Down round features are typically seen in convertible preferred stock, warrants and convertible debt issued by emerging-growth or development-stage companies. A down round feature causes an instrument with an exercise or conversion price to be adjusted downward upon the issuance of equity linked instruments (in a separate financing) at a price lower than the instrument’s exercise or conversion price. For example, a company issued a convertible note with a strike price of $100 and subsequently completes a share issuance with a $80 per share price. As a result of this, the convertible note’s conversion price will be reduced. Depending on the terms of the note, the conversion price could be reduced to $80 (the new selling price of the Company’s stock), or some mathematically determinable price in between $100 and $80. Under current GAAP guidance, instruments with down round features are not considered to be indexed to a company’s stock and will frequently result in liability classification. As a result of liability classification, this feature is required to be marked to market each reporting period and the corresponding changes in fair value are required to be recognized in earnings for both increases and decreases in share price which causes volatility in the company’s income statement. These fair value adjustments are required even though an increase in share price will not cause the down round feature to be triggered, and a decrease will cause an adjustment to the strike price only if and when an entity engages in a subsequent equity offering.
ASU 2017-11 revises ASC 815-10-15-74 to allow instruments with a down round features to qualify for equity classification. Under the new guidance, the issuer would recognize the value of the feature only when it is activated and there is an actual reduction of the strike price or conversion feature. The value of the adjustment is then to be recorded as deemed dividend and a reduction of income available to common stockholders. The adjustment will impact earnings per share (“EPS”). If a company does not present EPS, no accounting entry is required.
ASU 2017-11 is effective for public business entities for fiscal years beginning after December 15, 2018, and interim periods within those annual periods. For all other entities, the amendments are effective for annual periods beginning after December 15, 2019, and interim periods within annual periods beginning after December 15, 2020. Early adoption is permitted for any entity in any interim or annual period.