Question

Nearly There (the “Company”), an SEC registrant, designs, develops, manufactures, and sells various navigation products and services. Because of significant research and development expenses and slumping sales results in recent periods, the Company is in need of additional capital to continue product development and to meet projected operating budgets for the coming year.

In November 2012, the Company issued 5 million shares of Series B preferred stock at $1.20 per share (the “Original Issue Price”) to new investors (the “Series B Preferred Stock”). Total proceeds, net of issuance costs, received by the Company from this issuance were approximately $5.9 million. The significant terms of the Series B Preferred Stock are as follows:

• The par value of the Series B Preferred Stock is $0.01 per share.

• Dividends — In each calendar year, the holders of the then outstanding Series B Preferred Stock are entitled to receive, when, as and if declared by the Company’s board of directors, cumulative dividends at the annual dividend rate of 8 percent of the Original Issue Price, as appropriately adjusted for any stock dividends, combinations, reclassifications, recapitalizations, or splits with respect to such shares.

• Voting rights — Holders of the Series B Preferred Stock have protective voting rights to vote together with the common stock holders on an as-converted basis on certain significant events (e.g., change in control, major asset sales, extraordinary distributions).

• Conversion option — At the holders’ option and at any time after the date of issuance, each share of the Series B Preferred Stock can be converted into the Company’s common stock. The initial conversion price is $1.20, which is subject to certain adjustments including:

o Stock dividends and combinations or subdivisions of common stock.

o Reclassification and reorganization.

o Adjustments for additional issuance of the Company’s equity securities.

• Conversion price adjustment — The conversion price will adjust downward if any equity security is issued by the Company for an amount per share that is less than the then-existing conversion price of the Series B Preferred Stock, thus providing “down-round protection” to the holders of the preferred stock.

• Redemption option — After the third anniversary of the original issue date of the Series B Preferred Stock and upon the vote or written consent of at least a majority of the then outstanding shares of Series B Preferred Stock, holders can redeem the outstanding shares of the Series B Preferred Stock for cash. The redemption value is the Original Issue Price plus all declared but unpaid dividends.

• Mandatory redemption — After the sixth anniversary of the original date of the Series B Preferred Stock, the outstanding shares of the Series B Preferred Stock must be redeemed for cash. The redemption value is the Original Issue Price plus all declared but unpaid dividends.

Upon evaluation of the Series B Preferred Stock, the Company considered the economic payoff profile of the potential embedded features and concluded that the following separate units of account require further evaluation: (1) the conversion option and (2) the redemption option.

Additional facts:

• The Company has adopted Accounting Standards Update 2014-16, Determining Whether the Host Contract in a Hybrid Financial Instrument Issued in the Form of a Share Is More Akin to Debt or to Equity.

• The conversion option was set at the money at issuance.

• The Company is well capitalized. The market capitalization of its common stock is $100 million.

• The Company’s common stock is publicly traded and the number of shares to be exchanged in the event that the Series B Preferred Stock is converted is small relative to the daily transaction volume of the Company’s common stock.

• The Series B Preferred Stock is not remeasured at fair value with any changes recognized in earnings under any other applicable U.S. GAAP after the issuance.

• The embedded features are deemed not to meet any scope exceptions in ASC 815- 10-15.

Required:

1. Is the host contract more akin to a debt or equity instrument for the purpose of analyzing the embedded features in the Series B Preferred Stock under the whole- instrument approach?

2. Should the Company separate the conversion option feature in the Series B Preferred Stock from the host contract and account for it as a derivative instrument?

3. Should the Company separate the redemption option in the Series B Preferred Stock from the host contract and account for it as a derivative instrument?

4. Would your answer to Questions 2 or 3 change if the Company was a private company and its common stock was not publicly traded?

Answer 1

1)

Apply either the "whole instrument" (consider all embedded features) or the "chameleon" (exclude the feature being analyzed) approach to gauge whether the host contract is more debt-like or equity-like, focusing on redemption and return provisions.

A debt or equity instrument that contains a conversion feature is referred to as a "hybrid instrument," which theFASB Accounting Standards Codification® (ASC) Master Glossary defines as "[a] contract that embodies both an embedded derivative and a host contract." To determine whether an embedded conversion option must be bifurcated from a hybrid instrument, it is first necessary to determine the nature of the host contract (that is, whether it is more akin to debt or equity).

