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Guidance Addresses Warrants and Embedded Conversion Features

The SEC's Division of Corporation Finance, in an update to its guidance on current accounting and disclosure issues, has added information on the classification and measurement of warrants and embedded conversion features. The staff notes that EITF 00-19 provides explicit guidance on the classification and measurement of warrants and instruments with embedded conversion features. Before considering the requirements of EITF 00-19, the staff advises registrants that issue warrants, convertible preferred shares or convertible debt to first determine whether the instruments fall within the scope of FASB Statement 150. If the instruments are excluded from its scope, registrants must determine whether the instruments are within the scope of FASB Statement No. 133. This issue has been the subject to staff reviews in recent months, according to the guidance.

Warrants, as free standing instruments, should be analyzed to determine whether they meet the definition of a derivative under SFAS 133, according to the staff, and, if so, whether they meet the scope exception outlined in paragraph 11. If the warrant does not meet the definition of a derivative, it must be evaluated under EITF 00-19 to determine whether it should be accounted for as a liability or as an equity instrument. The staff urges registrants to appropriately analyze all warrant and registration rights agreements in determining the appropriate classification and accounting for their warrants.

The staff describes the two most common reasons for warrants to be accounted for as liabilities. One is where they are required to be settled for cash if certain events occur, such as the delisting from the registrant's primary stock exchange or where the registration statement covering the shares underlying the warrants is not declared effective by a certain date. The second is where the warrants contain registration rights in which significant liquidated damages could be required to be paid to the holder of the instrument if the issuer fails to register the shares under a preset time frame, or where the registration statement fails to remain effective for a preset period.

The staff noted that the liquidated damages are usually expressed as a percentage of the amount invested by the holder and may be subject to a cap. The issuer of the warrants must determine under EITF 00-19 whether the liquidated damages are meant to compensate the holder for the difference between a registered share and an unregistered share. The EITF is currently deliberating the effect of certain issues relating to free-standing warrants, according to the guidance, and registrants should monitor its progress. The staff also pointed out that, in analyzing instruments under EITF 00-19, the probability of an event occurring is not a factor.

The embedded conversion feature within convertible debt and convertible preferred shares must be assessed to determine whether it should be bifurcated from the host instrument and accounted for as a derivative at fair value with changes in fair value recorded in earnings. Embedded conversion features that meet the criteria for bifurcation under SFAS 133 may qualify for a scope exception. To determine whether the conversion feature meets the scope exception, the registrant must determine whether it would be classified within shareholders' equity. The analysis under EITF 00-19 must determine whether the host contract is a conventional convertible instrument. If it is, the embedded conversion option would qualify for the equity classification under EITF 00-19 and for the scope exception in SFAS 133. It would not be bifurcated from the host instrument.

If the instrument does not qualify as a conventional convertible instrument, it must be analyzed to determine if the conversion feature should be accounted for as a liability or an equity. If the feature is classified as a liability under EITF 00-19, it would not qualify for the SFAS 133 scope exception, so would be accounted for as a derivative at fair value, with changes in fair value recorded in earnings. If the feature is classified as equity and meets the other criterion in the SFAS 133 scope exception, the embedded conversion option is not bifurcated from the host instrument. The guidance advises registrants to assess whether the convertible preferred stock instrument should be classified in permanent or in temporary equity and whether there is a beneficial conversion feature for which to account.

One of the most common causes of improper accounting for the conversion feature arises when the number of shares issuable upon conversion is variable and there is no cap on the number of shares that can be issued. The other cause is when the agreements contain registration rights where significant liquidated damages could be required to be paid to the holder of the instrument if the issuer fails to register the shares issuable upon conversion under a preset time frame or where the registration statement fails to remain effective for a preset time period.

In the first instance, since there is no limit on the number of shares to be delivered upon the exercise of the conversion feature, the registrant is not able to assert that it will have enough authorized and unissued shares to settle the conversion option. In that case, the conversion feature would be accounted for as a derivative liability with changes in fair value recorded in earnings each period. A variable share-settled instrument that results in a liability classification may impact the classification of previously issued instruments as well as instruments issued in the future, according to the staff.

The guidance advises registrants to make sure that they have appropriately analyzed all of the terms contained in their convertible preferred share and debt agreements, including any registration rights associated with the agreements and to properly account for these instruments under all of the applicable accounting literature.