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

The evaluation of whether an instrument is indexed to the entity’s own stock is applicable to contracts and transactions that are linked to or settled in the company’s equity shares. In order for an equity-linked contract to avoid fair value accounting, it must be both indexed to the company’s stock (the subject of this post) and be eligible for equity classification.

The first test in determining whether an instrument is indexed to the entity’s own stock is to evaluate any exercise contingencies. Any exercise contingency, that is any condition that must be met or a trigger that must tripped in order for the holder exercise, is linked directly to the company’s stock (e.g., stock price, trading volume) or to an index that is directly related to the entity’s operations (e.g., sales revenue, EBITDA, net income) will pass this first test. Conversely, if any exercise contingency is linked to the stock of another company, a stock index (e.g., Fortune 500 index), an interest rate, a regulatory event or really anything else not associated with the company’s stock or its operations, will fail this test.

If the first test is failed, the instrument is automatically deemed not indexed to the entity’s own stock and fair value accounting must be applied. If, however, this first test is passed, the second test must be evaluated.

The second test for determining whether an instrument is indexed to the entity’s own stock looks at the settlement provisions; specifically, the settlement amount must be equal to the difference between the fair value of a fixed number of its shares and either a fixed monetary amount or a fixed amount of debt (ASC 815-40-15-7C and 7I).

In determining whether this criteria is met, the settlement amount must be evaluated based on all of its terms and conditions. If there are terms and/or conditions that are not normal inputs to the pricing of a fixed-for-fixed option or forward contract, then the contract or provision is not considered indexed to the company’s own stock. Thus, if the instrument’s has variables, terms and/or conditions other than those used as inputs to determine the fair value of a fixed-for-fixed option or forward contract or that increases the exposure to those used to determine the fair value of a fixed-for-fixed option or forward contract, then the contract or provision is not considered indexed to the company’s own stock.

This second criteria is covered in detail in our post, Evaluating the Settlement Provisions of a Contract in an Entity’s Own Stock.

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.

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

A fixed-for-fixed option is an option contract the gives the holder the right to acquire a fixed number of a company’s equity shares for a fixed per-share price. The number of shares issuable and the per-share price remain fixed throughout the the life of the contract.

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.

Posted by & filed under Debt, Derivatives.

I’ve had numerous requests to show how the constant yield rate for debt cost amortization is computed in the sample Excel effective interest method calculations. The idea is pretty simple once you have the formulas set up. The objective is to determine the rate that drives the amortization balance to zero on the maturity date of the note. All of the cell formulas are available in the downloaded spreadsheet, but here are two important calculations in words:

Periodic amortization (quarterly in the example) is:

Beginning principal balance x annual rate / # calculation periods in the year (we are dividing by 4 in the example since there are 4 quarters)

Debt issuance cost at the end of each quarter is therefore:

Beginning issuance cost balance – periodic (i.e., quarterly) interest amortization

Since the effective interest method is be definition a constant interest rate, all you are doing is solving for the rate that drives the interest cost balance to zero by the notes maturity date. The screen shots below show how to use Excel’s Goal Seek feature.

Before the Goal Seek function is run:

Before

Setup of the Goal Seek Inputs:

During

After the Goal Seek function has run:

After

 

Posted by & filed under Debt, Equity-Linked Transactions.

The effective interest rate method, or interest method as it is referred to by the FASB in the codification, spreads the total cost of debt over the life of the debt at a constant interest rate.

This constant interest rate is also referred to as the constant interest yield. The constant interest rate includes the contractual interest rate stated in the debt agreement PLUS other borrowing costs such as original issue discount or premium, up-front borrowing costs, and any other costs associated with the debt that should be spread over the life of the debt as interest cost. These can include some rather complicated items when the borrowing is associated with equity-linked components such as warrants or conversion features which may cause recognition of a beneficial conversion feature. All of these costs must be spread over the term of the debt in a manner that yields a constant interest rate. As a result, the actual interest cost may fluctuate from period-to-period as the principle balance changes (which would include accrued interest costs that add to principle!) over time. Once the constant yield rate is set it does not change UNLESS there is a modification of the debt agreement that changes its terms. Any unamortized costs at the time of the modification, plus any costs incurred as a result of the modification, would be spread over the remaining modified term of the debt. This will most likely result in a change to the constant yield rate.

