Pipe Transactions And Derivatives

Overview: ASC 815, Derivatives and Hedging (pre-Codification Statements on Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities) was issued to bring transparency and consistency to the accounting for derivatives and hedging activities. The Standard requires all companies to recognize derivative instruments as assets or liabilities and to subsequently measure them at fair value. Issued as an interim step toward the FASB’s broader initiative to measure all financial instruments at fair value, ASC 815 was designed to address immediate problems concerning the recognition and measurement of derivative instruments. However, as companies began to apply the Standard, it became clear that additional guidance was needed. As a result, ASC 815 has resulted in exhaustive interpretation, including the unprecedented establishment of the Derivatives Implementation Group. Indeed, application of these standards is daunting. However, applying a consistent step-by-step process minimizes the disruption and assures a reasonably accurate outcome in evaluating transactions (such as PIPE transactions under ASC 815 and the interpretations).

Services: Our derivative services largely relate to application of ASC 815, as well as ASC 480 (pre-Codification Statement 150) (plus a multitude of interpretations) to PIPE (Private Investment in Public Enterprise) and other complex financing transactions. We obtain all documents associated with the financing arrangement and identify all derivatives (freestanding and embedded) in the arrangement as defined in ASC 815. Based on these findings, we executed a disciplined step-by-step approach to evaluating the accounting for each derivative or combination thereof (i.e. compound derivatives). We report our findings in SAS 50 reports.

Our clients also ask us to perform the inception date allocation of financing basis and fair value measurements of the derivative financial instruments. Our valuation professionals use a number of different valuation techniques based on the risks associated with the derivative and present calculated amounts applying the Statement on Standards for Valuation Services, published by the AICPA.

Case Study: Derivatives are defined by characteristics, not form.

Time after time, we find the following problems in a company’s PIPE analysis:

Failure to analyze all contracts. PIPE transactions usually involve many individual agreements. When evaluating a PIPE transaction, the arrangement must be considered as a whole. Accordingly, terms and conditions in one agreement (such as a Securities Purchase Agreement) that have an effect on another agreement in the arrangement (such as a convertible note) must be evaluated together.

Failure to consider embedded derivatives. ASC 815 defines derivatives, not by their form but by their characteristics. It further provides that derivatives may be embedded in other financial instruments. ASC 815 may require liability classification and fair value measurement apart from the host instrument.

Failure to consider ASC 480 relative to share-based financial instruments, such as preferred stock. ASC 480 may result in liability classification for this type of instrument in its entirety. However, ASC 480 requires liability classification when cash settlement is certain, and certain means certain. If the preferred stock is convertible into common stock, cash settlement is not certain so long as the conversion option is effective.

Failure to identify all derivatives, including those embedded. A conversion option embedded in a debt instrument is a derivative. A default penalty that provides for acceleration and, perhaps, a penalty is a derivative (specifically, a Put). An anti-dilution protection feature is also a derivative (specifically a Put on the company’s enterprise value). There are many, many derivatives that arise from PIPE transactions and each requires separate evaluation.

Failure to compound embedded derivatives. ASC 815 explicitly precludes accounting discretely for each embedded derivative. Rather, it requires the development of a compound derivative financial instrument. That is, one derivative that embodies all of the constituent features and risks of the individual derivatives. Defining a compound derivative financial instrument requires careful modeling techniques.