US GAAP: Liability vs. Equity Classification of Public Warrants Issued by a SPAC

In its initial public offering (IPO), a special purpose acquisition company (SPAC) typically issues units to third-party investors at $10.00 per unit. Each unit generally contains a fraction of a warrant to purchase a Class A common share (commonly referred to as a “Public Warrant” or a “Redeemable Warrant”).

To determine the appropriate classification of the Public Warrants, SPACs must address the following accounting questions:

1.      Does the Public Warrant represent a freestanding financial instrument, and therefore should it be evaluated for liability under FASB ASC 480, Distinguishing Liabilities from Equity (“ASC 480”)?

2.      Should the Public Warrant be classified liability under ASC 480?

3.      Is the Public Warrant required to be accounted for as a derivative (i.e., liability) under FASB ASC Topic 815, Derivatives and Hedging ("ASC 815")? In other words, does the Public Warrant meet the derivative scope exception under ASC 815 (specifically under ASC Subtopic 815-40 (“ASC 815-40”))?

Q1. Does the Public Warrant represent a freestanding financial instrument, and therefore should it be evaluated for liability under ASC 480?

Yes. “Although initially issued as a unit, the Class A Shares and Public Warrants become separately tradable shortly after the IPO. In addition, upon exercise, the Public Warrants do not alter the terms of the Class A Shares previously issued. Therefore, the Public Warrants (1) are legally detachable and separately exercisable from the Class A Shares issued as part of the units and (2) meet the definition of a freestanding financial instrument in ASC 480-10-20.” [source: see below]

Continue to Q2.

Q2. Should the Public Warrant be classified liability under ASC 480?

The evaluation of whether Public Warrants are liabilities under ASC 480 will generally depend on when the warrants become exercisable:

·         The Public Warrants may be exercised before a merger with a target.

Yes, because the Class A common shares received upon exercise of the warrants may be redeemed at the holder’s option upon a merger of the SPAC. The SPAC is obligated to use its best efforts to complete a merger. [ASC 480-10-25-8]

·         The Public Warrants may be exercised only after a merger with a target.

No, because once the warrants are exercisable, the holder will receive Class A common shares that are not redeemable. Note that once a merger with a target is completed, the holders of Class A common shares no longer have any ability to redeem their shares. [ASC 480-10-25-8]

Note: The SPAC should further consider whether the Public Warrants represent an obligation to issue a variable number of equity shares whose monetary value is based solely or predominantly on (1) a fixed amount, (2) variations in something other than the fair value of the Class A common shares, or (3) variations that are inversely related to the fair value of the Class A common shares, which would represent liabilities. [ASC 480-10-25-14] However, in practice, this would be unusual.

Continue to Q3.

Q3. Does the Public Warrant meet the derivative scope exception under ASC 815-40?

Public Warrants generally meet the definition of a derivative under ASC 815. However, SPACs should evaluate whether such warrants meet the derivative scope exception under ASC 815-40.

To meet the derivative scope exception, and therefore to be classified as equity under ASC 815-40, the Public Warrants must meet the following two requirements:

• They are indexed to the SPAC’s stock. [“Indexation” requirement]; AND

• They meet the criteria for equity classification (i.e., the SPAC controls the ability to settle the warrants in shares). [“Equity Classification” requirement]

The devil is in the details! Public Warrants typically contain multiple features (e.g., settlement provisions) that must be evaluated individually by SPACs. If any one of the features prevents the Public Warrants from meeting both Indexation and Equity Classification requirements, they may not be classified in equity and must be classified as derivative liabilities. The guidance in ASC 815-40 is complex to apply. Therefore, consultation with an entity’s accounting advisers is encouraged.

 

Source: Financial Reporting Alert 20-6, Accounting and SEC Reporting Considerations for SPAC Transactions (October 2, 2020; Last Updated March 25, 2021)

New hedging standard - Nonfinancial Hedges

For cash flow hedges of nonfinancial items, an entity may designate the variability in cash flows attributable to changes in a contractually specified component as the hedged risk. This would be good news for manufacturers who buy raw materials and lock in the prices with derivatives.

