SEC Observations at 2010 AICPA Conference (Equity-Linked Instruments — Debt vs. Equity Classification; Inadequacies of Black-Scholes Model)

At the AICPA National Conference held in December 2010, invited members of the SEC and PCAOB presented their views on current developments in the Division of Corporate Finance.

In its remarks, the SEC discussed issues that its staff has encountered related to equity-linked instruments:

• The SEC cited a failure by registrants to appropriately apply the guidance on distinguishing equity from liabilities (as outlined in Accounting Standards Codification Topic 815-40, Derivatives and Hedging – Contracts in Entity’s Own Equity [“ASC 815-40”]) – in particular when evaluating whether an instrument (or an embedded feature) is considered indexed to an entity’s own stock. The guidance in ASC 815-40 requires a company to evaluate the contingent exercise provisions (if any) and then determine the related settlement amount.
• Two examples of instruments for which the SEC has raised issues were cited: (i) stock purchase warrants and (ii) debt instruments with embedded conversion options.
• One of the common problems that the SEC staff has seen in these instruments relates to “down-round” protection provisions that specify that the strike or conversion price would be adjusted downward if a company subsequently issues stock at a lower price than the strike price or conversion price due to declining market prices. Such a provision often makes an instrument “not indexed to an entity’s own stock” – resulting in a conclusion that the instrument or feature be presented as a derivative liability at fair value.

• It was also noted that some registrants have not properly considered the guidance in ASC 815-40 when valuing equity-linked instruments with variable inputs (e.g., where certain aspects like exercise price or number of shares are subject to change). The SEC indicated that such instruments are often erroneously valued utilizing the Black-Scholes option pricing model. The Black-Scholes model relies on fixed inputs involving assumptions like term, price, and volatility to develop a fair value estimates. Companies attempting to estimate the fair value of an instrument with variable inputs should use a model that has the ability to address variability in assumptions, such as lattice models or Monte Carlo simulations.
• Finally, the SEC stressed the need for improved disclosures about provisions of an instrument that may trigger an adjustment to the exercise price or the number of shares (like down-round provisions as referenced above). It was noted that the SEC may challenge generic disclosures like “the instrument contains standard anti-dilution provisions.”
• Click here for a copy of the slides from the 2010 AICPA National Conference. Please see pages 70 to 77 for details related to the issues highlighted above.