Accounting for Transaction Costs

Accounting for SPAC Transaction Cost

2021-08-01T23:33:30+00:00 05/10/2021|Accounting for Transaction Costs|

SPAC Shares, Warrants: Background

A 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 is registered with the SEC and is a publicly traded company.

As part of SPAC‘s formation, the newly formed company issues its founders or sponsors shares in exchange for nominal amount of equity capital. Founder shares are not subject to redemption by the company and are classified as part of SPAC’s permanent equity. Sponsors may also provide the SPAC with debt financing. Debt and equity capital are used to fund entity’s formation and the cost of the initial IPO.

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 requirements apply. SPACs classify public shares as part of temporary equity, outside of permanent equity, to the extent that permanent equity is not lower than $ 5,000,001.

As part of the IPO, SPACs issue to public shareholders warrants, i.e., equity-linked instruments that give SPAC’s shareholders an option to buy additional shares of the entity in the future at the price agreed in the warrant agreement. The warrants issued to public shareholders are referred to as “public”. In connection with the IPO, SPACs also issue warrants to its founders, referred to as “private” warrants.

Accounting for Debt and Equity Issuance Cost

Generally, issuance of stock classified as permanent equity (e.g. founder shares) is recorded by crediting common stock account at par value (e.g. $ 0.001/share) while the excess of the issuance proceeds over the par value is recognized as part of Additional Paid-In Capital (APIC). Consider the following example:

Example 1 SPAC issued its founder 10,000,000 Class B common shares with par value of 0.0001 per share in exchange for $ 25,000 paid in cash. SPAC will record the above issuance as follows:

Db Cash:                                         $ 25,000

Cr Common Stock- Founder:                            $ 1,000 (calculated as 10,000,000 * $ 0.0001)

Cr APIC: Equity Issuance Discount:                 $ 24,000 (calculated as $ 25,000 less $ 1,000)

For stock classified in equity, direct and incremental costs related to its issuance should be accounted for as a reduction of stock issuance proceeds. Such costs are credited to SPAC’s APIC. The costs may include legal fees, bankers’ or underwriters’ fees, among others. Internal costs that meet the incremental and direct criteria (e.g., travel costs directly related to financing) may also be accounted for as a reduction of issuance proceeds.

ASC 340-10-S99-1 states that, specific incremental costs directly attributable to a proposed or actual offering of equity securities incurred prior to the effective date of the offering, may be deferred and charged against the gross proceeds of the offering when the offering occurs. The guidance states that costs of an aborted offering may not be deferred and charged against proceeds of a subsequent offering. A short postponement (up to 90 days) does not represent an aborted offering. In a classified balance sheet, deferred offering costs are reported as part of short-term assets.

Similar to equity issuance costs, GAAP has accounting requirements for cost directly related to issuing debt. ASC 835, Interest requires capitalizing debt issuance costs paid to third parties that are directly related to issuing debt. Such costs are recorded as a debt discount, i.e., a reduction of the carrying or “book” value of debt. Debt issuance costs should be amortized as an additional interest expense using the effective interest method.

Accounting for Transaction Costs Paid by Sponsor

In certain cases, sponsor pays issuance fees related to SPAC issuance of debt or equity directly to third-party service providers. Effectively, in such cases, the fees are paid by the sponsor on behalf of SPAC. Consider the following example:

Example 2: SPAC issued its founder 10,000,000 Class B shares with par value of 0.0001 per share in exchange for $ 25,000. According to SPAC’s article of incorporation, SPAC is also authorized to issue 100,000,000 Class A common shares. Out of 100 million shares SPAC plans to issue 50 million to public investors as part of the IPO transaction. Sponsor has paid $ 3,000 of legal fees incurred in connection the IPO transaction before the transaction was complete. SPAC is not obligated to repay $ 3,000 to the sponsor. The question is how to account for the above legal fees.

SEC Staff Accounting Bulletin Topic 5T: Accounting for Expenses or Liabilities Paid by Principal Stockholder(s) discusses certain transactions where a principal stockholder pays an expense for the company. According to the SEC, the substance of the transaction should be analyzed to determine if the economic interest holder makes a capital contribution to the reporting entity. Generally, payment of entity’s expenses is considered a capital contribution unless the “stockholder’s action is caused by a relationship or obligation completely unrelated to his position as a stockholder or such action clearly does not benefit the company.” If the transaction was considered a capital contribution, the entity should record it as such, i.e. by crediting entity’s equity account or APIC. For example, if the shareholder settled legal case when the entity was a defendant by transferring $ 1,000,000 in cash, the entity would record the following expense: Db Legal Expenses; Cr Equity Contribution- APIC for $ 1,000,000.