Posted by & filed under Variable Interest Entity.

Here’s a high-level look at the consolidation process under ASC 810, Consolidation. The focus is on the variable interest entity model with an overview of the analysis process as well as more detailed comments on the scope exceptions and characteristics of a VIE.

Posted by & filed under Revenue Recognition, Software.

I’m looking forward to the day when revenue recognition falls under one overarching model. The FASB and the IASB are working on a converged model for customer contracts that will completely revamp the revenue recognition rules and replace much of the guidance currently in place. As of this writing, the effective date for the guidance would be January 1, 2017. That may shift was the deliberation process continues. Until then we have ASC 985-605 to guide us through software revenue recognition.

What follows is a summary of the current accounting guidance. There is much nuance in software revenue accounting which will be addressed in future posts. So, use what follows with that caveat in mind.

In an arrangement with a single deliverable, software revenue recognition is not difficult. It’s just a matter of selecting the correct method for the deliverable. Here’s a chart of the most common software deliverables and related revenue recognition methods:

Deliverable Revenue recognition method
Tangible software product (e.g., CD, download) Upon 1) physical delivery or download, as applicable and 2) delivery of access code or keys, if applicable for access by the customer
Software license On date license period begins
Post-Contract Services (PCS) Ratably over the PCS term
Software services Depends upon the nature of the services. Available methods include: Specific Performance (use if the services involve a single act); Upon Completion (use if the services have little to no value to the customer until completion); Proportional Performance (use if the services are provided over a period of time and have value to the customer as provided; performance should be measured using either an input method, an output method or ratably over the services period, as applicable); Subscription (use if the services are made available to the customer for consumption over a specified period of time and for certain discounts on future purchases)
Development, modification and customization services Use Contract Account under ASC 605-35
Software hosting (must meet specific requirements to be considered a software element) Subscription

An arrangement with multiple deliverables offers much more complexity due to 1) the need to allocate arrangement consideration (the fee) to the various deliverables, including deliverables that may not fall within the software guidance, 2) the concept of vendor-specific objective evidence (VSOE) of fair value as the basis of allocation, 3) the treatment of incremental discounts on future purchases, 4) the impact on revenue recognition amount, timing and methods if VSOE is not available for one or more of the deliverables, and 5) the multiple revenue recognition methods that may arise out of one arrangement.

Allocation

The starting point in most allocation situations is selling price. The term selling price can have many meanings, but in revenue recognition it is the price that the entity would transact a sale of the deliverable on a stand-alone basis. Thus, selling price is frequently not list price or rate card price. In fact, selling price for a deliverable on a stand-alone basis may not be easy to determine if the deliverable has never been sold separately. Selling price may then be either the selling price of a third party for a substantially similar deliverable, or a management’s estimate. A full discussion of the hierarchy of evidence of selling price follows in the “Selling Price” section.

If the arrangement includes both software and non-software elements, then the allocation process must first start with allocating the arrangement consideration to the software and non-software elements as groups then proceed to allocating the amount allocated to each group to the individual elements within each group. This group-level allocation process is governed primarily by ASC 605-25, but can be impacted by the GAAP guidance applicable to each type of deliverable in the arrangement. This is a subject worthy of separate coverage and will be addressed in a later post.

Once you have the amount of arrangement allocation applicable to the software elements, or if the arrangement contains only software elements, allocation of consideration to individual software elements is based on relative selling price. There are a few important exceptions to this general rule as follows:

