Accounting challenges mount as private firms embrace sophisticated financial tools

Private companies are increasingly turning to complex financing arrangements, featuring embedded derivatives and contingent events, to raise capital and manage risk, according to recent industry discussions with the FASB.

These instruments are proving difficult to navigate, leading to increased costs and complexity for companies and their accountants, members of the American Institute of Certified Public Accountants' (AICPA) Private Companies Practice Section (PCPS) Technical Issues Committee (TIC) said on Sept. 24, 2024.

Curt Hurd, a partner at Plante Moran, noted that the prevalence of complex financing arrangements has increased significantly over the past few years, with features such as conversion options, puts, and contingent events becoming more common. These features can lead to significant costs and challenges for private companies, which often lack the expertise and resources to properly evaluate and account for them, he said.

Embedded derivatives refer to components of a financial instrument that have characteristics of a derivative, such as options or warrants. Contingent events are specific circumstances that trigger a change in the instrument's terms, such as a change of control or initial public offering (IPO).

The challenge of separating components

Hurd cited the example of a convertible debt instrument with multiple embedded features, including a standard conversion option and a put option upon a change of control or IPO. It's not uncommon to see "eight to 10 different embedded features" in some of these instruments, he said.

The accounting for these features can be complex, requiring companies to separate the components of the instrument and evaluate the likelihood of various contingent events, a process known as "componentization." This can be a time-consuming and costly process, particularly for smaller private companies.

"We're seeing a lot of different outcomes on instruments that are largely the same, which is leading to potential diversity in practice," he said. "Some entities are electing the fair value option as a cost-saving measure, while others are not, depending on the specific features included in their instruments."

Clarity through disclosure

FASB Chair Richard Jones acknowledged the challenges posed by these complex financing arrangements, but questioned whether users of private company financial statements are finding value in the current accounting treatment. "And is that really a shortcoming in our guidance that if we actually required more transparency on financings that entities enter into, maybe that would help highlight some of the accounting issues and some of the costs associated with those financings that right now they're forgetting about?" he asked.

Hurd and Julie Killian, chair of the AICPA's PCPS TIC, suggested that more explicit disclosure in debt footnotes could help address some of the issues, by providing users with a clearer understanding of the terms and features of these complex financing arrangements. However, they also acknowledged that this may not be a complete solution, given the complexity and diversity of these instruments.

Killian noted, "I do think the pace at which these arrangements are changing has been significant and really in the past two years."

The FASB is considering limited changes under Proposed Accounting Standards Update (ASU) No. 2024-ED100, Derivatives and Hedging (Topic 815) and Revenue from Contracts with Customers (Topic 606): Derivatives Scope Refinements and Scope Clarification for a Share-Based Payment from a Customer in a Revenue Contract, which may help address some of the issues related to the decoupling of a derivative from a host contract (larger agreement).

The comment period on the proposal ends on Oct. 21.

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