the contract by delivering unregistered shares to the counterparty.

Some contracts may permit the settlement with unregistered shares, provided that the entity pays a penalty in either cash or additional shares. The basic rule is that a penalty settled in shares does not disqualify an instrument from being classified as equity as long as it reflects the difference in fair value between registered and unregistered shares (see Exhibit 1). The exact means of calculating the difference is not yet settled, and preparers and auditors may wish to consult with the SEC on this matter. The consideration whether the penalty itself is a derivative is, according to FASB’s website (www.fasb.org) as of March 12, 2007, inactive pending further research on how entities currently evaluate and account for registration rights agreements in practice and compare registration rights penalties with other penalties that do not meet the definition of a derivative. (See EITF 05-4, The Effect of a Liquidated Damages Clause on a Freestanding Financial Instrument Subject to Issue No. 00-19.)

On December 21, 2006, FASB issued FSP EITF 00-19-2, “Accounting for Registration Payment Arrangements,” which requires the recognition and measurement of a contingent liability if the reporting entity determines that such payment is probable, as defined in SFAS 5, Accounting for Contingencies. This pronouncement is effective for penalty payment arrangements entered into or modified after December 21, 2006, and for all such arrangements included in financial statements for fiscal years beginning after December 15, 2006. Thus, public companies with a calendar year-end must apply this pronouncement in the first quarter of 2007. Exhibit 1 illustrates the application of FSP EITF 00-19-2.

The company has sufficient shares to settle the contract after considering all other potential commitments. The entity must have sufficient authorized and unissued shares available to settle the contract after considering all other commitments that may require the issuance of stock during the maximum outstanding period of the contract’s term; this includes debt that is convertible to common stock, stock options that are exercisable during the contract period, and common shares that are contingently issuable pursuant to a penalty payment arrangement (see Exhibit 5). If a sufficient number of shares are available and the other conditions in EITF 00-19 are met, then share settlement is within the control of the company and the contract should be classified as permanent equity. Otherwise, share settlement is not within the control of the company and an asset/liability classification is required. If an entity needs to obtain shareholder approval to increase the company’s authorized shares in order to net-share or physically settle a contract, it does not control share settlement and must classify the contract as an asset/liability.

The contract contains an explicit limit on the number of shares to be delivered in a share settlement. If the contract does not have an explicit limit on the number of shares to be delivered, then the company cannot represent that it knows how many shares it must issue to settle the contract and whether it has a sufficient number of authorized shares to cover all of its obligations. Accordingly, asset/liability classification is required.

Certain contracts may have an indeterminate number of shares to be issued subject to a cap. For example, if the contract presented in Exhibit 2 has a cap of 40,000 shares to be issued, Company B would use the maximum number of shares to be issued (40,000) in determining whether it has sufficient authorized but unissued shares available to meet its commitments. Circumstances such as those presented in Exhibit 5 may cause the entire contract to be classified as an asset/liability.

Contracts requiring the entity to make its best efforts to obtain sufficient shares to meet its obligations satisfy this condition. Best efforts can include amending the corporate charter to increase the number of authorized shares. This condition is met only when shareholder approval is not required for such an increase because, as noted above, such approval is considered outside the control of the company.

There are no required cash payments to the counterparty if the company fails to timely file with the SEC. EITF 00-19 concludes that the ability to timely file with the SEC is not within the reporting entity’s control. Contracts permitting share settlement, but requiring net-cash settlement if the entity does not make timely filings with the SEC, must be classified as assets/liabilities.

The contract requires net-cash settlement only when holders of shares underlying the contract also would receive cash. Generally, contracts must be classified as assets/liabilities if an event not within the entity’s control could require net-cash settlement. An example of such circumstances is a change in control of the entity. Equity classification would not be precluded, however, if both the holders of the shares underlying the contract and the counterparties receive the same consideration (such as cash, other assets, or debt) in the event that circumstances specified in the contract occur. One contract-holder cannot have first rights to receiving cash or receiving debt with different terms than offered to the other holders.

The counterparty has no rights higher than a shareholder. To be classified as equity, the contract cannot contain any provisions that give the counterparty any rights as a creditor in the event of bankruptcy. In other words, the counterparty cannot have rights that rank higher than those of a shareholder of the stock underlying the contract.

Other conditions. There are no required cash payments to the counterparty if the shares initially delivered upon settlement are subsequently sold by the counterparty and the sales proceeds are insufficient to provide the counterparty with full return of the amount due (for example, the contract has no “make-whole” provisions).

There is no requirement in the contract to post collateral at any point or for any reason.

Embedded Conversion Features

A beneficial conversion feature is a nondetachable conversion feature of either debt or preferred stock. In order to be deemed beneficial, the feature must be both in-the-money at the date when an agreement of terms has been reached and the investor must be committed to purchase the securities. Beneficial conversion features included in the basic debt or preferred stock contracts are deemed to be embedded in those contracts, but are recognized and measured separately, ordinarily as an allocation to additional paid in capital. Exhibit 4 and Exhibit 7 present examples of accounting for typical beneficial conversion features.

