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Enron Mail |
EITF - Emerging Issues Task Force
1996\Issue 96-13: Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock Abstract EITF ABSTRACTS Issue No. 96-13 Title: Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock Dates Discussed November 12-13, 1987; January 19, 1995; March 23, 1995; May 18-19, 1995; July 20-21, 1995; September 20-21, 1995; January 18, 1996; July 18, 1996; September 18-19, 1996; November 14, 1996; January 23, 1997 References FASB Statement No. 80, Accounting for Futures Contracts FASB Statement No. 123, Accounting for Stock-Based Compensation FASB Statement No. 128, Earnings per Share FASB Discussion Memorandum, Recognition and Measurement of Financial Instruments, November 18, 1991 APB Opinion No. 9, Reporting the Results of Operations APB Opinion No. 14, Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants APB Opinion No. 15, Earnings per Share APB Opinion No. 21, Interest on Receivables and Payables SEC Accounting Series Release No. 268, Presentation in Financial Statements of "Redeemable Preferred Stocks" ISSUE For a number of business reasons, a company may enter into contracts that are indexed to, and sometimes settled in, its own stock. Examples of these contracts include written put options, written call options (and warrants), purchased put options, purchased call options, forward sale contracts, and forward purchase contracts. These contracts may be settled using a variety of settlement methods, or the issuing company or counterparty may have a choice of settlement methods. The settlement methods are: Physical settlement - the party designated in the contract as the buyer delivers the full stated amount of cash to the seller, and the seller delivers the full stated number of shares to the buyer. Net share settlement - the party with a loss delivers to the party with a gain shares with a current fair value equal to the gain. Net cash settlement - the party with a loss delivers to the party with a gain a cash payment equal to the gain, and no shares are exchanged. The contracts described above may be either freestanding or embedded in another financial instrument. A freestanding contract is entered into separate and apart from any of the company's other financial instruments or equity transactions, or it is entered into in conjunction with some other transaction and is legally detachable and separately exercisable. This Issue applies only to freestanding derivative financial instruments (for example, forward contracts, options, and warrants). This Issue does not apply to security price guarantees or other financial instruments indexed to, or otherwise based on, the price of the issuer's stock that are issued in connection with a purchase business combination [Note See STATUS section.], nor does it address the accounting for either the derivative component or the financial instrument when the derivative component is embedded in and not detachable from the financial instrument. This Issue does not address the accounting for contracts that are issued to compensation employees or to acquire goods or services from nonemployees. The issue is how freestanding contracts that are indexed to, and potentially settled in, a company's own stock should be classified and measured. EITF DISCUSSION A. Framework for Accounting The Task Force discussed the accounting for freestanding contracts that are indexed to, and potentially settled in, a company's own stock and reached several consensuses, as described below. The consensuses in this Issue are to be applied to all freestanding derivative financial instruments that are indexed to, and potentially settled in, a company's own stock; however, nonpublic companies may continue to apply the consensus in Issue No. 88-9, "Put Warrants ," to the instruments covered by that Issue. Hereinafter, the framework for accounting that is established in this Issue is referred to as the "Model." (1) Initial balance sheet classification The initial balance sheet classification generally is based on the concept that contracts that require net cash settlement are assets or liabilities and contracts that require settlement in shares are equity instruments. If the contract provides the company with a choice of net cash settlement or settlement in shares, the Model assumes settlement in shares; if the contract provides the counterparty with a choice of net cash settlement or settlement in shares, the Model assumes net cash settlement. However, this Model is not applicable when settlement alternatives do not have the same economic value attached to them or when one of the settlement alternatives is fixed or contains caps or floors. In those situations, the accounting for the instrument (or combination of instruments) should be based on the economic substance of the transaction.1 1 For example, if a freestanding contract, issued together with another instrument, requires that the issuer provide to the holder a fixed or guaranteed return such that the instruments are, insubstance, debt, the issuer should account for both instruments as liabilities, regardless of the settlement terms of the freestanding contract. Accordingly, unless the economic substance indicates otherwise, contracts would be initially classified as equity, or as assets or liabilities, in