Certified Public Accounting Firm

Embedded Financial Derivative Accounting

Raising Capital with Embedded Financial Derivatives

Frequently, small public companies choose to obtain financing from sources which rely on a public company’s stock or underlying warrants to pay off the capital injection or loan. This has led numerous companies to enter into financings which have embedded financial derivatives that have major accounting and valuation issues that can be both costly and time consuming.

Convertible debt, convertible preferred stock and warrants are the three typical financing instruments that could have these issues. The relevant guidance companies must look to include:

  • ASC 480 (Distinguishing Liabilities from Equity)
  • ASC 815 (Derivatives and Hedging)
  • ASC 470-20 (Debt with Conversion and Other Options)

Derivative accounting involves isolating and separately assigning fair values to various debt or equity features for which the eventual financial settlement by the public company is not 100% within its control and/or the settlement of certain features is not fixed but instead variable.

Typical features that can cause problems:

  • The provision you are looking for is a provision that adjusts the exercise price or the conversion price of the original instrument if the company were to issue an instrument later at a price or with a conversion price or exercise price lower than the original price, conversion price or exercise price. If you have any such instruments with this provision, you will need timely valuations of these instruments each quarter and year end.
  • The conversion price or exercise price is variable with no lower limit. Often times this feature is either the market price at conversion or a discount to the market price at conversion.
  • Liquidated damages provisions, anti-dilution, puts and calls, inflation-indexed interest payments, credit sensitive payments, interest rate floors, caps, collars, equity-indexed interest payments, etc.

How can MaloneBailey, LLP help?

We encourage our clients to show us their term sheets prior to finalizing financing. While we cannot help you determine whether the financing is a “good deal” we can discuss with you the potential accounting, valuation and reporting requirements. This will provide you with the necessary information to understand what the consequence of your financing might be on your accounting and reporting.

If a financial derivative exists we can recommend outside experts to value each derivative instrument.

For a no-cost consultation, contact Steven Vertucci at svertucci@malonebailey.com.

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