SPAC accounting issues

Founder Shares Transferred to Anchor Investors

2021-08-30T06:31:30+00:00 08/29/2021|SPAC accounting issues|

Accounting for SPAC Founder Shares Transferred to Anchor Investors

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 entity issues its founders or sponsors shares in exchange for nominal amount of equity capital, e.g. $ 25,000. In many cases, the amount of founder shares issued and outstanding is determined to be 20% of total common shares after closing of the IPO transaction, excluding impact of warrants. 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 units to public investors. One unit consists of one common share and one or a fraction of a warrant. Warrants issued to public shareholders give SPAC’s shareholders an option to buy additional shares of the entity in the future at the price stated 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. Private warrants are generally sold to the sponsor at $ 1.0 or $ 1.5 per warrant.

Founder common stock and common shares sold to public shareholders have different rights and privileges. Public shareholders can redeem their shares for cash in connection with the proposed merger transaction or, upon SPAC liquidation, if the merger transaction did not take place. Generally, founder shares are non-redeemable. Founder shares are also subject to certain transfer restrictions.

Some SPAC public offering transactions include an arrangement involving anchor investors. Anchor investors are typically known and respected investment firms (e.g. BlackRock, Inc.). Their involvement with the IPO transaction intended to build other investors’ confidence in the issuer and the transaction in question.

A typical arrangement involving anchor investors include the following terms:

  • SPAC may sell, through its underwriters, to anchor investors specified amount of SPAC units;
  • If anchor investors purchase specified amount of SPAC units, the sponsor will also sell to the investors an agreed-on amount of founder shares;

Generally, anchor investors purchase SPAC units at the same price paid by other investors purchasing the units as part of the IPO.

In many cases the price paid by anchor investors for founder shares is the issuance price of the shares originally paid by the sponsor. Generally, the price is lower than estimated market value of the shares.

According to the terms of some deals, SPAC may also sell to anchor investors private warrants. Anchor investors pay the same price for private warrants that is paid by the sponsor.

Transfer of founder shares between the sponsor and anchor investors is the transaction between SPAC shareholders and does not directly involve the reporting entity.

Many SPACs raised a question of how to account for sponsor’s transfer of founder shares to anchor investors.

Although our analysis is performed in relation to SPAC shares, similar consideration would apply to transactions involving operating companies.

Executive Summary

When a principal stockholder pays an expense for the company, the company should recognize corresponding expense and equity contribution from the shareholder unless shareholder’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.

Sponsor transfers founder shares to anchor investors as part of its effort to promote SPAC’s IPO. The sponsor acts in its capacity of a shareholder and with understanding that involvement of anchor shareholders will benefit SPAC’s business. Therefore, consistent with SEC guidance in SAB Topic 5T, transfer of shares by SPAC sponsor to anchor investors may have to be reflected in SPAC’s financial statements.

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. GAAP also 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.

We believe that cost incurred in attracting anchor investors by virtue of transferring sponsor shares can be considered part of specific, direct and incremental offering cost.

Although application of the specific measurement basis to sponsor shares will depend on relevant facts and circumstances, generally, we believe that measuring issuance cost represented by founder shares transferred to anchor investors at shares fair value is appropriate. Specifically, the value of issuance costs will be determined as follows:

Estimated FMV of Founder Shares less Cash Proceed Paid by Anchor Investors

Similarly, if terms of the deal include anchor investor purchase of private warrants, issuance costs may include the excess of estimated fair market value of private warrants over proceeds paid for the warrants by anchor investors.

Transfer of founder share associated with issuance of equity instruments is recorded at the time of transaction close by debiting APIC- Issuance Cost and crediting APIC- Sponsor Contribution. Therefore, the above transaction does not have any net impact on SPAC’s APIC or equity.

However, SPACs may have to allocate issuance costs associated to liability-classified warrants, if any. In this case, the allocated amount would be expensed as incurred. The following journal entry will be recognized:

Db Warrant Issuance Expense

Cr APIC- Sponsor Contribution

FinAcco’s publication Accounting for SPAC Transaction Cost provides more details about allocation of transaction cost to instruments with multiple components.

Accounting Analysis

Topic 1: Impact of Shareholder Transactions on Company’s Financial Statements

SEC accounting guidance discusses impact of certain transactions involving company’s shareholders on company’s financial statements. Specifically, SEC Staff Accounting Bulletin (SAB) Topic 5T: Accounting for Expenses or Liabilities Paid by Principal Stockholder(s) discusses a transaction where a principal stockholder settles a legal claim involving the company by transferring shares to the plaintiff. If the company had settled the litigation directly, the company would have recorded the settlement as an expense. SEC response is that the value of the shares transferred should be reflected as an expense in the company’s financial statements with a corresponding credit to contributed (paid-in) capital.

According to SEC staff, similar accounting is required for other transactions where a principal stockholder pays an expense for the company. The substance of transactions 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 additional paid-in capital (APIC).

SEC staff provided another example where share-based payments awarded to an employee of the reporting entity by a related party (or other holder of an economic interest in the entity) as compensation for services provided to the entity. According to ASC 718-10-15-4, such transactions between employees of a nonpublic reporting entity and the holder of an economic interest in the nonpublic entity are within the scope of stock compensation guidance. The scope inclusion does not apply if the arrangement “is clearly for a purpose other than compensation for goods or services.” When ASC 718 applies, the nonpublic reporting entity should record vested stock-based awards by debiting compensation (payroll) expense and crediting equity, i.e. APIC. The credit to APIC represents a capital contribution by a related party or shareholder to the reporting entity. According to ASC 718-10-15-4:

…The substance of such a transaction is that the economic interest holder makes a capital contribution to the reporting entity, and that entity makes it share-base payment to the grantee in exchange for services rendered or goods received. An example of the situation in which such a transfer is not compensation is a transfer to settle an obligation of the economic interest holder to the grantee that is unrelated to goods or services to be used or consumed in a grantor’s own operations.

In a number of cases, cash payments or grants of stock-based instruments are made to current or future employees in connection with a business combination. An acquirer may agree to make a payment to a selling shareholder or existing employees to incentivize their future employment with the combined company. Such contracts should be analyzed to determine if they constitute a compensation arrangement separate from the business combination. The analysis is performed using the indicators listed in ASC 805-10-55-18. If it was determined that the arrangement is compensatory, related compensation expense should be recognized in acquirer’s accounting records.

Sponsor transfers founder shares to anchor investors as part of its effort to promote SPAC’s IPO. The sponsor acts in its capacity of a shareholder and with understanding that involvement of anchor shareholders will benefit SPAC’s business. Therefore, consistent with SEC guidance in SAB Topic 5T, transfer of shares by SPAC sponsor to anchor investors may have to be reflected in SPAC’s financial statements.

Topic 2: Accounting for Equity and Debt Issuance Cost

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.

Generally, expense that may qualify for a deferral and reporting as a reduction of equity (or debt) proceeds include specific legal and accounting expenses, underwriting commission, registration fees, listing and filing, transfer agent and registrar fees. The expenses also include road show travel expenses and relevant printing and engraving expenses.

Management salaries including potential increases associated with IPO work do not qualify as specific, incremental costs directly attributable to an offering.

We understand that issuance of sponsor shares to anchor investors at nominal consideration is performed to promote SPAC offering transaction. From this perspective, cost incurred in attracting anchor investors by virtue of transferring sponsor shares can be considered part of specific, direct and incremental offering cost.

Topic 3: Measurement of Issuance Cost in Arrangements Involving Anchor Investors

Anchor investors purchase SPAC units at the same price that apply to purchases of respective financial instruments by other investors. From this perspective, anchor investors do not appear to enjoy any benefits that would not be available to other market participants. However, sponsor transfers founder shares to anchor investors in exchange for cash consideration generally considered lower than the estimated fair market value of the shares. In many cases, the purchase price equals the issuance price for sponsor shares, e.g. 0.006/share.

To develop appropriate measurement basis, some reporting entities applied accounting guidance relating to transactions with related parties. Generally, transactions with related parties are recorded at the face amount, i.e. the amount indicated in applicable legal terms (see exceptions in SAB Topic 1.B.1, Questions 3 and 4). SAB Topic 5T provides further discussion on the matter as follows:

…The staff notes, however, that FASB ASC Topic 850 does not address the measurement of related party transactions and that, as a result, such transactions are generally recorded at the amounts indicated by their terms. However, the staff believes that transactions of the type described above differ from the typical related party transactions.

The transactions for which FASB ASC Topic 850 requires disclosure generally are those in which a company receives goods or services directly from, or provides goods or services directly to, a related party, and the form and terms of such transactions may be structured to produce either a direct or indirect benefit to the related party. The participation of a related party in such a transaction negates the presumption that transactions reflected in the financial statements have been consummated at arm’s length. Disclosure is therefore required to compensate for the fact that, due to the related party’s involvement, the terms of the transaction may produce an accounting measurement for which a more faithful measurement may not be determinable.

However, transactions of the type discussed in the facts given do not have such problems of measurement and appear to be transacted to provide a benefit to the stockholder through the enhancement or maintenance of the value of the stockholder’s investment. The staff believes that the substance of such transactions is the payment of an expense of the company through contributions by the stockholder. Therefore, the staff believes it would be inappropriate to account for such transactions according to the form of the transaction. (footnotes are omitted)

Although SEC staff did not directly address the use of the measurement basis (e.g. fair value or historical cost), it indicated that “it would be inappropriate to account for such transactions according to the form of the transaction”.

With certain exceptions, US GAAP requires or allows the use of the fair value measurement basis for transactions involving reporting entity’s shares or other financial instruments. In many cases involving market transactions, such as issuance of shares in a public offering, the transactional price of a financial instrument approximates its fair value.

Although application of the specific measurement basis to sponsor shares will depend on relevant facts and circumstances, generally, we believe that measuring issuance cost represented by founder shares transferred to anchor investors at shares fair value is appropriate. Specifically the value of issuance costs will be determined as follows:

Estimated FMV of Founder Shares less Cash Proceed Paid by Anchor Investors

Similar considerations may apply to purchase by anchor investors of private warrants. If the purchase price is considered lower than estimated market value, the excess (discount) may have to be considered part of offering costs.

Topic 4: Presenting Issuance Cost in SPAC GAAP Financial Statements

Transfer of founder shares between the sponsor and anchor investors is the transition that does not involve any assets (including cash) or liabilities of the reporting entity. Therefore, many SPACs have raised a question of how offering costs associated with transfer of founder shares should be reflected in SPAC financial statements.

Since the share transfer is effective on the IPO date, the arrangement may not have any impact on SPACs primary forms included in GAAP historical financial statements filed with Form S-1.

Transfer of founder share associated with issuance of equity instruments is recorded at the time of transaction close as follows:

Db APIC- Issuance Cost

Cr APIC- Sponsor Contribution

There is no net impact on SPAC’s reportable APIC or equity.

SPAC units issued as part of IPO transaction have multiple components including common stock and public warrants. Public warrants may be classified as liability or equity instruments depending on the results of separate accounting analysis. Similarly, private warrants issued at the time of the IPO may also be classified as liability or equity instruments.

Accounting for transaction cost depends on classification of the underlying instrument. For example, transaction costs allocated to liability-classified warrants are expensed as incurred in reporting entity’s income statement. Therefore, part of issuance costs associated with transfer of founder shares to anchor investors allocated to liability-classified warrants would be recorded as follows:

Db Warrant Issuance Expense

Cr APIC- Sponsor Contribution

As treatment of transaction cost depends on classification of the underlying instrument, generally, reporting entities should allocate transaction costs related to issuance of the instruments with multiple components to the individual components. US GAAP offers limited accounting 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. Refer to FinAcco’s publication Accounting for SPAC Transaction Cost for more details about allocation of transaction cost to instruments with multiple components.

Consider the following example:

Example 1: A reporting entity issued units consisting of commons and warrants for total proceeds of $ 100 m. The entity appropriately classified common shares as permanent equity while warrants were classified as liabilities. Initial fair value of warrants was estimated to be $ 15 m.

As part of the transaction, entity’s shareholder transferred to anchor investors shares with the estimated fair market value of $ 1.025 m in exchange of $ 0.025 m of cash proceeds.

Question A: How should the entity determine total amount of transaction cost associated with transfer of shares to anchor investors?

Total transaction cost associated with the transfer of share equals to excess of shares FMV over cash proceeds or $ 1 m, i.e. $ 1.025 m – $ 0.025 m.

Question B: How should the entity allocate the transaction cost to liability-classified warrants and common shares?

Transaction proceeds allocated to common share would be $ 85 m or $ 100 m, i.e. total proceeds less $ 15 m, estimated fair value of warrants. The amount of transaction costs allocated to warrants would be $ 15 / $ 100 * $ 1 or $ 0.15 m, i.e. $ 150,000.

Transaction costs allocated to common shares is $ 1 m – $ 0.15 m or $ 9.85 m.

Question C: How should the entity recognize transaction costs allocated to multiple components?