the following situations: Equity instruments Contracts that require physical settlement or net share settlement Contracts that give the company a choice of net cash settlement or settlement in its own shares (physical settlement or net share settlement). Assets or liabilities Contracts that require net cash settlement Contracts that give the counterparty a choice of net cash settlement or settlement in shares (physical settlement or net share settlement). (2) Initial measurement, and subsequent balance sheet classification and measurement The Model requires that all instruments be initially measured at fair value and subsequently accounted for based on the initial classification and the assumed or required settlement method in (1) above.2 Contracts that are initially classified as equity are accounted for in permanent equity. If physical settlement was assumed or required and the company is obligated to deliver cash as part of the physical settlement,3 then public companies should refer to ASR 268, which provides guidance by analogy for those transactions, and account for the transactions as provided below under "Equity instruments - temporary equity." 2 For contracts that are classified as equity instruments that provide the company with a choice between either net share settlement or physical settlement that may require that the company deliver cash, net share settlement should be assumed. For contracts that are classified as equity instruments that provide the counterparty with a choice of either net share settlement or physical settlement that may require that the company deliver cash, physical settlement should be assumed. 3 For example, if the company sells put options indexed to its own stock that enable the holder to sell shares back to the company at the strike price. Equity instruments - permanent equity Contracts that require that the company deliver shares as part of a physical settlement or a net share settlement should be initially measured at fair value and reported in permanent equity. Subsequent changes in fair value should not be recognized. Contracts that give the company a choice of (a) net cash settlement or settlement in shares (including net share settlement, or physical settlement that requires that the company deliver shares) or (b) either net share settlement or physical settlement that requires that the company deliver cash should be initially measured at fair value and reported in permanent equity. Subsequent changes in fair value should not be recognized. If such contracts are ultimately settled in a manner that requires that the company deliver cash, the amount of cash paid or received should be reported as a reduction of, or an addition to, contributed capital. Equity instruments - temporary equity4 4 Classification and measurement in temporary equity is required for public companies. ASR 268 provides guidance by analogy for transactions classified as temporary equity. Contracts that (a) require that the company deliver cash as part of a physical settlement, (b) give the company a choice of either net cash settlement or physical settlement that requires that the company deliver cash, or © give the counterparty a choice of either net share settlement or physical settlement that requires that the company deliver cash should be initially measured at fair value and reported in permanent equity, and an amount equal to the cash redemption amount under the physical settlement should be transferred to temporary equity. Assets or liabilities Contracts that are initially classified as assets or liabilities should be measured at fair value, with changes in fair value reported in earnings and disclosed in the financial statements. If contracts initially classified as assets or liabilities are ultimately settled in shares, any gains or losses on those contracts should continue to be included in earnings. B. Hedging The SEC Observer stated that the SEC staff has consistently held the position that hedge accounting is not permitted for transactions involving the contracts within the scope of this Issue because those transactions have not met all the criteria of Statement 80. The SEC staff also believes that hedge accounting for transactions involving those contracts is inconsistent with paragraph 28 of Opinion 9. Because of the SEC staff's position, the Task Force decided to end its discussion of whether the contracts described above can qualify for hedge accounting. C. Application of the Model to Specific Instruments The following reflects several Task Force consensuses with respect to the application of the Model, described in Section A of this Issue, to certain freestanding derivative financial instruments that are indexed to, and potentially settled in, a company's own stock. (1) Written put options5 and forward purchase contracts 5 Includes shareholder rights (SHARP rights) issued by the company to shareholders that give the shareholders the right to put a specified number of common shares to the company for cash. Description The company (the buyer) agrees to buy from the seller shares at a specified price at some future date. The contract may be settled by physical settlement, net share settlement, or net cash settlement, or the issuing company or the counterparty may have a choice of settlement methods.6 6 Application of the Model