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Understanding "mezzanine” equity · PwC's accounting podcast

0:00
SPEAKER_01: Thought Leadership from PWC's National Office.
0:06
SPEAKER_00: Welcome to PWC's Accounting Podcast.
0:09
SPEAKER_00: I'm Heather Horn.
0:11
SPEAKER_00: In today's episode, we continue our mini-series on financing transaction and popular topics from our very popular financing guide.
0:20
SPEAKER_00: Our focus today is on mezzanine equity.
0:23
SPEAKER_00: And you may be asking, what is mezzanine equity?
0:26
SPEAKER_00: If so, you're in the right place.
0:28
SPEAKER_00: As we've previously touched on in this mini-series, public companies have to consider if the equity instruments that they issue are accounted for as equity or liabilities, or, as we explain in further detail today, an in-between category, mezzanine equity, something our guest calls the fourth category after assets, liabilities, and equity.
0:50
SPEAKER_02: So what is it?
0:50
SPEAKER_02: So what does it require?
0:52
SPEAKER_02: It requires certain instruments to be classified outside of permanent equity in this separate section of the balance sheet.
0:58
SPEAKER_02: And like I said, it's often referred to as mezzanine equity or sometimes colloquially uh temporary equity.
1:04
SPEAKER_02: Um while the guidance is only is only required for SEC registrants, you know, all companies are highly encouraged to follow it, you know, especially if if a company has thoughts of going public because then they'll have to go back and recast their balance sheets anyways.
1:23
SPEAKER_00: That was Chip Curry, a partner in PwC's National Office with almost 30 years of experience assisting companies and resolving complex business and accounting issues.
1:34
SPEAKER_00: He has a lot to say about mezzanine equity, so let's get started.
1:38
SPEAKER_00: Chip, welcome back to the podcast.
1:40
SPEAKER_00: It's always so nice to have you on.
1:41
SPEAKER_00: And I think today's topic is a great one, mezzanine equity.
1:46
SPEAKER_00: And I think that's a topic that people often have heard of, but perhaps don't know quite as much about as they should.
1:52
SPEAKER_00: So I'm especially happy we're covering it.
1:55
SPEAKER_00: Uh, but perhaps even before we get into the details of the accounting model, we should explain even what we mean when we say mezzanine equity.
2:03
SPEAKER_02: Yeah.
2:03
SPEAKER_02: So when we learned accounting, like in in in college and in school, you know, they taught us that the balance sheet has three categories assets, liabilities, and equity.
2:12
SPEAKER_02: Uh well, I'm here to tell you today that's that's not true.
2:15
SPEAKER_02: There's actually four categories on the balance sheet.
2:17
SPEAKER_00: So you're gonna be like write rewriting 101 textbooks in your spare time.
2:21
SPEAKER_02: Aaron Powell Well, funny you should say that.
2:23
SPEAKER_02: Uh when my son was taking an accounting class at Syracuse, I kind of got into it with him on this exact topic when I was helping him with homework.
2:30
SPEAKER_02: Aaron Powell And then he didn't do so well in his test because you taught him something that uh No, he did because he went with what the professor said, which is there's three categories as opposed to what his father, who's a partner in a national office, said.
2:42
SPEAKER_02: So all right.
2:43
SPEAKER_00: Well, very interesting.
2:44
SPEAKER_00: So for our audience, however, it's actually important to know about this fourth category.
2:47
SPEAKER_00: So I will let you keep quiet.
2:48
SPEAKER_02: Aaron Powell So mezzanine, or sometimes you'll hear it referred to as temporary equity, is this sort of fourth category.
2:54
SPEAKER_02: So if you think about the balance sheet for a minute, it's it's reported after liabilities, but before what we'll call permanent equity.
3:01
SPEAKER_02: Um the requirements for mezzanine equity, it comes from the SEC.
3:04
SPEAKER_02: It comes from SEC issued guidance and and the guidance addresses both classification, i.e., this you know, fourth category, as well as measurement, which we'll get into.
3:14
SPEAKER_02: The guidance has evolved over the years, but but most of it can be found in the codification in 480 10 S99.
3:21
SPEAKER_02: Um, so so what is it?
3:22
SPEAKER_02: So what does it require?
3:23
SPEAKER_02: Um it requires certain instruments to be classified outside of permanent equity in this separate section of the balance sheet.
3:30
SPEAKER_02: And like I said, it's often referred to as mezzanine equity or sometimes colloquially uh temporary equity.
3:36
SPEAKER_02: Um while the guidance is only required for SEC registrants, you know, all companies are highly encouraged to follow it, you know, especially if if a company has thoughts of of going public, because then they'll have to go back and recast their balance sheets anyways.
3:50
SPEAKER_02: Um so so high level, the guidance requires any instrument that's not already classified as a liability under other gaps.
3:59
SPEAKER_02: So if it's already classified as a liability, we're good.
4:01
SPEAKER_02: We we leave it as a liability that meets any of these conditions.
4:05
SPEAKER_02: So the first condition is it's redeemable at a fixed date or a determinable price on a fixed date uh or a determinable date.
4:12
SPEAKER_02: And and so that's just basically saying if it's redeemable on a date that we know is gonna happen or we know it's gonna be determined, that can't be reported as permanent equity.
4:22
SPEAKER_02: Spoiler alert, most of those are gonna be liabilities anyways, under 480.
4:26
SPEAKER_02: So so we don't run into a lot of those for mezzanine.
4:29
SPEAKER_00: The ones Oh, because this is an any of, so they don't have to meet all of.
4:33
SPEAKER_00: It's always important in the podcast to emphasize that.
4:36
SPEAKER_00: So, okay, so great clarification.
4:38
SPEAKER_02: Okay, it's any of these.
4:39
SPEAKER_00: Okay, so the first one is redeemable at a either a fixed or determinable price on a fixed or determinable date.
4:47
SPEAKER_00: Right.
4:48
SPEAKER_00: Which does sound a lot like a liability.
4:50
SPEAKER_00: But 100%.
4:52
SPEAKER_00: Okay.
4:52
SPEAKER_02: And and part of it is remember this SEC guidance originated actually before the liability guidance came out a number of years ago.
