FASB Issues Accounting Standard Update for Equity-Linked Financial Instruments

The Financial Accounting Standards Board (FASB) has issued an Accounting Standard Update (ASU) that simplifies the accounting for certain financial instruments with down round features—a provision in an equity-linked financial instrument (or embedded feature) that provides a downward adjustment of the current exercise price based on the price of future equity offerings. The ASU is based on recommendations from the Private Company Council (PCC).

Down round features are common in warrants, convertible preferred shares, and convertible debt instruments issued by private companies and development-stage public companies. Private company and other stakeholders expressed concern that current accounting guidance creates unnecessary cost and complexity for organizations that issue financial instruments with down round features by requiring, on an ongoing basis, fair value measurement of the entire instrument or conversion option. It creates, they assert, unnecessary income statement volatility associated with changes in value of a company’s own share price, and does not reflect the economics of the down round feature, which exists to protect certain investors from declines in the issuer’s share price under certain circumstances.

The new ASU addresses these concerns by requiring companies to disregard the down round feature when assessing whether the instrument is indexed to its own stock, for purposes of determining liability or equity classification. Companies that provide earnings per share (EPS) data will adjust their basic EPS calculation for the effect of the feature when triggered (that is, when the exercise price of the related equity-linked financial instrument is adjusted downward because of the down round feature) and will also recognize the effect of the trigger within equity.