Current GAAP: Total-Price-Risk Hedge·        Except for foreign exchange risk, an entity is prohibited from designating changes in fair value or cash flows of a component of a nonfinancial item as the hedged risk. For example, if an entity wants to hedge the price risk related to the forecasted purchase or sale of a commodity, it is required to designate changes in the total price of the commodity as the hedged risk.
·        Because derivative instruments are often only available at the component level, the total-price-risk hedge results in hedge ineffectiveness being recorded in current period earnings.
·        Portfolio hedging of commodities on a total-price-risk basis is extremely challenging, particularly for situations in which an entity has suppliers for the same commodity in various locations. Although the contracts are priced based on the same traded commodity, the basis differentials related to the location and/or the grade of the commodity involved (e.g., transportation costs, quality, supply and demand) often create too much variability on a total-price-risk basis to enable an entity to hedge these forecasted purchases on a portfolio basis. As a result, many entities choose not to hedge at all because of the cost and effort of separately hedging each contract from each supplier.
New Standard: Specific Risk Component Hedge·        An entity may designate the variability in cash flows attributable to changes in a contractually specified component as the hedged risk for cash flow hedges of nonfinancial items (e.g., forecasted purchase or sale of a nonfinancial item).
·        This avoids the hedge ineffectiveness that results from basis differentials because the entity could hedge just the portion of the purchase that is linked to a base price or market index (e.g., New York Mercantile Exchange or the London Metals Exchange) for which there is a matching derivative that would create the “perfect hedge.”
·        For portfolio hedging of commodities, an entity would more easily be able to designate the variability in cash flows attributable to changes in a contractually specified component from multiple suppliers as the hedged risk, which would potentially reduce the entity’s costs and more closely align hedge accounting with its risk management activities.
·        An entity is even allowed to apply cash flow hedge accounting to a not-yet-existing contract (that is, beyond the contractual period during which the nonfinancial items are expected to be sold or purchased) as long as the requirements in paragraph 815-20-25-22A will be met in the future contract and all other requirements for cash flow hedge accounting are met.

815-20-25-22AIf the price for the purchase or sale of a nonfinancial asset includes a contractually specified component, the variability in cash flows attributable to changes in that component may be designated as the hedged risk in a cash flow hedge if all of the following are met:
a.      The purchase or sale contract for the nonfinancial asset creates an exposure related to the variability in cash flows attributable to changes in the contractually specified component throughout the life of the hedging relationship.
1.      If the variability in cash flows attributable to changes in the contractually specified component of the hedged forecasted transaction is limited by a cap or floor, an entity may designate a derivative as the hedging instrument that does not have a limited exposure to the contractually specified component risk. However, to make that designation, the entity shall establish that the hedging relationship is expected to be highly effective in achieving offsetting changes in cash flows attributable to changes in the contractually specified component during the period in which the hedging relationship is designated in accordance with paragraph 815-20-25-75.
b.     The stated components of the price of the nonfinancial contract all relate to the cost of purchasing or selling the nonfinancial asset in the normal course of business in a particular market. The following are examples of items that may be individually stated price components or aggregated to form a single stated price component:
1.      Transportation costs
2.      Labor costs
3.      Quality or grade differentials between the hedged component and standard market prices that are quoted in purchases or sales contracts for the nonfinancial asset in the normal course of business
4.      Local supply and demand factors for the purchase or sale of the nonfinancial asset in the normal course of business.
c.      All of the stated components of the price of the nonfinancial contract reflect market conditions at contract inception. For example, labor costs stated in the contract are in line with local markets, and transportation costs reflect market conditions for the distance between the supplier and the customer.

