The Financial Accounting Standards Board has made a definitive decision concerning accounting treatment for warrants with a net-share settlement feature--they are to be marked to market. Some market practitioners thought net-share settled warrants were exempt from mark-to-market treatment because of a confusing passage in Statement number 133, the FASB's hedge accounting statement. "In hindsight, we wrote [the passage] badly," said Stephen Young, practice fellow in Norwalk, Conn. Net settlement, for example for an equity call option, is where the option is settled via the holder receiving a quantity of the underlying equal to the intrinsic value of the option upon exercise.
The FASB staff had recommended that net share settled warrants be marked to market, but there was significant opposition from the industry. The FASB elected to approve the recommendation, said Young.
The definition of a derivative in FAS 133 features a paragraph that in part defines derivatives as instruments that are net settled, and explains net settlement. A passage in this paragraph uses "or" where it should use "and," which introduced confusion as to whether cashless exercise warrants, or net-share settled warrants, were in fact considered derivatives. But Young emphasized that the spirit of the definition is clear.
The companies most concerned about this debate were typically technology companies, which often receive net settled warrants, to cement partnerships or as payment from suppliers, said Young. Some companies prefer to avoid marking these instruments to market--the underlying security is often illiquid, making getting a current fair value for these instruments difficult.
The FASB also decided last week that commodity purchase and sale agreements linked to the consumer price index are generally to be considered derivatives under FAS133. Many companies hoped these contracts would be exempted. Usually, plain vanilla commodity supply contracts are exempted from mark-to-market accounting. If they are indexed, they can still be exempted, as long as they are linked to an index that is clearly and closely related to the underlying. In this case, the FASB decided that the CPI is not clearly and closely related to single commodity prices, and hence the contracts should generally be marked to market.
