Equity-linked securities have proliferated to a point where questions around accounting for them are more the norm than the exception. To address the latest emerging issues, PwC has published a 24-page instruction manual of sorts to walk through the trickiest parts of the accounting analysis.

Companies often enter equity-linked financing transactions to raise money at a reduced cost, with the tie to equity lowering the cash interest cost. Examples of such transactions include debt instruments with detachable warrants for preferred or common equity instruments, conventional or non-conventional convertible debt, convertible preferred stock, and many others. The complexity inherent to such transactions demands a detailed analysis to understand the terms of each instrument issued, the underwriting agreement, and any related derivatives, PwC says.

“We continue to find team in the field that still struggle with how to analyze embedded features in these kinds of instruments,” says Greg McGahan, a partner with PwC. “Every time we consult with clients internally and externally, heads are spinning in this area.” The guide lays out the accounting guidance applicable to equity-linked financing transactions for both when they are issued and at subsequent financial reporting dates. It also provides illustrative flow charts that lead preparers through the critical questions that must be answered for freestanding instruments and embedded features, for free-standing equity-linked instruments, for embedded equity-linked features, and for convertible bonds.

The Financial Accounting Standards Board has kicked around how to sort out the difference between liabilities and equities for more than two decades. The board wrote a limited-scope standard in 2003, then a smattering of implementation guidance for a few years following the new standard, with plans to eventually deliver a more comprehensive standard. The board renewed its work in 2007 and 2008, but put it on the back burner again last fall as it placed higher priority on its projects to eliminate major differences between U.S. and international accounting rules.

McGahan said there are strong differences of opinion over how to define equity. “Some would very narrowly define it,” he says. “Most of what is called equity today wouldn't meet that narrow definition.” That would bulk up liabilities on corporate balance sheets, which makes the prospect of a new definition controversial. “They're really struggling with how to come up with a workable model to define what is debt and what is equity.”

In the meantime, the PwC guide helps explain how to classify and measure securities and their embedded features issued in equity-linked financing transactions. The guide says depending on terms, features such as freestanding warrants and conversion options embedded in debt instruments may have to be accounted for as derivative liabilities at fair value, with changes recognized in income each period. “It's a framework for how you think about the various pieces of accounting literature and how you analyze a transaction when there's an embedded equity feature,” says McGahan.

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