APB Opinion 14, Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants, applies only to conversion features where the initial conversion price is greater than the market value at the day of issuance and the conversion price does not decrease over the instrument’s term, except under antidilution protection. APB Opinion 14 addresses neither embedded conversion features in the money at issuance nor convertible preferred stock.

Reporting entities should first determine if the conversion feature is an embedded derivative under SFAS 133. If it is, the feature should be separated from the basic instrument, measured separately, and classified as a liability. In addition, any detachable warrant may also be classified as a liability.

SFAS 133, paragraph 12, requires the classification of a conversion feature as an embedded derivative if all of the following conditions are met:

• The conversion feature terms are based on equity rather than interest rates, which causes the feature to not be clearly and closely related to the debt.
• The convertible debt or preferred stock is not marked to market, with changes in fair value reflected in earnings.
• If the features were separate instruments, they would be classified as derivatives subject to SFAS 133.

Companies should analyze the third condition, because many instruments meet the first two conditions. The reporting entity should analyze the provisions to determine whether the instrument meets the definition of a derivative, as presented in Exhibit 3. If the instrument meets those terms, the entity should evaluate the scope exceptions of SFAS 133, paragraph 11(a), which excludes as derivatives those contracts that are both indexed to the reporting entity’s own stock and, if freestanding, would be classified in stockholders’ equity. The instrument is clearly indexed to the entity’s stock because it converts to that stock. The entity would determine whether the instrument would be classified as stockholders’ equity by applying EITF 00-19.

As discussed above, EITF 00-19 excludes from its scope “conventional” convertible debt, as described in EITF 05-2. Conventional convertible debt is debt with a fixed price attached to the stock. This exclusion applies even if registration rights are attached to the stock after conversion.

If the basic instrument is deemed to be conventional convertible debt, the reporting entity should apply APB 14, which requires an estimation of the fair value of the debt and warrants, and then a determination if a beneficial conversion feature exists pursuant to EITF 98-5, Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios, and EITF 00-27, Application of Issue No. 98-5 to Certain Convertible Instruments. In these circumstances, the SFAS 133 scope exception is not met and the embedded conversion feature needs to be separated and accounted for at fair value.

Basic instruments not deemed to be conventional convertible debt should be measured and classified in conformity with EITF 00-19. The 2006 “SEC Current Issues” does not consider convertible debt instruments with reset provisions to be conventional convertible debt. Reset provisions permit changing the conversion price of existing debt to reflect a lower conversion price of a subsequently issued convertible debt. The subsequent issuance of similar instruments may change the classification of existing instruments. Financial instruments convertible to common stock at a variable price are not considered, for purposes of EITF 00-19, to be conventional convertible debt. For example, EITF 00-19 does not apply if the instrument converts at a fixed stock price of $5 per share, but does apply if the stock is priced at 80% of market value at the conversion date.

According to EITF 05-2, certain convertible preferred stock with a mandatory redemption date may be excluded from EITF 00-19 if that instrument is more akin to debt than equity. Generally, cumulative fixed-rate preferred stock with a mandatory redemption feature is considered closer to debt than equity.

Recent Events

Various standards-setting bodies are constantly issuing or proposing revisions to EITF 00-19. In December 2006, the AICPA issued a 130-page working draft of a technical practice aid on convertible instruments and other equity-related instruments, including many covered by EITF 00-19. In addition, the EITF submitted for FASB’s ratification a consensus addressing changes in certain terms of a convertible instrument, which may affect EITF 00-19’s criteria on classification (see EITF 06-6, Issuer’s Accounting for a Previously Bifurcated Conversion Option in a Convertible Debt Instrument When the Conversion Option No Longer Meets the Bifurcation Criteria in FASB Statement No. 133).

Caution Advised

In recent years, the accounting for detachable warrants and convertible securities has grown more complex. The increased SEC interest and the constantly evolving rules have created much risk for both preparers and auditors of financial statements. The incorrect application of EITF 00-19 has resulted in financial statement restatements reflecting the reclassification of equity instruments to liabilities and changes in fair value of those liabilities as charges to earnings. Because of the recent restatements and evolving rules, financial statement preparers and auditors should apply caution before modeling their application of EITF 00-19 on already issued financial statements, so as to avoid adopting an approach already rejected by the SEC. Accordingly, financial statement preparers and auditors should mitigate this risk by studying existing accounting literature, and consulting with experienced and knowledgeable SEC staff.

Robert A. Dyson, CPA, is a managing director with RSM McGladrey, Inc., New York, N.Y. He is also a past chair and a current member of the NYSSCPA’s Financial Accounting Standards Committee and FASB’s Small Business Advisory Committee. He won the Max Block Award for Best Article in the area of Techinical Analysis in 2005 for “Basic Principles in the New Accounting for Stock Options: A Road Map for Navigating SFAS 123(R).” He can be reached at robert.dyson@rsmi.com.

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