Transaction costs allocated to liability-classified warrants will be expensed immediately. The following journal entry will be recorded:

Db Warrant Issuance Expense:                       $ 150,000

Cr APIC- Sponsor Contribution                        $ 150,000

$ 9.85 m of transaction costs allocated to equity will be recorded as a reduction of equity, i.e. APIC at the time of transaction close:

Db APIC- Issuance Cost:                                  $ 9,850,000

Cr APIC- Sponsor Contribution:                      $ 9,850,000

Recognizing transaction cost allocated to the equity instrument will not have any impact on company’s total equity or its individual components.

As part of Form S-1, SPACs prepare capitalization table showing the impact of the IPO transaction on company’s capital structure including debt and equity. Generally, equity structure, as disclosed in the capitalization table, shows separate categories including APIC, Accumulated Deficit, etc. As noted above, part of transaction cost allocated to liability-classified warrants will impact SPAC’s APIC and accumulated deficit. The above impact should be appropriately disclosed in the capitalization table included in company’s Form S-1.


Important Note: FinAcco Consulting LLC is not responsible for, and no person should rely upon, any advice or information presented on this website. Note that entity’s financial statements, including, without limit, the use of generally accepted accounting principles (“GAAP”) to record the effects of any proposed transaction, are the responsibility of management. Therefore, any written comments by FinAcco Consulting LLC about the accounting treatment of selected balances or transactions or the use of GAAP are to serve only as general guidance. Our comments are based on our preliminary understanding of the relevant facts and circumstances and on current authoritative literature. Therefore, our comments are subject to change. FinAcco Consulting LLC does not assume any responsibility for timely updates of its website overall or any information provided in the Insights section of the website, specifically.


 

Accounting for Underwriter Overallotment Option

2021-08-22T20:52:46+00:00 08/22/2021|Financial Instruments, SPAC accounting issues|

Background

Many public offering transactions include a feature that allows the sale of additional debt or equity securities to underwriters of the offering company. The terms of the feature are that underwriters can purchase, at their discretion, specified amount of securities within certain amount of days following the transaction close at a price agreed on now. Generally, in equity offerings, the amount of additional shares issuable to underwriters is 15% of the initial offering while the option term varies between 30 and 45 days. The feature is referred to as an overallotment option and, in essence, represents a written call (purchase) option.

Historically, overallotment provisions (or a greenshoe provision) have been used to accommodate potential investor demand in excess of the base offering amount, which may not be known until the issuance date or shortly thereafter. Therefore, the option permits the issuer to issue more securities without the time and expense of an additional filing. For example, an issuer plans to issue 20 million of equity securities at $ 10 per share, yet discovers at the issuance date that there is additional demand in the marketplace for the instruments. To accommodate for this additional demands, terms of the offering include the overallotment option allowing to issue, at underwriter option, 3 million more securities at $ 10 per share during 30 days after the initial issuance.

Amount of issuable shares under some overallotment options is impacted by underwriter sale or purchase of equity securities at the open market. For example, according to terms of some overallotment options, the amount of issuable shares may be reduced by underwriter purchase of shares at the open market. The reduction may be permanent or temporary. If the reduction was temporary, the amount of issuable shares can increase to the original level, if the underwriter sells some or all of securities previously purchased at the open market.

In most cases, the exercise of overallotment option is contingent upon underwriter receipt of orders for more shares than included in the base offering.

Being a common feature in public offerings of operating companies, overallotment options are also included in public offerings by Special Purpose Acquisition Company (SPAC). Under the terms of SPAC overallotment option, underwriters will have an option to purchase additional units from the SPAC. SPAC units including common stock and warrants. If underwriters exercise their option, SPAC sponsor will also be expected to purchase additional warrants referred to as “private” at the time when underwriters exercise the option. The sponsor will purchase additional warrants at the same price (e.g. $ 1 or $ 1.5 per warrant) that it paid for the original warrants.

Many overallotment options found in SPAC offerings do not have any terms whereby the amount of issuable shares is impacted by underwriter transactions in the open market. Generally, underwriters of SPAC offerings can only exercise the option provided the amount of securities per base offering is not sufficient to satisfy all investor orders.

Many reporting entities including SPACs raised a question of how to account for underwriter overallotment option.

Executive Summary

Underwriter’s overallotment option may be classified as instrument embedded in the host securities, i.e. shares or warrants. Proponents of the above view believe that overallotment options are not considered legally detachable, i.e. underwriters cannot sell or otherwise legally transfer them. Economic characteristics and risk of embedded overallotment option are considered clearly and closely related to those of the host. Therefore, the option component is not to be bifurcated under ASC 815-15 and is accounted for as part of the host instrument. SPACs account for embedded underwriter overallotment options as part of IPO units. SPACs also account for overallotment options embedded in private warrants as part of the warrants.

Alternatively, overallotment options may be considered freestanding financial instruments. The above treatment is based on the understanding that the option may be exercised subsequent to transferring securities from underwriters to investors and that, in this case, the option should be detached from the initial securities before it is exercised. Freestanding overallotment options may also be considered subject to ASC 480 and, if so, classified as a separate liability. Such liability-classified overallotment options are measured at fair value initially and subsequently.

Freestanding overallotment options not considered in the scope of ASC 480, have to be analyzed to determine if they meet the scope exception from the application of derivative guidance. The analysis involves applying indexation guidance as well as additional equity classification requirements. If freestanding options receive the scope exception, they are reported as part of entity’s equity. In this case, equity issuance proceeds may have to be allocated to the instrument in question on a relative fair value basis. Subsequently, equity-classified overallotment options are not remeasured and are carried at the initial amount. If freestanding options do not meet derivative scope exception, they have to be the accounted for at fair value at issuance and subsequently with changes in fair value reported in earnings. The above accounting treatment is conceptually similar to the treatment under ASC 480.

Most SPACs took the position that underwriter overallotment option should not be accounted for as liabilities, separately from the host. This accounting treatment applies to overallotment options that are either a) embedded and not freestanding financial instruments; b) freestanding financial instruments outside of the scope of ASC 480 and meeting requirements of derivative scope exception.

Accounting Analysis

Overallotment options represent equity-linked financial instruments. Appendix A: Accounting for Equity-Linked Instruments shows an overall approach to accounting for overallotment options or other equity-linked instruments. At a high level, an overallotment option may have to be recognized and reported as a) part of the host instrument or b) separately per ASC 480, Distinguishing Liabilities from Equity or ASC 815, Derivatives and Hedging. Separate reporting of the option will entail measuring the option at fair value initially and subsequently with changes in fair value reported in earnings.

Topic 1: Freestanding vs. Embedded Instruments

Box A Freestanding vs. Embedded. Current accounting guidance has different set of rules applicable to so embedded and freestanding instruments.

An instrument is considered freestanding if either of the following two conditions apply (ASC 815-40-20, Glossary):

  1. the instrument is entered into separately and apart from any of the entity’s other financial instruments;
  2. it is entered into in conjunction with some other transaction and is legally detachable and separately exercisable;

A reporting entity should first determine whether the components (1) were issued contemporaneously and in contemplation of each other or (2) were negotiated separately and/or at different points in time. Overallotment options are issued in connection with the underlying securities. From this perspective, the two instruments were not entered into separately.

U.S. GAAP does not provide specific guidance on the meaning of “legally detachable.” “Legally detachable” generally refers to ability of the instrument holder to legally transfer, e.g., sale the instrument without transferring all other related instruments.

We noted two views in legally detachable and separately exercisable analysis, referred below as View 1 and View 2.

View 1 is based on the understanding that the terms of the underwriting agreement do not envisage legal transfer of the overallotment option. In other words, the option can only be exercised by underwriters. From this perspective, the option appears to be embedded in the host contract and does not represent a freestanding instrument.

The above view is supported, in part, by the following provisions of ASC 815-10-15-5:

The notion of an embedded derivative…does not contemplate features that may be sold or traded separately from the contract in which those rights and obligations are embedded. Assuming they meet [the] definition of a derivative instrument, such features shall be considered attached freestanding derivative instruments rather than embedded derivatives by both the writer and the current holder.

Proponents of View 1 believe that if an item is separately exercisable but not considered legally detachable, it would not be a freestanding financial instrument under item (b) of the definition of a freestanding financial instrument.

View 1 Conclusion: underwriter’s overallotment option is an embedded instrument.

Topic 2: Accounting for embedded instruments

If an overallotment option is considered a feature embedded in the securities initially issued, that embedded feature should be analyzed to determine if it should be bifurcated from the host instrument. That determination will involve evaluating the hybrid instrument (the security and embedded overallotment feature) pursuant to ASC 815-15.

Box C1 Fair Value Option: ASC 825-10, Financial Instruments provides reporting entities with an option to measure some financial instruments at fair value on an instrument-by-instrument basis. ASC 825-10-15-5 par. f does not allow application of the fair value option to “financial instruments that are, in whole or in part, classified by the issuer as a component of shareholder’s equity (including temporary equity)…”. IPO shares issued by SPACs and subject to redemption terms are classified as part of temporary equity. Shares issued by operating companies are commonly considered part of issuer’s permanent equity. From this perspective, reporting entities may not apply the fair value option.

Box C3 Clearly and Closely Related Evaluation: The evaluation refers to a comparison of the economic characteristics and risks of the embedded feature and those of the host. US GAAP does not offer a specific definition of clearly and closely related concept, however, it illustrates the concept through examples provided in ASC 815-15-25-23 through 50.

Generally, to be considered clearly and closely related to the host, the underlying that causes the value of embedded feature to fluctuate, must be related to the inherent economic characteristics of the host instrument. To assess whether an embedded feature is considered clearly and closely related to the host, reporting entity should first determine the nature of the host contract.

The overallotment option represents a written call or purchase option. Generally, the economic characteristics and risks of the embedded written call option are considered clearly and closely related to the economic characteristics and risks of the host contract. The underlying to the overallotment option is the same security as the host instrument.

Box C2: If the economic characteristics and risks of the embedded feature and the host are clearly and closely related to each other, ASC 815 does not require bifurcation of the feature from the host. The host (IPO units and private warrants) and the overallotment option are recorded as one instrument.

Based on the above analysis, the overallotment option would not be bifurcated from the host instrument.

Some SPAC IPO units are classified as temporary equity, based on the redemption terms and consistent with the requirements of ASC 480-10-S99-3A. We believe that the temporary equity treatment does not impact the above clearly and close related conclusion as option underlying has the same economic risk and characteristics as does the host instrument.

Option to issue additional private warrants is entered into in connection with the initial issuance of private warrants and not separately. The option is not legally transferrable, i.e. it can only be exercised by the sponsor. Additionally, transferability of private warrants is restricted until SPAC merger. Therefore, the option to purchase additional private warrants is considered an embedded and not a freestanding instrument, based on the requirements of ASC 815-40-20, Glossary.

Further, we believe that economic risk and characteristics of the option to acquired additional private warrants are clearly and closely related to the initial warrants.

Based on the above considerations, option to acquire additional private warrants is not separated from the underlying warrants.

Some reporting entities raised a question of whether the overallotment option considered a derivative financial instrument as defined in ASC 815-10. Per ASC 815-10-15-83 a derivative instrument is a financial instrument or other contract with all of the following characteristics: a) one or more underlyings, b) one or more notional amounts or payment provisions or both, c) no or limited initial net investment, d) net settlement.

The underlying of an overallotment option is the price of the underlying securities. Overallotment options have little or no initial net investment, similar to other options. The net settlement requirement is likely to be satisfied because the securities delivered upon the exercise of the option are readily convertible to cash through the market in which they are offered. However, some entities believe that overallotment options do not have a notional amount, i.e. the number of units, shares or other face amount stated in the contract. Specifically, this view applies to overallotment options where the amount of issuable securities depends on underwriter sale or purchase of securities in the open market. Since the amount of issuable securities depends on underwriter activities, the notional amount is not known. We generally believe such overallotment options do not have a notional amount and are not considered derivatives. However, in cases, when the amount of overallotment shares does not depend on underwriter market activity, the notional amount is assumed to be the contractual maximum of shares. Such overallotment options will likely be considered derivative instruments.

Conclusions: overallotment options may be considered financial instruments embedded in the host instruments e.g. shares or warrants. Economic characteristics and risk of such overallotment option are considered clearly and closely related to those of the host. Therefore, the option component is not to be bifurcated under ASC 815-15. Overallotment option is to be accounted for as part of the host instrument. SPACs account for embedded underwriter overallotment options as part of IPO units. SPACs also account for overallotment options embedded in private warrants as part of the warrants.

Topic 3: Freestanding Instruments- View 2, Scope of ASC 480

Some believe that as part of “legally detachable and separately exercisable” evaluation a reporting entity should consider whether (1) a right in a component may be exercised separately from other components that remain outstanding and (2) if, once a right in a component is exercised, the other components are no longer outstanding. Since separate exercisability invariably requires the component first be detached prior to exercise, this is a strong indicator that the components are freestanding.

