The Financial Accounting Standards Board issued a proposed Accounting Standards Update on Monday that the board says would simplify the application of the indexation guidance in Subtopic 815-40, Derivatives and Hedging—Contracts in Entity’s Own Equity.
According to the FASB, the guidance is used in determining whether equity-linked contracts, such as warrants, are considered indexed to an entity’s own stock and potentially classified as equity.
The proposed ASU would also improve the decision usefulness of information provided to investors, the standard-setting board says.
The proposal responds to feedback from the FASB’s 2025 agenda consultation, in which stakeholders said the indexation guidance is complex, costly to apply, a frequent source of financial statement restatements, and that diversity in practice exists in how certain contract features are assessed. As a result, some contracts that should qualify for equity classification don’t under the current guidance.
Investors told the FASB that they sometimes exclude fair value changes in liability-classified instruments from their analyses because they don’t view those changes as useful to their investment decisions.
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Under the indexation guidance in Section 815-40-15, an entity determines whether a contract is indexed to its own stock by evaluating the following:
- The contract’s contingent exercise provisions, if any (Step 1); and
- The contract’s settlement provisions—that is, the settlement amount (Step 2).
Steps 1 and 2 must both be met for a contract to be considered indexed to the entity’s own stock and potentially classified as equity, the proposed ASU says.
Under current GAAP, when applying Step 2 of the indexation guidance, an entity must evaluate the fixed-for-fixed assessment for all freestanding instruments and embedded features, which collectively are referred to as “instruments” or “contracts,” the proposed ASU says. In doing so, an entity first analyzes whether an instrument’s settlement amount equals the difference between:
- The fair value of a fixed number of the entity’s equity shares; and
- A fixed monetary amount or a fixed amount of a debt instrument issued by the entity.
An instrument’s strike price or the number of shares used to calculate the settlement amount is not fixed if the terms provide for any potential adjustments. If the settlement amount is not fixed, the instrument is considered indexed to the entity’s own stock only if the variables that could affect the settlement amount would be inputs to the fair value of a fixed-for-fixed forward or option on equity shares, the proposed ASU states.
The amendments in the proposal would eliminate the requirement to evaluate the fixed-for-fixed assessment.
Under the proposed amendments, unless Step 1 precludes it, an equity-linked instrument would be considered indexed to an entity’s own stock as long as the variables (or contingent events) that could cause the instrument’s settlement amount to vary (including through an adjustment to the strike price or the number of shares used to calculate the settlement amount) are related to the following specified acceptable variables (regardless of the magnitude of the adjustment):
- The entity’s own stock price;
- Term of the instrument;
- The entity’s own expected dividends or other dilutive activities;
- Stock borrow costs associated with the entity’s own stock;
- Interest rates;
- The entity’s own stock price volatility;
- The entity’s own credit spread; and
- The entity’s own operations or activities.
“The amendments in this proposed Update are intended to (1) simplify the application of the indexation guidance (including the assessment of leverage factors) and (2) improve the decision usefulness of information provided to investors,” the proposed ASU says. “The proposed amendments also are expected to result in more contracts being considered indexed to the entity’s own stock.”
To improve the decision usefulness of information provided to investors, the proposal also would require annual disclosure of variables that could, or did, cause the settlement amount of equity-classified contracts to vary significantly.
Comments about the proposed ASU are due by Jan. 4, 2027.
Photo credit: Financial Accounting Standards Board
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