On Dec. 7, 2016, the Financial Accounting Standards Board (FASB) released an exposure draft of changes to ASC Topic 480, Distinguishing Liabilities from Equity. The proposed update has two parts, accounting for certain financial instruments with down round features and updating language related to the indefinite deferral for mandatorily redeemable financial instruments of certain nonpublic entities and certain mandatorily redeemable noncontrolling interests with a scope exception.

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A publication of the Professional Standards Group
December 2016
FASB May Simplify the Accounting for Instruments with Down Round Provisions
On Dec. 7, 2016, the Financial Accounting Standards
Board (FASB) released an exposure draft of
changes to ASC Topic 480, Distinguishing Liabilities
from Equity. The proposed update has two parts,
accounting for certain financial instruments with
down round features and updating language related
to the indefinite deferral for mandatorily redeemable
financial instruments of certain nonpublic entities
and certain mandatorily redeemable noncontrolling
interests with a scope exception.
Accounting with Financial Instruments with
Down Round Features
Financial instruments that have embedded features
where the strike price is reduced on the basis of
the pricing of future equity offerings are considered
to have down round features. Down round features
are a common form of investor protection included
in financial instruments that are equity-linked or
convertible to protect investors from dilution that can
occur if equity interests are issued at a lower price in
the future.
Under current U.S. generally accepted accounting
principles (U.S. GAAP) entities evaluate how to
classify such a financial instrument, or embedded
feature, under a multi-step approach. First they
determine whether the instrument is classified as a
liability. If not, they apply ASC Topic 815, Derivatives
and Hedging to determine if the instrument meets
the definition of a derivative. When evaluating the
derivative guidance, an entity considers whether
the instrument meets an exception to derivative
accounting because the instrument is indexed to the
reporting entity’s own stock. If it does not meet the
exception, the free standing instrument or bifurcated
conversion option is classified as a liability and the
reporting entity must measure the instrument’s fair
value at each reporting date.
Warrants and conversion options embedded in
instruments that have a debt host with down round
featurestypicallydonotmeettheexceptiontoderivative
accounting, which means they are accounted for as
liabilities. The FASB received comments that the
requirement to measure instruments with down round
features at fair value at each reporting date creates
a significant burden and may also lead to income
statement volatility. In the event of decreases in
investment value, it was commented that recognizing
increases in value—as may be required for a liability
classified financial instrument with a down round
provision—is not representative of the economics of
the down round feature.
The exposure draft proposes a change that impacts
warrants and bifurcated conversion options of certain
convertible instruments that are currently classified
as liabilities solely because of the existence of down
round protection. Under the proposal, an entity would
not consider the down round feature when evaluating
whether the instrument that meets the definition of
a derivative qualifies for the exception to derivative
accounting for an instrument indexed to an entity’s
own stock.
Warrants that would no longer be required to be
accounted for as liabilities under the proposal would
be recognized as equity instruments and would not be
measured at fair value on an annual basis. Conversion
options that were bifurcated solely because of
the existence of a down round feature would no

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contact your MHM auditor to further discuss the impact on your audit or audit report.
longer be required to be bifurcated. As a result, the
fair value of the down round feature would not be
measured annually within the financial statements.
Instead, reporting entities would recognize the effect
of the down round feature when it is triggered .For
financial instruments classified as equity, the entity
would recognize the value of the effect of the down
round feature as a dividend. For financial instruments
classified as a liability, an entity would recognize the
effect as a charge to net income.
If the down round feature were triggered during the
reporting period, the entity would disclose it as well as
the value of the effect of the down round feature being
triggered and the financial statement line item where
the value of the effect is reported.
Reworking the Indefinite Deferral
Part II of the exposure draft re-characterizes the
indefinite deferral related to certain mandatorily
redeemable shares of nonpublic entities that are
not Securities and Exchange Commission (SEC)
registrants as a scope exception to the accounting for
mandatorily redeemable shares, which are otherwise
accounted for as a liability. The change is not expected
to have an effect on financial statement reporting;
rather it is designed to improve the readability of the
subtopic and make its guidance easier to follow.
Stay Tuned
Comments on the exposure draft are due to the
FASB by Feb. 6, 2017. The FASB determined that the
transition would be handled using a cumulative effect
approach in which the cumulative change caused by
adoption would be recognized in beginning retained
earnings in the period of adoption. The FASB will not
set an effective date for the changes until it considers
its feedback.
We will monitor developments as they become
available and keep you up-to-date on the latest
activity related to this change. For specific comments,
questions or concerns, please contact Mike Loritz of
MHM’s Professional Standards Group. Mike can be
reached at mlortiz@cbiz.com or 816.945.5611.