Down-Round Options: A Divided FASB Approves Updated Guidance

In a 4 to 3 vote, the Financial Accounting Standards Board (FASB) agreed to finalize an update to U.S. Generally Accepted Accounting Principles (GAAP) that’s intended to simplify the accounting requirements for companies that issue warrants with embedded down-round options. These options are often used to protect early-stage investors in private companies from investment losses during later rounds of funding.

The long and winding road

A project to update the guidance for down-round options — which was supposed to be a relatively straightforward solution — has been a difficult task for the FASB. Over the last year, there have been several back-and-forth discussions between FASB members about whether the planned fix would help financial professionals or the start-up businesses that typically use the options.

Down-round options lower the exercise price for a stock option or other type of equity instrument if the company’s value declines. Current GAAP prohibits certain instruments with down-round features from being indexed to a company’s own stock, which means they must be classified as a liability (and not equity) under Subtopic 815-40, Derivatives and Hedging — Contracts in Entity’s Own Equity. Critics have said the presence of a down-round feature shouldn’t automatically require instruments to be classified as liabilities.

The planned update stems from the December 2016 Proposed Accounting Standards Update (ASU) No. 2016-370, Distinguishing Liabilities from Equity (Topic 480). The proposed amendments would let businesses ignore the existence of a down-round feature when determining whether an instrument should be classified as a liability or equity, but it would require recognition of the feature once it’s triggered.

Consensus on the proposal was tough to find, however. The comments submitted in response to the proposal were mixed. Some financial professionals wanted the FASB to consider more extensive improvements to the liability and equity guidance. So, they asked the FASB not to add another rule to the already complex guidance. Others, including the FASB’s Private Company Council (PCC), questioned whether the proposed change would truly simplify accounting.

A divided board

At its May 10 meeting, the FASB voted to finalize the updated guidance for down-round options. The updated standard will let businesses ignore the existence of a down-round feature in a financial instrument when deciding whether to classify the instrument as a liability or equity. If the protection feature gets triggered, the effect wouldn’t have to be recorded on the balance sheet or income statement; rather, it would be reported in earnings per share.

The change would apply to freestanding warrants and to businesses that are within the scope of FASB ASC 260, Earnings Per Share. It also would apply to businesses that aren’t required to report earnings per share but voluntarily choose to do so.

Three FASB members voted against the final amendment. FASB member Christine Botosan agreed that the accounting for down-round options needed to be simplified, but she didn’t think the amendments simplified the rules. In her view, by letting companies ignore the effects of a down-round trigger, the FASB was letting them ignore economic events.

Before Botosan joined the FASB in July 2016, she was an accounting professor at David Eccles School of Business at the University of Utah. “I’m frankly really glad I don’t have to teach this to anyone because I don’t know how I’d explain this,” she said.

FASB member Lawrence Smith, who voted for the final amendment, countered that the current accounting was equally hard to explain. The existing standard requires businesses to record a counterintuitive gain when their stock price declines in value — and an equally counterintuitive loss when the value of their shares rises.

“When the stock market is going up, and these things are recorded under current GAAP as liabilities, and you have a charge to earnings to reflect that change, how do you explain that?” Smith said. He favors the planned update not for conceptual reasons, but for “practicalities.”

Coming soon

The FASB plans to publish the update in the third quarter of 2017. It’s tentatively expected to go into effect for public companies for fiscal years beginning after December 15, 2018, including quarterly periods within that fiscal year. Other organizations must follow it for annual reports after December 15, 2019, and quarterly periods after December 15, 2020. The FASB also plans to allow early adoption.

© 2017