4:59
SPEAKER_02: Um the second time, which is one that is is very frequent, is it's redeemable at the option of the holder.
5:05
SPEAKER_02: So the the holder of the equity instrument can put it back to the company, and the company would have to pay um to redeem it.
5:11
SPEAKER_02: And the last one, which again is very common, is it's redeemable upon the occurrence of an event, and that event is not solely within the control of the company, of the issuing entity.
5:23
SPEAKER_00: So, can I ask a question before we get into more of the details?
5:26
SPEAKER_00: So we also talk about preferred equity.
5:29
SPEAKER_00: We've talked before.
5:30
SPEAKER_00: So this is even separate from that.
5:32
SPEAKER_00: So, because the preferred would still be considered permanent equity.
5:36
SPEAKER_00: This is again this sort of in-between category.
5:39
SPEAKER_02: So so great question.
5:40
SPEAKER_02: So um mezzanine equity applies, can can be applied to any equity instrument.
5:46
SPEAKER_02: So it could be a preferred stock, it could be a common stock, it could be a non-controlling interest.
5:51
SPEAKER_02: In some cases, it might even be a derivative on owned stock.
5:55
SPEAKER_02: So if you have an equity instrument that's not reported as a liability, we have to take every instrument and run it through this guidance to see the ha if it has to be mezzanine.
6:04
SPEAKER_02: Preferred stock, great point.
6:06
SPEAKER_02: That's the one that we see the most that gets tripped up and has to be reported as mezzanine.
6:10
SPEAKER_00: All right, so it's helpful.
6:11
SPEAKER_00: So basically, if if it's not a liability, apply this model before you conclude that it's equity.
6:16
SPEAKER_00: So then with all that said, if the point is to sort of highlight to use the financials that this equity isn't permanent, then we kind of just talked about this, but other than preferred stock, are there any other types of instruments we often see there?
6:32
SPEAKER_02: Yeah, I mean, like you said, preferred preferred stock is usually the most frequent thing that we see reported in mezzanine.
6:38
SPEAKER_02: Probably the next one is like non-controlling interest.
6:41
SPEAKER_02: So, you know, like it's the you you have a subsidiary that you own a majority of the subsidiary, but you don't all own all of it.
6:47
SPEAKER_02: And so it's that minority interest.
6:49
SPEAKER_02: Um, sometimes we see that reported as mezzanine.
6:52
SPEAKER_02: Less frequently we see sort of these instruments on your own stock.
6:55
SPEAKER_00: And Chip, are we seeing a lot of new instruments issued that meet these criteria?
7:00
SPEAKER_00: Or is this more, oh, the company may have had something historically, and so it's just kind of still there?
7:08
SPEAKER_02: No, I mean, the if you think about what the what what the purpose of this is, the purpose of this is to sort of highlight um separate from permanent equity is this temporary equity, meaning outside of the company's control, it can be redeemed.
7:21
SPEAKER_02: They can be forced to redeem it.
7:22
SPEAKER_02: And so what the SEC is trying to do is try to highlight that on the face of the balance sheet to make it clear that this is different than than equity that can't be sort of, you know, put back to the company.
7:33
SPEAKER_02: And investors, you know, particularly in preferred stocks or instruments like that, they like to have features where they can force the company to redeem it.
7:40
SPEAKER_02: They like to have an exit strategy as opposed to like a preferred stock that has no maturity date.
7:46
SPEAKER_02: That's a permanent instrument where there's no exit strategy, there's no exitability.
7:50
SPEAKER_02: So that's why you see a lot of these sort of, you know, redemption options, or and we'll talk about contingent redemption options that get embedded in these agreements.
7:59
SPEAKER_02: And, you know, they've they've been in agreements for many, many years.
8:01
SPEAKER_02: They continue to be in newly negotiated agreements, but that's generally why they're in there.
8:06
SPEAKER_00: All right, so it's helpful refresher, and we talked about preferred stock.
8:10
SPEAKER_00: We just did a series on that.
8:12
SPEAKER_00: So definitely encourage people to listen to that if they have more interest specifically in those types of instruments.
8:18
SPEAKER_00: But in terms of classification, then why don't we go into some more detail about when you would be applying this guidance?
8:24
SPEAKER_02: Yeah, good good place to start.
8:26
SPEAKER_02: We touched on this, we touched this on this a little bit, but a number of instruments get reported in mezzanine equity because the way the rule works is any event, regardless of the probability of that event ever occurring, that could cause the company to have to redeem that instrument by paying assets, so cash or other assets, would require that to be reported as mezzanine.
8:50
SPEAKER_02: Um, the entire instrument would be required to be reported as mezzanine.
8:53
SPEAKER_02: So this is another example.
8:55
SPEAKER_02: Um, and you and I have been on other podcasts and talked about other areas of gap that's like this, but this is another example where a contingent feature that in isolation may not have like a tremendous amount of economic value, you know, when you look at it on a standalone basis, but it could have a very significant impact on the accounting.
9:13
SPEAKER_02: So any of the any event, any feature where the company could be forced to redeem the security outside of the company's control is going to cause that security to be reported as mezzanine if it's not already reported as a liability somewhere else.
9:28
SPEAKER_02: So let's go with a basic example.
9:30
SPEAKER_02: We'll start we'll start basic.
9:31
SPEAKER_02: Let's say you have a preferred stock instrument, and that preferred stock instrument does not have any stated maturity date.
9:38
SPEAKER_02: But it does have a redemption option held by the investor.
9:43
SPEAKER_02: So it has an embedded put option that let's say the investor can exercise that option anytime after five years following its issuance.
9:53
SPEAKER_02: And if it's exercised, the company's gonna have to repurchase that instrument by paying cash.
9:59
SPEAKER_02: So in this example, because after five years, the investor can choose to redeem the security for cash, that redemption is not within the control of the issuer, that's a mezzanine instrument.
10:10
SPEAKER_02: Now that was a pretty simple example.
10:13
SPEAKER_02: Pretty obvious example.
10:15
SPEAKER_02: Um but so so not all redemption options are that obvious because a lot of them are not certain to become exercisable.