  • Specified upgrade right – If the arrangement includes a “specified upgrade” right, the right should be an amount equal to its selling price. The theory here is that it is difficult to know whether the customer is purchasing the current version or the upgraded version, so the guidance presumes that it is the latter. The effect is that any discount in the arrangement, express or inherent, is allocated to the other elements and away from the specified upgrade right.
  • Discount on a future purchase – An incremental and “significant” discount on a future purchase must be allocated among the arrangement elements. The discount allocation process depends upon the nature of the discount and is address in the “Discounts” section below.of
  • Reallocation of consideration – The general rule that the allocation of proceeds occurs at inception of the arrangement and does change subsequently (see Selling Price below)  is broken when the only undelivered elements remaining from the arrangement have a selling price evidenced by VSOE. In this situation, two things happen. First, revenue on the delivered elements, including those that do not have VSOE (see Selling Price and Timing discussions below), can be recognized. Secondly, arrangement consideration is reallocated so that all undelivered elements are reflected at full selling price as evidenced by VSOE instead of at the original allocated amount based on relative selling price. This is called the “Residual Method” and has the effect of allocated any discount in the arrangement, express or inherent, to the delivered elements.

Selling Price

The hierarchy of evidence of selling price is as follows:

  1.  Vendor-specific objective evidence (VSOE) – VSOE is defined as the price of the deliverable when sold separately and is evidenced by actual sales of the deliverable on a stand-alone basis. If the deliverable is not yet sold separately, then price of the deliverable  established by management with relevant authority may be used. If this price is subsequently proved wrong by actual sale transactions, then the company will have to consider whether the original price was used in error and correct the previously-issued financial statements.
  2. Third party evidence – Third party evidence includes prices charged by competitors on a stand-alone basis for products and/or services, as applicable, with substantially similar features. Since many software elements are by nature unique, third party evidence of selling price is infrequently available.
  3. Management estimate – If neither VSOE or third party evidence is available, then the company should use management’s estimate of selling price on a stand-alone basis.

The selling prices used for allocation should be as of the contract date and should not change subsequently, even of the changed price is based on subsequently available VSOE. Additionally, if VSOE is subsequently available and supports the selling price originally used in the allocation, the availability of VSOE should impact the revenue recognition analysis in the period the VSOE becomes available in a manner similar to a subsequent event.

As noted above, selling price is defined as the price at which entity would transact a sale of the deliverable on a stand-alone basis. Selling price may or may not be objectively determinable and this will have a significant impact on revenue recognition. Unlike for other deliverables, the availability of VSOE of selling price for software elements will affect the timing, and potentially the amount, of revenue recognition. Here’s how. If VSOE is available for ALL elements, then revenue may be recognized as delivery occurs assuming all other conditions for revenue recognition are met. If VSOE does not exist for all software elements, then revenue must generally be deferred until all elements have been delivered (except under the Residual Method as noted above). Since many software elements, such as post-contract services (PCS), are not sold separately, there is frequently VSOE lacking for at least some of the software elements in the arrangement. So, while VSOE is not an absolute requirement for purposes of allocating arrangement consideration, lack of VSOE for one or more software elements will retard revenue recognition for all software elements, including those with VSOE.

Incremental Discounts

Generally, an incremental discount on a future purchase, if significant, must be allocated to each of the arrangement elements. The type of discount, however, will significantly affect the allocation process.

  • Discount on a specified future purchase – A discount on a future purchase for which the monetary amount of the discount is known or can be computed should be treated as a separate element and allocated to the other software elements in the arrangement based on relative selling price ONLY IF VSOE exists for all software elements. If VSOE is available for all elements except the future purchase element, then the consideration allocated to the discount as well as all other elements may need to be deferred and recognized upon the earlier of (assuming all other conditions for revenue recognition have been met) 1) VSOE becomes available, 2) the customer makes the future purchase and uses the discount or 3) the discount period expires. Finally, if VSOE is not available for one or more of the current elements, then all arrangement consideration, including that allocated to the discount, should be deferred and recognized as revenue when either VSOE becomes available for all arrangement elements, or all elements have been delivered (assuming all other conditions have been met).
  • Discount on specified upgrade right – As noted previously, a discount on a specified upgrade right should not be allocated to the upgrade right. Instead, the discount should be allocated to the other software element such that the upgrade right is reflected at full selling price of the upgrade software.
  • Discount on an unspecified future purchase – If the arrangement is silent on the future product or services purchases to which the incremental discount applies, then a portion of the arrangement fee should be allocated to both the current and future elements based on relative selling price assuming the maximum discount will be taken. If the maximum discount amount is not determinable because either 1) the amount of the future purchases is not specified or capped and/or 2) VSOE is not available for the future purchase elements, then the consideration allocated to each software element should be reduced by the discount percentage. If this is the case, the portion of arrangement consideration allocated to the future purchases should be recognized over the discount period as a subscription. If no discount period is specified, then revenue should be recognized as delivery of the future purchases occur, assuming all other conditions for revenue recognition are met.