As noted above, the overallotment option cannot be legally transferred from the IPO units. However, according to the terms of most overallotment options, underwriters can exercise their option even after the underlying securities are sold to investors. For example, according to standard terms of SPAC overallotment option:

“Said option may be exercised in whole or in part at any time on or before the 45th day after the date of the Prospectus upon written notice by the Representatives to the Company setting forth the number of Option Securities as to which the several Underwriters are exercising the option and the settlement date.”

Some believe that the overallotment option should be first detached from the initial shares transferred to the investors prior to exercising. From this perspective, the option to acquire additional IPO units appear to be detachable and, therefore, freestanding.

Proponents of the above View 2 believe that even though the option cannot be transferred by underwriters, the option is not necessarily embedded; it is merely attached. Supporter of View 2 believe that underwriter overallotment options are considered freestanding financial instruments.

If the overallotment option is considered a freestanding financial instrument, it has to be evaluated pursuant to ASC 480, Distinguishing Liabilities from Equity. Instruments included in the scope of ASC 480 are considered liability (or asset) instruments to be recognized and presented separately. Generally, ASC 480 applies to the following freestanding equity-linked instruments:

  • mandatorily redeemable securities as defined in ASC 480-10-25-4 through 7;
  • securities that may require the issue to settle the obligation by transferring assets as defined in ASC 480-10-25-8 through 13;
  • instruments meeting other specific requirements per ASC 480-10-25-14;

ASC 480-10-S99-3A contains additional classification and measurement requirement applicable to public companies.

According to ASC 480-10-25-8:

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:

  1. It embodies an obligation to repurchase the issuer’s equity shares, or is indexed to such an obligation.
  2. It requires or may require the issuer to settle the obligation by transferring assets.

ASC 480-10-25-8 does not apply to an outstanding share including share classified as temporary equity. However, ASC 480-10-25-10 specifically includes in the scope of ASC 480 forward purchase contracts or written put (purchase) options on issuers equity shares that are to be physically settled or net cash settled. According to the terms of a written put option, a reporting entity agrees to buy its own shares from a counterparty.

SPAC public shareholders may, at their option, redeem ordinary shares upon completion of business combination transaction subject to certain limitations. ASC 480 has specific provisions concerning warrants, i.e. written call options issued on contingently redeemable (puttable) stock. According to ASC 480-10-55-33:

A warrant for puttable shares conditionally obligates the issuer to ultimately transfer assets—the obligation is conditioned on the warrant’s being exercised and the shares obtained by the warrant being put back to the issuer for cash or other assets. Similarly, a warrant for mandatorily redeemable shares also conditionally obligates the issuer to ultimately transfer assets—the obligation is conditioned only on the warrant’s being exercised because the shares will be redeemed. Thus, warrants for both puttable and mandatorily redeemable shares are analyzed the same way and are liabilities under paragraphs 480-10-25-8 through 25-12, even though the number of conditions leading up to the possible transfer of assets differs for those warrants. The warrants are liabilities even if the share repurchase feature is conditional on a defined contingency.

The above requirements cover warrants on shares that may require transfer of assets, i.e. conditional obligations, not just mandatorily redeemable shares.

According to ASC 480 measurement requirements, warrants for puttable shares are measured at fair value initially (ASC 480-10-30-7) and subsequently (ASC 480-10-35-5) with the changes in the fair value reported in earnings.

The above guidance may apply to overallotment options by analogy. The application by analogy is based on conceptually similar nature of overallotment options and warrants, both considered written call options.

Overallotment options deemed as a liability under ASC 480 are accounted for using one of the two accounting methods:

  1. based on proceeds allocated from the offering and, thus, reducing, the amount of the offering amount or
  2. as a separate instrument issued for no proceeds with the offset to expense or deferred equity issuance cost, i.e. Cr Overallotment Option Liability; Db Equity Issuance Costs or Db Issuance Expense;

Allocation of proceeds to liability-classified instruments is generally performed using “with-and-without”. Under this method, a portion of the proceeds equal to the fair value of the instrument measured at fair value is first allocated to that instrument on the basis of its initial fair value. The remaining proceeds are then allocated to the other instrument issued in the same transaction on a residual basis. The with-and-without approach avoids recognition of “day 1” gain or loss in the income statement.

Following either of the above methods, reporting entities measure the overallotment option at its fair value initially. The option is remeasured at fair value subsequently until it is exercised or expires.

We understand that the application of ASC 480-10-55-33 and ASC 480-10-25-8 by analogy to overallotment options does not represent the only established accounting method. We understand that physically settled written call options or forward sale contracts under which the issuer will deliver shares that contain an unconditional or conditional redemption obligation (e.g., shares that are redeemable upon an event that is outside the control of the issuer) might be subject to guidance applicable to contingently redeemable securities. Given the lack of specific requirements to apply the existing guidance for contingently redeemable securities to overallotment options, some reporting entities concluded that the options are outside of the scope of ASC 480. We understand that no single accounting treatment is currently established or is required by GAAP in the area of accounting for overallotment options.

If the overallotment option is not considered an ASC 480 liability, the option has to be evaluated using indexation guidance and additional equity classification requirements per ASC 815.

Box B2 Indexation Guidance: An overallotment option for equity securities may qualify for the scope exception in ASC 815-10-15-74(a) because the options are settled in the underlying equity security. The option would be classified as equity if it is both (1) indexed to its own stock and (2) classified in stockholders’ equity in its statement of financial position pursuant to ASC 815-40, Contracts in Entity’s Own Equity.

ASC 815-40-15 includes the guidance analyzing if the instrument is indexed to entity’s own stock or indexation guidance. Generally speaking, instruments are indexed to entity’s own stock when economic characteristics and risk of the instrument are similar to those of entity’s equity.

Indexation guidance requires an entity to apply a two-step approach (ASC 815-40-15-7). Step 1 covers the evaluation of instrument’s contingent exercise provisions, if any. If the evaluation of Step 1 does not preclude an instrument from being considered indexed to the entity’s own stock, the analysis shall proceed to Step 2. Step 2 of the indexation guidance is focused on the analysis of instrument’s settlement provisions. Settlement condition or a provision that affects whether the option can be exercised, such as occurrence of overallotment event, is considered an example of exercise contingency.

As part of Step 1, management should evaluate all contingencies or conditions associated with exercise of underwriter rights under the terms of the instrument. An exercise contingency shall not preclude an instrument (or embedded feature) from being considered indexed to an entity’s own stock provided that it is not based on either of the following:

  1. An observable market, other than the market for the issuer’s stock (if applicable)
  2. An observable index, other than an index calculated or measured solely by reference to the issuer’s own operations (for example, sales revenue of the issuer; earnings before interest, taxes, depreciation, and amortization of the issuer; net income of the issuer; or total equity of the issuer).

An exercise condition linked to investor orders for entity’s IPO shares is based on the market for issuer’s stock. Therefore, such an exercise condition does not prevent equity classification.

As part of Step 2, management should evaluate all adjustments to instrument’s exercise price as well as the amount of issuable shares. Generally, settlement provisions will not preclude equity classification if the exchange terms are as such that fixed number of entity’s shares is exchanged for fixed monetary amount, i.e., fixed exercise price, subject to certain exceptions. The above rule is referred to as “fixed-for-fixed”.

Certain settlement adjustments impacting amount of issuable shares and settlement price may comply with Step 2 requirements. Examples include equity restructuring adjustments such as stock dividend, stock split, etc. (ASC 815-40-20, Glossary) or adjustments based on variables used as inputs to the valuation model utilized to determine the fair value of a fixed-for-fixed forward or option on equity shares (ASC 815-40-15-7E).

Generally, under the terms of SPAC underwriting agreements, additional securities are purchased at the same price per unit as the underwriters paid for the initial securities. Further, we understand that standard terms of SPAC underwriting agreements do not include substantive adjustments impacting the per unit price. In such cases, overallotment settlement provisions will not preclude equity classification. However, terms of settlement provisions applicable to issuance of securities by operating companies to their underwriters should be carefully analyzed to determine if they meet the requirements of the fixed-for-fixed rule.

SPACs should also determine if settlement terms of public shares issuable under an overallotment option are consistent with Step 2 requirements. Generally, SPACs classify public shares as temporary equity, subject to certain redemption limitations stated in legal documents and consistent with the requirements of ASC 480-10-S99-3A. According to ASC 815-10-15-76:

“Temporary equity is considered stockholders’ equity for purpose of the scope exception in paragraph 815-10-15-74(a) even if it is required to be displayed outside of the permanent equity”.

Based on the above, classification of commons shares as temporary equity is consistent with Step 2 equity classification requirements for the overallotment option.

Box B4 Additional Equity Classification Requirements: Generally, additional equity classification requirements are intended to identify situations when the instrument holder can force the issuer to settle in cash and not in equity. Additional equity classification requirements are as follows:

  1. Settlement is permitted in unregistered shares;
  2. Entity has sufficient authorized and unissued shares;
  3. Contract should contain an explicit limit on the number of shares to be delivered;
  4. No required cash payment if entity fails to make timely filings with SEC;
  5. No cash-settled top-off or make-whole provisions;
  6. No counterparty rights rank higher than shareholder rights;
  7. No collateral required;

Recently issued accounting updated ASU 2020-06 eliminated conditions one, six and seven. ASU 2020-06 is effective for smaller reporting companies for fiscal years beginning after December 15, 2023. Early adoption is permitted for fiscal years beginning after December 15, 2020, as the earliest.

We understand that, in general, the amount of authorized shares at the time of the IPO was determined as such that SPACs have enough unissued shares to satisfy their obligations under underwriting agreements including overallotment options. In this case, requirement two above will be met. Overall, we understand that most SPACs will likely meet other applicable requirements, however, a careful analysis should be performed to corroborate that.

Box B5, B6: If the overallotment option receives an exception from derivative accounting, it is recorded together within reporting entity’s equity. Equity issuance proceeds may have to be allocated to the instrument in question on a relative fair value basis. Subsequently, the overallotment option is not remeasured and is carried at the initial amount. Overallotment options that do not qualify for equity classification pursuant to ASC 815 are classified as liabilities. Such instruments are measured at fair value at issuance and subsequently adjusted to fair value through earnings until the option expires or is exercised. As part of initial recognition, reporting entities should allocate IPO proceeds to the liability-classified option, thus reducing equity proceeds as reported in company’s equity, i.e. additional paid-in capital (ASC 815-15-30-2 through 30). The above accounting including the allocation method is similar to overallotment options classified as a liability pursuant to ASC 480.

Conclusions: overallotment options may be considered freestanding financial instruments. The above determination is based on the understanding that the option may be exercised subsequent to transfer of the securities from underwriters to investors and that, in this case, the option should be detached from the initial securities before it is exercised. Freestanding overallotment options may also be considered subject to ASC 480 and, if so, classified as a separate liability. Such liability-classified overallotment options are measured at fair value initially and subsequently.

Freestanding overallotment options not considered in the scope of ASC 480, have to be analyzed to determine if they meet the scope exception from the application of derivative guidance. The analysis involves applying indexation guidance as well as additional equity classification requirements. If freestanding options receive the scope exception, they are reported as part of entity’s equity. In this case, equity issuance proceeds may have to be allocated to the instrument in question on a relative fair value basis. Subsequently, equity-classified overallotment options are not remeasured and are carried at the initial amount. If freestanding options do not meet derivative scope exception, they have to be the accounted for at fair value at issuance and subsequently with changes in fair value reported in earnings. The above accounting is similar to overallotment options classified as a liability pursuant to ASC 480.

Appendix A

Accounting for Equity-Linked Instruments

 

 


Important Note: FinAcco Consulting LLC is not responsible for, and no person should rely upon, any advice or information presented on this website. Note that entity’s financial statements, including, without limit, the use of generally accepted accounting principles (“GAAP”) to record the effects of any proposed transaction, are the responsibility of management. Therefore, any written comments by FinAcco Consulting LLC about the accounting treatment of selected balances or transactions or the use of GAAP are to serve only as general guidance. Our comments are based on our preliminary understanding of the relevant facts and circumstances and on current authoritative literature. Therefore, our comments are subject to change. FinAcco Consulting LLC does not assume any responsibility for timely updates of its website overall or any information provided in the Insights section of the website, specifically.


 

 

Accounting for Redeemable Shares

2021-09-21T08:00:15+00:00 08/08/2021|SPAC accounting issues|

Background

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:

  1. It embodies an obligation to repurchase the issuer’s equity shares, or is indexed to such an obligation.
  2. 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.

 


Important Note: FinAcco Consulting LLC is not responsible for, and no person should rely upon, any advice or information presented on this website. Note that entity’s financial statements, including, without limit, the use of generally accepted accounting principles (“GAAP”) to record the effects of any proposed transaction, are the responsibility of management. Therefore, any written comments by FinAcco Consulting LLC about the accounting treatment of selected balances or transactions or the use of GAAP are to serve only as general guidance. Our comments are based on our preliminary understanding of the relevant facts and circumstances and on current authoritative literature. Therefore, our comments are subject to change. FinAcco Consulting LLC does not assume any responsibility for timely updates of its website overall or any information provided in the Insights section of the website, specifically.