Source:Proposed Accounting Standards Update—Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging ActivitiesFASB in FocusTentative Board Decisions Reached to Date (as of June 7, 2017)Need to Know: The Upcoming Hedging Standard

FASB Issues New Hedging Standard

On August 29, 2017, the FASB issued a final ASU that will improve and simplify accounting rules around hedge accounting. The ASU is effective for public companies in 2019 and private companies in 2020. Early adoption is permitted in any interim period or fiscal years before the effective date of the standard (i.e., as early as in the current quarter, Q3’17).

• The final ASU
• In the News
• FASB in Focus
• Understanding Costs and Benefits
• Heads-up: New hedging standard coming your way

New hedging standard - Benchmark Interest Rates

Under the current guidance [ASC 815], companies are limited to hedging the following benchmark interest rates only:

·         Interest rates on direct Treasury obligations of the U.S. government (the U.S. Treasury Rate)

·         London Interbank Offered Rate (LIBOR) Swap Rate

·         Fed Funds Effective Swap Rate (also referred to as the Overnight Index Swap Rate or OIS)

The new hedging standard will newly allow i) any contractually specified interest rates and ii) Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate to be designated as the hedged interest rate risk.

i) Cash flow hedges of variable-rate financial instruments

·         The concept of benchmark interest rate will be eliminated.

·         An entity may designate any contractually specified interest rate as the hedged risk in cash flow hedges of interest rate risk. For example, a bank could hedge the variability in cash flows of a variable-rate loan based on its own prime rate as long as the rate is contractually specified in the loan.

·         An entity may designate as the hedged risk only the change in cash flows of the contractually specified interest rate index, not an implied rate embedded in the interest rate index. For example, if an entity issues variable-rate debt based on its own prime rate, it cannot designate the change in cash flows of the Fed Funds Target rate or the Wall Street Journal prime rate as the hedged risk.

ii) Fair value hedges of fixed-rate financial instruments

·         The concept and definition of the term benchmark interest rate and list of the current eligible benchmark interest rates (see above) is retained.

·         The SIFMA Municipal Swap Rate is added to the list of permissible benchmark rates, which would allow an entity that issues or invests in fixed-rate tax-exempt financial instruments to designate as the hedged risk changes in fair value attributable to interest rate risk related to the SIFMA Municipal Swap Rate rather than overall changes in fair value.

·         SIFMA is the average rate at which high-credit-quality U.S. municipalities may obtain short-term financing and currently is the predominant rate referenced in issuances of variable-rate municipal bonds. For that reason, the FASB believes that it should be considered a benchmark rate.

·         If an entity modifies a tax-exempt financial instrument’s hedged risk from total price risk to interest rate risk related to the SIFMA Municipal Swap Rate, the modification would be considered a dedesignation and immediate redesignation of the hedging relationship. In this situation, the cumulative basis adjustment of the hedged item from the dedesignated hedging relationship would be amortized to earnings over the remaining life of the hedged item on a level-yield basis.

Heads-up: New hedging standard coming your way

During the third quarter of 2017, the Financial Accounting Standards Board (FASB) is expected to issue a new standard that will improve and simplify hedge accounting. The new standard will take effect for public companies in 2019 and private companies in 2020. Early adoption will be permitted upon issuance. Companies may want to evaluate whether the early adoption is feasible and the benefit of applying the new guidance (even those that do not currently apply hedge accounting).

The new guidance will:

·         Expand hedge accounting for nonfinancial and financial risk components to allow entities to qualify for hedge accounting for more of their risk management activities;

·         Decrease the complexity of preparing and understanding hedge results by eliminating the separate measurement and reporting of hedge ineffectiveness;

·         Enhance transparency, comparability, and understandability of hedge results through enhanced disclosures and changing the presentation of hedge results to align the effects of the hedging instrument and the hedged item; and

·         Reduce the cost and complexity of applying hedge accounting by simplifying the way assessments of hedge effectiveness may be performed.