10:23
SPEAKER_02: So in that fact pattern we just talked about, it's certain to become exercisable because they can exercise it after five years.
10:30
SPEAKER_02: It's not certain they're gonna exercise it.
10:33
SPEAKER_02: It's just certain it's gonna become exercisable.
10:36
SPEAKER_00: So does so, unlike some other areas, this is nothing to do with intent or probability or anything else.
10:41
SPEAKER_00: It's the existence of this feature that would lead to the conclusion.
10:46
SPEAKER_02: Hold that thought.
10:46
SPEAKER_02: Okay.
10:47
SPEAKER_02: So for the purposes of classification, which is what we're talking about now, you're absolutely right.
10:51
SPEAKER_02: Probability, intent, irrelevant.
10:53
SPEAKER_02: Okay.
10:53
SPEAKER_02: If it can happen outside of the issuer's control, it's mezzanine.
10:57
SPEAKER_02: Okay.
10:57
SPEAKER_02: Now there are there are lots of instruments out there that don't have like a time-based put, like we described in our first example.
11:04
SPEAKER_02: Um the redemption option will only kick in or only become exercisable if an event either happens or an event doesn't happen.
11:14
SPEAKER_02: Um we sometimes call those contingent options.
11:17
SPEAKER_02: I think I mentioned them earlier.
11:19
SPEAKER_02: So what's a good example?
11:20
SPEAKER_02: Um if you had a preferred stock where the investor could put it or it became redeemable if the company was delisted, if there was a change in control of the company, um, or if the company failed to complete an initial public offering, um, all of those features will generally require it to be recorded in mezzanine equity because those events are not solely within the issuer's control.
11:47
SPEAKER_02: So, for example, the issuer can't prevent the SEC from delisting them.
11:52
SPEAKER_02: Um the issuer can't prevent a change in control if they could go through its potential they could go through a hostile takeover.
12:00
SPEAKER_00: I think a key point there though, I just want to make sure I heard you correctly, the instrument itself has to have the feature.
12:07
SPEAKER_00: So like you're just a regular common share of some stock isn't necessarily going to have a feature that says, oh, well, if you get to delisted by the SEC, it's redeemable by the holder.
12:20
SPEAKER_02: There's there there, you're absolutely right.
12:21
SPEAKER_02: There's lots of instruments that don't have these features, like a plain vanilla.
12:24
SPEAKER_00: Well, that's what I was thinking of, because otherwise, all common stock, you know, if a company, if there's a possibility, then you wouldn't wouldn't have common stock, basically.
12:33
SPEAKER_00: So this is a specific type of st of stock in this example that would have this feature embedded in it because basically the person who holds it wants to make sure they have an out strategy effectively.
12:46
SPEAKER_02: Exactly what what we just like we said earlier, they're putting, they're deliberately negotiating this feature into the agreement because they want an exit strategy.
12:53
SPEAKER_02: Yeah.
12:54
SPEAKER_02: Um, or they want protection.
12:55
SPEAKER_02: So, for example, if there's a change in control of the company and the management that they signed on and is no longer managing the company, they want to be able to have an exit.
13:03
SPEAKER_02: So they'll have a contingent put option, giving them the right to put their instrument back to the company.
13:08
SPEAKER_02: And and and that happens a lot with you you're pointing out like preferred, because you know, preferred is not as liquid as common stock if it's not trading on an exchange.
13:16
SPEAKER_02: And so you can't just sell it.
13:18
SPEAKER_02: Right.
13:18
SPEAKER_02: And so this gives you sort of a way, a way out.
13:21
SPEAKER_02: Um sometimes like these these features are called deemed liquidation events, if if you read the the the arrangement.
13:29
SPEAKER_02: Um Why deemed liquidation event?
13:32
SPEAKER_02: Like where does that title come from?
13:34
SPEAKER_02: Well, it's from the investor, it's sort of operating like a liquidation event because they're being liquidated out of their position, you know, their instruments being redeemed by the company, but it's a deemed liquidation because the company's not actually liquidating.
13:46
SPEAKER_02: Um, because yeah, all the other shares are still going to be out there and whatnot.
13:50
SPEAKER_02: Um so sometimes these events, like some of the ones we described, will be under a heading called deem liquidation event.
13:56
SPEAKER_02: Now, ordinary liquidation, like if the whole company is liquidating, that does not create something as being mezzanine because you're just, you know, you are um you know, you're liquidating the company, it's going away.
14:08
SPEAKER_02: The preferred instrument has lived throughout the entire life of the company.
14:12
SPEAKER_02: So an ordinary liquidation event would not make something mezzanine.
14:15
SPEAKER_00: All right.
14:15
SPEAKER_00: So two couple of things that stood out for me there is one thing is, and we say this often, but it's worth reiterating, you really need to understand these contracts because you need to be looking for all these features.
14:27
SPEAKER_00: You can't just assume something.
14:29
SPEAKER_00: Another interesting thing you said at the very beginning is sort of no matter how small the feature, and what I think is really interesting, and I know Chip, you deal with a lot of people who are negotiating contracts and otherwise, and there's often this sort of, oh, well, that feature doesn't really matter.
14:44
SPEAKER_00: Well, it does matter, or you wouldn't have put the feature in.
14:47
SPEAKER_00: And so I think that's clearly the case here is that these features are put there for a reason.
14:52
SPEAKER_00: And so then you have to give them the appropriate accounting recognition.
14:56
SPEAKER_02: Absolutely.
14:57
SPEAKER_02: And you and you're right, like a lot of times these features are in there because the investor is trying to protect themselves against something happening that may be remote, but if it happens, they want the protection.
15:08
SPEAKER_02: Right.
15:09
SPEAKER_02: And so people tend to think about it, well, it doesn't have a lot of value on a standalone basis because the probability of us going through a change in control or a hostile takeover may be really small.
15:19
SPEAKER_02: For some companies it may not be so small, but for other companies it is.
15:23
SPEAKER_02: But because the feature exists, to your point, it's in there for a substantive reason, it will drive the accounting.
15:30
SPEAKER_02: And and what we've talked so far is it'll drive the classification of the instrument as a mezzanine instrument.
15:35
SPEAKER_00: All right.