 

SPAC Financial Close

2021-09-28T08:05:28+00:00 07/11/2021|SPAC accounting issues|

SPAC Financial Close

SPAC 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.

SPACs have limited activities. Entity’s transactions include receiving legal and accounting services, interest income, accruing and payment of franchise and income taxes, etc. SPACs also account for cash, prepaid assets, IPO proceeds kept at a trust account, prepaid assets, accounts payable, deferred underwriting commission, temporary and permanent equity, among other items.

Financial Close

SPAC financial close includes recording relevant entries in entity’s accounting system as well as preparation of, based on recorded entries, full set U.S. GAAP financial statements. The financial statements include primary forms, i.e. balance sheet, income statement, cash flow statement and statement of change in equity and footnotes to the financial statements.

Diagram A: SPAC Accounting Close provides an overview of key activities performed as part of SPAC financial close. Accounting activities are broken down between current period bookkeeping, i.e. recording of journal entries and financial close activities.

Box A- Recognize current period activities including income and expenses

SPAC accounting team should recognize current period income and expense items as well other relevant transactions. Generally, SPAC current period income (expense) includes the following:

  • legal, audit, tax, other professional fees and expenses;
  • interest income associated with IPO proceeds kept at a trust account;
  • interest expenses associated with a promissory note issued to a related party, if any;
  • warrant revaluation adjustments for warrants classified as liability instruments;

SPAC current period activities also include cash receipts and payments as well as other activities impacting entity’s balance sheet (e.g. amortization of prepaid assets).

Box B- Recognize quarterly income tax provision, if any

SPAC quarterly financial statements should reflect income tax provision including current and deferred income taxes, if applicable, recognized according to with ASC 740, Income Taxes. Some SPACs are also subject to state franchise tax, i.e. a state tax generally based on such non-income measures as total capital or net worth of the reporting entity.

Box C- Determine per share redemption value for redeemable shares

SPAC shares issued to public shareholders are subject to potential redemption by the SPAC. The redemption is at shareholder’s option that may be exercised in connection with completion of the merger transaction, subject to other limitations described below. SPACs repot common stock subject to potential redemption as temporary equity, consistent with requirements of ASC 480-10-S99-3A.

As part of monthly, close the financial reporting team should determine the redemption value of public shares. Generally, the redemption value per public share is determined using the following formula:

Per Share Redemption Value  = ( IPO Proceeds Held in Trust – Current Income Tax Liability (net) ) /  Public Shares Issued and Outstanding

IPO proceeds above include earned interest. Current income tax liability relates to interest income subject to taxation. No deduction of current income tax is required, if the amount of interest associated with trust funds is already net of taxes.

For more details regarding presentation and measurement of temporary equity refer to FinAcco’s publication SPAC Accounting Issues.

Box D- Determine quarterly adjustments to permanent & temporary equity (before the impact of recent SEC Comment Letters concerning reporting of temporary equity)

As noted above, SPACs report common stock subject to potential redemption as part of SPAC temporary equity. However, 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. The above limitation was introduced to ensure that SPAC NTA will be at least $ 5,000,000 so that it is not subject to SEC rules applicable to “penny stock”. NTAs are defined as total assets less liabilities and intangible assets. For most SPACs, the amount of net tangible assets is not materially different from SPAC’s permanent equity.

Based on the above redemption requirements, many SPACs measure their period-end permanent equity not to be lower than $ 5,000,001, e.g. $ 5,000,001 or $ 5,000,002. Remaining IPO proceeds is to be reported as part of temporary equity. SPAC financial reporting team determine journal entries, impacting quarter-end temporary and permanent equity, consistent with the above presentation of redeemable and non-redeemable public shares.

Box E- Recognize quarterly adjustments to permanent and temporary equity (before the impact of recent SEC Comment Letters concerning reporting of temporary equity)

Accounting team recognizes quarter-end adjusting entries to appropriately reflect temporary and permanent equity. Entries impacting permanent equity are recorded in entity’s additional paid-in capital. Following recognition of the above entries, quarter-end monetary value of SPAC permanent equity should be approximately $ 5,000,001.

Box F- Determine quarter-end amount of redeemable and non-redeemable shares (before the impact of recent SEC Comment Letters concerning reporting of temporary equity)

After financial reporting team determined redemption value per public share (Box C) and monetary value of temporary equity (Box D), it calculates the amount of quarter-end shares subject to potential redemption. The amount of potentially redeemable shares is determined as follows:

Redeemable Shares  =      Temporary Equity / Per Share Redemption Value

Then, the amount shares not subject to potential redemption is calculated as the difference between all authorized and issued public shares and shares subject to potential redemption per above.

Amount of shares subject to potential redemption is reflected on the face of entity’s balance sheet using the following language:

“Common stock subject to possible redemption, [A] and [B] shares at redemption value at December 31, 20X0 and December 31, 20X1, respectively”.

Amount of shares not subject to potential redemption is also presented on the face of the balance sheet using the following language:

“Class A Common stock, $0.0001 par value; [C] shares authorized; [D] and [E] issued and outstanding (excluding [A] and [B] shares subject to possible redemption at December 31, 20X0 and December 31, 20X1, respectively)”.

Box G- Recognize par value of non-redeemable stock in permanent equity (before the impact of recent SEC Comment Letters concerning reporting of temporary equity)

SPACs report non-redeemable common shares in its equity statement at par value while the excess of par value over issuance proceeds in recognized as part of additional paid-in capital (APIC). Par value of most SPAC common shares is $ 0.0001/share. Once the financial reporting team determined the amount of non-redeemable shares (Box F), the accounting team should reflect the par value of the shares in entity’s statement of changes in equity. Respective period-end journal entries impact commons stock at par value as well as entity’s APIC. The above entries do not result in net change in SPAC permanent equity.

Impact of recent SEC Comment Letters concerning reporting of temporary equity:

Historically, SPACs measured their period-end permanent equity not to be lower than $ 5,000,001, e.g. $ 5,000,001 or $ 5,000,002. Remaining IPO proceeds were to be reported as part of temporary equity. Following the above accounting practice has resulted in classification of some but not all public shares as contingently redeemable, i.e. part of temporary equity. Historical 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

As part of the revised approach, the amount of temporary equity is determined without the regard to the $ 5,000,001 threshold for permanent equity (see Box D above).

Consistent with the historical approach as reflected in Box E above, the amount of temporary equity is recognized to reduce the reportable value of permanent equity. However, 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.

Since the amount of redeemable and non-redeemable shares under the “new” approach have changed, i.e. all public shares are classified as redeemable, the change directly impacts the disclosures provided in Box F above.

The revised approach also impacts procedures described in Box G. No adjustments to entity’s par value of IPO shares and APIC would be required as all public shares are reported as part of temporary equity upon their initial recognition.

Diagram B: SPAC Accounting Close provides an overview of key closing activities under the revised approach for presentation of IPO shares.

The above changes impact SPAC’s financial statements as well as information presented in capitalization table disclosing SPAC’s temporary and permanent equity and debt capital at a historical pre-IPO date and immediately after the IPO.

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.

Box H- Prepare primary forms: BS, IS, CF, Equity Statement

After all relevant journal entries are recognized in SPAC’s general ledger, the financial reporting team prepares primary forms. Generally, SPACs primary forms are the balance sheet, income statement (or statement of operations), statement of changes in equity and cash flow statement. Many existing software products automate the process of preparing primary forms, however, depending on a software product, some financial reporting teams find it more convenient to prepare the statement of changes in equity and cash flow statement in Excel using other primary forms as an input.

Box I- Calculated EPS for redeemable  and non-redeemable shares

Once the financial reporting term determined the amount of quarter-end shares subject to potential redemption and non-redeemable shares, the share information is used to calculate earnings per share (EPS). Generally, SPACs follow two-class EPS method consistent with the requirements of ASC 260-10-55-23 through 55-31. SPACs should determine weighted average shares outstanding for both classes of shares. For more details regarding application of the two-class EPS method refer to FinAcco’s publication SPAC Accounting Issues.

Box J- Update footnotes to the financial statements

Financial reporting team will need to prepare footnotes to the financial statements. Footnotes should disclosure applicable information as required by U.S. GAAP. Generally, SPAC footnotes include description of SPAC operations including terms of the initial IPO, SPAC accounting policies, warrant terms, classes of common and preferred stock including related rights and privileges, fair value measurements, income taxes and subsequent events. Fair value disclosures cover such balance sheet items as cash and cash equivalents held in the trust account and, if applicable, liability-classified warrants. Income tax disclosures include income tax reconciliation per ASC 740-10-50-12.

As part of the close, accounting or financial reporting team should prepare bank reconciliation. The team should also prepare reconciliations of other balance sheet accounts to ensure that period-end balances are accurate. Management should establish other financial reporting controls to ensure all transactions are authorized by the appropriate personnel.

 

Diagram A: SPAC Accounting Close

(before the impact of recent SEC Comment Letters concerning reporting of temporary equity)

 

 

Diagram B: SPAC Accounting Close

(after the impact of recent SEC Comment Letters concerning reporting of temporary equity)


Important Note: FinAcco Consulting LLC is not responsible for, and no person should rely upon, any advice or information presented on this website. Note that entity’s financial statements, including, without limit, the use of generally accepted accounting principles (“GAAP”) to record the effects of any proposed transaction, are the responsibility of management. Therefore, any written comments by FinAcco Consulting LLC about the accounting treatment of selected balances or transactions or the use of GAAP are to serve only as general guidance. Our comments are based on our preliminary understanding of the relevant facts and circumstances and on current authoritative literature. Therefore, our comments are subject to change. FinAcco Consulting LLC does not assume any responsibility for timely updates of its website overall or any information provided in the Insights section of the website, specifically.


 

SPAC Equity Forward Agreements

2021-07-12T21:39:13+00:00 07/05/2021|SPAC accounting issues|

SPAC 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. Therefore, general public can buy SPAC’s shares before the merger or acquisition takes place.

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. SPAC will also use proceeds received from public investors to finance potential acquisition transaction. SPAC’s time to identify a suitable target is limited to 24 months. The identity of the target as well as whether the acquisition will take place is uncertain, at the time of SPAC’s IPO.

FPA Background

Some SPACs signed a forward purchase agreement (FPA), an arrangement that  obligates SPAC to issue to its sponsor a specified amount of SPAC units in exchange for cash at the time of closing of merger transaction. The agreement become effective concurrently with the IPO. SPAC units issuable under the terms of FPA include common stock and warrants. Cash consideration is defined as a fixed amount per unit (e.g. $ 10 per a unit). The amount of units can be increased, at the option of the sponsor, by a specified amount, in which case overall cash consideration will increase accordingly.

As an example, concurrently with the closing of business combination SPAC shall issue and sell to the sponsor 1,000,000 units at a price of $ 10 per unit and total consideration of $ 10,000,000. At the option of the sponsor, the amount of units can increase to up to 2,000,000 at a price of $ 10 per unit and total consideration of $ 20,000,000. Each unit consists of 1 Class A common share and half of a warrant.

Generally, warrants sold as part of FPA are the same warrants that were issued to public investors as part of SPAC’s IPO, i.e. so-called public warrants.

The purpose of FPAs is to commit to the combined entity capital required to finance its operations while enabling sponsors to potentially benefit from the additional equity interest. Per unit contract price is usually set at market so that the intrinsic value of the contract is zero at inception. Contract value at settlement depends on the relationship between the initial FPA price and the price of underlying shares at that time. The contract results in a gain to one party and a loss to the other party as the underlying share price fluctuates.

The contract is settled in shares and warrants only. Generally, FSA settlement price (e.g. $ 10) is fixed throughout the life of the contract.

Based on the information we have, approximately 20% of all SPACs signed a forward purchase agreement (statista.com).

Questions arose of how to account for SPAC forward purchase agreements under U.S. GAAP.

Accounting Analysis- General

A forward purchase agreement signed by a SPAC is considered a type of equity forward or a contract between two parties under which one party must deliver, at a future date (settlement date), an equity security in exchange for an agreed-on price that the other party must pay. The equity forward in question is contingent on the occurrence of an event that is not certain to occur. Unlike an option, both parties to an FSA are required to perform in accordance with the agreed-on terms.

Price per unit is referred to as forward or contract price. The number of underlying equity securities to be delivered is called the notional amount.

U.S. GAAP refers to the above FPA arrangements as forward sale agreements (FSA) as from the issuer perspective, the units will be sold to the sponsor. FSAs are further defined in ASC 815-40-55-13.

Forward Sale Agreement: Classification and Measurement

FSAs signed by SPACs are considered equity-linked financial instruments as the contract involves future issuance of equity units including common stock and warrants. Appendix A Accounting for Equity-Linked Financial Instruments illustrates a general approach to accounting to equity-linked instruments.

Box A: The first step in the analysis is to determine if the instrument is considered an embedded or free-standing.