Example 2 (continuation): SPAC has determined that the substance of the transaction was the capital contribution. Generally, contribution is considered made when the sponsor settles legal invoices. As noted above, direct and incremental costs associated with issuance of equity are accounted for as a reduction of equity proceeds. However, entities can defer eligible transaction costs incurred prior to the effective date of the offering.

Based on the above considerations, SPAC records the following entry when the sponsor settles transaction related expenses:

Db Deferred Offering Cost:                 $ 3,000

Cr APIC- Capital Contribution:              $ 3,000

SPAC records the following entry on the effective date of IPO:

Db APIC- Equity Issuance Cost:            $ 3,000

Cr Deferred Offering Cost:                    $ 3,000

The overall impact of both entries does not have any impact on SPAC’s APIC account.

It is important to understand specifics of transaction services provided by third-parties. For example, if the legal services relate to issuance of shares to the founder, this transaction is considered complete when the shares are issued in exchange for cash proceeds. Following the above example, SPAC will record the following entry: Db APIC- Equity Issuance Cost, Cr APIC- Capital Contribution for $ 3,000. Transaction costs related to issuance of founder shares should not be deferred until the IPO date.

SPACs and their accountants should carefully examine settlement terms related to third-party fees to determine if the contribution by the sponsor took place. In certain cases, SPAC is obligated to repay the sponsor legal or other professional fees paid on behalf of the SPAC. Consider the fact patters in the example 2 above, except that SPAC is obligated to repay the sponsor relevant legal fees. In this case, the sponsor did not make a capital contribution as the SPAC is obligated to repay. SPAC has to recognize the fees when paid by the sponsor as follows:

Db Deferred Offering Cost:          $ 3,000

Cr Accounts Payable to the Sponsor:   $ 3,000

SPAC records the following entry on the effective date of IPO:

Db APIC- Equity Issuance Cost:   $ 3,000

Cr Deferred Offering Cost:             $ 3,000

If transaction costs related to issuance of shares to the sponsor (not IPO shares) and the SPAC is obligated to repay the fees, the entity recognizes the fees as follows:

Db APIC- Equity Issuance Cost:             $ 3,000

Cr Accounts Payable to the Sponsor:          $ 3,000

The above entry is recorded at the time of issuing founder shares in exchange for cash.

In certain cases, the repayment of legal or other relevant fees occurs in form of reduction of sponsor payment in exchange for founder share. Consider the fact patter in the following example.

Example 3: SPAC issued its founder 10,000,000 Class B shares with par value of 0.0001 per share in exchange for $ 25,000. According to SPAC’s article of incorporation, SPAC is also authorized to issue 100,000,000 Class A common shares. Out of 100 million shares SPAC plans to issue 50 million to public investors as part of the IPO transaction. Sponsor has paid $ 3,000 of legal fees incurred in connection the IPO transaction before the transaction was complete. Sponsor pays the entity $ 22,000 or $ 25,000 reduced by $ 3,000 of transactional fees paid directly to third-parties. The question is how to account for the above legal fees.

In the above fact patter, sponsor did not make a capital contribution as SPAC remains responsible for third party fees. Entries to recognize issuance of founder’s share and transaction fees are as follows.

Db Cash                                               $ 22,000

Db Deferred Offering Cost:                 $ 3,000

Cr Common Stock- Founder                            $ 1,000 (calculated as 10,000,000 * $ 0.0001)

Cr APIC- Equity Issuance Discount:                 $ 24,000 (calculated as $ 25,000 less $ 1,000)

SPAC records the following entry on the effective date of IPO:

Db APIC- Equity Issuance Cost:        $ 3,000

Cr Deferred Offering Cost:                 $ 3,000

If the legal fees related to issuance of shares to the founder, entries to recognize issuance of founder’s share and the legal fees are as follows.