15:35
SPEAKER_00: So then let me ask another follow-up question because you made a big point here about the difference between a deemed liquidation and then just, you know, an actual liquidation event.
15:46
SPEAKER_00: And so how how do we distinguish here and what's sort of the key here that we should be focused on?
15:52
SPEAKER_02: Yeah, I mean, probably the like the way I like to think about it is if the entire company is liquidating, it the company won't exist anymore.
15:59
SPEAKER_02: And we're just paying the preferred shareholder their place in the waterfall.
16:04
SPEAKER_02: Well, everybody's getting taken out.
16:06
SPEAKER_02: Right.
16:06
SPEAKER_02: The preferred's gone, the common's gone, the debt's gone, liabilities hold, everybody's gone.
16:10
SPEAKER_02: The company's liquidated.
16:11
SPEAKER_02: That's not in that case, the equity has lived through the entire life of the entity.
16:17
SPEAKER_02: As opposed to a deemed liquidation event, is where maybe only you, a particular class of equity, or maybe another you and another class of equity is being taken out by the event.
16:27
SPEAKER_02: Not all the equity holders are being taken out.
16:30
SPEAKER_02: The common folks are still there.
16:31
SPEAKER_02: Um, and you know, the company is not liquidating.
16:34
SPEAKER_02: So that's it, it's a very limited exception, you know, and and it's based upon the fact, well, yeah, the equity was there for the entire life of the company.
16:41
SPEAKER_00: Yeah.
16:41
SPEAKER_00: So, Chip, one of the reasons we picked this topic is because it is in one of our most popular guides, and it is actually one of the most popular topics, which I have to admit, I was a little surprised because I wouldn't have thought there were that many of these instruments floating around.
16:57
SPEAKER_00: But so sort of a two-part question.
16:59
SPEAKER_00: The first part, are you guys getting a lot of questions on these types of instruments?
17:04
SPEAKER_00: And I guess for the audience's benefit, Chiva's nodding, so I'll move on to the next part of the question.
17:08
SPEAKER_00: So is with that then, what are some of the more common examples that can illustrate some of the other complexities you see in these arrangements?
17:18
SPEAKER_02: Yeah, so so so far um we've talked about obvious redemption features, it's puttable after year five, and we've talked about contingent puts, you know, it's redeemable if this event happens.
17:31
SPEAKER_02: The way the guidance works is if there's any event outside of the company's control that could force them to redeem it for cash or other assets, it's mezzanine.
17:39
SPEAKER_02: I I might repeat that another 27 times on the podcast.
17:42
SPEAKER_02: Uh it's sort of like a lot of people.
17:43
SPEAKER_02: That will be our quote.
17:44
SPEAKER_00: We like to have a quote, so that can be the quote.
17:46
SPEAKER_00: Although that is interesting as some of our other quotes.
17:48
SPEAKER_00: No offense, Jeff.
17:49
SPEAKER_02: Well, yeah, I I was thinking maybe we'd do a t-shirt, but it I don't I don't think it would sell well.
17:53
SPEAKER_02: Um advertise them.
17:55
SPEAKER_02: So so let me give you a different another example.
17:58
SPEAKER_02: So so let's say that you had a preferred stock, and that preferred stock was convertible into common stock.
18:06
SPEAKER_02: So the the investor could hand in their preferred stock and get common shares.
18:11
SPEAKER_02: So at first glance, you'd say, well, okay, the preferred stock could be redeemed outside of the company's control.
18:17
SPEAKER_02: However, the company is not going to force, you know, be forced to part with cash or other assets.
18:22
SPEAKER_00: Yeah, they could just issue.
18:23
SPEAKER_02: They're going to issue shares.
18:25
SPEAKER_02: However, there can be cases where the issuance of the company's shares are not totally within the company's control.
18:31
SPEAKER_02: So, for example, if they don't have enough authorized or unissued shares to satisfy the conversion option.
18:37
SPEAKER_02: So the way the accounting literature works is if it's not totally within the control of the company to settle that conversion option in shares, the accounting literature assumes that the company's going to have to settle it in cash, and that would make them the instrument mezzanine.
18:52
SPEAKER_00: So in that particular case, then, are you could you wind up with a change in classification because either they get more shares authorized or they use up some of their authorized shares?
19:03
SPEAKER_02: Yes.
19:04
SPEAKER_02: Wow.
19:04
SPEAKER_02: It's a the classification is a constant thing you have to keep looking at every single reporting period.
19:12
SPEAKER_00: All right.
19:13
SPEAKER_00: Very interesting.
19:14
SPEAKER_00: Any other examples you would highlight that you've seen recently that may surprise people?
19:19
SPEAKER_02: One one thing that surprised some folks was you got to think about the mezzanine equity guidance on what could happen on an individual share.
19:27
SPEAKER_02: So um, and we've had some publications on SPACs, you know, special purpose acquisition entities.
19:32
SPEAKER_02: So they had a feature, and the way the feature works is let's let's assume for a moment you had like 100,000 shares outstanding with a thousand dollar value to each.
19:41
SPEAKER_02: But and and and those shares could be redeemed, could be put back to the company by the in by the investor.
19:47
SPEAKER_02: However, there's a cap, and and and it says the investor can't redeem or force redemption if the company's already had to redeem, call it 50 million shares or$50 million worth of stock.
19:59
SPEAKER_02: So there's a cap.
19:59
SPEAKER_02: So the question came up is well, does that mean some of the equity can be reported as permanent because not all of it can be put?
20:07
SPEAKER_02: And the answer is no, because what we're looking at is each individual share.
20:12
SPEAKER_00: Yeah, and you don't know which are the shares that will be able to be put and which ones won't.
20:16
SPEAKER_02: 100%.
20:17
SPEAKER_02: So in that case, the entire class of securities were reported as mezzanine.
20:22
SPEAKER_00: All right.
20:22
SPEAKER_00: So again, definitely you really have to understand all the nuances of the situation to deal with this accounting.
20:29
SPEAKER_00: So one other thing then, Chip, is we've been really talking about these features that are embedded in the instruments, but I know often we'll see also freestanding agreements or we'll see embedded features that have to be bifurcated.