to purchased call options is discussed in C(3). Consensus The Model would be applied as follows: One Settlement Method Physical (a) Net Share Net Cash (1) Initial Classification: Equity x x Asset Liability x (2) Initial Measurement, Subsequent Classification and Measurement: Fair value, permanent equity - no changes in fair value x Fair value, transfer to temporary equity an amount equal to cash redemption amount (b) x Fair value, asset/liability - adjusted for changes in fair value © x (a) Physical settlement of the contract requires that the company deliver cash to the holder in exchange for the shares. (b) Classification and measurement guidance within temporary equity applies only to public companies. © Subsequent changes in fair value should be reported in earnings and disclosed in the financial statements. (d) If the contracts are ultimately settled in shares, any gains or losses on those contracts should continue to be included in earnings. (e) If the contracts are ultimately physically settled by the company, requiring that the company deliver cash, or are ultimately settled in net cash, the amount of cash paid or received should be reported as a reduction of, or as an addition to, contributed capital. (f) If the contracts are ultimately settled in net cash or net shares, the amount reported in temporary equity should be transferred and reported as an addition to permanent equity. Company Choice Net Share or Physical (a) Net Share or Net Cash Net Cash or Physical (a) (1) Initial Classification: Equity x x x Asset Liability (2) Initial Measurement, Subsequent Classification and Measurement: Fair value, permanent equity - no changes in fair value x(e) x(e) Fair value, transfer to temporary equity an amount equal to cash redemption amount (b) x x(f) Fair value, asset/liability - adjusted for changes in fair value © (a) Physical settlement of the contract requires that the company deliver cash to the holder in exchange for the shares. (b) Classification and measurement guidance within temporary equity applies only to public companies. © Subsequent changes in fair value should be reported in earnings and disclosed in the financial statements. (d) If the contracts are ultimately settled in shares, any gains or losses on those contracts should continue to be included in earnings. (e) If the contracts are ultimately physically settled by the company, requiring that the company deliver cash, or are ultimately settled in net cash, the amount of cash paid or received should be reported as a reduction of, or as an addition to, contributed capital. (f) If the contracts are ultimately settled in net cash or net shares, the amount reported in temporary equity should be transferred and reported as an addition to permanent equity. Counterparty Choice Net Share or Physical (a) Net Share or Net Cash Net Cash or Physical (a) (1) Initial Classification: Equity x Asset Liability x x (2) Initial Measurement, Subsequent Classification and Measurement: Fair value, permanent equity - no changes in fair value x Fair value, transfer to temporary equity an amount equal to cash redemption amount (b) x(f) Fair value, asset/liability - adjusted for changes in fair value © x(d) x(d) (a) Physical settlement of the contract requires that the company deliver cash to the holder in exchange for the shares. (b) Classification and measurement guidance within temporary equity applies only to public companies. © Subsequent changes in fair value should be reported in earnings and disclosed in the financial statements. (d) If the contracts are ultimately settled in shares, any gains or losses on those contracts should continue to be included in earnings. (e) If the contracts are ultimately physically settled by the company, requiring that the company deliver cash, or are ultimately settled in net cash, the amount of cash paid or received should be reported as a reduction of, or as an addition to, contributed capital. (f) If the contracts are ultimately settled in net cash or net shares, the amount reported in temporary equity should be transferred and reported as an addition to permanent equity. (2) Forward sale contracts, written call options or warrants, and purchased put options Description The issuing company (the seller) agrees to sell shares of its stock to the buyer of the contract at a specified price at some future date. The contract may be settled by physical settlement, net share settlement, or net cash settlement, or the issuing company or counterparty may have a choice of settlement methods. Consensus The Model would be applied as follows: One Settlement Method Physical (a) Net Share Net Cash (1) Initial Classification Equity x x Asset/Liability x (2) Initial Measurement, Subsequent Classification and Measurement: Fair value, permanent equity - no changes in fair value x x Fair value, asset/liability - adjusted changes in fair value (b) x (a) Physical settlement of the contract requires that the company deliver shares to the holder in exchange for cash. (b) Subsequent changes in fair value should be reported in earnings and disclosed in the financial statements. © If the contracts are ultimately settled in net cash, the amount of cash paid or received should be reported as a reduction of, or an addition to, contributed capital. (d) If the contracts are ultimately settled in