According to ASC 815-10, Glossary, an instrument is considered freestanding if either of the following two conditions apply:

  1. the instrument is entered into separately and apart from any of the entity’s other financial instruments;
  2. it is entered into in conjunction with some other transaction and is legally detachable and separately exercisable;

FSA becomes effective concurrently with the IPO and, as such, is linked to the underlying IPO transactions. Therefore, some believe that FSA was not entered separately from other financial instruments. Generally, FSA terms do not allow transfer of the underlying rights and responsibilities. Therefore, if the instrument is considered to be entered in conjunction with another transaction, it is likely considered embedded and not freestanding.

Opponents of this view believe that an FSA constitutes a legally separate agreement and, therefore, a freestanding instrument. According to an extract from ASC 815-15-25-2:

The notion of an embedded derivative in a hybrid instrument refers to provisions incorporate into a single contract, and not to provisions in separate contracts between different counterparties.

Overall, we believe that classifying FSA as a freestanding contract is likely to be appropriate.

Box B1: Next step in the analysis is to determine if the instrument is included in scope of 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 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).

An issuer is not required to redeem FSA as a freestanding instrument. Therefore, at FSA-level, i.e. ignoring redemption terms applicable to underlying commons stock and warrants, the instrument is not redeemable. However, according to the established accounting practice, forward sale contracts issued on redeemable (puttable) stock are considered redeemable instrument subject to ASC 480.

Public shareholders may, at their option, redeem ordinary shares upon completion of business combination 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. Generally, the redemption value is aggregate amount held in the trust account at the time of the redemption including interest less related taxes.

A share redeemable at the option of the issuer or the holder, or which redemption is contingent on the occurrence or nonoccurrence 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 position is consistent with 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.

Similarly, a reporting entity does not have an unconditional obligation to repurchase warrants issuable under the terms of FSA. The warrants are not puttable at the option of the equity holders and, thus, not included in the scope of ASC 480 (ASC 480-10-55-33).

Overall, instruments issued under the terms of FSA are not considered mandatory redeemable per ASC 480. Generally, SPAC FSA does not meet requirements for other types of instruments described in ASC 480-10-25-14 and included in the scope of ASC 480.

Generally, SPACs classify public shares issuable under FSA as temporary equity, subject to certain redemption limitations stated in legal documents. Some respondents raised a question of whether SPAC’s classification of common stock as temporary equity in accordance with ASC 480-10-S99-3A would imply that an FSA will be subject to ASC 480. According to ASC 815-10-15-76, classification as temporary equity is considered consistent with equity classification per ASC 815-40-15 even though the underlying shares are presented outside of permanent equity. We believe that classification of underlying shares as temporary equity does not automatically result in the FSA agreement to be subject of ASC 480.

Box B2: ASC 815-40-15 includes the guidance analyzing if the instrument is indexed to entity’s own stock or indexation guidance. Generally speaking, instruments are indexed to entity’s own stock when economic characteristics and risk of the instrument are similar to those of entity’s equity.

Indexation guidance requires an entity to apply a two-step approach (ASC 815-40-15-7). Step 1 covers the evaluation of instrument’s contingent exercise provisions, if any. If the evaluation of Step 1 does not preclude an instrument from being considered indexed to the entity’s own stock, the analysis shall proceed to Step 2. Step 2 of the indexation guidance is focused on the analysis of instrument’s settlement provisions.

As part of Step 1, management should evaluate all contingencies or conditions associated with exercise of investor’s rights under the terms of the instrument. Settlement condition or a provision that affects whether contract is settled, such as occurrence of a merger transaction, is considered an example of exercise contingency.

An exercise contingency shall not preclude an instrument (or embedded feature) from being considered indexed to an entity’s own stock provided that it is not based on either of the following:

  1. An observable market, other than the market for the issuer’s stock (if applicable)
  2. An observable index, other than an index calculated or measured solely by reference to the issuer’s own operations (for example, sales revenue of the issuer; earnings before interest, taxes, depreciation, and amortization of the issuer; net income of the issuer; or total equity of the issuer).

A settlement condition linked to the change in control or merger involving the reporting entity is not based on an observable market or index. Therefore, such a settlement condition does not prevent equity classification.

As part of Step 2, management should evaluate all adjustments to instrument’s exercise price as well as the amount of issuable shares. Generally, settlement provisions will not preclude equity classification if the exchange terms are as such that fixed number of entity’s shares is exchanged for fixed monetary amount, i.e., fixed exercise price, subject to certain exceptions. The above rule is referred to as “fixed-for-fixed”.

Certain settlement adjustments impacting amount of issuable shares and settlement price may comply with Step 2 requirements. Example includes adjustments based on variables used as inputs to the valuation model utilized to determine the fair value of a fixed-for-fixed forward or option on equity shares (ASC 815-40-15-7E).

Analysis of settlement provisions applicable to FSA is conceptually similar to the analysis performed for SPAC’s private and public warrants. Following SEC statement issued on April 12, 2021, concerning the accounting of warrants, many SPACs determined that settlement terms of private and/or public warrants are inconsistent with equity classification requirements. Specifically, provisions of tender offer and related warrant cash settlement were as such that, under certain conditions, warrant holders appear to be entitled to a more favorable settlement than other stockholders would. The above disparity in settlement terms is inconsistent with equity classification requirements discussed in ASC 815-40-55-2 through 55-5. Additionally, certain inputs in the valuation of the cash redemption value were also inconsistent with the inputs used to determine the fair value of a fixed-for-fixed equity-linked instrument stated in ASC 815-40-15-7E through 15-7H.

If a reporting entity concluded that warrants issuable under the terms of FSA do not meet Step 2 equity classification requirements, the FSA is presumed not to meet Step 2 requirements either. Conversely, if a reporting entity concluded that warrants issuable under the terms of FSA meet Step 2 equity classification requirements, settlement terms of the warrants do not prevent classification of FSA as equity.

Next, reporting entities should determine if settlement terms of public shares issuable under FSA are consistent with Step 2 requirements. Generally, SPACs classify public shares as temporary equity, subject to certain redemption limitations stated in legal documents and consistent with the requirements of ASC 480-10-S99-3A. According to ASC 815-10-15-76:

“Temporary equity is considered stockholders’ equity for purpose of the scope exception in paragraph 815-10-15-74(a) even if it is required to be displayed outside of the permanent equity”.

Based on the above, classification of commons shares as temporary equity is consistent with Step 2 equity classification requirements for FSA.

Box B4: Generally, additional equity classification requirements are intended to identify situations when the instrument holder can force the issuer to settle in cash and not in equity. Additional equity classification requirements are as follows:

  1. Settlement is permitted in unregistered shares;
  2. Entity has sufficient authorized and unissued shares;
  3. Contract should contain an explicit limit on the number of shares to be delivered;
  4. No required cash payment if entity fails to make timely filings with SEC;
  5. No cash-settled top-off or make-whole provisions;
  6. No counterparty rights rank higher than shareholder rights;
  7. No collateral required;

Recently issued accounting updated ASU 2020-06 eliminated conditions one, six and seven. ASU 2020-06 is effective for smaller reporting companies for fiscal years beginning after December 15, 2023. Early adoption is permitted for fiscal years beginning after December 15, 2020, as the earliest.

We understand that, in general, the amount of authorized shares at the time of the IPO was determined as such that SPACs have enough unissued shares to satisfy their obligations under FSA agreement. In this case, requirement two above will be met. Overall, we understand that most SPACs will likely meet other applicable requirements, however, a careful analysis should be performed to corroborate that.

Box B5, B6: An FSA that receives an exception from derivative accounting is recorded within reporting entity’s equity. Equity issuance proceeds may have to be allocated to the instrument in question on a relative fair value basis. Subsequently, FSA is not remeasured and is carried at the initial amount.

FSA that does not qualify for equity classification pursuant to ASC 815 is classified as a liability (or asset). The instrument is measured at fair value initially and subsequently until the instrument expires or is settled. Fair value remeasurement adjustments are recorded in earnings. As part of initial recognition, reporting entities should allocate IPO proceeds to the liability-classified FSA, thus reducing equity proceeds as reported in company’s equity, i.e. additional paid-in capital.

Based on the above analysis, the key consideration that will determine equity or liability/asset classification and resultant measurement is the classification of warrants underlying the FSA. Liability-classified warrants likely result in liability-classified FSA, while equity-classified warrants do not prevent equity classification of the FSA.

Additional Considerations: Impact of ASC 815-40-55-13

ASC 815-40-55-13 includes a table that provides guidance for accounting of a freestanding forward sale agreement depending on the type of relevant settlement methods. Settlement methods and related accounting options are presented in Appendix B Accounting for Forward Sale Contracts.

According to FSA, the sponsor (buyer) delivers the full stated amount of cash to SPAC (seller) and the SPAC delivers the full stated amount of units to the buyer. Therefore, only physical settlement method is allowed.

When the contract allows physical settlement only, GAAP indicates that the reporting entity should check the requirements of ASC 815-40-25 to see if the contract should be classified as a liability or equity. ASC 815-40-25, Contracts in Entity’s Own Equity, Recognition provides guidance on classification of derivative instruments as either liability or equity. The guidance specifically focuses on a) impact of cash settlement provisions and b) additional equity classification requirements. ASC 815-40-25 does not include indexation guidance covered in ASC 815-40-15.

Standard FSA agreements do not envisage cash settlement. If the above equity classification requirements are met, application of ASC 815-40-55-13 would result in FSA to be classified as an equity instrument.

Although literal reading of ASC 815-40-55-13 guidance does not involve application of derivative scope exception per ASC 815-40-15, existing accounting practice is that the scope exception is still analyzed (in addition to requirements in ASC 815-40-25) to determine classification of FSA. We support application of the indexation guidance as part of FSA analysis, absent further clarification from authoritative bodies.

Conclusions: SPAC forward sale agreements are likely to be considered freestanding equity-linked financial instruments. FSAs are likely not to be classified as assets or liabilities under ASC 480. FSA with an obligation to issue warrants properly classified as liabilities are not considered indexed to entity’s own stock. Such FSAs are classified as a liability or asset measured at fair value initially and subsequently through the date the contract is settled or expired. As part of initial recognition, reporting entities should allocate IPO proceeds to the liability-classified FSA, thus reducing equity proceeds as reported in company’s equity (additional paid-in capital).

FSAs with obligation to issue warrants property classified as equity are considered indexed to entity’s own stock. Reporting entities should analyze such FSAs to determine if they additional equity classification requirements including share sufficiency are met. Our understanding is that most FSAs would meet the equity requirements. If so, reporting entities should classify such FSAs as equity.

Analysis of Components of Forward Sales Agreements: Warrants, Common Stock, Sponsor’s Option

A typical SPAC FSA contains a number of components including the obligation to issue common stock, warrants both of which are considered equity-linked components. Once a reporting entity determines that an equity-linked component is embedded in a host instrument, it should evaluate whether the instrument should be (1) accounted for as a single, hybrid instrument, or (2) separated into the host instrument and the equity-linked component.

Box A: First step in this analysis is to determine if the warrants are considered freestanding or embedded. Warrants and common stock instruments are part of one FSA agreement and were not contracted for separately. Obligation to issue common stock and warrants are not legally detachable in a sense that both common stock and warrant are issued together. Therefore, warrants are not legally separable. The warrant component represents an embedded feature and not a freestanding instrument.

If the feature is considered embedded, it should be analyzed to determine if it should be bifurcated from the host instrument. That determination will involve evaluating the hybrid or compound instrument pursuant to ASC 815-15, Embedded Derivatives.

Box C1: ASC 825-10, Financial Instruments provides reporting entities with an option to measure many financial instruments at fair value on an instrument-by-instrument basis. ASC 825-10-15-5(f) precludes election of the fair value model for financial instruments that are, in whole or in part, classified by the issuer as a component of shareholder’s equity (including temporary equity). Therefore, if FSA was classified in entity’s equity, the fair value option does not apply.

Box C3: Clearly and closely related evaluation refers to a comparison of the economic characteristics and risks of the embedded feature and those of the host. US GAAP does not offer a specific definition of clearly and closely related concept, however, it illustrates the concept through examples provided in ASC 815-15-25-23 through 50.

Generally, to be considered clearly and closely related to the host, the underlying that causes the value of embedded feature to fluctuate, must be related to the inherent economic characteristics of the host instrument. To assess whether an embedded feature is considered clearly and closely related to the host, reporting entity should first determine the nature of the host contract.

As discussed in Box B5, B6, FSA as a freestanding contract may be classified as a liability or equity, predominantly based on the classification of underlying warrants. Since warrant classification is likely to be consistent with FSA classification, economic characteristics and risk of the warrants are likely to be considered clearly and closely related to those of FSA. In this case, obligation to issue warrants will not be accounted for separately from the FSA.

In cases when FSA will be classified as a liability, economic risk and characteristics of the obligation to issue common stock are likely not to be clearly and closely related to those of the host as the economic characteristics and risk of the common stock component are more closely aligned with equity instruments, not liability instruments. In this case further analysis of accounting for the common stock component is required.

