Nearly There Case
Economic Characteristics/Accounting Issues
Nearly There designs, develops, manufactures and sells various navigation products and services. They are a public company registered with the SEC and their common stock trades on the stock exchange. The Company is well capitalized with a $100 million market capitalization for its common stock. Due to R&D expenses and slumping sales, Nearly There is in the need of additional capital. The Company's solution was to issue 5 million shares of Series B preferred stock at $1.20 per share. The proceeds received by the company totaled $5.9 million. The important terms of the Series B preferred stock included dividends, voting rights, conversion options, conversion price adjustment, …show more content…
ii) Should the Company separate the Conversion Option feature in the Series B Preferred Stock from the host contract and account for it as a derivative instrument?
The conversion option in the Series B Preferred stock is considered an embedded derivative. Topic ASC 815-15 relates to embedded derivatives and whether the embedded derivatives are separate accounting units. By going further into ASC 815-15-25, the guidance gives us three criteria that each must be met to bifurcate the derivative from the host contract.
The first condition requires the embedded derivative not to be clearly and closely related to the host contract. We have already established the host contract to be substantially similar to debt. The conversion option is more like equity than debt because the common stock price gives the option value. Additionally, Topic ASC 815-15-25-16 and 17 provide clearer guidance on applying the clearly-and-closely related criteria. The Company's preferred stock is not clearly and closely related to the host because the host contract does not carry residual interest to the company and the preferred stock is fixed rate with a mandatory redemption feature.
The second condition requires that none of the embedded features in the contract are measured at fair value. The case states, "The Series B Preferred Stock is not re-measured at fair value with any changes recognized in earnings under any other applicable U.S. GAAP after the issuance.” The means the second