Although the Master Glossary does not define a "host contract," over time practitioners have developed two methods that preparers currently use to evaluate whether a host contract is more akin to debt or equity:

1. The "whole instrument" approach

2. The "chameleon" approach

Under the "whole instrument" approach, an entity considers all of the terms and features of the hybrid instrument, including the feature that is being evaluated for bifurcation, to determine the nature of the host contract.

Under the "chameleon" approach, an entity considers all of the terms and features of the hybrid instrument, except for the embedded feature the entity is evaluating for bifurcation, to determine the nature of the host contract. Therefore, the nature of the host contract could change, depending on the feature the entity is evaluating. For example, if a hybrid instrument contains an embedded conversion feature and an embedded put option, the host contract could be considered more debt-like when evaluating the conversion feature and more equity-like when evaluating the put option.

The FASB has issued limited guidance on determining the nature of a host contract, as explained in the following paragraphs.

The guidance in ASC 815-15-25-16, Derivatives and Hedging: Embedded Derivatives, states that

If the host contract encompasses a residual interest in an entity, then its economic characteristics and risks shall be considered that of an equity instrument and an embedded derivative would need to possess principally equity characteristics (related to the same entity) to be considered clearly and closely related to the host contract. However, most commonly, a financial instrument host contract will not embody a claim to the residual interest in an entity and, thus, the economic characteristics and risks of the host contract shall be considered that of a debt instrument.

ASC 815-15-25-17 goes on to state that

Because the changes in fair value of an equity interest and interest rates on a debt instrument are not clearly and closely related, the terms of convertible preferred stock (other than the conversion option) shall be analyzed to determine whether the preferred stock (and thus the potential host contract) is more akin to an equity instrument or a debt instrument. A typical cumulative fixed-rate preferred stock that has a mandatory redemption feature is more akin to debt, whereas cumulative participating perpetual preferred stock is more akin to an equity instrument.

The preceding guidance describes the "chameleon" approach, because the host contract includes the terms of convertible preferred stock other than the conversion option, which is the feature being analyzed. The SEC staff, however, has indicated that either the "chameleon" or the "whole instrument" approach is acceptable, as explained in "SEC staff's guidance on determining the nature of a host contract" below.

SEC staff's guidance on determining the nature of a host contract

There is a third approach that is no longer being used to determine whether a host contract is more akin to debt or equity. Under the "clean" approach, an entity excludes all of the features embedded in the hybrid instrument to determine the nature of the host contract. With this approach, the nature of a host contract in a hybrid instrument that contains both an embedded conversion feature and an embedded put option depends primarily on whether the instrument is structured as equity or debt. If the instrument is preferred stock, it would likely be considered an equity host regardless of the embedded features. Although some entities used this approach after the FASB issued Statement 133, Accounting for Derivative Instruments and Hedging Activities, the SEC staff has since issued guidance that we believe effectively forbids the "clean" approach.

As documented in EITF Topic D-109, Determining the Nature of a Host Contract Related to a Hybrid Financial Instrument Issued in the Form of a Share under FASB Statement No. 133, which is now codified in ASC 815-10-S99-3, Derivatives and Hedging, the SEC staff announced that it believes

... in performing an evaluation of an embedded derivative feature under [ASC] paragraph 815-15-25-1(a), the consideration of the economic characteristics and risks of the host contract should be based on all of the stated or implied substantive terms and features of the hybrid financial instrument ... In evaluating the stated and implied substantive terms and features, the existence or omission of any single term or feature is not necessarily determinative of the economic characteristics and risks of the host contract (that is, whether the nature of the host contract is more akin to a debt instrument or more akin to an equity instrument). Although the consideration of an individual term or feature may be weighted more heavily in the evaluation, judgment is required based upon an evaluation of all the relevant terms and features. For example, ... the fact that a preferred stock contract without a mandatory redemption feature would be classified as temporary equity under [ASC] paragraph 480-10-S99-3A is not in and of itself determinative of the nature of the host contract (that is, whether the nature of the host contract is more akin to a debt instrument or more akin to an equity instrument). Rather, ... the nature of the host contract depends upon the economic characteristics and risks of the preferred stock contract.

Following the March 2007 publication of Topic D-109, both financial statement preparers and standard setters questioned the SEC staff's intent in issuing this guidance. Although the Commission has provided no formal clarification, it is our view that the SEC staff's intent in issuing the guidance in Topic D-109 was to express that the "clean" approach to evaluating the nature of a host contract is not acceptable, rather than to require use of the "whole instrument" approach when evaluating a conversion feature embedded in a hybrid instrument issued in the form of a share, such as convertible preferred stock.

