FASB changes accounting for ‘down round’ financial instruments

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The Financial Accounting Standards Board has released an accounting standard update aimed at simplifying the accounting for financial instruments that have so-called “down round” features.

A down round is a provision or embedded feature in an equity-linked financial instrument that provides a downward adjustment to the current exercise price, based on the price of future equity offerings. Down round features can often be found in warrants, convertible preferred shares and convertible debt instruments issued by private companies and development-stage public companies.

The standards update came from a recommendation by the Private Company Council, which advises FASB on issues facing privately held companies. Some private companies and other stakeholders complained the current accounting guidance leads to unnecessary expense and complexity for businesses that issue financial instruments with down round features because they are forced to do fair value measurement of the entire instrument or conversion option on an ongoing basis. They argued those types of adjustments created too much income statement volatility because of changes in the value of a company’s share price. They contended the adjustments didn’t reflect the true economics of the down round feature, which is actually supposed to protect investors from declines in share prices in some circumstances.

FASB is trying to address those problems by requiring companies to disregard the down round feature when they’re determining whether the financial instrument is indexed to its own stock, for purposes of determining liability or equity classification. Companies that offer earnings per share data will need to adjust their basic EPS calculation, however, 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.

The update also addresses some navigational concerns that have been raised with the FASB Accounting Standards Codification stemming from an indefinite deferral available to private companies with mandatorily redeemable financial instruments and certain noncontrolling interests, which created some significant “pending content” in the Codification. To address this concern, FASB decided to reclassify the indefinite deferral as a scope exception, which does not have an accounting effect.

The new update takes effect for public companies with fiscal years, and interim periods within those fiscal years, beginning after Dec. 15, 2018. For all other organizations, the amendments are effective for fiscal years beginning after Dec. 15, 2019, and interim periods within fiscal years beginning after Dec. 15, 2020. FASB is also allowing early adoption for all types of organizations.

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