SEC Accounting Series Release 268: Triggers and Measurement

SEC Accounting Series Release 268, known as ASR 268, requires public companies to pull certain redeemable equity instruments out of permanent stockholders’ equity and present them in a separate balance sheet caption between liabilities and equity. That caption is commonly called temporary equity or mezzanine equity. The rule applies whenever an instrument could be redeemed for cash under circumstances the issuer does not fully control, and it exists so investors can tell apart capital that will stay in the business from capital that could be pulled out by shareholders or triggered by outside events. The rule was codified into Regulation S-X at Rule 5-02.27, and its interpretive guidance now lives in ASC 480-10-S99 through EITF Topic D-98.¹

The Three Triggers That Force Mezzanine Classification

A redeemable equity instrument must sit outside permanent equity if any one of the following is true:

Fixed redemption date or price. The instrument is redeemable at a set price on a set date, such as through a sinking fund that requires the company to buy back shares on a predetermined schedule.
Redemption at the holder’s option. The holder can force the company to buy the instrument back, whether the company wants to or not.
An event outside the issuer’s sole control. Any event that could trigger redemption and that the company cannot single-handedly prevent, even if the event is unlikely.

These three conditions come directly from Regulation S-X, which requires redeemable preferred stocks meeting any of them to appear in a separate caption rather than under stockholders’ equity.² The SEC staff has confirmed that the same three conditions apply to any equity instrument, not only preferred stock, when deciding whether temporary equity classification is required.³

Probability Does Not Matter for Classification

This is the point that trips up companies most often. The SEC staff has said that temporary equity classification is required whenever a triggering event is not solely within the issuer’s control, without regard to probability. It does not matter if the event is remote or practically impossible. A single redemption trigger the company cannot unilaterally prevent sends the entire instrument to mezzanine equity. The standard is meant to be applied strictly, with no room for a judgment call about how likely redemption actually is.

Probability comes back into the picture later, at the measurement stage. Classification asks whether redemption could happen. Measurement asks how likely it is and what it will cost. An instrument classified in temporary equity because of a low-probability trigger may not need to be accreted to its full redemption value unless that redemption becomes probable.

Common Events Outside the Issuer’s Control

The third trigger generates the most complexity in practice. Contracts frequently allow redemption on any of the following:

Change in control. A merger, acquisition, or transfer of a controlling ownership stake. The company cannot stop its shareholders from selling to a buyer who accumulates majority control.
Death or disability of the holder. A shareholder agreement may require the company to buy back shares if a founder or key investor dies or becomes disabled.
Regulatory or legal changes. A shift in law or regulation that forces liquidation of the investment.
Delisting. Removal of the company’s shares from a stock exchange.
Debt covenant violation. A breach of a lending agreement that trips cross-default provisions in the equity instrument.

A working test: if the triggering event depends on a shareholder vote, third-party action, market condition, or regulatory decision, the company does not have sole control. Even board composition counts. If an instrument must be redeemed when a specific slate of directors fails to win re-election, the company cannot guarantee the outcome, because shareholders vote on directors.

Which Instruments Fall Under the Rule

Redeemable preferred stock is the most common instrument classified in temporary equity, particularly when it carries a mandatory buyback date or a holder put. But the reach of ASR 268 goes well beyond preferred stock. Although the rule originally targeted preferred stock, the SEC staff later extended its logic to all redeemable equity instruments, including common stock, derivatives, noncontrolling interests, and share-based payment awards.

Common stock with put options. If holders can sell common shares back to the company at a set price under conditions the company does not control, those shares belong in mezzanine equity.
Warrants with cash-settlement features. A warrant that allows the holder to receive cash instead of shares upon exercise, in circumstances the issuer cannot prevent, triggers temporary equity classification.
Share-based compensation. Stock awards granted to employees can require temporary equity classification if the redemption features fall outside the issuer’s control. The SEC has specifically stated that registrants must evaluate employee share-based payment arrangements under ASR 268.³
Noncontrolling interests. A minority interest in a subsidiary can land in mezzanine equity if the minority holder has the right to force the parent company to buy the interest back.

The label on the instrument does not matter. A security called common stock in the legal documents still goes to mezzanine equity if its economic terms include a conditional redemption feature outside the issuer’s control. The accounting follows the substance of the arrangement.

SPAC Public Shares

Special purpose acquisition companies are one of the most visible modern applications of ASR 268. In a typical SPAC, public investors buy shares in the IPO and keep the right to redeem those shares for a pro rata portion of the trust if they vote against a proposed business combination or if no deal closes by the deadline. Because individual shareholders decide whether to redeem, the event sits outside the SPAC’s control.

The SEC staff has objected to SPACs that classify only a portion of their publicly traded redeemable shares in temporary equity. Every public share carries the same redemption right, the unit of account is the individual share, and so the full aggregate redemption amount must appear in temporary equity.⁴ This often leaves a SPAC reporting a negative book value in its permanent equity section, because nearly all of its capital sits in the trust.

Deemed Liquidation Provisions

Many venture-backed companies and private equity deals include deemed liquidation provisions in their preferred stock terms. A deemed liquidation triggers the same payout as a full company liquidation, but the company keeps operating afterward. Common triggers include a change-of-control transaction, a sale of substantially all assets, or a merger.