Box C2: If the economic characteristics and risks of the embedded feature and the host are clearly and closely related to each other, ASC 815 does not require bifurcation of the feature from the host. FSA and embedded components are recorded as one instrument.

Box C4: This analysis concerns accounting for the commons stock component of FSA when the FSA is classified as a liability instrument. Generally, we believe that the common stock component will meet requirements of Step 1 and Step 2 indexation guidance. Additional analysis will have to be performed to determine if the component meets other equity classification requirements. The analysis will be based on the evaluation performed in relation to FAS as a whole (Box B4).

FSA also contains a sponsor option to purchase additional units at the specified price. Same price applies to potential purchase of additional and initial units. Sponsor’s option to buy additional units is similar to an overallotment option. Essentially, it represents a written options for additional securities.

The option should first be analyzed to determine if it is considered a freestanding or an embedded instrument. The option is freestanding if it can be transferred separately from the related units. Conversely, if sponsor’s option and related units cannot be separated, the option would be considered a feature embedded in the FSA host. Generally, sponsor’s option to purchase additional shares cannot be separated from the host and, therefore, is considered embedded.

Next, a reporting entity should analyze clearly and closely related criterion. Generally, we believe that the economic characteristics and risks of the embedded written call option are considered clearly and closely related to the economic characteristics and risks of the FSA host contract. Therefore, sponsor’s option would not have to be bifurcated from the FSA.

Conclusions: A typical FSA contains a number of components including the obligation to issue common stock, warrants and sponsor’s option to acquire additional units. All these components are considered embedded and not freestanding instruments. Reporting entities should analyze if the components should be bifurcated or accounted for as part of FSA host.

Economic characteristics and risk of warrant components are likely to be considered clearly and closely related to those of the host, regardless of classification of warrants as equity or liability. Therefore, warrant component is likely not to be bifurcated under ASC 815-15.

Common stock component is likely to be considered indexed to entity own stock. Reporting entity should perform additional analysis to determine if the component meets additional equity classification requirements. Our understanding is that common stock component of most FSAs would meet equity classification requirements. In these cases, ASC 815-15 does not require bifurcation of the feature from the host.

The economic characteristics and risks of sponsor’s option to acquire additional units are considered clearly and closely related to the economic characteristics and risks of the host contract. Therefore, sponsor’s option would not have to be bifurcated from the host instrument.

Reassessment Requirements

The reporting entity should reassess equity vs. liability classification of equity-linked instruments at the end of each reporting period (ASC 815-40-35-8 through 35-10). Similarly, an embedded components should be reassessed at the end of each reporting period to determine whether it should be separated or, if previously separated, whether it no longer meets separation requirements. However, an analysis of the clearly and closely related criterion is generally a onetime assessment.

Reclassification is often times triggered by changes in facts and circumstances relevant to FSA host, underlying warrants or common stock. For example, classification of warrants may change due to changes in the warrant terms. Meeting additional equity classification requirements and, specifically, share sufficiency requirement, may be impacted by issuance of company’s common stock.

If an FSA previously classified as equity no longer meets equity classification requirements, it has to be re-classified as an asset or a liability at its then current fair value. In this case, the instrument is remeasured at fair value subsequently with the changes recognized in earnings.

If an instrument previously classified as a liability or asset needs to be re-classified to equity, the instrument is recorded as part of entity’s equity at fair value on the reclassification date with no subsequent revaluation. Similarly, if a previously bifurcated embedded feature no longer meets bifurcation requirements, it is recognized as part of entity’s equity at instrument’s then current fair value.

There is no limit on the number of times an FSA may be reclassified.

Additional thoughts: look-through and instrument-level approaches

The complexity of accounting for SPAC FSA is largely driven by characteristics of underlying equity-linked components (warrants and commons stock), which need to be analyzed in addition to characteristics of the forward sale agreement. To streamline the above multi-level analysis, some reporting entities developed the following two accounting approaches:

1: evaluating only the FSA’s direct exercise and settlement provision (the FSA-level view) or

2: “looking through” to all direct and indirect exercise and settlement provisions (the look-through view)

As part of FSA-level view any exercise and settlement terms of underlying commons stock and warrants are disregarded as the analysis focuses on terms directly relevant to the FSA. All exercise and settlement terms relevant to FSA itself as well as the underlying components are analyzed as part of the look-through view.

Under the FSA-level view, SPAC FSAs are to be classified as equity instruments regardless of the classification of underlying warrants as the price at which SPAC is obligated to issue commons stock and warrants is generally fixed. As noted above, under look-through view some FSAs will be classified as liability or equity, mostly depending on the classification of the underlying warrants.

Although an approach that focuses on direct characteristics of the host may be appropriate in certain circumstances, generally, we believe that following a look-through approach to SPAC FSAs is preferable as the approach more comprehensively addresses all FSA relevant terms and conditions.

 

Appendix A

Accounting for Equity-Linked Instruments

 

Appendix B:

Accounting for Forward Sale Contracts

 

SPAC Accounting Issues

2021-08-08T23:57:04+00:00 05/17/2021|SPAC accounting issues|

Background

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.

To close the acquisition, SPAC must meet substantial reporting requirements relating to the target. One of the most substantial requirements is provision of financial statements prepared under US GAAP and SEC reporting requirements and audited under PCAOB standards. The financial statements should be for at least two most recent fiscal years or since inception.

SPAC Accounting for Warrants

Refer to FinAcco’s publication SPAC: Measurement and Classification of Warrants.

Note that a warrant on redeemable shares is considered a liability instrument included in the scope of ASC 480 (ASC 480-10-55-33). Redeemable shares include mandatorily redeemable shares as we all as shares puttable at the option of the holder.

Earnings per Share: Two-Class Method

Entities that have multiple classes of common stock are required to use the two-class method in calculation and presentation of earnings per share (EPS) information. The method should also be used when an entity issued other securities participating in dividends or so-called participating securities.

As part of the two two-class method, EPS is calculated for each class of common stock and participating security. To calculate respective EPS numbers, an entity should allocate its earnings between more than one class of securities. ASC 260-10-45-60B(d) requires separate presentation of both basic and diluted EPS for each class of common stock. Entities are allowed but not required to present EPS numbers for participating securities other than common stock (ASC 260-10-45-60).

Application of the two-class method involves the following three steps (ASC 260-10-45-60B):

Step 1, Dividend Allocation: Net income shall be reduced by the amount of dividends declared in the current period for each class of stock and by the contractual amount of dividends that must be paid for the current period.

Step 2, Earning Allocation: The remaining earnings shall be allocated to common stock and participating securities to the extent that each security may share in earnings as if all of the earnings for the period had been distributed.

Step 3, EPS Calcs: the total earnings allocated to each security as part of Step 1 and 2 shall be divided by the number of outstanding securities to which the earnings are allocated to determine the EPS for security.

Many SPACs have to calculate EPS separately for redeemable and non-redeemable shares. If shares are redeemed, current period earnings available for distribution equal to interest income reduced by applicable income taxes and other eligible expenses. Generally, potential redemption will be pro-rata to all common stock issued and outstanding, not just redeemable commons stock. Earnings allocated to potentially redeemable shares are calculated as gross interest less applicable expenses multiplied by the ratio determined as follows: amount of potentially redeemable shares divided by total common shares as of period end. Earnings allocated to non-redeemable common shares are determined as net earning for the period less earnings allocated to redeemable shares. Appendix A, Example of Two-Class Method illustrates application of the two-class method to calculations of basic EPS assuming no dividends were declared or contractually due.

Although presentation of basic and diluted EPS for participating securities other than common stock is not required, such securities impact allocation of earnings to common stock and, therefore, EPS disclosed in entity’s financial statements.

More guidance on participating securities and undistributed earnings is included in ASC 260-10-55-24 through 55-31.

Summary: Basic and diluted EPS have to be calculated and disclosed for each class of common stock using the two-class method. Application of the method requires allocation of earnings to each class of commons stock. SPACs calculate and disclose EPS for shares subject to redemption and non-redeemable common stock.

Acquisition Close- Accounting for Reverse Acquisition

Merger with target is often structured as a reverse acquisition. A reverse acquisition occurs if the legal acquirer or the entity that issues securities is identified as the acquiree for accounting purposes and the entity whose equity interests are acquired or the legal acquiree is the acquirer for accounting purposes. Generally, shareholders of the accounting acquirer become controlling shareholders of the combined entity. Appendix B Reverse Acquisition: Example of Transaction Diagram reflects general terms of a reverse acquisition transaction.

As part of applying acquisition accounting, a determination will need to be made if the SPAC or the target is considered the accounting acquirer, from the US GAAP perspective.

The accounting acquirer is the entity that has obtained control of another entity, the acquiree. The determination of the acquirer involves examination of a number of factors especially in instances when the purchase consideration issued to execute the acquisition consists of a mix of cash and equity or all-equity. Specifically, management team will need to evaluate relative voting rights, structure of the board of directors, management, comparative size of combining entities, other terms and conditions of the equity exchange. Determination of the acquirer is particularly important, as it impact the accounting including potential fair value adjustments and financial statement presentation.

If a SPAC is determined to be the accounting acquirer, the fair value of target’s assets and liabilities are recognized in accordance with ASC 805, Business Combinations. If, instead, the target is determined to be the accounting acquirer, the merger is considered to be a capital transaction and not a business combination as the SPAC, being the company without substantial operations may not be considered a business as defined in ASC 805-10-55-3A. The only asset the SPAC has before the merger is likely to be cash obtained from sponsors and other investors.

Many merger transactions involving SPACs are structured in a way where the target is considered the accounting acquirer (legal acquiree) and SPAC is considered the accounting acquiree (legal acquirer).

Following the merger, legal capital of the combined entity reflects the capital of the legal acquirer, not accounting acquirer. Legal capital reflects structure or classes of shares issued and outstanding, amount of such shares by class as well as their nominal or par value. Legal capital of the combined entity is retroactively adjusted to reflect the impact of the merger. The adjusted share capital is determined by taking historical or pre-merger amounts of shares issued and outstanding by the target and multiplying them by the shares exchange ratio. Following the example presented in Appendix B, the exchange ratio is determined as follows:

(amount of shares issues by SPAC as part of the transaction) / (amount of shares tended by target shareholders).

ASC 805-40, Reverse Acquisitions provides further accounting requirements relevant to reverse acquisitions.

Summary: if the merge with the target is structure as a reverse acquisition, management needs to determine accounting acquirer and acquiree, from the US GAAP perspective. If operations of the acquiree, i.e., acquired operations constitute a business, its assets and liabilities need to be measured at fair value consistent with requirements of ASC 805, Business Combinations. Following the transaction, legal capital of the combined entity reflects the capital of the legal acquirer, not accounting acquirer. Legal capital of the combined entity is retroactively adjusted to reflect the impact of the merger.

 

 

 

 

 


Important Note: FinAcco Consulting LLC is not responsible for, and no person should rely upon, any advice or information presented on this website. Note that entity’s financial statements, including, without limit, the use of generally accepted accounting principles (“GAAP”) to record the effects of any proposed transaction, are the responsibility of management. Therefore, any written comments by FinAcco Consulting LLC about the accounting treatment of selected balances or transactions or the use of GAAP are to serve only as general guidance. Our comments are based on our preliminary understanding of the relevant facts and circumstances and on current authoritative literature. Therefore, our comments are subject to change. FinAcco Consulting LLC does not assume any responsibility for timely updates of its website overall or any information provided in the Insights section of the website, specifically.


 

Accounting for SPAC Warrants

2021-07-18T14:40:56+00:00 04/18/2021|Financial Instruments, SPAC accounting issues, SPAC Warrants|

Background

As part of SPAC‘s formation, the newly formed company issues its founders or sponsors shares in exchange for nominal amount of equity capital. 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 its founders warrants, i.e., equity-linked instruments that give SPAC’s founders an option to buy additional shares of the entity in the future at the price agreed in the warrant agreement. The warrants issued to sponsors are referred to as “private”. Warrants are also issued to public investors in connection with their purchase of SPAC’s IPO shares. Terms of private and public warrants have certain differences. Main differences concern rights of warrant holder to transfer the warrant and issuer’s cash redemption rights.

Generally, both types of warrants have the same exercise price and the term. Warrants can only be exercisable 30 days after completion of SPAC merger but not earlier than 12 months after SPAC initial IPO. The exercise price is subject to certain adjustments as described in the warrant agreement.

The question is how to classify and measure warrants issued by SPACs in accordance with US GAAP and SEC accounting guidance. Historically, many SPACs classified private and public warrants as equity instruments.

On April 12, 2021 SEC has issued a public statement on Accounting and Reporting Considerations for Warrants Issued by SPACs. In the statement SEC has described certain warrant terms that would be inconsistent with equity classification. SEC has noted warrant settlement provisions where all warrant holders would be entitled to receive cash for their warrants upon successful completion of a merger with an operating company. While all warrant holders will be entitled to cash, only certain holders of common stock would be entitled to cash. Given the disparity in treatment of equity and warrant holders, SEC has concluded the above warrants should be classified as a liability instrument.

