On July 13, 2017, the Financial Accounting Standards Board (FASB) issued Accounting Standard Update (ASU) 2017-11 to provide new guidance for the classification and accounting of financial instruments with down round features.
Prior to this update, financial instruments with down round features were generally classified as liabilities and required to be measured at fair value each reporting period. The new guidance is intended to reduce the cost and complexity of accounting for such instruments by no longer precluding them from equity classification, resulting in a potential reduction in the frequency (and cost) of recurring fair value measurements.
A down round feature is a provision in certain equity-linked financial instruments that provides for a downward adjustment of the instrument’s strike price based on the pricing of future equity offerings. Down round features are most common in warrants, convertible preferred shares, and other convertible debt instruments.
As a result of the ASU, down round features should be excluded from the consideration of whether a freestanding financial instrument is indexed to the entity’s own stock for the purposes of determining whether the instrument qualifies for a scope exception from derivative accounting in accordance with Subtopic 815, Derivatives and Hedging.
Accordingly, a freestanding financial instrument no longer would be required to be accounted for as a derivative liability as a result of the existence of a down round feature. Convertible instruments with down round features are now subject to contingent beneficial conversion features guidance rather than bifurcating the conversion option and measuring at fair value each reporting period.
For a freestanding financial instrument with a down round feature that’s classified as equity, when the down round feature is triggered (an event occurs that results in a reduction of strike price), an entity should record a dividend as a reduction to retained earnings and an increase to additional paid-in capital for the difference between the fair value of the financial instrument measured using the original strike price and the fair value of the instrument measured using the reduced strike price. Both of these fair values should be calculated at the point in time immediately after the triggering event. The effect of a down round feature should only be remeasured upon another triggering event.
When calculating earnings per share, the effect of a down round feature in an equity-classified freestanding financial instrument should be treated as a dividend and reduce income available to common stockholders.
When a triggering event occurs, an entity should disclose in its financial statements the fact that a down round feature was triggered and the value of the effect that was recorded.
Effective Dates and Transition
ASU 2017-11 is effective for:
- Public business entities. Annual periods beginning after December 15, 2018, including interim periods within those periods.
- All other entities. Annual periods beginning after December 15, 2019, and interim periods within annual periods beginning after December 15, 2020.
Early adoption is permitted as of the beginning of an annual or interim period for which financial statements haven’t yet been issued or made available for issuance.
Entities may elect to apply either of the following approaches as of the date of adoption:
- Retrospectively to outstanding financial instruments with a down round feature by means of a cumulative-effect adjustment to the statement of financial position as of the beginning of the first annual period and interim period(s) of adoption effective (modified retrospective)
- Retrospectively to outstanding financial instruments with a down round feature for each prior reporting period presented (full retrospective)
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