Timing

If all software elements have VSOE, then revenue is recognized as delivery occurs (assuming all other conditions have been met). If the VSOE is NOT available for all elements, then revenue for all elements, including those with VSOE, is deferred and recognized when 1) VSOE for all elements becomes available (and all other conditions, including delivery, are met) or 2) all elements have been delivered. Here are two additional special cases that affect the timing of revenue recognition:

  • Last deliverable is PCS – If the last deliverable under the arrangement is PCS, then the entire arrangement fee should be recognized ratably over the PCS term, including any expected renewal period(s) is renewal is probable.
  • Last deliverable is services – Similarly, if the last deliverable under the arrangement is services, then the entire arrangement fee should be recognized as the services are performed based on the revenue recognition method applicable to the services performance pattern (i.e., based on inputs, outputs or ratably over the service period).

Posted by & filed under Variable Interest Entity.

It’s nice when I can reuse some language from a previous post on a different topic. Today, the topic is materiality in the context of the variable interest entity (VIE) consolidation model. Here’s the recycled language from my post on derivatives and materiality:

 “When I think about materiality I do so from both a qualitative and quantitative perspective. In most cases, the quantitative approach is sufficient since there is generally not a lot of sensitivity around the ‘what’ it is. It’s mostly about ‘how much’ it is. So materiality becomes primarily a percentage of total assets, net assets (i.e., equity), revenue, net income/loss, or whatever the most appropriate measure is in the circumstances. The qualitative aspect is less relevant in these instances and usually enters when the item in question takes a reporting entity over a threshold…from profit to loss, for example. Some issues, on the other hand, are material from a qualitative perspective without regard to the amount.”

A VIE falls into the netherworld of the not-so-well-understood accounting areas. The analysis is time consuming and very complicated and I fully understand the desire to avoid the cost and brain damage. But, sorry to say, this is one of those areas that is in my opinion virtually always qualitatively material. That does not mean ALWAYS, but it does mean you’re probably begging for a fight with your auditors.

Here are my reasons:

  • Recall that the VIE guidance is a direct result of the Enron scandal. This makes it a lightning rod. Failure to apply the guidance based on a quantitative materiality theory begs for “What are you hiding?” questions from users of the financial statements.
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  • Quantitative materiality is rarely, if ever, brought up in the context of the voting interest consolidation model. It is assumed that if you own a subsidiary, you will consolidate. Period. So what is the justification for applying a different standard to the VIE consolidation model?
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  • For many VIE’s, the material issues are in the disclosures, not on the face of the balance sheet, operating statement or cash flow statement.
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  • The VIE model is a two-edged sword in that it can force consolidation when the voting interest model does not, and it can force deconsolidation when the voting interest model would require consolidation. A materiality claim starts to look like selective application of the guidance when you find yourself in both situations. I just don’t think it is wise to deconsolidate a VIE but not consolidate another VIE based on materiality. And vice versa. Apply the guidance uniformly.
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  • In most circumstances you will have to do the analysis whether you choose to consolidate or not based on materiality. You have to determine whether or not you have a VIE first. All of the cost and effort of applying the VIE guidance is incurred in the analysis phase. The actual process of consolidation is mechanical and trivial in comparison. A cost-benefit argument does not hold water when the cost is already sunk.
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  • The guidance requires application when the reporting entity first has a relationship with a potential VIE and/or when the relationship with the potential VIE changes in some way such that the reporting entity now holds, or now no longer holds, a variable interest. So, again, you have to perform this determination at inception of the relationship and at each change in the relationship. Even if the amounts are not quantitatively material, you still have to go through the vast majority of the effort and expense regardless.
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