The accounting guidance for instruments with characteristics of both debt and equity can be a complex area of U.S. GAAP. There are three main areas of the Accounting Standards Codification (ASC) that serve as a road map to accounting for instruments with characteristics of both debt and equity, ASC Topic 470, Debt, ASC Topic 480, Distinguishing Liabilities from Equity and ASC Topic 815, Derivatives and Hedging. A missed step early in the evaluation process could result in an incorrect accounting conclusion. Reporting entities often have difficulty applying guidance for two types of instruments in particular, freestanding warrants and conversion options embedded in debt instruments. Understanding common accounting mistakes related to these instruments as well as the accounting guidance to which the instruments may be subject can assist with navigating through complex debt and equity transactions.

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A publication of the Professional Standards Group
May 2017
How to Navigate Complex Debt and Equity Transactions
The accounting guidance for instruments with
characteristics of both debt and equity can be a
complex area of U.S. GAAP. There are three main
areas of the Accounting Standards Codification
(ASC) that serve as a road map to accounting
for instruments with characteristics of both debt
and equity, ASC Topic 470, Debt, ASC Topic 480,
Distinguishing Liabilities from Equity and ASC Topic
815, Derivatives and Hedging. A missed step early
in the evaluation process could result in an incorrect
accounting conclusion.
Reporting entities often have difficulty applying
guidance for two types of instruments in particular,
freestanding warrants and conversion options
embedded in debt instruments. Understanding
common accounting mistakes related to these
instruments as well as the accounting guidance to
which the instruments may be subject can assist
with navigating through complex debt and equity
transactions.
Common Application Errors with
Distinguishing Liabilities from Equity
A significant evaluation in the accounting for
freestanding warrants and conversion options
embedded in debt instruments is the misapplication of
certain sections within ASC Topic 480 and ASC Topic
815. Mistakes tend to arise when reporting entities
incorrectly answer one of the following five questions:
Is the instrument freestanding?
If a reporting incorrectly concludes the instrument
is not a freestanding instrument, the reporting entity
would then not consider additional provisions in
ASC Topic 480, which provides situations in which a
warrant would be classified as a liability.
Istheinstrumentindexedtoanobligationtorepurchase
the issuer’s equity shares?
Such redemption features in question are typically
not found in a warrant agreement but an operating
agreement where the terms and the rights of the
underlying shares are defined. As a result, reporting
entities may overlook the correct answer to the
question.
Is the embedded instrument clearly and closely
related to the host contract?
This question is frequently applied incorrectly when
the debt instrument is convertible into redeemable
preferred stock or similar instruments that have a
cash conversion feature.
Does the embedded conversion option meet the
definition of a derivative?
For an embedded conversion option to be classified
as a liability under ASC Topic 815, the underlying
shares generally must be readily convertible to cash.
Nonpublic entities in particular often overlook this
detail.

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Does the instrument meet the additional conditions
required for equity classification?
Freestanding warrants must consider the guidance in
ASC Topic 480 and ASC Topic 815. In order to remain
classified as equity instruments, such instruments
must meet seven additional criteria. Reporting
entities frequently forgo the criteria evaluation on the
assumption that they are scoped out of ASC Topic
815.
A More Detailed Look at Freestanding
Warrant Instruments
An instrument is considered a freestanding warrant
instrument if:
• It is entered into separately and apart from any of
the entity’s other financial instruments or equity
transactions; or
• It is entered into in conjunction with some
other transaction and is legally detachable and
separately exercisable.
Entities that ascertain they have a freestanding
warrant then begin with an analysis of whether the
instrument is subject to ASC Topic 480. Embedded
financial instruments, such as conversion options
embedded in debt instruments are not subject to the
Distinguishing Liabilities from Equity guidance. If a
freestanding warrant is provided in conjunction with a
debt instrument, then it is subject to ASC Topic 480.
Freestanding warrants subject to ASC Topic 480 will
be accounted for as liabilities if the warrants have the
following characteristics:
• It is a mandatory redeemable financial instrument
(excluding those triggered upon the reporting
entity’s liquidation or termination);
• It has a conditional obligation to redeem the
instrument when the condition or event occurs, is
resolved or is certain to occur;
• It has the following two characteristics at
inception:
◦◦ Embodies an obligation to repurchase the
issuer’s equity shares or is indexed to such
an obligation; and
◦◦ Requires or may require the issuer to settle
the obligation by transferring assets
• It has an unconditional or conditional obligation to
be settled by issuing a variable number of equity
shares if the fixed monetary amount is known at
inception, variations are indexed to something
other than the fair value of equity shares (such
as S&P 500) or variations are inversely related to
the changes in the fair value of the issuer’s equity.
Accounting for Freestanding Warrants When ASC
Topic 480 Does Not Apply
If an instrument is not classified a liability in accordance
with ASC Topic 480, the reporting entity then evaluates
whether the freestanding warrants meet the definition
of a derivative under the guidance in ASC Topic 815.
A derivative instrument is a financial instrument with
an underlying, a notional amount, payment provisions,
and an initial net investment and can be settled net. If
the reporting entity determines that the freestanding
warrants meet the definition of a derivative, then the
reporting entity should evaluate whether the equity-
linked financial instrument is considered indexed to
its stock (i.e. indexed to, and settled in its own stock).
As noted earlier, entities need to carefully consider
whether their freestanding warrant instruments are
within the scope of ASC Topic 815. Even if a reporting
entity determines that the instrument is indexed to the