In the public statement SEC staff has also noted that the above potential cash payment to warrant holders represents a settlement provision that would not be consistent with inputs used to determine the fair value of a fixed-for-fixed equity option.

SEC has indicated that the warrants in question should be classified as liabilities, not equity.

Executive Summary

Public and private warrants are considered freestanding financial instruments. Many SPACs have concluded that the warrants are not in the scope of ASC 480.

Detachable warrants are classified as an equity instrument if the instrument is indexed to entity’s own stock and meets other equity classification requirements. If any of the above equity classification requirements are not met, the instrument is considered a liability. In this case, it is measured at fair value initially and subsequently. Changes in the fair value are reported in the income statement.

Indexation guidance has two steps. Step one focused on exercise contingencies while step two deals with settlement provisions, i.e., potential adjustments to the exercise price or the amount of issuable shares. As part of step two analysis, settlement provisions will not preclude equity classification if the exchange terms are as such that fixed number of entity’s shares is exchanged for fixed monetary amount, i.e., fixed exercise price, subject to certain exceptions. The above rule is referred to as “fixed-for-fixed”. Certain other adjustments comply with step two requirements including adjustments based on inputs to the valuation model used to determine the fair value of a fixed-for-fixed forward or option on equity shares.

If an entity is required to settle an equity-linked instrument in cash due to the occurrence of fundamental transaction (i.e. change of control), the instrument has to be classified as a liability unless, according to the terms of fundamental transaction, all holders of underlying shares are entitled to cash. Existing standard terms of warrants issued by SPACs contain certain adjustments to the exercise price and warrant redemption value in the event of fundamental transaction. Specifically:

  1. In the event of fundamental transaction, as defined in the agreement, warrant holders can be entitled to more favorable settlement that some shareholders will be;
  2. In the event of fundamental transaction, as defined in the agreement, private and public warrant holders can be entitled to a different settlement amounts;
  3. Definition of fundamental transaction in standard terms is inconsistent with U.S. GAAP definition of the change of control.

Each of the above terms, individually trigger classification of both private and public warrants as liability instruments.

Cash redemption terms applicable to public warrants, cashless settlement terms of private warrants and SPAC’s net share settlement of both warrants triggered by the trading of shares at least $ 10 per share prevent equity classification of both types of warrants. Specifically:

  • Different settlement terms including cash redemption of public warrants and cashless exercise of private warrants prevent private warrants from being classified as equity instruments;
  • Existing warrant table specifying the number of net issuable shares depending on remaining terms and stock trading value prevents equity classification of both private and public warrants;

Consistent with SEC observations, existing standard terms of public and private warrants issued by SPACs prevent their classification as equity instruments.

In an effort to establish warrant terms consistent with equity classification requirements, many SPACs made the following changes to the warrant agreement: a) removed or substantially modified terms of fundamental transaction; b) aligned terms of public and private warrants; c) removed or substantially modified the warrant table.

SPAC sponsors and their service providers may consider alternative warrant terms, which will require balancing commercial interests of SPAC public investors, SPAC management and the sponsor.

Equity-Linked Financial Instruments: Accounting Guidance

A warrant is a written call option represents a type of an equity-linked instrument. U.S. GAAP guidance covering equity-linked instruments is provided in ASC 815, Derivatives and Hedging.

Appendix A: Accounting for Equity-Linked Instruments shows an overall approach to accounting for warrants and other equity-linked financial instruments. Appendix B: Accounting for Freestanding Equity-Linked Instruments shows an overall approach to accounting for detachable warrants and other freestanding equity-linked financial instruments. The analysis in Appendix B does not apply to warrants that are not considered detachable, i.e. freestanding instruments.

Box A Freestanding vs. Embedded: Current accounting guidance has different set of rules applicable to so embedded and freestanding instruments. An instrument is considered freestanding if either of the following two conditions apply:

  1. the instrument is entered into separately and apart from any of the entity’s other financial instruments;
  2. it is entered into in conjunction with some other transaction and is legally detachable and separately exercisable;

“Legally detachable” generally refers to ability of the instrument holder to legal transfer, e.g., sale the instrument without transferring all other related instruments, e.g., equity shares originally issued along with warrants.

Public warrants can be “detached” from the shares they were originally issued with and transferred to a different holder through a market mechanism subject to 52-day time window as described in par. 2.5 of the standard warrant agreement. Generally, public warrants are considered freestanding instruments.

Private warrants will be transferrable by their original holders only subsequent to Company’s initial business combination transaction. However, private warrants were issued as separate financial instruments to sponsors in connection with the IPO. According to an extract from ASC 815-15-25-2:

The notion of an embedded derivative in a hybrid instrument refers to provisions incorporate into a single contract, and not to provisions in separate contracts between different counterparties….

Since private warrants were sold as part of a separate contract between SPAC and the sponsor, the warrants are considered freestanding instruments.

Overall, warrants issued by SPACs likely represent freestanding instruments.

Box B1 Scope of ASC 480: Next step in the analysis is to determine if the instrument is included in scope of 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).

Redemption of SPAC Shares: SPAC public shareholders may, at their option, redeem ordinary shares upon completion of business combination 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. Generally, redemption of shares in connection with the merger applies to public but not private shares. SPAC will redeem public if no business combination transaction takes place. Generally, the aggregate redemption value is the amount held in the trust account at the time of the redemption including interest less related taxes. Terms of liquidation redemption also apply to shares held by the sponsor acquired after the initial IPO.

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 Company 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.

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.

Management noted that warrants issued on contingently redeemable (puttable) stock may still be considered a redeemable instrument subject to ASC 480. According to ASC 480-10-55-33:

A warrant for puttable shares conditionally obligates the issuer to ultimately transfer assets—the obligation is conditioned on the warrant’s being exercised and the shares obtained by the warrant being put back to the issuer for cash or other assets. Similarly, a warrant for mandatorily redeemable shares also conditionally obligates the issuer to ultimately transfer assets—the obligation is conditioned only on the warrant’s being exercised because the shares will be redeemed. Thus, warrants for both puttable and mandatorily redeemable shares are analyzed the same way and are liabilities under paragraphs 480-10-25-8 through 25-12, even though the number of conditions leading up to the possible transfer of assets differs for those warrants. The warrants are liabilities even if the share repurchase feature is conditional on a defined contingency.

The above requirements cover warrants on shares that may require transfer of assets, i.e. conditional obligations, not just mandatorily redeemable shares.

A warrant on a redeemable preferred share that may require the issuer to transfer assets is a liability unless the issuer can avoid triggering redemption by controlling the exercise contingency. If the future event that triggers the redemption (or possible redemption) of the preferred shares is completely within the issuer’s control, an obligation does not exist and will not exist until the issuer takes (or fails to take) action. Accordingly, the share is not considered redeemable. An argument can be made that SPAC’s management controls initiation of the merger and, therefore, can prevent redemption in connection with the merger transaction. If so, the warrants will not be considered in the scope of ASC 480.

As noted above, the warrants become exercisable 30 days after completion of business combination but not earlier than 12 months after SPAC’s IPO (par. 3.2 of standard warrant agreement). At that point, ordinary shares will not be redeemable. Since, no redeemable shares can be issued upon exercise of the warrant, shares underlying the warrant are not considered contingently redeemable.

Based on the above considerations, many SPACs have concluded that private and public warrants are not subject to ASC 480.

The above analysis covers redemption features associated with the underlying shares. Redemption of the warrant as a freestanding instrument is analyzed in a separate section of this paper.

Generally, SPAC warrants do not meet requirements for other types of instruments described in ASC 480-10-25-14 and included in the scope of ASC 480.

Box B4: Indexation Guidance The analysis starts with the question of whether the instrument is indexed to entity’s own stock. Generally speaking, instruments are indexed to entity’s own stock when economic characteristics and risk of the instrument are similar to those of entity’s equity.

The so-called indexation guidance requires an entity to apply a two-step approach (ASC 815-40-15-7). Step 1 covers the evaluation of instrument’s contingent exercise provisions, if there are any. Step 2 is focused on the analysis of instrument’s settlement provisions.

An exercise contingency shall not preclude an instrument from being considered indexed to an entity’s own stock provided that it is not based on either of the following:

  1. An observable market, other than the market for the issuer’s stock (if applicable)
  2. An observable index, other than an index calculated or measured solely by reference to the issuer’s own operations (for example, sales revenue of the issuer; earnings before interest, taxes, depreciation, and amortization of the issuer; net income of the issuer; or total equity of the issuer).

The warrants can only be exercised subsequent to completion of a merger transaction (par. 3.1 of the standard warrant agreement). An exercise condition linked to the change in control or merger involving the reporting entity is not based on an observable market or index. Therefore, such a settlement condition does not prevent equity classification.

As part of Step 2, management should evaluate all adjustments to instrument’s exercise price as well as the amount of issuable shares. Generally, settlement provisions will not preclude equity classification if the exchange terms are as such that fixed number of entity’s shares is exchanged for fixed monetary amount, i.e., fixed exercise price, subject to certain exceptions. The above rule is referred to as “fixed-for-fixed”. In a way, Step 2 requirement draws an analogy to general terms applicable to issuance and sale of equity, e.g. common stock when fixed amount of shares is exchanged for fixed consideration.

Certain other adjustments comply with Step 2 requirements. Such adjustments include:

  1. variables used as inputs to the valuation model utilized to determine the fair value of a fixed-for-fixed forward or option on equity shares (ASC 815-40-15-7E);
  2. equity restructuring adjustments including stock dividend, stock split, spin-off, rights offering or recapitalization through a large, nonrecurring cash dividend (ASC 815-40-20, Glossary);
  3. down round protection clauses (ASC 2017-11);
  4. subjective modification provisions benefiting the counterparty, not the reporting entity (ASC 814-40-15-7H);
  5. terms of fundamental transactions triggering payment to debt holders of the same consideration (e.g., cash, debt, etc.) that will be provided to all stockholders impacted by the transaction (ASC 815-40-55-2 through 55-6);

In this paper we cover settlement adjustments specifically relevant to standard terms of SPAC warrants, i.e. items 1. and 5.

Generally, if the entity may be required to settle the warrant in cash, the warrant is considered a liability instrument. According to ASC 815-40-25-7:

Contracts that include any provision that could require net cash settlement cannot be accounted for as equity of the entity (that is, asset or liability classification is required for those contracts), except in those limited circumstances in which holders of the underlying shares also would receive cash.

Cash settlement prevents equity classification regardless of the probability of the settlement event or scenario. However, certain other provisions in the US GAAP imply that if net cash settlement can be triggered only by the event that is solely within the entity’s control, such a net cash settlement provision does not preclude equity classification. The above treatment is based, in part, on ASC 815-40-25-8:

Generally, if an event that is not within the entity’s control could require net cash settlement, then the contract shall be classified as an asset or a liability. However, if the net cash settlement requirement can only be triggered in circumstances in which the holders of the shares underlying the contract also would receive cash, equity classification is not precluded.

Inputs in Pricing of Fixed-For-Fixed Instruments

If a potential adjustment to the settlement terms is consistent with the inputs used in the valuation of a fixed-for-fixed option (e.g., stock price, exercise price), the instrument is considered indexed to the entity’s own stock. Examples of qualifying inputs include risk-free rates, stock volatility, expected dividends, entity’s credit spread and term/duration of the instrument. However, in situations when a contract contains a settlement feature that results in greater exposure to an input or a variable than the exposure to the input in the pricing of a fixed-for-fixed option, the contract is not considered indexed to entity’s own stock. Similarly, if the settlement amount varies in response to changes in inputs other than those used in the fair value measurement of a fixed-for-fixed equity option, the instrument is not indexed to the reporting entity’s stock. Ineligible variables include entity’s operating metrics e.g., revenue, EBITDA, etc., inflation rate, commodity prices, etc.

To illustrate the above point, if the terms of the warrant provide for the increase in the amount of issuable shares if entity’s revenue in a given fiscal year increases by more than 10% from the prior year, such an adjustment will be considered inconsistent with equity classification. This is because entity’s revenue is not an input in the standard Black-Scholes valuation model.

Fundamental Transaction

Many warrants contain special provisions impacting settlement terms in the event of a fundamental transaction. The term fundamental transaction is defined to include a sale of substantially all of company’s assets, change in control through a merger or otherwise and other similar transactions. Certain fundamental transactions are executed through a tender offer, i.e. a public offer to purchase some or all of shareholders’ shares.

In the event of a fundamental transaction, terms of some warrants state that warrant holders can be entitled to cash payable in exchange for their warrants. For example, warrant terms may specify that warrant holder shall have the right to receive, for each warrant share that would have been issuable upon exercise immediately prior to the occurrence of a fundamental transaction, at the option of the holder the number of shares of common stock of the successor company or any other consideration (“alternate consideration”) receivable as a result of such fundamental transaction by a holder of common stock.

