The tougher it gets to raise capital, the more creative the instruments become. That can create accounting hazards that companies need to watch carefully, says audit firm McGladrey & Pullen.

Debt and equity offerings increasingly include various “sweeteners,” the firm says in a recent alert to its clients, such as warrants, forward contracts to sell or purchase shares, or conversion options. Such equity-linked instruments can be complicated because of the complex web of accounting guidance that must be considered to arrive at the right conclusion. Companies often issue such instruments, then face unpleasant surprises when they sort out the accounting consequences, the firm says.

Those consequences can include having warrants, conversion features, and certain stock treated as liabilities, adding to the debt load on the balance sheet. They might also include a requirement to measure certain debt at fair value, with the remeasurement each period producing volatility in the income statement.

As an example, the firm says, warrants that are conditionally redeemable and stock that is mandatorily redeemable generally must be treated as liabilities with ongoing measurement at fair value, but stock that is conditionally redeemable can be treated as temporary equity. When measured at fair value or redemption value, the changes in value each period flow directly to the income statement, producing earnings volatility as those values change each period. Other hybrid instruments that must be treated as liabilities, with changes in value flowing to earnings, include instruments that convert to a fixed dollar value of shares, or equity-linked instruments with provisions that require or give the holder the option of net cash settlement.

McGladrey advises companies to take a close look at accounting consequences, discussed in more detail in its 26-page alert, when they undertake such transactions. The majority of the relevant accounting guidance is contained in Accounting Standards Codification Topics 480, Distinguishing Liabilities from Equity, and 815, Derivatives and Hedging, the firm says. “In many cases, the outcome can be significantly impacted by the existence or absence of one sentence in the relevant documents,” the firm says, making it important to take a close look at the contract and any shareholder rights or other relevant agreements that might come into play.

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