ASU 2017-11: Down Round Features & Redeemable Instruments

The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2017-11 to simplify the accounting for certain financial instruments. This guidance addresses two areas: the accounting for instruments with down round features and the classification of certain mandatorily redeemable instruments. The update was a response to the complexity and costs of previous accounting rules, providing a more straightforward approach for companies, particularly emerging-growth entities, that issue these instruments.

The Accounting for Down Round Features

A financial instrument is a contract that creates a financial asset for one party and a financial liability or equity instrument for another, such as warrants or convertible debt. A “down round feature” is a provision within these instruments that protects an investor from a decline in a company’s share price. This feature triggers a downward adjustment to the instrument’s exercise or conversion price if the company later issues new shares at a lower price than the original instrument’s price. For instance, if an investor holds a warrant to buy shares at $10 each and the company subsequently sells new shares for $8, the down round feature would reduce the original investor’s exercise price.

Before ASU 2017-11, a down round feature created accounting complexity. The feature meant the instrument was not considered “indexed to an entity’s own stock,” a technical requirement for equity classification. Consequently, these instruments, such as warrants or the conversion options in debt, were required to be classified as liabilities on the balance sheet.

This liability classification mandated that the instrument be measured at its fair value at the end of each reporting period. Changes in the instrument’s fair value were recorded in the company’s income statement, which could lead to earnings volatility. This process was often costly and did not always align with the economic substance of the arrangement.

The change introduced by ASU 2017-11 is that a down round feature, by itself, no longer prevents an instrument from being classified as equity. The guidance removes the down round feature from the list of items that would automatically result in liability accounting. As a result, instruments like warrants or conversion options are more likely to be classified within equity, simplifying the accounting and eliminating recurring fair value measurements through earnings.

Impact on Earnings Per Share Calculation

The reclassification of instruments with down round features affects the calculation of Earnings Per Share (EPS). The new guidance simplifies the previous, more complex approach by specifying a treatment that occurs only when the down round feature is triggered by a new financing event.

Under ASU 2017-11, when a down round feature is triggered, the economic benefit transferred to the instrument holder is recognized as a charge to earnings. This value is treated as a deemed dividend and is deducted from the net income available to common stockholders when calculating basic EPS. This adjustment reflects the value given to the instrument holders.

The value of this benefit is measured as the difference between the fair value of the instrument immediately before and after the trigger event. For diluted EPS, since the instruments are now classified as equity, the additional shares that could be issued upon conversion or exercise are included in the diluted EPS calculation using standard methods like the treasury stock or if-converted method.

Changes for Mandatorily Redeemable Instruments

Part II of ASU 2017-11 addresses mandatorily redeemable financial instruments. These are instruments, often shares, that a company has a firm obligation to buy back from the holder upon a specific event or at a set date. The accounting for these instruments has varied, particularly for nonpublic companies.

Previously, accounting rules under Accounting Standards Codification (ASC) Topic 480 had an “indefinite deferral” for certain mandatorily redeemable instruments issued by nonpublic entities. This deferral allowed many nonpublic companies to classify these instruments as equity instead of liabilities, creating inconsistency in how these obligations were presented.

ASU 2017-11 eliminates this indefinite deferral and replaces it with a specific scope exception. This change clarifies the accounting for mandatorily redeemable noncontrolling interests and certain instruments issued by nonpublic companies not registered with the Securities and Exchange Commission (SEC). The guidance allows these specific instruments to be classified as equity under certain conditions, providing more definitive rules.

Required Financial Statement Disclosures

The updated standard also introduces new financial statement disclosure requirements to ensure transparency for companies with instruments that contain down round features. The goal is to provide investors and other financial statement users with clear information about the existence and potential impact of these features.

A company must now disclose that it has issued financial instruments with down round features in the footnotes to its financial statements. This includes describing its accounting policy for such instruments.

When a down round feature is triggered, the disclosure requirements become more specific. The company must disclose the value of the effect of the feature being triggered. This includes the amount recognized in the financial statements, which provides direct insight into the economic impact of the down round event during the reporting period.