New guidance brings consistency to accounting for hybrid financial instruments and embedded derivatives; entities to reassess all outstanding hybrid equity instruments upon adoption.
In November 2014, the FASB issued ASU 2014-16 Derivatives and Hedging – Determining Whether the Host Contract in a Hybrid Financial Instrument Issued in the Form of a Share Is More Akin to Debt or to Equity. The new guidance addresses the significant diversity in practice in the assessment of preferred stock and other hybrid equity instruments. The widely used “chameleon approach” has been eliminated and entities must reassess all outstanding hybrid equity instruments upon adoption.
HYBRID INSTRUMENTS AND THE NATURE OF THE HOST
Preferred stock often contains conversion options, redemption features or other terms that provide special rights and privileges to the issuer or investor. Any such terms that affect the amount or timing of cash flows or the value exchanged is an embedded derivative that may require bifurcation and separate accounting from the preferred shares. The preferred share is the host contract and, when combined with one or more embedded derivatives, becomes a hybrid instrument.
Issuers and investors must analyze preferred stock and other hybrid instruments to determine if the embedded features require bifurcation and separate accounting as a derivative under ASC 815. A critical step in this process is assessing whether the economic characteristics and risks of the embedded features are “clearly and closely related” to the economic characteristics and risks of the host contract. Importantly, embedded features with economic characteristics and risks that are clearly and closely related to the host contract do not require bifurcation and separate accounting.
There are two types of host contracts for preferred stock: debt and equity. Regardless of the legal form of the preferred stock, the nature of the shares may be considered to be more debt-like or equity-like for accounting purposes, based on the specific terms and features.
Debt-like Features: Cumulative fixed-rate dividends, fixed-rate redemption option, covenants similar to debt agreements.
Equity-like Features: Participating dividends, voting rights.
An embedded feature that is clearly and closely related to the host instrument does not require bifurcation. A simple example is a conversion feature which allows the investor to convert the preferred stock to common stock. This feature is equity-like as it gives the investor exposure to the underlying changes in the equity of the company. This option would not be bifurcated from equity-like preferred stock, but may be bifurcated from debt-like preferred stock.
ELIMINATION OF THE CHAMELEON APPROACH
Two approaches have evolved in practice to determine the nature of the host:
1. The chameleon approach
2. The whole-instrument approach
To understand the two approaches, consider preferred stock with a conversion option and a redemption or put option. Under the chameleon approach, all terms and features of the hybrid instrument are considered except the feature that is being evaluated. So when the conversion option is evaluated, the host contract would be preferred stock with a redemption option; conversely, when the put option is evaluated, the host contract would be preferred stock with a conversion option. This may result in a host contract that is debt-like for purposes of evaluating the conversion option and equity like for purposes of evaluating the put option. The nature of the host may change like a chameleon.
Also true to its name, under the whole-instrument approach all terms and features of the hybrid instrument are considered including the feature that is being evaluated. In the previous example, the conversion option and put option would both be considered when analyzing the conversion option and put option, along with the various dividend, voting and other rights and privileges. The nature of the host is evaluated once and is consistent for the analysis of each embedded feature.
With ASU 2014-16, the FASB has eliminated the chameleon approach and mandated the use of the whole-instrument approach. Further, the FASB provided clarifying guidance to aid in the qualitative analysis under the whole-instrument approach, including the relative importance of certain features, such as a fixed-price redemption feature and conversion option.
WHAT TO DO NOW?
The guidance will be effective for public entities for fiscal years beginning after December 15, 2015 (and interim periods within those years). The guidance will be effective for non-public entities for fiscal years beginning after December 15, 2015 and interim periods within fiscal years beginning after December 15, 2016. Upon adoption, entities will be required to reassess all outstanding hybrid equity instruments using the new rules and guidelines. Features that were not previously bifurcated may now require bifurcation and vice versa.
For new issuances of equity instruments prior to adoption, investors and issuers of such instruments will want to ensure consistency with the new rules. Although the new guidance will go a long way towards consistency in practice, the analysis will remain highly subjective. A thorough understanding of the economics of the transaction, the potential outcomes of the instrument and a thoughtful weighting of the various terms of the instrument will be required.