Db Cash:                                               $ 22,000

Db APIC- Equity Issuance Cost:           $ 3,000

Cr Common Stock- Founder:                            $ 1,000 (calculated as 10,000,000 * $ 0.0001)

Cr APIC- Equity Issuance Discount:                 $ 24,000 (calculated as $ 25,000 less $ 1,000)

 Summary: For stock classified as equity, direct and incremental costs related to its issuance should be accounted for as a reduction stock issuance proceeds. Specific incremental costs directly attributable to a proposed or actual offering of equity securities incurred prior to the effective date of the offering, may be deferred and charged against the gross proceeds of the offering when the offering occurs, however, transaction costs of an aborted offering may not be deferred. In a classified balance sheet, deferred offering costs are reported as part of short-term assets.

Transaction cost related to issuance of founder’s shares are recognized as a reduction of equity proceeds as part of APIC- – Equity Issuance Cost when SPAC issues shares in exchange for cash. Such costs are not deferred until the IPO date.

Cost directly related to issuing debt should be recorded as part of debt discount, i.e., a reduction of the carrying or “book” value of debt. Capitalized debt issuance costs should be amortized as an additional interest expense using the effective interest method.

Sponsor payment of SPAC equity issuance costs directly to third-party service providers should be analyzed to determine if the payment constitutes a capital contributions. SPAC recognizes capital contributions by crediting APIC- Capital Contribution account. The contribution is recognized when the sponsor settles third party invoices.

Accounting for Transaction Costs Related to Instruments with Multiple Components

Debt and stock may be hybrid instruments that contain debt or equity host and embedded features, e.g., conversion, put or call options. Such embedded features may require bifurcation or accounted for separately pursuant to provisions of ASC 850, Derivative and Hedging.

Debt and stock may also be issued with detachable warrants, generally considered freestanding financial instruments, and accounted for separately from the host as a liability or equity. Issuance of stock can be classified as an equity or, in certain instances, as a liability based on the requirements of ASC 480, Distinguishing Liabilities from Equity. Generally, equity instruments within the scope of ASC 480 are mandatorily redeemable shares, i.e. securities the embody an unconditional obligation requiring the issue to redeem the instrument by transferring its assets at a specified or determinable dates or event certain to occur.

As noted above, specific incremental costs directly attributable to equity offering should be charged against the gross proceeds of the offering as part of APIC. Such costs are not recorded as an expense in the income statement. ASC 835, Interest also requires entities to recognize debt issuance costs paid to third parties that are directly related to issuing debt as part of debt discount, i.e. a reduction of the carrying value of debt.

Reporting entities raised a question of how to account for transaction costs related to instruments with multiple components, i.e., separated embedded or freestanding components.

The accounting treatment of transaction costs varies depending on the classification of an embedded or freestanding feature. If, in a situation of issuance of stock with warrants, the warrants and the underlying stock were properly classified as equity instruments, issuance cost can be properly recorded as a reduction of equity proceeds.

However, costs allocated to a liability-classified warrants attached to an equity instrument, should be expensed as incurred. Same accounting applies to transaction costs allocated to bifurcated derivative, e.g., a conversion option embedded in a debt instrument. Such embedded features are measured at fair value initially and subsequently.

The above treatment of transaction costs is developed by analogy to accounting for debt issuance costs associated with debt measured at fair value because of the election of the fair value option. Such debt issuance costs should be expensed as incurred (ASC 825-10-25-3).

Generally, costs related to issuance of mandatorily redeemable equity classified as a liability pursuant to requirements of ASC 480 are reported consistently with debt issuance costs, i.e. as a deduction from the amount of redeemable securities as reported on the balance sheet.

Table below summarizes treatment of transactions costs depending on the type of transaction they relate to:

Type of Transaction Accounting for Issuance Cost
Issuance of stock classified as permanent equity Reduction of equity issuance proceeds or share balance.
Issuance of debt classified as a liability Reduction of carrying amount of debt or part of debt discount.
Issuance of mandatorily redeemable shares classified as liability pursuant to ASC 480. Reduction of carrying amount of shares or part of issuance discount unless fair value option is elected for the shares, in which case issuance costs are expensed as incurred.
Issuance of equity shares with detachable warrants where both the shares and warrants are classified as equity. Reduction of equity issuance proceeds, generally, part of APIC.
Issuance of equity shares with detachable warrants or embedded features (e.g. conversion option) where the shares were classified as equity while warrants or embedded feature(s) were classified as liability instruments. Cost allocated to equity are reported as a reduction of equity issuance proceeds or share balance.

Cost allocated to liability-classified warrants or embedded features are expensed as incurred.