If the events that could trigger a deemed liquidation are not solely within the issuer’s control, the preferred stock must be classified in temporary equity. A narrow exception exists where all holders of equally or more subordinate equity would always receive the same form of consideration on the triggering event, but in practice it rarely applies because preferred stock documents almost never guarantee proportionate treatment for common stockholders across every conceivable scenario.

Measuring the Instrument After Classification

When a company first issues a mezzanine-classified instrument, it records the instrument at fair value, typically the proceeds received minus specific costs directly tied to the issuance. That is the starting carrying amount.

After issuance, the accounting depends on whether redemption is probable. If redemption depends solely on the passage of time, it is generally treated as probable from day one. If redemption hinges on an uncertain future event, the company must monitor whether that event becomes probable.

Two Accepted Measurement Methods

Once redemption is probable, the SEC staff accepts two approaches for adjusting the carrying amount, provided the company applies its chosen method consistently:

Redemption-value method. The company adjusts the instrument’s carrying amount to its current redemption value at the end of each reporting period. If the redemption price fluctuates with fair value, that means marking to the new redemption amount every quarter.
Accretion method. The company gradually increases the carrying amount from the issuance-date value to the redemption price over the period from issuance (or from the date redemption becomes probable, if later) to the earliest redemption date, using the effective interest method.²

If the instrument is currently redeemable, because the holder already has the right to put shares back, the company must adjust immediately to the full maximum redemption amount. There is no waiting period.

Where the Charges Land

Increases in the carrying amount are charged against retained earnings. If retained earnings are insufficient, the charge flows to additional paid-in capital. If paid-in capital is also exhausted, the charge creates or increases an accumulated deficit.⁵ These charges never pass through net income or comprehensive income, so a reader looking only at the income statement will not see them. They show up on the balance sheet and in the earnings-per-share calculation.

Effect on Earnings Per Share

Accretion on mezzanine equity works like a preferred stock dividend for EPS purposes. Even though no cash has changed hands, the increase in carrying amount reduces the income available to common stockholders in the basic EPS formula. The numerator shrinks by the amount of the accretion, just as it would for a declared preferred dividend.

If the redemption value later drops, the company may reverse prior accretion, creating what accountants call a negative deemed dividend that increases income available to common stockholders. The carrying amount in temporary equity cannot be reduced below its initial value, so the positive EPS adjustment is capped by the cumulative accretion recognized to date.

For redeemable common stock with a redemption price above fair value, the excess represents a preferential distribution. Companies must use the two-class method for EPS in that situation, allocating earnings between common shares and the redeemable shares based on their respective participation rights. Redeemable instruments can materially dilute reported EPS even when no shares have actually been redeemed.

Balance Sheet Presentation and Footnote Disclosures

Regulation S-X requires companies to present redeemable equity in a separate balance sheet caption that is not included under stockholders’ equity and not combined with permanent equity totals.² Beyond the face of the balance sheet, the rules require a dedicated footnote, captioned “Redeemable Preferred Stocks” or an analogous title for other redeemable instruments, that includes:

A description of each issue. The redemption features, including whether redemption is mandatory, at the holder’s option, or triggered by specific events. The note must also describe what happens to junior securities if a required dividend or redemption payment is missed.
A five-year redemption schedule. The combined dollar amount of redemption requirements for all issues for each of the five years following the balance sheet date.
Period-over-period changes. A reconciliation showing how the carrying amount of each issue changed during every period for which an income statement is presented.

The balance sheet itself must show the title of each issue, the carrying amount, and the redemption amount. If the carrying amount differs from the redemption amount, the footnote must explain the accounting treatment for the gap, which will typically be a description of the accretion method the company has chosen.²

What Happens When Classification Is Wrong

Misclassifying a mezzanine instrument as permanent equity is not a theoretical risk. The SEC staff reviews classification during the IPO registration process and in ongoing periodic filing reviews, and has a track record of issuing comment letters that require reclassification. When an instrument moves from permanent to temporary equity, the consequences cascade.

Permanent equity shrinks and mezzanine equity appears or grows. If the instrument has been outstanding for multiple periods, the company may need to retroactively recognize accretion it never recorded, reducing retained earnings for prior periods. The EPS calculation for all affected periods changes, because accretion that was never deducted from the numerator now must be. If the errors are material, the company must restate its financial statements and file a Form 8-K under Item 4.02 disclosing that previously issued financials should no longer be relied upon.

For companies approaching an IPO, classification errors can delay the offering. The SEC’s Division of Corporation Finance reviews registration statements closely, and ASR 268 issues are among the most common accounting comments directed at registrants with redeemable securities. Catching classification before filing is far less expensive than restating after the fact, and companies routinely underestimate how broadly the SEC applies the “not solely within the issuer’s control” test.

1
FASB. EITF Topic D-98 – Classification and Measurement of Redeemable Securities
2
eCFR. 17 CFR Part 210 – Form and Content of Financial Statements
3
U.S. Securities and Exchange Commission. Staff Accounting Bulletin No. 107
4
U.S. Securities and Exchange Commission. Final Rules – Special Purpose Acquisition Companies
5
U.S. Securities and Exchange Commission. Convertible Redeemable Preferred Shares