In our view, the key language in the SEC staff announcement is that "...the consideration of the economic characteristics and risks of the host contract should be based on all of the stated or implied substantive terms and features of the hybrid financial instrument [emphasis added]." On the surface, this language appears to require the use of the whole instrument approach. However, the SEC staff announcement includes the following footnote:

The "hybrid financial instrument" includes the terms and features pertaining to other embedded derivatives that are separately evaluated under [ASC] paragraph 815-15-25-1. However, the SEC staff understands that as an accounting policy some registrants exclude the terms and features pertaining to the individual embedded derivative being evaluated under paragraph 815-15-25-1 in determining the nature of the host contract for that particular embedded derivative.

2)

When raising capital, many early-stage or credit-starved firms turn to convertible bonds or similar instruments to entice investors while limiting the near-term cash flow burden of interest payments. Bonds and preferred stock with conversion features or attached warrants (referred to as “Convertibles”) often have two key features that deviate from plain-vanilla financing: (1) the stated interest rate on the Convertible is likely below market rates for non-convertible financing and (2) the Convertible investor gains equity exposure via the conversion feature or warrant.

While Convertibles can provide the issuer operational flexibility by limiting interest or dividend payments, Convertibles can also create accounting and valuation challenges for the reporting entity at issuance of the instrument, as well as in subsequent reporting periods.

Overview of Convertibles

Convertibles are hybrid securities that exhibit characteristics of both debt and equity. Convertibles are debt-like in that investors earn periodic coupon or dividend payments, maintain liquidation preference over common stock, and may have a definitive maturity date (if the security is not converted) at which time the investor receives the full principal amount plus accrued but unpaid interest. Convertibles are equity-like in that the investor has the right to convert the security into a predetermined number of common shares at any time prior to maturity (to the extent it is economically advantageous) and typically have voting rights on an “as-if” converted basis throughout the life of the Convertible.

Plain-vanilla Convertibles are essentially equity call options attached to a straight bond.

Given their hybrid nature, Convertibles are often viewed as a straight bond plus an equity call option. A company issuing Convertibles is effectively exchanging call options on its equity in favor of a lower cost of debt financing.

In addition to the above characteristics, Convertibles often have additional call and put provisions. The call allows the issuer to buy back the security at a predetermined price, and consequently limit the investor’s returns if interest rates fall or stock prices rise. The put allows the investor to return the Convertible to the issuer for cash, thus providing additional downside protection.

Issuers have several reasons to use Convertible financing, including:

• The company can lower the cash flow burden of its debt financing compared to straight debt (or preferred stock) alone. In periods of rising stock prices or high volatility, the reduction in coupon or dividend payments can be substantial.

• Lower-credit companies that may not be able to access the traditional debt or preferred stock markets can more readily find financing via Convertibles.

• Companies that anticipate equity appreciation can use Convertibles to defer equity financing to a time when growth has been achieved, thus lowering interim dilution.

Convertibles allow issuers to pay lower interest rates in exchange for a share of the upside in its equity, and generally increase flexibility for the issuer.

Applicable Accounting Guidance

The accounting literature pertaining to Convertibles is complex—which is to be expected given that Convertibles often have highly unique attributes that are specific to each security. In general, Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 815, Derivatives and Hedging (“FASB ASC 815,” formerly known as SFAS 133) governs derivatives embedded in Convertibles. Further, any aspect of the Convertible that is measured at fair value must adhere to FASB ASC Topic 820, Fair Value Measurements and Disclosures (“FASB ASC 820”).

The FASB views Convertibles as “hybrid instruments,” which are defined as contracts that embody both (a) a host contract and (b) an embedded derivative. The straight bond component of a Convertible is viewed as the host contract and the equity call option component is viewed as the embedded derivative.

Separately identified embedded derivatives must be measured at fair value on each balance sheet date, with changes in fair value flowing through earnings.

When evaluating the appropriate accounting treatment for Convertibles, the principal issue addressed in this article pertains to whether the embedded derivative requires separate recognition from the host contract. Separately identified derivatives must be measured at fair value on each balance sheet date, with changes in fair value flowing through earnings. However, the host contract (i.e., the straight debt component) may not require fair value measurement in subsequent reporting periods. Accordingly, the accounting treatment can be particularly critical for reporting entities that issue Convertibles due to the potential impact on earnings volatility.

