Accounting for Redeemable Shares
SPAC or a special purpose acquisition company is a shell company listed on a stock exchange with the purpose of acquiring a private company and, therefore, making it public without going through the traditional IPO process. SPAC process differs from tradition IPO in a way that the target that eventually becomes the public company is not involved in SPAC’s formation and IPO. Financial compensation of SPAC sponsors and managers is as such that they have a strong incentive to identify and merge with the target.
Entity’s time to identify a suitable target is limited. If SPAC is unable to complete a merger within 24 months, the entity is liquidated.
As part of SPAC’s formation, the newly formed company issues its founders or sponsors shares in exchange for nominal amount of equity capital.
As part of the IPO, SPACs issue common stock to public investors. SPACs may issue to public investors the same class of common stock that was issued to founders or a different class. Public shares are redeemed by the company under certain conditions. Generally, public shareholders can redeem their shares for cash in connection with the proposed merger transaction or, upon SPAC liquidation, if the merger transaction does not take place. Additional specific redemption terms apply.
IPO proceeds received by a SPAC are held in the trust account. The proceeds are invested in low-risk securities such as U.S. government treasury obligations.
Share Redemption Terms
SPAC public shareholders may, at their option, redeem ordinary shares for cash upon completion of the merger transaction subject to certain limitations. According to SPAC certificate of incorporation, the entity will not redeem its public shares in an amount that would cause SPAC net tangible assets (NTA) to be less than $5,000,001. SPAC will also redeem public shares if no business combination transaction takes place and the entity has to liquidate.
Net tangible assets are defined as total assets less intangible assets and liabilities. For most SPACs, the amount of net tangible assets is not materially different from SPAC’s permanent equity.
In the event of redemption upon completion of the merger, the aggregate distributable value is the amount of IPO proceeds held in the trust account at the time of the redemption including interest less related taxes. Redemption value in the event of liquidation is reduced by $ 100,000 of liquidation expenses.
Additionally, many SPACs restrict the amount of redemption by a single shareholder (or affiliated group) 20% of total public shares in the event management seek shareholder approval of the merger and does not conduct redemptions pursuant to the tender offer. The decision to seek shareholder approval of a proposed business combination or conduct a tender offer will be made by the SPAC at its discretion unless the terms of the transaction would require the company to seek shareholder approval under the law or stock exchange listing requirements.
Shares held by the sponsor are not subject to redemption. However, shares acquired by the sponsor after the initial IPO may be subject to redemption in the event of liquidation. Founder shares, i.e. shares issued to the sponsor before the IPO are not subject to redemption by the company and are classified as part of SPAC’s permanent equity.
Mandatorily Redeemable Shares
Accounting for redeemable securities is subject to ASC 480, Distinguishing Liabilities from Equity. ASC 480 applies to freestanding equity-linked instruments considered mandatorily redeemable or meeting other specific requirements. Generally, instruments included in the scope of ASC 480 are considered liability (or asset) instruments.
Mandatorily redeemable shares are defined as instruments that embody an unconditional obligation requiring the issuer to redeem the instrument, at the option of the holder, by transferring its assets at a specified event or upon an event that is certain to occur (ASC 480-10-20, Glossary). When the obligation is conditional, e.g., it depends on an uncertain event, the instrument becomes mandatorily redeemable if the event occurs or becomes certain to occur (ASC 480-10-25-5). Redemption linked to entity’s liquidation or dissolution does not trigger liability classification (ASC 480-10-25-4).
A share redeemable at the option of the issuer or the holder, or share redemption contingent on the occurrence of an uncertain event, does not meet the definition of a mandatorily redeemable instrument before the option is exercised or the event occurs. The above view is based on par. B25 of the Background Information and Basis for Conclusions of FASB Statement 150:
Board considered whether to include within the scope of this Statement shares that could be redeemed – mandatorily, at the option of the holder, or upon some contingent event that is outside the control of the issuer and the holder. However, this Statement limits the meaning of mandatorily redeemable to unconditional obligations to redeem the instrument by transferring assets at a specified or determinable date (or dates) or upon an event certain to occur.
Since ordinary public shares are redeemable at the option of the holder and upon occurrence of the merger or, mandatorily, in the event of liquidation (i.e. if no merger occurs), the shares are not considered mandatorily redeemable, from the ASC 480 perspective.
According to ASC 480-10-25-8 through 9:
25-8 An entity shall classify as a liability (or an asset in some circumstances) any financial instrument, other than an outstanding share, that, at inception, has both of the following characteristics:
- It embodies an obligation to repurchase the issuer’s equity shares, or is indexed to such an obligation.
- It requires or may require the issuer to settle the obligation by transferring assets.
25-9 In this Subtopic, indexed to is used interchangeably with based on variations in the fair value of. The phrase requires or may require encompasses instruments that either conditionally or unconditionally obligate the issuer to transfer assets. If the obligation is conditional, the number of conditions leading up to the transfer of assets is irrelevant.