The new standard will include a number of changes that will impact all areas of hedge accounting, including (but not limited to) financial and nonfinancial hedges, the timing of documentation, effectiveness testing, and presentation and disclosure. Summarized below are some of the key changes:

·         Benchmark Interest Rates

·         Nonfinancial Hedges

·         Recognition and Presentation of Changes in the Fair Value of Hedging Instruments

·         Fair Value Hedges of Interest Rate Risk

·         Shortcut Method and Critical Terms Match (CTM) Method

·         Documentation and Effectiveness Testing

·         Disclosures

·         Transition

ASU 2014-15 Going Concern Assessment

ASU 2014-15 Disclosure of Uncertainties About an Entity’s Ability to Continue as a Going Concern is effective December 31, 2016 for calendar year-end companies.

For 2016 calendar year companies, management is required to apply the new guidance (i.e., ASU 2014-15) related to the assessment of the reporting entity’s ability to continue as a going concern. Management is required to consider events and conditions up to and within one year from the issuance date of the financial statements to determine if conditions exist, or will exist, that give rise to “substantial doubt” about the company’s ability to meet its obligations. If it is determined that substantial doubt exists, certain disclosures are required, regardless of whether such doubt is alleviated by management’s plans.

On August 27, 2014, the FASB issued ASU 2014-15, which provides guidance on determining when and how to disclose going-concern uncertainties in the financial statements. The new standard requires management to perform interim and annual assessments of an entity’s ability to continue as a going concern within one year of the date the financial statements are issued. An entity must provide certain disclosures if “conditions or events raise substantial doubt about [the] entity’s ability to continue as a going concern.” The ASU applies to all entities and is effective for annual periods ending after December 15, 2016, and interim periods thereafter, with early adoption permitted.

Additional information:

Accounting Standards Update No. 2014-15, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern
PwC In depth FASB defines management’s going concern assessment and disclosure responsibilities
EY To the Point - FASB requires management to assess an entity’s ability to continue as a going concern 
BDO FASB Flash Report - September 2014
Deloitte Heads Up — FASB Issues ASU on Going Concern

FASB Issues New Guidance on Accounting for Credit Losses

On June 16, 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update 2016-13, Financial Instruments – Credit Losses (Topic 326) (the “ASU”) that improves financial reporting by requiring timelier recording of credit losses on loans and other financial instruments. The new ASU will impact both financial services and non-financial services entities.

 

Highlights from FASB News Release on 06/16/16

 

 

The ASU requires an organization to measure all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will now use forward-looking information to better inform their credit loss estimates...

 

The ASU requires enhanced disclosures to help investors and other financial statement users better understand significant estimates and judgments used in estimating credit losses, as well as the credit quality and underwriting standards of an organization’s portfolio. These disclosures include qualitative and quantitative requirements that provide additional information about the amounts recorded in the financial statements.

 

Additionally, the ASU amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration.

 

The ASU will be effective for SEC filers in fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. For all other entities, the ASU is effective for fiscal years beginning after December 15, 2020, and interim periods within those fiscal years beginning after December 15, 2021. Early application of the guidance will be permitted for all entities for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years.

 

Additional Information:

• ASU FASB ASU 2016-13—Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments
• FASB In Focus: Accounting Standards Update No. 2016-13, Financial Instruments—Credit Losses (Topic 326)
• FASB Understanding Costs and Benefits: Accounting Standards Update, Credit Losses (Topic 326)
• KPMG Defining Issues: FASB Accelerates Recognition of Credit Losses
• EY To the Point - FASB issues sweeping changes to credit loss guidance
• Deloitte Heads Up — FASB issues standard on accounting for credit losses
• PwC In brief - Allowance for loan and lease losses – FASB issues final impairment standard
• GT On the Horizon -- FASB issues new standard on measuring credit losses
• BDO FASB Flash Report - FASB Issues ASU on Credit Losses on Financial Instruments

Understanding the Impact of ASU 2012-06

Deloitte Banking & Securities Alert

October 25, 2012

Background

On October 23, 2012, the FASB issued ASU 2012-06,1 which clarifies existing guidance on the subsequent measurement of an indemnification asset recognized as a result of a government-assisted acquisition of a financial institution. ASC 8052 specifies that an acquirer must record an indemnification asset at the same time as it recognizes the indemnified item in a business combination. The indemnification asset is initially measured on the same basis as the indemnified item (with a valuation allowance for amounts deemed uncollectible) and is subsequently also measured on the same basis as the indemnified item, subject to any contractual limitations on the asset’s amount (including an assessment of its collectibility when it is not measured at fair value).