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entity’s own stock, they are still required to consider
the seven criteria in ASC Topic 815-40-25-10 to
qualify for equity classification:
1. Settlement permitted in unregistered shares;
2. Entity has sufficient authorized and unissued
shares;
3. Contract contains an explicit share limit;
4. No required cash payment if entity fails to
timely file;
5. No cash-settled top off or make whole
provisions;
6. No counterparty rights rank higher than
shareholder rights; and
7. No collateral required.
A More Detailed Look at Convertible Debt
Options
The first step in accounting for embedded conversion
options within a debt instrument is to determine
whether the instrument should be separately
accounted for as a derivative under the guidance in
ASC Topic 815. An embedded derivative should be
separated from the host contract and accounted for
as a derivative instrument if and only if the following
criteria are met:
1. The economic characteristics and risks of
the embedded derivative (the conversion
feature) are not clearly and closely related to
the economic characteristics and risks of the
host contract (debt agreement without the
conversion feature).
2. The hybrid instrument (the combination of the
host contract/agreement with the conversion
feature) is not remeasured at fair value under
otherwise applicable U.S. generally accepted
accounting principles (GAAP), with changes
in fair value reported in earnings as they
occur.
3. A separate instrument with the same terms as
the embedded derivative would, pursuant to
Section 815-10-15, be a derivative instrument
subject to the requirements of this Subtopic.
(The initial net investment for the hybrid
instrument shall not be considered to be
the initial net investment for the embedded
derivative.)
The nature of the host instrument and the conversion
feature should then be evaluated to determine if they
are more akin to debt or equity. They are not clearly
and closely related if the host instrument is more akin
to debt and conversion feature is more akin to equity,
and vice versa.
Generally, the shares underlying the conversion
feature must be readily convertible to cash for the
embedded conversion option to be considered a
derivative. There is a scope exception: If the contract
issued or held by the reporting entity is both indexed
to the reporting entity’s own stock and classified in
stockholder’s equity in its statement of financial
position.
Cash Conversion Feature
Reporting entities must then determine whether the
conversion option qualifies as a cash conversion
feature under ASC Topic 470. A cash conversion
feature is one that allows the investor to convert
the debt instrument into cash rather than shares at
the fair value of the shares, rather than the principal
amount of the debt. If a cash conversion option exists
(in whole or part), entities will separate the instrument
into a debt component (measured at fair value) and an
equity component (difference between the proceeds
and the fair value debt component).

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The information in this MHM Messenger is a brief summary and may not include all the details relevant to your situation. Please
contact your MHM auditor to further discuss the impact on your audit or audit report.
Accounting for Debt Conversion Features When ASC
Topic 815 Does Not Apply
If the reporting entity determines that the instrument
does not qualify for accounting as a derivative
instrument ASC Topic 815, it then determines whether
the conversion option qualifies as a beneficial
conversion feature under ASC Topic 470. A beneficial
conversion feature is a nondetachable conversion
feature that is in the money at the commitment date.
Beneficial conversion features should be recognized
separately by allocating a portion of proceeds equal
to the intrinsic value of the feature to additional paid-in
capital. The effective conversion price should be used
to compute the intrinsic value. A beneficial conversion
feature’s effective conversion price is based on the
proceeds received for or allocated to the convertible
instrument. Intrinsic value determination follows a
three step process:
1. Allocate the proceeds received to the
convertible instrument and any other
detachable instruments included in the
exchange on a relative fair value basis,
2. Apply the guidance in paragraph ASC 470-
20-25-4 to the amount allocated to the
convertible instrument, and then
3. Calculate the effective conversion price and
use the effective conversion price to measure
the intrinsic value, if any, of the embedded
conversion option.
Intrinsic value should be calculated at the commitment
date as the difference between the conversion price
and the fair value of the common stock/securities into
which the security is convertible, multiplied by the
number of shares into which the security is convertible.
Seek the Help of a Professional
Accounting for instruments with both debt and equity
can be complex. An accountant experienced with the
reporting requirements under ASC Topics 470, 480
and 815 may be able to help you navigate the correct
accounting path for your instruments.
For specific comments, questions or concerns
about debt and equity transactions, please see our
webinar or contact Christine McAlarney or Mike
Loritz of MHM’s Professional Standards Group.
Christine can be reached at cmcalarney@cbiz.com or
727.572.1400. Mike can be reached at mloritz@cbiz.
com or 816.945.5611.