FASB ASC 815-15-25 outlines three primary criteria that must be met in order for derivatives embedded in a Convertible to be accounted for as a separate liability:

• The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract. That is, if the economic characteristics and risks of the two components of a Convertible are closely related, the embedded derivative does not require separate recognition.

• The hybrid instrument is not re-measured at fair value under otherwise applicable generally accepted accounting principles (“GAAP”), with changes in fair value reported in earnings as they occur. If the hybrid instrument is already reported at fair value under other applicable GAAP, there is no need to separately recognize the embedded derivative since changes in the derivative’s fair value would already be incorporated in the fair value measurement of the security as a whole.

• A separate instrument with the same terms as the embedded derivative would be considered a derivative subject to the requirements of this FASB ASC 815. If the embedded derivative would not necessitate fair value measurement on a standalone basis, there is no need to separate the derivative from the host contract.

In addition to the factors outlined above, the appropriate accounting treatment for the Convertible may differ based on the settlement alternatives for the instrument, particularly in the case of convertible preferred stock. Convertible preferred stock may be classified as equity or as a liability on the balance sheet, depending on whether the security may ultimately be settled in cash or in shares of common stock. While all Convertibles must initially be measured at fair value, Convertibles that are classified as equity may not require subsequent measurement at fair value, whereas Convertibles that are classified as liabilities must be re-measured at fair value, with changes in fair value being reported in earnings.

In general, unless the economic substance of the instrument indicates otherwise, Convertibles are initially classified as liabilities in both of the following situations:

• If the Convertible requires net cash settlement upon conversion or maturity.

• If the Convertible gives the counterparty (i.e., the owner of the Convertible) the choice of a net cash settlement or settlement in shares.

The balance sheet classification for Convertibles generally depends on whether the instrument is assumed to be settled in cash (liability) or shares (equity).

Conversely, Convertibles are initially classified as equity in both of the following situations:

• If the Convertible requires physical settlement or net share settlement upon conversion or maturity.

• If the Convertible gives the reporting entity (i.e., the issuer of the Convertible) the choice of a net cash settlement or settlement in shares.

Valuation Methodology

In the event that a reporting entity determines that an embedded derivative requires separate recognition, it is necessary to determine its fair value as of each reporting period. Given the unique characteristics of Convertibles, and in the absence of reliable quoted market prices for comparable instruments, a lattice or binomial option pricing model is typically the most appropriate valuation approach. A lattice or binomial approach is a preferred valuation methodology relative to a closed-form option pricing model (e.g., the Black-Scholes option pricing model) since it allows increased flexibility that is critical when valuing complex derivative instruments.

The lattice or binomial option pricing model is a preferred approach when valuing Convertibles.

The binomial model utilizes a “decision tree” whereby future movement in the subject company’s common stock is estimated based on a volatility factor. Once the binomial lattice has been developed for the common stock, the next step is to build a corresponding tree of future Convertible values based on the greater of (a) the principal amount of the Convertible, (b) the conversion value of the Convertible, or (c) the potential future value of the Convertible if conversion is deferred (based on projected future prices for the common stock). These future values are then discounted to the valuation date based on a risk-neutral framework using a credit-adjusted discount rate.

The credit-adjusted discount rate, calculated at each node (or time period) in the binomial tree, is simply a probability-weighted rate of return derived by the sum of (a) the product of (i) the probability of converting into common stock and (ii) the risk-free rate (since hedging the option with common stock results in a riskless investment over a short time period) and (b) the product of (i) one minus the probability of converting into common stock and (ii) a “risky” market yield on debt for the issuer (since the debt component remains subject to default and other debt-related risks). In general, the “risky” market yield on debt will always be greater than the stated interest rate on the Convertible since the instrument should theoretically have preferable terms from an interest perspective. This is because the issuer effectively traded equity call options in exchange for a lower interest rate.

Finally, in order to separate the bond component from the embedded derivative contained in a Convertible, it is possible to recalculate the binomial model such that conversion does not occur in any node. By setting the common stock value as of the valuation date to $0, the company’s common stock in the binomial tree will never appreciate to a level sufficient to make it economically advantageous to exercise the conversion feature. The resulting value represents the Convertible’s value as if there were no conversion feature (i.e., the bond component). Finally, subtracting the bond component from the total fair value of the Convertible results in the value of the embedded derivative.