As part of their capital structure, companies may use both debt and equity financing to fund the purchase of a business or assets or for ongoing operations. Properly accounting for these types of financial instruments requires a careful read and understanding of the complex terms and conditions contained within lengthy legal agreements as well as an in-depth understanding of the relevant generally accepted accounting principles under U.S. GAAP. Even small nuances in the legal language may have a substantial impact on the accounting assessment for debt and equity financings.

As a result, auditors typically engage their subject matter experts to closely review the legal agreements and accounting evaluations for debt and equity financings due to the complexity and risk of material misstatement if accounted for incorrectly.

Companies that engage a third-party service provider that has subject matter experts to help evaluate the accounting for debt and equity financings generally have higher success in correctly evaluating the accounting for these financial instruments in accordance with U.S. GAAP.

What are the major accounting considerations when evaluating complex debt and equity financial instruments?

• Whether there are multiple freestanding financial instruments that should be accounted for separately
• Whether financial instruments should be accounted for as liabilities at fair value or whether the fair value election is allowed
• How consideration should be allocated to multiple freestanding financial instruments
• Whether there are embedded derivatives that require bifurcation and separate accounting at fair value on a recurring basis
• Whether the financial instruments or embedded derivatives receive a scope exception in order to record to equity (i.e., indexed to equity and equity classification)
• Whether the equity financing should be presented as temporary (or mezzanine) equity on the balance sheet, if applicable for SEC reporting requirements
• How equity financings and convertible debt should be treated in earnings per share calculations
• Inclusion of the appropriate financial instrument and fair value measurement financial statement disclosures
• Complex valuation methodologies and judgmental assumptions used to fair value financial instruments or embedded derivatives, if required

Key Considerations for Common Debt or Equity Financing

Convertible debt: A loan that can be converted into equity at the lenders' options upon a specified future event.

• Key accounting considerations: Are there embedded features that should be bifurcated and accounted for separately? 
• Potential valuation required? Yes, valuation is required at issuance and each reporting period if the embedded derivative meets certain criteria. A bond plus call option model combined with other considerations is generally required to calculate the fair value of the convertible debt and embedded derivatives.

Warrants to purchase common or preferred stock: An instrument that gives investors a right to buy a certain underlying security at a specified rate in the future.

• Key accounting considerations: Should the warrant be accounted for as a liability or equity?
• Potential valuation required? Warrants issued with another freestanding financial instrument will need to be fair valued in order to separate the warrants from the other freestanding financial instrument. Warrants are typically valued utilizing an option pricing model. Additionally, liability-classified warrants should be valued at issuance and each reporting period.

Preferred stock: A type of share capital that may have any combination of features not possessed by common stock, including attributes of both an equity and a debt instrument. Generally, preferred stock has a prior claim whenever a company pays dividends or distributes assets to shareholders.

• Key accounting considerations: Is the preferred stock a debt or equity host? Are there embedded features that should be bifurcated and accounted for separately? If equity, should the preferred stock be classified in permanent or mezzanine equity?
• Potential valuation required? As preferred stock can have debt and/or equity characteristics, there could be several methodologies (i.e. discounted cash flow analysis, option pricing model, binomial model, etc.) that are appropriate when determining the fair value.

Valuation for Debt and Equity Instruments

As the features related to debt and equity financings can be unique and complex, the accounting determination and valuation methodology should be determined in parallel to evaluate the debt and equity financings appropriately. Generally, the necessary valuations are not intuitive, and determining the key accounting considerations renders the required valuations and methodology clearer, as there are a variety of acceptable models for different cases.

Third-party Assistance

Since complex debt and equity instruments often defy easy categorization and require a deep understanding of their underlying structures, U.S. GAAP and valuations of such complex instruments, reputable third parties can help ensure accuracy and compliance with accounting standards and regulatory requirements. Moreover, an independent assessment of the fair value of these complex instruments provides investors, regulators, and stakeholders with greater confidence in financial reporting and decision making.

This article was originally published in Accounting Today.