Embedded Financial Derivatives Accounting

MaloneBailey LLP Tax Service Houston Texas

Raising Capital with Embedded Financial Derivatives

Frequently, small public companies choose to obtain financing from sources which rely on a public company’s stock or underlying warrants to pay off the capital injection or loan. This has led numerous companies to enter into financings which have embedded financial derivatives that have major accounting and valuation issues that can be both costly and time consuming.

Derivative accounting involves isolating and separately assigning fair values to various debt or equity features for which the eventual financial settlement by the public company is not 100% within its control.

Recent Rule Change In June 2008, the following pronouncement came out:

  • EITF 07-05 – “Determining whether an Instrument (or Embedded feature) is Indexed to an Entity’s Own Stock”
  • Effective Date – This Issue is effective for financial statements issued for fiscal years beginning after
    December 15, 2008, and interim periods within those fiscal years. Earlier application by an entity that has previously adopted an alternative accounting policy is not permitted.

The above will probably affect many small filers. And the quarter ended 3/31/09 for entities with fiscal years ended 12/31/08 are the first affected. The new accounting must be applied in this first quarter of the new fiscal year. To avoid late scrambles in documentation and disclosures, we suggest that you and your client review the following kinds of agreements for the provision noted below:

  • convertible debt
  • convertible preferred stock
  • financing warrants
  • warrants for services to non employees where the services have already been performed but the warrants remain outstanding
  • employee stock options where the option holder is no longer an employee and the option has been modified and remains outstanding

The provision you are looking for is a provision that adjusts the exercise price or the conversion price of the original instrument if the company were to issue an instrument later at a price or with a conversion price or exercise price lower than the original price, conversion price or exercise price. If you have any such instruments with this provision, the client will have to get timely valuations of these instruments beginning with the 3/31/09 quarter. We’re happy to discuss with you the impact of this EITF and the accounting for these instruments for you and your clients.

Does this sound familiar?

Hope Co. is raising capital to finance it new patent and turn it into a viable business and has just completed a reverse merger and is now a public company. They recently signed a financing deal with First Born Financing Co. where they received $250,000 cash in exchange for preferred stock. Each preferred share is convertible into 1,000 shares of common stock and has two series of warrants attached for the purchase of common shares one series at $0.50 and one series at $ 0.75 both currently out of the money. The instrument also calls for Hope Co. to register the number of shares that would be issued on conversion of all the instrument within 90 days or it must pay 18% interest as a registration rights penalty.

Does Hope Co. have a Financial Derivative?

Probably, as can each of the following debt or equity instruments and /or features:

  • Debt with attached warrants
  • Preferred stock with attached warrants
  • Convertible debt
  • Convertible preferred stock
  • Registration rights
  • Other features, including liquidated damages provisions, anti-dilution, puts and   calls, inflation-indexed interest payments, credit sensitive payments, interest rate floors, caps, collars, equity-indexed interest payments, etc.

How can MaloneBailey, LLP help?
We as your auditor can help you “Make the Determination” by reviewing your debt or other securities instruments to decide whether one or more derivative instruments exist.

 We can help you avoid common accounting and valuation errors which include:

  • Treating the attached warrants as a Beneficial Conversion Feature
  • Attempting to fix the problem after the fact by requesting lender waivers
  • Using Black-Scholes to value derivatives that have multiple variables
  • Misjudging what ‘within the Company’s control’ means
  • Ignoring effect of registration rights damage provisions

We can help you navigate the relevant accounting pronouncements including:

  • Statement of Financial Accounting Standards 133
  • Statement of Financial Accounting Standards 155
  • Emerging Issues Task Force 00-19
  • Emerging Issues Task Force 05-04
  • Emerging Issues Task Force 06-07
  • New FASB Staff Positions Emerging Issues Task Force 00-19b
  • Emerging Issues Task Force 07-05

If a financial derivative exists we can recommend outside experts to value each derivative instrument.

MaloneBailey, LLP is a nationally-recognized expert on derivatives accounting.  For a no-cost consultation, email us at svertucci@malonebailey.com.