After months of debate over an update to accounting rules covering securities including down-round options, a close vote by the Financial Accounting Standards Board (FASB) finalized proposed changes designed to ease complexities involved in accounting for such instruments.
Financial instruments that include an option to convert those instruments to other securities frequently include down-round provisions, a tool to reduce the strike price for converting those instruments during periods of decline in market value of the underlying securities. For that reason, the exercise of a down-round option provides a useful hedge for venture and angel investors, since it can help offset investment losses in future funding cycles. Under current GAAP rules, companies cannot index down-round options to their stock price, meaning that they are generally classified as a liability (regardless of whether investors actually exercise them), with changes in the liability recorded in earnings.
The proposed amendment, Distinguishing Liabilities From Equity (Topic 480), sought to ease the accounting burden by letting companies essentially disregard down-round options for financial statement purposes unless they were actually exercised. Under that scenario, the company would then need to determine if the down-round option should be classified as equity (in which case all exercised options would be shown as a dividend) or as a liability (in which case all exercised options would be recognized as a charge to earnings). After mixed public comments on the proposed amendment issued last December, and subsequent debate among FASB members as to whether the changes would actually simplify matters for accounting leaders in smaller firms, the board voted 4-3 to finalize the amendments.
The updated rules will be added to GAAP later this year. For public companies, the new rules become effective for fiscal years beginning on or after December 15, 2018 (including interim periods). All other entities must begin following the new rules for annual report period starting on or after December 15, 2019. Early adoption is permitted.
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June 6, 2017