20:42
SPEAKER_00: Now we're going to start to get into um some of the embedded derivative guidance.
20:46
SPEAKER_00: So, how do we think about those types of features?
20:49
SPEAKER_02: Well, I mean, you know, anytime we talk about derivatives and embedded derivatives and bifurcated derivatives, I get excited.
20:54
SPEAKER_00: Yes, exactly.
20:55
SPEAKER_00: This is like Chip's favorite part of this whole podcast.
20:57
SPEAKER_02: 100% the best part of the podcast.
20:59
SPEAKER_02: Um it is a great question.
21:02
SPEAKER_02: So if we've been talking about embedded features, so a feature that's embedded in a share that could cause redemption outside of the issuer's control is gonna require to be bezanine.
21:13
SPEAKER_02: That is true whether the embedded derivative is embedded or bifurcated.
21:18
SPEAKER_02: If it's an embedded derivative, it's if it's part of the part of the asset or part of the equity instrument, it's gonna be mezzanine.
21:24
SPEAKER_02: If the contract is freestanding and we have guidance telling us on when contracts are embedded versus freestanding, but if it is freestanding, then we respect that separate unit of account.
21:34
SPEAKER_02: And a freestanding instrument does not mean that the underlying share is mezzanine.
21:39
SPEAKER_02: We would account for that freestanding security or freestanding put separately.
21:43
SPEAKER_02: So for example, if I issued a non controlling interest and there was an embedded put and it was embedded in the instrument, we would classify the entire instrument as mezzanine.
21:54
SPEAKER_02: If I issued a non controlling interest and like five years later, I wrote a put, and that put was deemed free.
22:00
SPEAKER_02: Free standing, we would not classify the NCI as mezzanine, but we would account for that written put.
22:06
SPEAKER_02: And in all likelihood, that written put would be marked to market through P ⁇ L under the guidance in 480.
22:12
SPEAKER_00: And I guess, Chip, one of the key points of that example is the fact you use the term five years later, because if those instruments are issued at the same time, aren't they often wouldn't you often need to look at them or wouldn't you need to look at them as being one instrument?
22:29
SPEAKER_00: Like if you wrote the put on the same day that you issued the equity, then wouldn't they be viewed together?
22:37
SPEAKER_02: Yeah, maybe, maybe.
22:38
SPEAKER_02: I didn't use that example.
22:39
SPEAKER_02: Potentially, absolutely.
22:40
SPEAKER_02: You're absolutely right.
22:41
SPEAKER_02: I I chose that to be an easy example of where of where it would be freestanding.
22:46
SPEAKER_00: Um I'm just not sure the casual listeners focused on the five-year part, so I wanted to make sure we talked about the question.
22:51
SPEAKER_02: No, no, great, great, great point.
22:52
SPEAKER_02: I threw that in there to make it easy on apologies to everybody.
22:55
SPEAKER_02: Um but you're right.
22:56
SPEAKER_02: If they're issued at the same time, then the the the the assessment of whether it's embedded or freestanding becomes becomes much more difficult.
23:03
SPEAKER_02: But again, we have a definition of freestanding financial instrument that we would apply in that scenario.
23:08
SPEAKER_00: All right.
23:08
SPEAKER_00: So definitely something to think about there.
23:10
SPEAKER_00: And I do think often people think of these bifurcated derivatives similar to freestanding, but and here's the case again, depending if you meet the criteria, that you would think about them differently.
23:21
SPEAKER_00: And then one other thing that we've talked about here is you've really been focused on contracts that could require the issuer to repurchase the equity instrument outside of their control.
23:33
SPEAKER_00: And I know that's something the SEC has also focused on in terms of what is in and what is not in the investor's control.
23:40
SPEAKER_00: So how do you think about that?
23:42
SPEAKER_02: Yeah, so and really the message is here you've got to look at all of the facts and circumstances surrounding the issuer and the investor.
23:49
SPEAKER_02: So so we will went over an example where at first glance it was convertible into common.
23:55
SPEAKER_02: We thought we were gonna be okay, but then we didn't have enough authorized to issue shares.
23:59
SPEAKER_02: So so that's that's an example where you got to look hard for outside of your control.
24:04
SPEAKER_02: Another common example we run into is let's say a company issues a preferred stock.
24:10
SPEAKER_02: And when you read the agreement, you don't see any investor-controlled redemption option.
24:15
SPEAKER_02: The only thing you see is an issuer option where the issuer can call the security back.
24:21
SPEAKER_02: Um, and let's say they pay liquidation preference in the case of a preferred, and that the decision of whether to call the instrument or back is made by the company's board of directors.
24:29
SPEAKER_02: So at first glance, you would say, we're good.
24:31
SPEAKER_02: That's not outside the company's control, it's the board of directors.
24:35
SPEAKER_02: However, if the preferred security holders control the board because they appointed a majority of the board members, then the analysis changes.
24:45
SPEAKER_02: And the way the SEC looks at that is they would say, well, hold on.
24:49
SPEAKER_02: Because the preferred holders control the board, and the board controls the decision to call the instrument, that's the same as an investor put option.
25:00
SPEAKER_02: And so as a result, that instrument would have to be classified as mezzanine.
25:04
SPEAKER_02: So the conversion option where we don't have enough shares, the board, call right, where um the preferred holders control the board, those are two good examples of like how far, how wide, how deep do you need to look to see if something is truly within the control of the company.
25:23
SPEAKER_00: Yeah, and it's interesting.
25:24
SPEAKER_00: I almost have to take back.
25:26
SPEAKER_00: Well, I guess I will still stick with my statement.
25:28
SPEAKER_00: You really need to understand the contract.
25:31
SPEAKER_00: However, I will expand my statement to say you also have to understand the circumstances surrounding the contract.
25:37
SPEAKER_00: Absolutely.
25:38
SPEAKER_00: So then if you're thinking through then these things that are outside the contract, what are some of the other types of examples that you would think about?
25:49
SPEAKER_02: Yeah, so maybe sticking with like the board of directors example for a minute, and an issue we we we get into a lot or we hear a lot about is some articles of incorporation, some stock exchanges or other organizations require companies to have independent board members.
26:06
SPEAKER_02: And an independent board member has a specific definition under each of those types of provisions.