shares, any gains or losses on those contracts should continue to be included in earnings. Company Choice Net Share or Physical (a) Net Share or Net Cash Net Cash or Physical (1) Initial Classification Equity x x x Asset/Liability (2) Initial Measurement, Subsequent Classification and Measurement: Fair value, permanent equity - no changes in fair value x x© x© Fair value, asset/liability - adjusted changes in fair value (b) (a) Physical settlement of the contract requires that the company deliver shares to the holder in exchange for cash. (b) Subsequent changes in fair value should be reported in earnings and disclosed in the financial statements. © If the contracts are ultimately settled in net cash, the amount of cash paid or received should be reported as a reduction of, or an addition to, contributed capital. (d) If the contracts are ultimately settled in shares, any gains or losses on those contracts should continue to be included in earnings. Counterparty Choice Net Share or Physical (a) Net Share or Net Cash Net Cash or Physical (a) (1) Initial Classification Equity x Asset/Liability x x (2) Initial Measurement, Subsequent Classification and Measurement: Fair value, permanent equity - no changes in fair value x Fair value, asset/liability - adjusted changes in fair value (b) x(d) x(d) (a) Physical settlement of the contract requires that the company deliver shares to the holder in exchange for cash. (b) Subsequent changes in fair value should be reported in earnings and disclosed in the financial statements. © If the contracts are ultimately settled in net cash, the amount of cash paid or received should be reported as a reduction of, or an addition to, contributed capital. (d) If the contracts are ultimately settled in shares, any gains or losses on those contracts should continue to be included in earnings. (3) Purchased call options Description The company (the buyer) purchases call options that provide it with the right, but not the obligation, to buy from the seller, shares of the company's stock at a specified price. If the options are exercised, the contract may be settled by physical settlement, net share settlement, or net cash settlement, or the issuing company or the counterparty may have a choice of settlement methods. Consensus The company should follow the table included in (2) above in accounting for the call options. (4) Detachable stock purchase warrants Description An enterprise issues senior subordinated notes with a detachable warrant that gives the holder both the right to purchase 6,250 shares of the enterprise's stock for $75 per share and the right (that is, a put) to require that the enterprise repurchase all or any portion of the warrant for at least $2,010 per share at a date several months after the maturity of the notes in about 7 years. Consensus The proceeds should be allocated between the debt liability and the warrant and the resulting discount should be amortized in accordance with Opinion 21. The warrants should be considered, in substance, debt and accounted for as a liability because the settlement alternatives for the warrants do not have the same economic value attached to them and they provide the holder with a guaranteed return in cash that is significantly in excess of the value of the share settlement alternative on the issuance date. (5) Put warrants Description Put warrants are instruments with characteristics of both warrants and put options. The holder of the instrument is entitled to exercise (a) the warrant feature to acquire the common stock of the issuer at a specified price, (b) the put option feature to put the instrument back to the issuer for a cash payment, or in some cases, © both the warrant feature to acquire the common stock and the put option feature to put that stock back to the issuer for a cash payment. Put warrants are frequently issued concurrently with debt securities of the issuer, are detachable from the debt, and may be exercisable only under specified conditions. The put feature of the instrument may expire under varying circumstances, for example, with the passage of time or if the issuer has a public stock offering. Under Opinion 14, a portion of the proceeds from the issuance of debt with detachable warrants must be allocated to those warrants. Consensus Because the contract gives the counterparty the choice of cash settlement or settlement in shares, public companies should report the proceeds from the issuance of put warrants as liabilities and subsequently measure the put warrants at fair value with changes in fair value reported in earnings. Nonpublic companies may continue to classify and measure the put warrants in accordance with the consensus in Issue 88-9. D. Earnings per Share The Task Force reached the following consensus on how written put options affect the earnings-per-share calculation: If the written put options are "in the money" during the period being reported on, the potential dilutive effect on earnings per share should be computed using the reverse treasury stock method. Under that method, the incremental number of shares is computed as (a) the number of shares that would need to be issued for cash at the then current market price to obtain cash to satisfy the put obligation less (b) the number of shares received from satisfying the puts. The Task Force