As noted above, warrants that an issuing entity could be required to settle in cash should be accounted for as a liability. However, implementation guidance in ASC 815-40-55-2 through 55-5 specifically discusses circumstances where equity classification is appropriate despite the possibility of a cash settlement if holders of the same class of underlying shares also would receive cash in exchange for their shares:

55-2 An event that causes a change in control of an entity is not within the entity’s control and, therefore, if a contract requires net cash settlement upon a change in control, the contract generally must be classified as an asset or a liability.

55-3 However, if a change-in-control provision requires that the counterparty receive, or permits the counterparty to deliver upon settlement, the same form of consideration (for example, cash, debt, or other assets) as holders of the shares underlying the contract, permanent equity classification would not be precluded as a result of the change-in-control provision. In that circumstance, if the holders of the shares underlying the contract were to receive cash in the transaction causing the change in control, the counterparty to the contract could also receive cash based on the value of its position under cone contract.

55-4 If, instead of cash, holders of the shares underlying the contract receive other forms of consideration (for example, debt), the counterparty also must receive debt (cash in an amount equal to the fair value of the debt would not be considered the same form of consideration as debt)

55-5 Similarly, a change-in-control provision could specify that if all stockholders receive stock of an acquiring entity upon a change in control, the contract will be indexed to the shares of the purchaser (or issuer in a business combination accounted for as a pooling of interests) specified in the business combination agreement, without affecting classification of the contract.

The nature of the above provisions is that if warrant holders have the same economic position in a fundamental transaction as other equity holders do, cash payment to the warrant holders do not preclude equity classification. Generally, for the warrant to be eligible for equity classification, the terms of fundamental transaction should specify that warrant holders will receive the same form of consideration as all holders of the underlying shares do.

As noted above, FASB’s view is that a change of control transaction is outside of entity’s control. The above view is based on the presumption that entity’s management may not be in a position to prevent fundamental transaction which takes place, for example, as a result of hostile take-over or shareholder vote.

Box B6: Additional Equity Classification Requirements If the warrants are considered indexed to entity’s own stock, the next step in the analysis is to consider additional equity classification requirements. Generally, additional equity classification requirements are intended to identify situations when the warrant holder can force the issuer to settle the instrument in cash and not in equity.

The additional equity classification requirements as stated in ASC 815-40-25-10 are as follows:

  1. Settlement is permitted in unregistered shares;
  2. Entity has sufficient authorized and unissued shares;
  3. Contract should contain an explicit limit on the number of shares to be delivered;
  4. No required cash payment if entity fails to make timely filings with SEC;
  5. No cash-settled top-off or make-whole provisions;
  6. No counterparty rights rank higher than shareholder rights;
  7. No collateral required;

Recently issued ASU 2020-06 eliminated requirements 1, 6 and 7 above. The new guidance is effective for SEC filers, excluding smaller reporting companies, for fiscal years beginning after December 15, 2021. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2023. Early adoption is permitted, but no earlier than fiscal years beginning after December 15, 2020.

Whether the entity has sufficient authorized and unissued shares is determined considering other agreements that may obligate SPAC to issue common stock, e.g. forward equity agreements. We understand that, in general, the amount of authorized common shares at the time of the IPO is determined as such that SPACs have enough unissued shares to satisfy their obligations under the terms of agreements involving issuance of SPAC shares.

Additional equity classification requirements should be carefully analyzed to determine if the entity meets them.

Instruments that meet all equity classification requirements are considered equity. Otherwise, the instrument has to be classified as an asset or liability. In this case, the instrument will be measured at fair value initially and subsequently with remeasurement adjustments reported in entity’s income statement.

Analysis of SPAC Standard Warrant Terms

Many SPACs use a warrant agreement with standard terms covering public and private warrants. Standard terms describe the impact of fundamental transaction, redemption, transfer and other relevant rights and obligations. Standard terms also clarify conditions and amount of certain adjustments to the exercise price and the amount of issuable shares.

Terms of Fundamental Transaction/Tender Offer

Appendix C: Terms of Fundamental Transaction and Accounting Considerations provides analysis of standard terms of fundamental transaction and relevant accounting considerations. The above terms are presented in par. 4.6 of the standard warrant agreement.

Based on the information provided in par. 4.6 as analyzed in the appendix:

  1. In the event of fundamental transaction, as defined in the agreement, warrant holders may be entitled to more favorable settlement that some shareholders will be;
  2. In the event of fundamental transaction, as defined in the agreement, private and public warrant holders can be entitled to a different settlement amounts;
  3. Definition of fundamental transaction in standard terms is inconsistent with U.S. GAAP definition of the change of control.

Any of the above consideration individually would prevent classification of both public and private warrants as equity instruments.

SPAC Standard Warrant Terms: Entity’s Redemption, Cashless Exercise

A SPAC may, at its own discretion, to redeem public warrants when they become exercisable and provided certain conditions are met. Specifically, SPAC may redeem public warrants while they are exercisable at $ 0.01 per warrant, when the market price of SPAC’s shares reaches $18.00 (par. 6.1 of the standard warrant agreement). Stock redemption is performed by issuing a 30-day redemption notice. The above cash redemption terms do not cover private warrants.

Redemption of public warrants is at SPAC option and is within its control. Therefore, as such, the above cash redemption terms do not prevent classification of public or private warrants as equity instruments.

Private warrants can also be exercised at any time during the exercise period on a cashless basis, at the option of the holder. Public warrants do not have the same exercise option.

When private warrants are transferred to certain non-permitted transferees, private warrants will inherit characteristics of public warrants.

Under the above provisions, warrants settlement value depends on the characteristics of the warrant holder. Since such characteristics are not considered inputs in the fair value of a fixed-for-fixed equity forward or option, the above settlement terms would be inconsistent with equity classification requirement. We understand that SPAC’s cash redemption and cashless settlement terms are interpreted as settlement characteristics specifically attributable to private warrants. Therefore, the above terms prevent equity classification of private but not public warrants.

SPAC warrant agreements also contain provisions which permit the issuer to force the exercise of public and private warrants on a net share basis, if the stock market price equals or exceeds $10.00. In this case, the number of issuable shares is determined by reference to a table (“warrant table”) and varies based on the then-current stock price and remaining warrant term. We understand that settlement amounts in the warrant table were determined using standard Black-Scholes model with an expected volatility being higher than the volatility number that would have been determined at the time the warrant agreement was executed. Use of overstated volatility as an input to determine the settlement amount is inconsistent with determining fair value of a fixed-for-fixed equity forward or option. Therefore, the above settlement terms would prevent equity classification of both private and public warrants.

Based on the analysis of cash redemption and net share settlement terms:

  • Different settlement terms including cash redemption of public warrants triggered by $ 18 stock price and cashless exercise of private warrants prevent private warrants from being classified as equity instruments;
  • Existing warrant table specifying the net number of issuable shares depending on remaining terms and stock trading value prevents equity classification of both private and public warrants;

Consistent with SEC observations, existing standard terms of public and private warrants issued by SPACs prevent their classification as equity instruments.

Reassessment Requirements

The reporting entity should reassess equity vs. liability classification at the end of each reporting period (ASC 815-40-35-8 through 35-10). Equity classified warrants may have to be re-classified as a liability and vice versa. Reclassification is often times triggered by changes in relevant facts and circumstances including assessment of meeting additional equity classification requirements in ASC 815-40-25-10 or warrant terms.

If a warrant previously classified as equity no longer meets equity classification requirements, it has to be re-classified as an asset or a liability at its then current fair value. In this case, the instrument is remeasured at fair value subsequently with fair value changes recognized in earnings.

If a warrant previously classified as a liability or asset needs to be re-classified to equity, the instrument is recorded in entity’s equity at the fair value on the reclassification date with no subsequent revaluation. There is no limit on the number of times a warrant may be reclassified.

Next Steps

SPAC sponsors and their service providers may consider alternative warrant terms, which will require balancing commercial interests and costs associated with the respective accounting treatment. One of the options is to make little or no changes to existing terms and classify both public and private warrants as a liability. Alternatively, SPACs may consider changing warrant terms to be able to classify the warrants as equity.

In general, to classify public and private warrants as equity, terms of fundamental transaction need substantial modifications to address observations 1 – 3 above. If the terms are revised so that the cash settlement is contingent on acceptance of the tender offer by more than 50% of all issuer’s securities, thus constituting a change in control, the above revision resolves issue 3 indicated above. For those SPAC that only one class of voting common stock, the above observation is not an issue. In an effort to classify warrants as equity instruments, many SPACs did away with existing cash settlement terms triggered by the change of control transaction.

Other changes required for equity classification include aligning terms of private and public warrants and adjusting the warrant table. Changes required to the warrant table are as such that revised amounts of net issuable shares under different scenarios is consistent with the outputs of standard Black-Scholes valuation model. Some SPACs decided to remove the warrant table and related settlement terms altogether.

Another alternative would be to a) keep private and public warrants separate and distinct from each other with no possibility of changes to their respective terms; b) ensure that private warrants are not subject to settlement terms per the warrant table. In this case, if substantial modifications to terms of fundamental transaction are made, private warrants can be classified as equity instruments. Classification of public warrants will largely depend on the terms of the warrant table.

As noted above, sponsors will need to decide among different alternative terms. The decision will require balancing commercial interests of SPAC public investors, SPAC management and the sponsor.

 

Appendix A

Accounting for Equity-Linked Instruments

 

Appendix B

Accounting for Freestanding Equity-Linked Instrument

 

Appendix C

Terms of Fundamental Transaction and Accounting Considerations

 
Standard Terms Accounting Considerations

In the event of fundamental transaction (merger, consolidation, sale of company’s assets), warrant holders may be entitled to the same consideration including cash, shares or any other assets received by existing shareholders assuming warrant holders exercised their warrant rights immediately before the transaction subject to the following conditions:

Condition A: if stockholders can elect as to the type and amount of considerations due to them, then consideration due to warrant holders will be weighted average amount received by stockholders.

Condition B: if as a result of the transaction a party including its affiliates own beneficially more than 50% of outstanding common stock of the successor, warrant holders are entitled to receive the highest amount of cash, equity or other assets it would be entitled to if it exercised its warrant rights immediately before the transaction.

Because of the condition B, warrant holders appear to enjoy more favorable settlement terms than other stockholders do since all warrant holders would be entitled to cash (or other assets), while only certain holders of Company’s common stock would be entitled to cash or the same amount of cash (or other assets). The above provision is not consistent with GAAP requirement that warrants holders would be entitled to the same consideration (e.g., cash, debt, stock) that all stockholders would be entitled to (ASC 815-40-55-2 through 55-5). Therefore, the warrants in question do not meet equity classification requirements.

Terms of the above provision apply to both private and public warrants. Therefore, neither type of warrants meets equity classification requirement and should be classified as liabilities.

If, in the event of fundamental transaction, the amount receivable by Company’s existing shareholders in shares of successor entity is less than 70% of the total consideration, warrant exercise price is adjusted to be the following amount:

Per Share Consideration [A] – Black Sholes Warrant Value [B]

[A] Per Share Consideration is the amount paid to existing holders of common stock as part of fundamental transaction. Additional terms apply to consideration paid in stock.

[B] Black Scholes Warrant Value means Black Scholes value immediately before the fundamental transaction for a capped American call option according to Bloomberg financial markets. The value is determined considering warrant redemption terms. Terms of the warrant agreement specify how model inputs (risk-free rate, volatility and stock market price) are determined.

Redemption/Transfer Terms: The Company has an option to redeem public warrants at $0.01 per warrant provided certain conditions are met. Conditions include trading price of common stock reaching certain level. Stock redemption is performed by issuing a 30-day redemption notice.

Private warrants are not subject to redemption as long as they are held by the sponsors or permitted transferee, as defined in the warrant agreement. Private warrants cannot be transferred by sponsors until 30 days after completion of the business combination

Private and public warrants have different redemption terms, which will impact their Black-Scholes value. As the holder of the instrument is not an input into the pricing of a fixed-for-fixed option on entity’s common stock, the warrants in question are not considered indexed to entity’s own stock (ASC 815-40-15-7E through 15-7H). The warrants do not meet equity classification requirements and should be classified as liability instruments. Liability instruments are measured at fair value initially and subsequently with changes in fair value reported in the income statement.

Additionally, determination of whether the fundamental transaction took place and 50% beneficial ownership referred to in Condition B are determined based on Class A common shares only. Many SPACs have two classes of commons shares: Class A issued to public shares and Class B shares issued to sponsors. Class B shares typically make up 20% of SPAC’s shares following the IPO (exclusive of warrants). Change in control determined based Class A shares only may not constitute a change of control from the U.S. GAAP perspective, i.e. considering all voting shares. If there is no accounting change of control, cash settlement exception per ASC 815-40-55-2 through 55-5 does not apply. Therefore, the cash settlement provision is inconsistent with equity classification.

 

 

 

 

 


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