26:12
SPEAKER_02: Just because they're deemed an independent board member for a stock exchange or for another purpose does not mean that they're considered an independent board member for the purposes of applying this guidance.
26:25
SPEAKER_02: So, for example, let's go back to our example of where the preferred holders get to appoint a majority of the board of directors.
26:34
SPEAKER_02: They may appoint members that are considered independent for other purposes.
26:38
SPEAKER_02: They're not part of the management of the company, they may not even be a preferred holder, they may not be a common holder.
26:43
SPEAKER_02: And so they may might meet the definition of an independent director for another purpose.
26:49
SPEAKER_02: However, for applying the mezzanine guidance, because we control that board seat, we're deemed to control that board.
26:56
SPEAKER_02: And so they wouldn't be considered independent from the preferred holders.
27:00
SPEAKER_02: Um, and and that creates a fair amount of conflict because you know legal counsel deems them independent for a different purpose, but their purpose doesn't line up with the definition and our purposes for this guidance.
27:13
SPEAKER_00: All right.
27:14
SPEAKER_00: So again, another sort of outside factor you really need to think about.
27:18
SPEAKER_00: So let me go back to something you said earlier, because when I was asking you about probability, you said we were going to get to that.
27:25
SPEAKER_00: And we've been really focused here on classification.
27:28
SPEAKER_00: We haven't talked about measurement.
27:30
SPEAKER_00: And I will say I think before I came to the national office, the sort of classification measurement always seemed it's always sort of all together, but I know that something in the national office we view those things, you know, it's kind of a two-step process there.
27:44
SPEAKER_00: So now we've talked about classification.
27:47
SPEAKER_00: What do we need to know from a measurement or counting perspective?
27:50
SPEAKER_00: And I'm guessing maybe this is where our probability comes in.
27:53
SPEAKER_00: Perhaps not.
27:54
SPEAKER_02: No, you're right.
27:55
SPEAKER_02: You're you're you're you're you're absolutely right.
27:56
SPEAKER_02: And you got a good memory because we did say park that or put a pin in that a while ago.
27:59
SPEAKER_00: Well, I did write it down.
28:00
SPEAKER_02: So um let's start with initial measurement.
28:04
SPEAKER_02: So, broadly speaking, if you have a mezzanine equity security, the initial measurement model is fair value.
28:09
SPEAKER_02: There are a couple of exceptions to that, and they're they're kind of laid out in the literature of where initial recognition might be something different.
28:16
SPEAKER_02: But let's just start with initial recognition is generally fair value.
28:19
SPEAKER_00: Yeah, and I guess maybe I'm gonna pause you here just to reiterate, and maybe we should have started with this because all the more recent is really important to understand where you're classified because regular equity is not measured for the most part at fair value.
28:34
SPEAKER_00: So all right, keep going.
28:36
SPEAKER_02: Okay, so subsequent measurement depends on whether the instrument is currently redeemable.
28:42
SPEAKER_02: The investor could show up today and redeem it, whether it is probable of becoming redeemable or whether it is not probable of becoming redeemable.
28:53
SPEAKER_02: Um so let's start the easiest.
28:55
SPEAKER_02: I like the easy stuff.
28:57
SPEAKER_02: If the instrument is currently redeemable, then it needs to be on the balance sheet at the maximum amount that it could be redeemed.
29:04
SPEAKER_02: So on the balance sheet at what the investor could walk in the door tomorrow and redeem it for.
29:10
SPEAKER_02: If the instrument is not currently redeemable, but it is probable of becoming redeemable.
29:17
SPEAKER_02: So let's go back to my easy example that I issued a perpetual preferred stock and five years out, they can put it back to me for a fixed amount.
29:27
SPEAKER_02: So it's probable of becoming redeemable because it's gonna happen simply due to the passage of time.
29:33
SPEAKER_02: So in in when that case comes, you actually have a a choice, an accounting policy choice of what you need to do.
29:39
SPEAKER_02: Either way, when the put becomes operable or when it becomes currently redeemable, um, you have to have it on the balance sheet that the amount it could be put to.
29:48
SPEAKER_02: How you get from the initial carrying amount to that is where your accounting policy choice comes in.
29:54
SPEAKER_02: So one method you could do is you could accrete.
29:56
SPEAKER_02: You could start with this balance.
29:58
SPEAKER_02: In my example, it issued for 100, it's putable at 110.
30:02
SPEAKER_02: We would accrete from 100 to 110 over that five-year period.
30:05
SPEAKER_00: Yeah, it counts like accretion.
30:07
SPEAKER_00: It's like an easy way to get an easy way to get from point A to point B.
30:10
SPEAKER_02: And it says to use the interest method, you know, you know, in the guidance.
30:13
SPEAKER_02: Yeah.
30:14
SPEAKER_02: Uh so in that case it's looking a little bit uh or a lot like debt.
30:17
SPEAKER_00: Yeah.
30:17
SPEAKER_02: The other method is to basically pretend like the redemption date is your balance sheet date.
30:24
SPEAKER_02: And so you would just mark to redemption value.
30:26
SPEAKER_02: You wouldn't accrete it over time, you would just mark to redemption value.
30:29
SPEAKER_00: Oh, like all in one period.
30:30
SPEAKER_00: You just make that change.
30:32
SPEAKER_02: That's right.
30:32
SPEAKER_02: And sometimes people choose that when the redemption amount is variable and therefore like accreting to a constantly changing number could be complicated.
30:40
SPEAKER_02: So a lot of people choose that method when when it's um, you know, when when the the repurchase price is variable.
30:47
SPEAKER_02: Um okay, so that's category two.
30:50
SPEAKER_02: Our third category we mentioned is if it's not currently redeemable and it's not probable of becoming redeemable, then we do not have to remeasure it.
31:00
SPEAKER_02: We do not have to accrete.
31:01
SPEAKER_02: Um so an example of that could be you have a preferred security, and the only way it could be redeemed outside of the company's control is if there's a change in control of the company, and we don't think a change in control of the company is probable of occurring.
31:15
SPEAKER_02: Okay, now I've said like accrete a bunch of times.
