Companies often finance operations with securities that have characteristics of both debt and equity. PwC’s Jonathan Rhine discusses three frequently encountered pieces of guidance, in the order they’re often considered: 1) Liabilities valued through earnings, 2) Embedded derivatives and 3) Mezzanine classified instruments. The accounting outcome can vary significantly based on the type of instrument issued and the literature that's applicable.
This video is part of The quarter close publication and video perspectives series.
Hi, I’m Jonathan Rhine.
Companies often finance operations with securities that have characteristics of both debt and equity. These securities, such as convertible debt or puttable preferred stock, are often referred to as equity-linked instruments. Equity-linked instruments can be an attractive form of financing for both investors and issuers. Investors often obtain a minimum guaranteed return, or a more senior security, and also benefit if the issuer’s stock appreciates. Issuer’s on the other hand obtain needed financing, and benefit from a lower cash coupon or dividend.
How might a company account for these various instruments? From a balance sheet perspective, equity-linked instruments can be classified as debt, equity, or mezzanine equity. Companies can also be required to separate embedded derivatives and classify each component appropriately. Additionally, while some instruments, are carried at amortized cost, others, are measured at fair value. Changes in instruments measured at fair value need to be reflected in either earnings or other comprehensive income, depending on the instrument.
Given the variety of possible outcomes, it’s helpful to think about the analysis of these instruments in the form of a decision-tree, as the literature is generally considered in specific sequence. Let’s discuss at a high-level three frequently encountered pieces of guidance, in the order they’re often considered.
1) Liabilities valued through earnings,
2) Embedded derivatives and
3) Mezzanine classified instruments.
Let’s start with certain equity-linked instruments classified as liabilities. In practice we see mandatorily redeemable shares often meeting this guidance, as the issuer has an unavoidable obligation to redeem them for cash. Also often included, are warrants for puttable shares. Unlike traditional debt that's often carried at amortized cost, equity-linked instruments that are classified as liabilities are generally measured at fair value and the changes in fair value are reflected in earnings.
If an instrument is not a liability carried at fair value, an issuer would evaluate whether any features embedded in the instrument must be separately accounted for as a derivative. Common features that need to be considered include put and call options, conversion options, and certain features that modify the interest rate. Generally speaking, separation is required when a derivative feature introduces economics that are considered different from the host contract, for example, an equity return embedded in a debt instrument. In such situations we would say the embedded feature is not clearly and closely related to the host contract. If separation of a derivative is required, also known as bifurcation, then a portion of the total proceeds would be allocated to the embedded derivative, and it would be marked to market through earnings. The host instrument would continue to be accounted for in accordance with other literature. It’s worth noting that if the host is a debt instrument, then for accounting purposes that debt would be considered issued at a discount, which would generate additional interest expense.
Once a company determines that the instrument, such as preferred stock, is not a liability, it must assess whether it should be classified as permanent equity or mezzanine equity. Mezzanine classification would be appropriate when a company issues an equity security that it might have to settle for cash at the option of the holder, but cash settlement is not certain. Examples include common shares that are contingently puttable upon a change of control, a violation of covenants, or in the event the Company fails to sell a division by a certain date.
As you can see from these highlights, analyzing and accounting for equity-linked instruments can be complex. The accounting outcome can vary significantly based on the type of instrument issued and the literature that's applicable. It’s important to emphasize that the direct financial statement impact is only one part of the outcome - the accounting conclusion can also impact key ratios, covenants, and business operations. That makes this topic particularly important to both issuers and users of financial statements.
To learn more about this topic, see chapters 7 and 8 of our financing guide available at CFOdirect.com.