The ASU was issued to eliminate the current diversity in practice in the interpretation of the terms “on the same basis” and “contractual limitations” in ASC 805-20 with respect to a government-assisted acquisition of a financial institution. Specifically, these terms have been interpreted differently when the performance of the indemnified asset has improved and the indemnification asset’s expected performance has therefore deteriorated. In such circumstances, most entities either (1) amortize the deterioration in the indemnification asset over the shorter of the remaining term of the loss-sharing agreement (LSA) or the term of the acquired loans or (2) impair the indemnification asset and recognize the impairment charge (i.e., the entire decrease in expected cash flows) immediately in earnings.

What Changed?

ASU 2012-06 clarifies that when a reporting entity recognizes an indemnification asset as a result of a government-assisted acquisition of a financial institution and there is a subsequent change in the amount of cash flows expected to be collected on the indemnified asset, the reporting entity should subsequently measure the indemnification asset on the same basis as the underlying loans by taking into account the contractual limitations of the LSA. For amortization of changes in value, the reporting entity should use the term of the LSA if it is shorter than the term of the acquired loans.

What Is the Scope of the ASU?

ASU 2012-06 affects both public and nonpublic entities that recognize, as part of a business combination, an indemnification asset (in accordance with ASC 805-20) that the government provides as part of a government-assisted acquisition of a financial institution. One example is a business combination for which the Federal Deposit Insurance Corporation (FDIC) enters into an LSA with the acquiring bank. The ASU does not apply to situations in which the indemnified asset is subsequently measured at fair value, and its scope does not expand beyond government-assisted acquisitions of a financial institution.

Example

Acquirer A purchases a pool of loans with a remaining term of 15 years as part of an FDIC-assisted bank acquisition (which meets the definition of a business). At acquisition, the acquired loans had a par value of $2 million and a fair value of $1 million (because of deteriorations in credit quality). In addition, the FDIC entered into an LSA with Acquirer A to reimburse 80 percent of certain losses on covered loans for the next five years. At acquisition, the fair value of the indemnification asset provided by the FDIC was assumed to be $400,000. After the acquisition date, the expected cash flows on the acquired pool of loan increased by $250,000 (which was accreted into income over the life of the pool of loans in accordance with ASC 310-30-35-2). As a result, the expected cash flows from the existing indemnification asset decreased by an assumed amount of $190,000, as determined under the terms of the LSA, and this amount would be amortized (on the same basis as the underlying loans) over the remaining term of the LSA.

What’s Next?

The amendments should be applied prospectively for fiscal years beginning on or after December 15, 2012 (and interim reporting periods within those years). Early adoption is permitted. The ASU applies to the unamortized balance of any existing indemnification assets as of the adoption date (rather than only to future changes in expected cash flows of unamortized indemnification assets existing as of the adoption date). Upon adoption, the amortization period for the remaining unamortized balance would be shortened to the remaining contractual life of the LSA, with the effect recorded in earnings for the period.

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1 FASB Accounting Standards Update No. 2012-06, Subsequent Accounting for an Indemnification Asset Recognized at the Acquisition Date as a Result of a Government-Assisted Acquisition of a Financial Institution — a consensus of the FASB Emerging Issues Task Force.

2 For titles of FASB Accounting Standards Codification (ASC) references, see Deloitte’s “Titles of Topics and Subtopics in the FASB Accounting Standards Codification.”