31:17
SPEAKER_02: And I've also focused on the balance sheet, right?
31:20
SPEAKER_02: So now the question comes like, all right, well, where's the debit go?
31:23
SPEAKER_02: So changes in redemption value that we've been calling accretion, those are recorded in retained earnings.
31:29
SPEAKER_00: Oh, so they don't go through the income statement.
31:31
SPEAKER_02: They do not go through the income statement because while it is temporary equity and not permanent equity, it's still not a liability.
31:37
SPEAKER_02: So it's still treated in that case like an equity instrument.
31:40
SPEAKER_02: So accretion and dividends, they go against retained earnings.
31:44
SPEAKER_02: Now, one very important point to note about the guidance.
31:47
SPEAKER_02: When you're accreting, you can always go up.
31:50
SPEAKER_02: So if you start at 100 and now the redemption value is currently redeemable and the redemption value is 110, you got to go up to 110.
31:57
SPEAKER_02: If the if you have if it's on the balance sheet at 100, but the current redemption value is 90, let's just say it's portable at a variable amount, it's currently 90.
32:06
SPEAKER_02: We do not go down.
32:07
SPEAKER_02: We do not decrete.
32:09
SPEAKER_02: We leave it on I might have made that up.
32:11
SPEAKER_00: It's a good word.
32:12
SPEAKER_00: I like it.
32:13
SPEAKER_02: I made it up.
32:13
SPEAKER_02: Okay, yeah.
32:14
SPEAKER_02: So we don't, we'll go with it.
32:15
SPEAKER_02: You don't do not decrete, so you can't go below the initial carrying amount of the instrument.
32:21
SPEAKER_00: But if I was at that 110 and it went down, I could decrete to 100, but then I just wouldn't go below 100.
32:29
SPEAKER_02: The word works.
32:30
SPEAKER_00: It does work.
32:30
SPEAKER_00: It really is a good word.
32:32
SPEAKER_02: Yeah, you just said that you decrete it, but you're correct.
32:35
SPEAKER_02: You can you can lower it to the extent that you've accreted before, uh, but you can't go below the initial carrying about.
32:42
SPEAKER_02: Um, the last thing what I want to point out just about accretion is as I mentioned, sometimes there are variable amounts.
32:48
SPEAKER_02: So the the the the redemption amount is at a variable amount, like um the fair value of the instrument or a multiple times EBITDA.
32:56
SPEAKER_02: So in that case, when we do the accretion, we base it upon what that value is at the balance sheet date.
33:02
SPEAKER_02: We don't, even if it's not exercisable for five years, we don't try to forecast what EBITDA is going to be.
33:07
SPEAKER_02: We just use the current amount.
33:09
SPEAKER_02: And that's how we do accretion.
33:10
SPEAKER_00: So, Chip, one thing I think is important there that I have to admit I didn't pick up when on when you first said it.
33:17
SPEAKER_00: You are not talking about the probability of it being redeemed.
33:22
SPEAKER_00: You're only talking about the probability that it could be redeemed.
33:27
SPEAKER_02: Absolutely.
33:27
SPEAKER_02: And and I'm glad you brought that up because that is an area where people get a lot, get confused, where they're like, I don't think the investor is going to redeem it.
33:36
SPEAKER_02: Like, doesn't matter.
33:37
SPEAKER_02: If it's if it's probable that they will have the ability to redeem it, that's all that matters from an accretion perspective.
33:44
SPEAKER_02: And everything we just talked about, right?
33:46
SPEAKER_02: Probability, we're only talking about whether you have to accrete and remeasure.
33:51
SPEAKER_02: If you're deciding whether it's permanent or mezzanine equity, probability is irrelevant.
33:56
SPEAKER_02: So for classification, I don't care about probability.
34:00
SPEAKER_02: For measurement, I care about probability, but to your point, only about whether or not the put option is probable of becoming exercisable.
34:08
SPEAKER_00: So it's actually from that point of view an easier model than it could have been because you're not having to deal with the motivations of some other party to the arrangement.
34:18
SPEAKER_02: Certainly for classification, you know, it's for classification and to a large degree for measurement.
34:24
SPEAKER_02: Um, some of those contingent events may be driven by what other third parties would do, like for example, a change in control.
34:31
SPEAKER_02: And so you still have to think about whether those things are probable of occurring and things like that.
34:34
SPEAKER_02: But you're right, it could have been, it could have been a more complicated model.
34:37
SPEAKER_00: Well, but then actually that was my next follow-up question, is because the example you gave, again, was very clear because it was written into the agreement that in five years they would become redeemable.
34:49
SPEAKER_00: But often, as you mentioned, these triggers could be something else.
34:53
SPEAKER_00: So how do you start to think about the probability of some of those other types of events?
34:58
SPEAKER_02: Yeah, it's it's it's it can be very difficult and it can be very judgmental.
35:03
SPEAKER_02: Um, you know, again, we've said this a couple times, it's really important that the company has to really think about all the facts and circumstances and and really document their judgment, you know, as to why something they think something is or not probable of becoming redeemable.
35:16
SPEAKER_02: If originally you didn't think it was probable and it becomes probable, we start agreeding.
35:21
SPEAKER_02: So that just like the classification is sort of an ongoing test.
35:25
SPEAKER_02: Um the SEC has given some guidance in this area.
35:29
SPEAKER_02: So one question that came that came up and they talked about it a number of years ago at a speech was so back to my favorite example, it's a preferred stock, it's putable after five years.
35:39
SPEAKER_02: However, let's throw in a complicating factor and say the investor could convert it into common stock.
35:46
SPEAKER_02: So the question went to the SEC was well, should I think about the fact that we may never get to the five-year mark because they might convert it to common stock?
35:56
SPEAKER_02: And does that mean I can say it's not probable of becoming redeemable?
36:00
SPEAKER_02: And the staff said no, that because both the conversion option and the put are in the investor's control.
36:08
SPEAKER_02: And if the investor doesn't do anything, it's gonna become putable in that fact pattern because they're both under the control.
36:14
SPEAKER_02: No, you you would still have to accrete in that fact pattern.
36:16
SPEAKER_02: But but you absolutely write, it's very judgmental.
