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

One of the requirements (the second of two requirements to be specific) for a contract or contract provision to be considered indexed to the entity’s own stock is that it equal the difference between the fair value of a fixed number of the entity’s equity shares and either 1) a fixed monetary amount or 2) a fixed amount of debt issued by the entity.

This a fairly strict requirement. Any potential adjustment to the number of shares or exercise price, regardless of the probability of it actually occurring, would render the terms not fixed and therefore not eligible to be considered indexed to the entity’s own stock. This applies even if the potential adjustment(s) is within the control of the entity.

But, wait! As with just about every rule in accounting, there is an exception. If each potential adjustment is driven by a variable or factor that is itself an input to the fair value of a fixed-for-fixed stock forward or fixed-for-fixed stock option, then the number of shares and/or exercise price of the contract would be considered fixed. Of course applying this exception requires that you know something about the inputs to fair value of a fixed-for-fixed forward or option.

The inputs to fair value are fairly well established based on a number of available valuation models. For example, inputs to fair value of a stock option can be determined by looking at the Black-Scholes option-pricing model which asks for the current price of the entity’s stock, its historic price volatility, the current risk-free interest rate, and the option’s term (usually in number of days). So if the number of shares or the exercise price are determined, in whole or in part, by reference to or by change in any one of these inputs, then the terms are considered fixed. Other pricing models require additional inputs such as the expected dividend rate on the shares. You don’t have to choose a model. All that is required is that the variable be an input of a model since these models explicitly require such inputs or make assumptions about the inputs. For example, the original Black-Scholes model assumes that the shares have no expected dividends (which still makes it an input albeit with a value of zero), but has been since modified to give effect for the ex-dividends date value of the shares.

Note that the requirements above are met when the number of shares or exercise price are affected by anti-dilution adjustments, adjustments for hedgeable events such as an announcement of an acquisition or merger.

Examples that would not meet the above test include reference to or a change in a commodity, reference to the company’s sales revenue, and contingent events that are not based on the company’s stock. Additionally, if the variable is an input to fair value but the exposure to the input is increased by a multiplier, leveraging or an inversion, then the test is not met. Further, if the settlement amount is denominated in a currency other than the entity’s functional currency then the requirement is not met since the contract introduces currency conversion rate exposure which is not an input to fair value of a fixed-for-fixed option or forward.

When originally issued, the settlement provision rules precluded having a ‘down round’ adjustment in the contract or provision. In July 2017, the FASB issued an update that excepted this type of adjustment.

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