discussed whether it should comprehensively address issues relating to earnings per share in this Issue. The Task Force agreed that the FASB should address the issues relating to earnings per share as part of its project on earnings per share. [Note: See STATUS section.] STATUS In February 1997, the FASB issued Statement 128, which supersedes Opinion 15. Statement 128 is effective for financial statements for both interim and annual periods ending after December 15, 1997, and earlier application is not permitted. Statement 128 affirms the consensus reached by the Task Force on how written put options affect the earnings per share calculation. That is, in computing diluted EPS, Statement 128 requires use of the reverse treasury stock method to account for the dilutive effect of written put options and similar contracts that are "in the money" during the reporting period. Statement 128 states that purchased options should not be reflected in the computation of diluted EPS because to do so would be antidilutive. At the July 23 and November 18-19, 1998 meetings, an FASB staff representative made an announcement (Topic No. D-72, "Effects of Contracts That May Be Settled in Stock or Cash on the Computation of Diluted Earnings per Share ") that for those contracts that provide the company with a choice of settlement methods, the company shall assume that the contract will be settled in shares. That presumption may be overcome if past experience or a stated policy provides a reasonable basis to believe that it is probable that the contract will be paid partially or wholly in cash. For contracts in which the counterparty controls the means of settlement, past experience or a stated policy is not determinative. Accordingly, in those situations, the more dilutive of cash or share settlement should be used. At the July 23-24, 1997 meeting, the Task Force addressed the accounting for contingent consideration issued to effect a purchase business combination in Issue No. 97-8. "Accounting for Contingent Consideration Issued in a Purchase Business Combination ." The Task force observed that Issue 96-13 should be applied to freestanding contracts that are indexed to, and potentially settled in, a company's own stock if those instruments meet the criteria in Issue 97-8 for recording as part of the cost of the business acquired in a purchase business combination. A related issue has been discussed in Issue No. 98-12, "The Application of Issue No. 96-13 to Forward Equity Sales Transactions ." That Issue deals with the accounting and earnings per share treatment of situations in which a freestanding derivative instrument (a forward contract) that is indexed to, and potentially settled in, a company's own stock is issued concurrent with the issuance of shares of the company's stock. This Issue is limited to situations in which the party to whom the common stock was sold is also the counterparty to the forward contract. Another related issue has been discussed in Issue No. 99-1, "Accounting for Debt Convertible into the Stock of a Consolidated Subsidiary ." That Issue deals with the accounting in the consolidated financial statements for debt issued by a consolidated subsidiary or a parent company that is convertible into the stock of a consolidated subsidiary. As part of the discussion of Issue 99-1, Task Force members agreed to consider further whether to clarify this Issue by indicating that equity shares of any entity under the control of the consolidated entity are considered "a company's own stock." A related issue was discussed at the May 19-20, 1999 meeting in Issue No. 99-3, "Application of Issue No. 96-13 to Derivative Instruments with Multiple Settlement Alternatives ." That Issue deals with how certain derivative contracts indexed to, and potentially settled in, a company's own stock that contain multiple settlement alternatives should be accounted for. The Task Force discussed another related issue in Issue No. 99-7, "Accounting for an Accelerated Share Repurchase Program ." That Issue addressed the accounting for, and pooling-of-interests implications of, purchasing treasury stock and simultaneously entering into a forward contract indexed to the company's own shares. At the March 16, 2000 meeting, the Task Force discussed a related issue in Issue No. 00-6, "Accounting for Freestanding Derivative Financial Instruments Indexed to, and Potentially Settled in, the Stock of a Consolidated Subsidiary ." That Issue addresses how freestanding derivative instruments entered into by a parent company that are indexed to, and potentially settled in, the stock of a consolidated subsidiary should be classified and measured in the consolidated financial statements. Another related issue was discussed at the March 16, 2000 meeting in Issue No. 00-7, "Application of Issue No. 96-13 to Equity Derivative Instruments That Contain Certain Provisions That Require Net Cash Settlement If Certain Events outside the Control of the Issuer Occur ." That Issue deals with how certain derivative contracts indexed to, and potentially settled in, a company's own stock that require a cash payment by the issuer upon the occurrence of future events outside the control of the issuer should be accounted for. No further EITF discussion is planned.
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