A guide for equity-linked financial instruments
On the Radar: Contracts on an entity’s own equity
Contracts on an entity’s own equity and the related accounting guidance are complex and filled with nuanced rules and exceptions. This issue of On the Radar is intended to help you navigate the accounting guidance provided in ASC 815-40 and overcome the complexity surrounding equity-linked financial instruments.
Understanding contracts on an entityʼs own equity
Entities raising capital must apply the highly complex, rules-based guidance in US GAAP to determine whether (1) freestanding contracts such as warrants, options, and forwards to sell equity shares are classified as liabilities or equity instruments and (2) convertible instruments contain embedded equity features that require separate accounting as derivative liabilities. To reach the proper accounting conclusion, they must consider the following key questions:
All entities are capitalized with debt or equity. The nature and mix of debt and equity securities that comprise an entity’s capital structure, and an entity’s decision about the type of security to issue when raising capital, may depend on the stage of the entity’s life cycle, the cost of capital, the need to comply with regulatory capital requirements or debt covenants (e.g., capital or leverage ratios), and the financial reporting implications. For example, early-stage and smaller-growth companies are often financed with preferred stock and warrants with complex and unusual features, whereas larger, more mature entities often have a mix of debt and equity securities with more plain-vanilla common stock capitalization.
Ashley Carpenter
