Debt and equity financings: A primer to prevent accounting surprises

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Organizations seeking funding have much to think about, and the long-term accounting considerations related to the debt and equity instruments they issue are not likely at the top of that list.

However, as many common terms and provisions give rise to unknown or unexpected accounting consequences, a basic understanding of these provisions can set the stage for the practical requirements going forward.

Complicating matters, an additional set of rules must be followed by SEC registrants in public filings. Accordingly, companies that are anticipating an IPO may be wise to apply these rules at the onset to prevent the need for retrospective application to historical periods during the already hectic IPO preparation process.

What follows is an overview of some of the most common features found in debt and equity instruments. The considerations here apply to companies following both U.S. GAAP and International Financial Reporting Standards, although each set of rules has its own particulars.

Convertible Debt

Convertible debt provides the investor with the ability to convert the debt into common stock or other equity securities of the company, either immediately or upon the occurrence of a certain event (such as the next round of financing, an IPO or a change of control). Convertible debt is an example of a “hybrid instrument,” a term used to describe a host instrument, in this case debt, that includes an embedded feature, such as the right to convert to equity.

Embedded features are analyzed to determine whether they must be “bifurcated” from the host instrument and accounted for separately, beginning on the issuance date of the debt. Whether a conversion option must be bifurcated depends on a number of factors, including how the conversion is calculated and whether the shares underlying the conversion feature are publicly traded. Bifurcated features generally are recorded at fair value both at the issuance date and at each reporting date, with changes in fair value recorded in earnings.

Redeemable Debt

Debt instruments often provide the investor with the ability to demand repayment of the debt prior to maturity. These provisions are typically triggered by the occurrence of an event, such as a default, a merger or acquisition of the company, or the closing of an equity financing. This right to demand repayment is a “put option” that is embedded in the debt instrument. Like convertible debt, this feature must be analyzed to determine whether separate accounting is required at the date the debt is issued.

Of particular importance here is the mechanics of the redemption provision. Terms that provide the investor with a premium on settlement are problematic and often require bifurcation and separate accounting. For example, upon the occurrence of a certain event, the company may be obligated to repay the principal on the debt and a 15 percent penalty fee.

Provided other conditions are met, the company would record this obligation separately from the debt at fair value. On a go forward basis, the company would be required to update the fair value of this obligation, taking the change in value to earnings in each period. Further, the initial value of this feature would be recorded as a discount to the debt and amortized as interest expense during the term of the debt.

Preferred Stock: Balance Sheet Classification

Preferred stock is legal form equity that combines rights and privileges typically found in debt and equity instruments. Unlike common stock that is nearly always recorded in the stockholders’ equity section of the balance sheet, preferred stock may be recorded as a liability or, for public companies, presented in between liabilities and equity as “temporary equity.” The balance sheet classification is critical, as it drives the subsequent accounting for the shares, such as if and when dividends and accretion must be recorded, whether fair value based adjustments are required, and how the shares are captured in the earnings-per-share calculation.

An additional set of rules must be followed by SEC registrants in public filings, including Form S-1, the SEC filing used by companies planning on going public to register their securities. Companies that anticipate going public often apply the SEC requirements early to prevent the need to retrospectively apply the rules to historical periods during the already hectic IPO preparation process.

Preferred Stock: Conversion, Redemption and Other Rights

The terms of preferred stock are closely negotiated to provide investors with rights and protections. Any terms that may affect the amount or timing of cash flows or the value exchanged is an embedded derivative that may require bifurcation and separate accounting from the preferred shares. Similar to convertible and redeemable debt, preferred stock often provides the investor with the ability to convert the shares to common stock and/or the ability to redeem the shares for a cash payment.

These features must be analyzed to determine whether separate accounting is required. A critical step in this process is assessing whether the preferred stock is more debt-like or equity-like. This is a subjective assessment, based on a weighting of the debt-like terms (cumulative fixed-rate dividends, fixed-rate redemption option, covenants similar to debt agreements) and equity-like terms (participating dividends and voting rights). If the preferred stock is deemed to be equity-like, then equity-like embedded derivatives, such as most conversion options, would not require separate accounting. However, the same conversion feature in preferred shares that are more debt-like would likely be separated and recorded at fair value.

Other common issues related to preferred stock include an obligation to issues shares in multiple tranches, right of first refusal provisions, and beneficial conversion features.

The rules governing the accounting for these debt and equity instruments are highly complex, with interpretive guidance filling many hundreds of pages. While arcane, the accounting literature aims to look through the form of an instrument and account for the economic substance of the rights provided to investors. Controllers and CFOs may not require an expertise in the technical accounting for these instruments, but a general understanding of the topic will assure that the appropriate team, comprising legal counsel, valuation specialists, external auditors and technical accounting advisors, is assembled at the right time.

Joshua Verni is a New York CPA and a managing director with CFGI, assisting clients with the accounting for complex debt and equity instruments and other technical accounting matters.

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