However, ASC 480-10-25-8 does not apply to instruments that have the legal form of an outstanding share. Redeemable shares fall in this category and are not subject to ASC 480-10-25-8. Instead, redeemable shares issued by SPACs are subject to accounting requirements applicable to mandatorily redeemable shares and SEC guidance applicable to temporary (mezzanine) equity.
Temporary Equity Classification
A redemption provision resulting in the redemption of the instrument upon an event qualifying as an ordinary liquidation does not cause the instrument to be classified as temporary equity. Per ASC 480-10-S99-3A(3)(f), ordinary liquidation involves the redemption and liquidation of all of an entity’s equity instruments for cash or other assets. Redemption of IPO shares by SPAC in the event of liquidation does not trigger classification of the shares as temporary equity.
According to ASC 480-10-S99-3A(2), classification as temporary equity is required for instruments that are redeemable for cash or other assets under any of the following terms:
- At a fixed or determinable price on a fixed or determinable date;
- At the option of the holder;
- Upon the occurrence of an event that is not solely within the control of the issuer;
Note that the probability that an instrument will become redeemable (i.e. the probability of occurrence of the triggering event) does not affect its classification as temporary equity.
First two conditions do not apply to public shares issued by SPACs. The question is whether the merger transaction is considered solely within the control of the issuer.
Generally, a change in control transaction is not considered solely within entity’s control as purchasers can obtain control of the issuer by purchasing shares from other investors. However, in some case, sale of the shares by existing investors may require approval by entity’s board in which case, change in control is considered within entity’s control.
SPAC merger transaction is different from most change in control transactions in a sense that the merger is initiated by entity’s management. From this perspective, the merger is considered to be within entity’s control. However, the design and purpose of a SPAC makes it committed to a merger transaction. Although the entity decides on the specific merger target, eventually, it should merge with one of the targets. From this perspective, it appears that the occurrence of the business combination transaction is not solely within entity’s control.
Temporary equity is presented below the liability section of the balance sheet and above entity’s permanent equity. When redeemable shares are classified as part of temporary equity, amount of shares issued and outstanding as reported in permanent equity should be adjusted (reduced) to reflect classification of some shares outside of permanent equity. The following language can be used on the face of entity’s statement of changes in equity and equity section of entity’s balance sheet:
Class A Common stock, $X par value; X shares authorized; Y shares issued and outstanding, excluding Z shares subject to possible redemption at December 31, 20X1.
The amount of common stock reported at par value on the face of the balance sheet and in the statement of changes in equity should be reduced to reflect classification of some IPO shares as part of temporary equity.
Temporary Equity Measurement
Generally, SPAC IPO shares classified as temporary equity are initially measured at fair value (ASC 480-10-S99-3A(12)). Subsequent measurement basis depends on whether the instrument is currently redeemable, i.e., whether an event triggering a redemption (at the option of the holder) has occurred.
Currently redeemable securities are subsequently measured at maximum redemption value. Per ASC 480-10-S99-3A14, if the maximum redemption amount depends on an index or other similar variable (for example, the fair value of the equity instrument at the redemption date or a measure based on historical EBITDA), the amount presented in temporary equity should be calculated based on the conditions that exist as of the balance sheet date (for example, the current fair value of the equity instrument or the most recent EBITDA measure). Redemption value of SPAC IPO shares is determined based on the amount of the initial IPO proceeds available for redemption and the amount of redeemable shares.
If securities are not currently redeemable, because, for example, the contingent event did not occur, no subsequent remeasurement is required unless the redemption event is probable. If the security is not currently redeemable and the likelihood of the redemption event is not considered “probable”, the redeemable securities are reported at fair value determined at their initial recognition.
If the redemption event is probable, entities should use one of the two methods to adjust the initial measurement basis:
- Accrete changes in the redemption value over the period from the date of issuance (or from the date that it becomes probable that the instrument will become redeemable, if later) to the earliest redemption date, using the effective interest rate method.
- Recognize changes in the redemption value as they occur and adjust the carrying amount of the instrument to equal the redemption value at the end of each reporting period. This method is consistent with subsequent measurement of currently redeemable instruments.
Entities can adopt one of the two reporting models as part of their accounting policy election. Accounting policy should be applied consistently and disclosed in the notes to the financial statements.
US GAAP does not formally define “probable” threshold. According to established accounting practices, the threshold refers to at least 75 – 80% likelihood of the occurrence. Practically all SPACs concluded that the likelihood of the merger transaction is “probable”. We noted that in a number of case, the above determination was made based on the general design and purpose of SPAC, rather than SPAC-specific facts and circumstances. We believe that the probability assessment should be made given specific facts and circumstances relevant to each SPAC.
Practically all SPACs have also adopted the redemption value method. The current redemption value is the maximum amount payable if redemption were to occur as of the balance sheet date.
Maximum redemption value is determined as SPAC’s permanent and temporary equity reduced by $ 5,000,001. Recording temporary equity at the above amount (i.e. total equity less 5,000,001) ensure that SPAC’s permanent equity or NTA is not less than $ 5,000,001. As part of the above approach, SPACs recognize changes in the redemption value by debiting or crediting permanent equity or APIC.