36:19
SPEAKER_00: All right, that's helpful.
36:20
SPEAKER_00: So we talked about classification, talked about measurement.
36:23
SPEAKER_00: How about then if we actually extinguish some of this?
36:27
SPEAKER_00: How how does that counting model work there?
36:30
SPEAKER_02: Yeah, so as I said a couple minutes ago, it is an equity instrument.
36:33
SPEAKER_02: It's just not permanent equity, it's temporary equity.
36:35
SPEAKER_02: So extinguishment gains and losses associated with that, they're gonna go to retained earnings.
36:40
SPEAKER_02: They're not gonna impact PL like it would if it was liability classified.
36:44
SPEAKER_02: Um so there are similarities to you know redemptions and extinguishments of permanent equity classified.
36:51
SPEAKER_02: Um, the one difference though is in many cases, if you redeem the security, especially if it's pursuant to one of the contractual terms, chances are it's already on the balance sheet or it should be on the balance sheet at its redemption amount already because we're accreting.
37:07
SPEAKER_02: And so, you know, when if an instrument gets redeemed or investor gives notice of redemption, we'll do one final accretion to the redemption, and then we're kind of done.
37:15
SPEAKER_02: It gets redeemed at that amount.
37:16
SPEAKER_02: Now, it doesn't really matter because the gain it goes to retaining anyways.
37:20
SPEAKER_02: Yeah.
37:20
SPEAKER_02: Um there are some times though when you will have a additional gain or loss that's not reflected through accretion.
37:28
SPEAKER_02: One example would be if instead of the investor redeeming it, you went and bought it from the investor, you negotiated a purchase price different from the redemption amount.
37:38
SPEAKER_02: So you haven't accreted to the thing you just negotiated.
37:40
SPEAKER_02: Um that could cause it.
37:42
SPEAKER_00: So you would make that adjustment then at the settlement.
37:44
SPEAKER_02: Well, you wouldn't make it as part of accretion, you would just be part of the gain or loss.
37:47
SPEAKER_02: But again, it all goes to retain earnings.
37:49
SPEAKER_02: Yeah.
37:49
SPEAKER_02: Um another good example would be remember we said earlier you can accrete and you can decrete, but you can't go below initial carrying amount.
37:58
SPEAKER_02: If the investor actually puts it at a price below initial carrying amount, we weren't allowed to decrete to that initial carrying amount price.
38:06
SPEAKER_02: That could create a gain or loss again, that or you know, a gain in that situation that would go to retained earnings.
38:12
SPEAKER_00: All right.
38:12
SPEAKER_00: So then let me ask one other question.
38:14
SPEAKER_00: Uh, one of the things we've focused a lot here on the podcast, and I'm actually talking to John Haran today, not on this topic, but is EPS.
38:22
SPEAKER_00: And so I know there's interaction with the EPS with these types of um classified instruments.
38:29
SPEAKER_00: So how do we think about that?
38:31
SPEAKER_02: Yeah, so um, so so great question, and and hopefully Haran says the same thing later that uh that I'm saying now.
38:37
SPEAKER_02: But um, we all of these accretion adjustments um are treated like dividends.
38:44
SPEAKER_02: And so accretion and decretion, they will impact income available to common shareholders.
38:48
SPEAKER_02: Um it'll impact the numerator of earnings per share, and then any gain or loss on extinguishment will similarly impact earnings per share, just like any any preferred stock would.
38:58
SPEAKER_00: All right.
38:58
SPEAKER_00: So then, Chip, maybe a final question for you is I know you said that you like to deal with easy things, but I don't think you'd be a national office partner if that was the case.
39:08
SPEAKER_00: So um to make things, however, easier for our audience, just curious.
39:14
SPEAKER_00: Obviously, you spent a lot of time dealing with these types of contracts, sort of seen the pitfalls from an accounting point of view.
39:20
SPEAKER_00: So if you are a controller somewhere, that maybe one of these comes across your desk, sort of what's your advice you have to kind of work through this whole model?
39:30
SPEAKER_02: Yeah, I mean, I think the biggest piece of advice that that we give is when you know your company is going to go out and do a capital raise, be involved with the treasury folks, be involved with the negotiation of the terms, understand, you know, not only what the term is, but why is it in there and what are all the facts and circumstances around the negotiation?
39:52
SPEAKER_02: Um that way you can react on a real-time basis and share, you know, feedback on, well, hey, that's gonna make this thing mezzanine classified.
39:59
SPEAKER_02: Does anybody care?
40:01
SPEAKER_02: Is it another thing?
40:02
SPEAKER_02: Well, hold on, that's gonna cause accretion, that accretion is gonna impact earnings per share, like you know, those types of things.
40:08
SPEAKER_02: It also allows you to kind of get into it and understand who the investor is, what other relationships do they have with the company.
40:15
SPEAKER_02: Um, it's better to get that on a real-time basis than try to figure it out, you know, two months after it was after it was issued.
40:22
SPEAKER_02: You know, also read the contract, make sure that the provisions in it are clear and drafted well from a legal perspective.
40:29
SPEAKER_02: So there's no ambiguity on how the features work.
40:31
SPEAKER_02: I mean, that's important not just from an accounting, but obviously just from a from a pure economic standpoint.
40:36
SPEAKER_02: Um, and again, you know, ask the probing questions, you know, like, hey, how is the investor getting liquidity in this investment?
40:44
SPEAKER_02: Are we giving them liquidity?
40:45
SPEAKER_02: Are there outs features like that?
40:47
SPEAKER_02: Like, ask, yeah, uh ask those questions throughout.
40:50
SPEAKER_00: All right.
40:51
SPEAKER_00: Well, definitely this great topic.
40:53
SPEAKER_00: A lot to think about.
40:54
SPEAKER_00: I think a lot more than people necessarily realize when they're dealing with some of these types of instruments.
40:59
SPEAKER_00: So it's always so nice to talk to you.
41:01
SPEAKER_00: And thanks for joining me today.
41:02
SPEAKER_02: Yeah, thanks for having me.
41:04
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41:07
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41:27
SPEAKER_00: From Thought Leadership at PwC, I'm Heather Horn.
41:31
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41:42
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41:44
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