Posted by & filed under Derivatives, Equity-Linked Transactions, Indexed to Own Stock.

A down round feature in a financial instrument (or component of an embedded feature) reduces the strike price the financial instrument after its issuance if the seller issues shares of its stock at a price lower than the strike price of the financial instrument or issues issues an equity-linked financial instrument having a lower strike price. In the past this type of feature, often referred to in a contract as a ‘ratchet’, served as a poison pill when evaluating a financial instrument as being linked to the entity’s own stock. If your agreement had this provision then it failed the indexed-to-own-stock criteria and fell into fair value accounting.

In July 2017, the FASB issued Accounting Standards Update 2017-11 Part I, Accounting for Certain Financial Instruments with Down Round Features. Effective for public companies with fiscal periods beginning after December 15, 2018, and for all entities after December 15, 2019, down round features are specifically excepted from consideration when evaluating whether a financial instrument is indexed to the entity’s own stock. AND, early adoption is permitted (so adoptable as early as July 2017), even in an interim period. What this means is that all equity-linked financial instruments that were previously accounted for under fair value accounting (either as a derivative or non-derivative) should be reevaluated. Down round features were frequently the triggering provision into fair value accounting and this is no longer the case effective as noted above.

For many, adoption of this update will cause reclassification of equity-linked contracts currently classified as liabilities measured at fair value to equity with no need to remeasure at fair value at each balance sheet date going forward. Take caution though! A convertible instrument (or embedded feature) that includes a down round component may then fall under the accounting guidance for a beneficial conversion feature. While somewhat complex, beneficial conversion feature accounting and disclosures carry a far lower cost than those of derivative and/or fair value accounting.

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