SPACs should also consider the amount of distributable assets held in the trust account at the balance sheet date. If, the amount of distributable assets is lower than determined using the above approach, temporary equity equals this lower amount. Consider the following example:
Example A-1: SPAC applies redemption value method to determine the amount of temporary equity as of 12/31/20×1. SPAC has calculated the amount of temporary equity as follows: temporary equity plus permanent equity less $ 5,000,001. Following the above approach, the amount of temporary equity was determined to be $ 100,000,000. However, the amount of assets distributable if all public shares are redeemed upon completion of the merger is $ 90,000,000. In this case, the amount of temporary equity reported as of 12/31/20×1 is $ 90 m, not $ 100 m.
Current accounting practice adopted for remeasurement of SPAC temporary equity is that remeasurement adjustments do not have any impact on SPAC earnings, i.e. income statement. ASC 480-10-S99 provides limited formal guidance on how to recognize changes in the measurement of temporary equity. ASC 480-10-S99-2 provides an example where increases in the value of redeemable preferred stock by amounts representing dividends payable upon redemption are recorded by debiting retained earnings or APIC. Otherwise, existing GAAP, covering measurement of temporary equity does not offer any specific guidance of how to recognize measurement adjustments.
Accounting for redeemable or contingently redeemable shares issued by a SPAC has unique challenges as the shares in question may not be specifically identifiable, in a sense that any public share can become redeemable upon occurrence of a qualifying event, i.e., a business combination.
Impact of recent SEC Comment Letters concerning reporting of temporary equity:
Historically, SPACs determined the amount of public shares classified as subject to redemption by a) determining SPAC’s temporary equity; and b) dividing SPAC’s temporary equity by the per share redemption value. The amount of temporary equity, reducing the amount of permanent equity, was calculated to ensure that the remaining permanent equity is not less than $5,000,001. Following the above accounting practice has resulted in classification of some but not all public shares as part of temporary equity, i.e. contingently redeemable. The accounting practice was justified by the legal terms according to which a SPAC will not redeem its public shares in an amount that would cause SPAC net tangible assets (NTA) to be less than $5,000,001.
Starting in late July 2021, SEC has issued a number of comment letters questioning SPAC’s historical accounting for public shares subject to redemption. SEC’s specific focus was that SPACs classified some but not all public shares as subject to redemption. Following SEC comment letters, many SPACs presented all public shares as part of their temporary equity. As part of the revised presentation, total value of temporary equity was calculated as follows:
Temporary Equity = Per Share Redemption Value * All Redeemable Shares
Consistent with the prior approach, amount of temporary equity is recognized to reduce the reportable value of permanent equity. Given that revised presentation resulted in reporting more shares as subject to redemption and corresponding increase in temporary equity, the revised presentation has also resulted in reduction of SPAC’s permanent equity.
We understand that some but all SPACs have adopted the revised presentation of public shares subject to redemption. SPACs following the revised rules have to give additional considerations to compliance with $ 5 m NTA requirement. Given the reduction in the amount of permanent equity, some SPACs had to attract additional financing, e.g. by issuing common stock or other equity instruments that would not be subject to redemption requirements.
Reporting entities should assess the above accounting change to determine if it is considered a change in the accounting principle or correction of an error as defined in ASC 250-10-20, Glossary. A change in the accounting principle takes place when a company changes from one generally accepted accounting principle to another generally accepted accounting principle or when a company changes the method of applying an accounting principle. An accounting error includes mistakes in the application of generally accepted accounting principles (GAAP). Change in the accounting principle should be applied retrospectively to all prior periods, unless it is impractical to do so. ASC 250-10-45-9 provides more information on the impracticability exception. Correction of material errors involves restatement of previously issued financial statements. Certain disclosure requirements apply.
We believe it is reasonable to expect issuance of additional accounting guidance giving proper consideration of redemption and other legal terms applicable to SPAC business and covering classification and measurement of public shares issued by SPACs. In the meantime, reporting entities should base their accounting treatment on application of existing FASB and SEC guidance and careful examination of relevant legal terms.
Summary: Contingently redeemable shares issued by a SPAC may have to be classified as temporary (or mezzanine) equity in accordance with ASC 480-10-S99-3A. Securities classified as temporary equity are initially measured at fair value. Subsequent measurement depends on whether the securities are currently redeemable and, if not, whether the redemption event is considered “probable”.
Accounting for redeemable or contingently redeemable shares issued by a SPAC has unique challenges such as application of $5,000,001 threshold as it applies to SPAC’s permanent equity and the impact of the value of distributable assets held in the trust account.
Redemption terms stated in legal documents governing SPAC’s business should be carefully analyzed to determine proper presentation and measurement of redeemable or contingently redeemable shares under existing FASB and SEC guidance.
Historically, SPAC’s classified some but not all public shares as part of entity’s temporary equity. Following recently issued SEC Comment Letters, some SPACs classified all public shares as part of temporary equity. The change in classification have resulted in increase in temporary and decrease in SPAC permanent equity.
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