 

US GAAP includes specific guidance on allocation of transaction costs relating to instruments in the scope of the cash conversion guidance applicable prior to adoption of ASU 2020-06. Such transaction costs are required to be allocated to the liability and equity components in proportion to the allocation of proceeds between each component. Costs allocated to respective components are accounted for as debt and equity issuance costs, respectively. US GAAP offers no other specific guidance on how transaction costs should be allocated between multiple components of a financial instrument.

A rational approach is to allocate cost associated with an instrument containing multiple components in proportion to proceeds allocated to the respective components. This approach is applied by analogy to guidance for instruments with cash conversion feature. Similar approach, i.e. allocation based on relative fair values is also used in allocation of total proceeds between debt-host and equity-classified warrants.

Consider the fact patter in the following example.

Example 4: SPA issued equity with liability-classified warrants for total proceeds of $ 100 m. Transaction costs amounted to $ 10 m. Initial fair value of warrants was estimated to be $ 15 m. Proceeds allocated to equity would be $ 85 m or $ 100 m less $ 15 m. The amount of transaction costs allocated to warrants would be $ 15 / $ 100 * $ 10 or $ 1.5 m. Transaction costs allocated to equity is $ 10 m – $ 1.5 m or $ 8.5 m. Transaction costs allocated to liability-classified warrants will be expensed immediately. $ 8.5 m of transaction costs allocated to equity will be recorded as a reduction of equity.

Allocation of Transaction Cost Relating to Temporary Equity

Some entities raised a question about accounting for transaction costs incurred in connection with equity classified as temporary (mezzanine) in accordance with requirements of ASC 480-10-S99-3A. Generally, 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;

As noted above, SPACs classify public shares issued as part of IPO as temporary or mezzanine equity.

Redeemable securities 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 has occurred. Currently redeemable securities are subsequently measured at maximum redemption value. If securities are not currently redeemable, no subsequent remeasurement is required unless the redemption event is probable. 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.

Transaction costs can be allocated to temporary equity using the same methodology as described above, i.e., based on the amount of relative proceeds.

The question is whether costs allocated to temporary equity should be recognized as a reduction of temporary equity or expensed immediately.

US GAAP does not offer specific guidance on the above matter. One accounting view is that reporting of transaction costs as a reduction of value of redeemable securities is inconsistent with the accounting requirement to initially measure the redeemable securities at fair value. Redeemable securities are measured at fair value initially and, depending on the terms of the redemption feature, subsequently. Upfront expensing of transaction cost appears consistent with treatment of debt issuance cost associated with debt instruments measured at fair value due to the election of the fair value option ASC 825-10-15-4, applied by analogy to issuance costs related to redeemable instruments.

An alternative accounting treatment would be to record the allocated cost as a reduction of temporary equity. This accounting approach is applied by analogy to reporting of transaction costs associated with debt or equity as a contra debt or equity item, respectively. When redeemable securities are subsequently accounted for by accreting changes in the redemption value using the effective interest method, allocated transaction cost are amortized or accreted in the same manner. As noted above, certain temporary equity is not remeasured subsequent to the initial recognition at fair value. Stock issuance costs initially reported as a reduction of such temporary equity are not amortized or accreted subsequently.

Recording of relevant issuance costs as a reduction of temporary equity is consistent with section 7.4.2 Stock issuance costs, PwC guide Financing Transactions.

In our view, entities can adopt any of the above reporting models as part of their accounting policy election for treatment of transaction cost related issuance of temporary equity. Accounting policy should be applied consistently and disclosed in the notes to the financial statements.

Summary: US GAAP offers limited specific guidance on how transaction costs should be allocated between a host instrument and a separated component, e.g., detachable warrants or conversion feature. A rational approach is to allocate cost in proportion to the allocation of proceeds between the two or more components.

Transaction costs allocated to a bifurcated derivative, e.g., a conversion feature embedded in a debt instrument measured at fair value initially and subsequently should be expensed as incurred. Same accounting guidance applies to costs allocated to liability-classified warrants attached to an equity or liability instrument.

Transaction cost allocated to instruments property classified as equity, e.g., equity-classified warrants are recorded as a reduction of equity.

Entities can make an accounting policy election to either expense transaction cost allocated to temporary equity immediately or record the transaction cost as a reduction of temporary equity. Accounting policy should be applied consistently and disclosed in the notes to the financial statements.

 


 

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