Derivatives Implementation Group

Statement 133 Implementation Issue No. C2

QUESTION

An entity that issues shares of its common stock with an embedded written put option requiring physical settlement is required by analogy to the SEC's Accounting Series Release No. 268, Presentation in Financial Statements of "Redeemable Preferred Stock," to reclassify an amount into temporary equity equal to the amount related to the number of the shares subject to the put option. For purposes of applying paragraph 11(a) of Statement 133, should items classified in temporary equity be considered classified in stockholders' equity even though temporary equity is displayed outside of stockholders' equity in the statement of financial position? In this example, is the embedded put option required to be separated from the host contract by the entity issuing the shares?

RESPONSE

FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, was issued in May 2003. The Statement requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). However, for purposes of analyzing the application of paragraph 11(a) of Statement 133 to an embedded derivative financial instrument as though it were a separate instrument, paragraphs 9–12 of Statement 150 should be disregarded. Those embedded features are analyzed by applying other applicable guidance.

EITF Issue No. 00-19, "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock," as partially nullified by Statement 150, requires that an embedded derivative financial instrument indexed to a company’s own stock to be settled in shares be reported in permanent equity and an amount equal to the cash redemption amount under the physical settlement be transferred to temporary equity. Paragraph 11(a) of Statement 133 requires that the reporting entity shall consider contracts indexed to its own stock and classified in stockholders’ equity in its statement of financial position not to be derivative instruments for purposes of Statement 133. Although ASR 268 requires reclassification of an amount from permanent equity into temporary equity equal to the amount related to the number of shares subject to the put option, temporary equity is considered stockholders’ equity even though it is required by the SEC to be displayed outside of the permanent equity section.

From the investor’s perspective, the purchase of common stock with an embedded purchased put option that requires physical settlement is a hybrid instrument that must be evaluated to determine whether it has an embedded derivative that must be accounted for separately. The embedded purchased put option must be separated from the equity host because the common stock and the embedded put option are not clearly and closely related (refer to paragraph 61(e) of Statement 133).

The above response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.