Warrants are frequently issued in connection with the formation and initial registered offerings of SPACs, but apparently there have been some problems with accounting for some of these warrants, or at least, so it appears from this Staff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (“SPACs”) from Acting Corp Fin Director John Coates and Acting Chief Accountant Paul Munter. The Statement is intended to “highlight the potential accounting implications of certain terms that may be common in warrants included in SPAC transactions” and to discuss what needs to be done if this Statement leads a company and its auditors to determine there is an error in any previously filed financial statements. The primary issue identified in the Statement is whether these warrants should be classified as equity or liability, which depends largely on the specific terms of the warrant and the entity’s specific facts and circumstances. If warrants are classified as a liability, according to the Statement, they should be “measured at fair value, with changes in fair value reported each period in earnings.”
To be classified as equity, the warrant must be considered “indexed” to the company’s own stock, for example, by providing for settlement of the warrant with a fixed number of shares. Warrants may also include variables that could affect the settlement amount, which, depending on the nature of the variable, could preclude a determination that the warrant is indexed to the company’s own stock. (For those who want to get into the weeds, the Statement advises that “variables do not preclude a conclusion that the instrument is indexed to an entity’s own stock if the variables would be inputs to the fair value of a fixed-for-fixed forward or option on equity shares.” See Statement note 6 for a list of acceptable inputs under GAAP.) In a recent review of various fact patterns, the staff found one pattern to be problematic: where the “warrants included provisions that provided for potential changes to the settlement amounts dependent upon the characteristics of the holder of the warrant.” That type of provision, the staff concluded, would “preclude the warrants from being indexed to the entity’s stock, and thus the warrants should be classified as a liability measured at fair value, with changes in fair value each period reported in earnings.”
Another problematic warrant provision identified by the staff related to tender offers. Under GAAP, “if an event that is not within the entity’s control could require net cash settlement, then the contract should be classified as an asset or a liability rather than as equity.” One exception is that the warrant may be classified as equity if net cash settlement can be triggered only in circumstances in which the holders of the shares underlying the contract also would receive cash, such as in changes of control. However, some warrants issued by SPACs include provisions that could preclude use of the exception. For example, the staff has seen warrants providing that, “in the event of a tender or exchange offer made to and accepted by holders of more than 50% of the outstanding shares of a single class of common stock, all holders of the warrants would be entitled to receive cash for their warrants. In other words, in the event of a qualifying cash tender offer (which could be outside the control of the entity), all warrant holders would be entitled to cash, while only certain of the holders of the underlying shares of common stock would be entitled to cash.” The staff determined that, in those circumstances, the warrants should be classified “as a liability measured at fair value, with changes in fair value reported each period in earnings.”
If the company and its auditors determine that, in light of this Statement, there has been an error regarding the classification of warrants in previously filed financials, the company will need to consider the materiality of the error in assessing whether it will need to restate its financials—which could involve amending one or more periodic reports—and file an Item 4.02 8-K, Non-Reliance on Previously Issued Financial Statements or a Related Audit Report or Completed Interim Review. These restatements may involve revisions to the financial statements and notes, as well as restated quarterly financial information (Reg S-K Item 302) and revisions to MD&A (Reg S-K Item 303).
In addition, the company will need to consider whether it must upgrade its internal control over financial reporting and disclosure controls and procedures and amend its prior disclosures on the evaluation of ICFR and disclosure controls. That analysis will require consideration of the severity of the control deficiency, if any, individually or in the aggregate. The Statement cautions that the “evaluation of the severity of any control deficiency should not be limited to the actual misstatement that occurred or whether that misstatement was material, but instead should consider the magnitude of the potential misstatement resulting from the deficiency or deficiencies, amongst other considerations. Where applicable, the auditor also will have to evaluate management’s assessment.”
If the company determines that the accounting error is not material to the required financial statements and disclosures included in pending submissions and filings, the company “may provide the staff with a written representation to that effect in correspondence” on EDGAR. The staff also reminds companies, as they consider possible changes to their disclosures, about their Reg FD obligations.