Equity securities are securities representing an ownership interest in an entity, such as common, preferred or other capital stock, along with the right to acquire such an interest, such as warrants, rights and call options, or to dispose of one, such as put options, at fixed or determinable prices. Three things the phrase sounds like it should cover are excluded by name: written equity options, because they represent obligations of the writer rather than investments, cash-settled options on equity securities and options on equity-based indexes, because those instruments do not represent ownership interests in an entity, and convertible debt or preferred stock that by its terms either must be redeemed by the issuing entity or is redeemable at the option of the investor (FASB Accounting Standards Update 2016-01, Master Glossary).
The Exclusions Do Real Work
Each one turns on a single question: after the transaction, does the reporting entity hold a piece of the issuer?
A purchased call is inside the class because it is a right to acquire that piece. The same option written by the reporting entity is outside it, because what the writer holds is an obligation. Nothing about the contract changed between those two sentences except which side of it the reporting entity sits on.
A cash-settled option, and any option on an equity-based index, is outside for a different reason. Settlement in money never delivers the underlying stake, and an index is a basket rather than an entity, so neither instrument conveys the ownership interest the definition is built on.
The third exclusion is the one that catches preparers. Convertible debt is outside the class, and so is preferred stock carrying a mandatory redemption or a redemption at the investor’s option, because a security the holder can compel the issuer to buy back is a promise to pay in substance whatever it is called on the certificate. How the issuer classifies its own side of that instrument is a separate question, worked through in redeemable equity.
Ownership Interests That Are Not Securities Get Pulled In
The accounting Topic is wider than its own name. It establishes standards of financial accounting and reporting for investments in equity securities and other ownership interests in an entity, including investments in partnerships, unincorporated joint ventures, and limited liability companies, as if those other ownership interests are equity securities (FASB Accounting Standards Update 2016-01, paragraph 321-10-15-4).
That sentence decides a lot of small-firm work. A membership interest in a closely held LLC has no certificate, no exchange and no quote, and it is still accounted for under the equity securities Topic unless one of the exceptions below applies to it.
Where the Topic Stops
Five categories fall outside it. Derivative instruments subject to the derivatives Topic are out, including those separated from a host contract, though where an investment would otherwise be in this Topic and carries an embedded derivative that has to be separated, the host instrument stays here. Investments accounted for under the equity method are out, and so are investments in consolidated subsidiaries. So is an exchange membership that has the ownership-interest characteristics the broker-dealer guidance specifies. So is Federal Home Loan Bank and Federal Reserve Bank stock (FASB Accounting Standards Update 2016-01, paragraph 321-10-15-5).
The two middle exclusions are the ones that move real balances in a firm’s work. An interest large enough to carry significant influence leaves the Topic for the equity method, and one large enough to consolidate leaves it for consolidation, so the size of the stake has to be settled before the measurement question is asked at all.
The Measurement Alternative Is an Election, Not a Policy
Where the mark on an equity security lands, and why the available-for-sale route closed for this class, is worked through in mark to market. What that leaves is the mechanics of the one alternative, and they are stricter than the word alternative suggests.
The election is made investment by investment. An entity may elect to measure an equity security without a readily determinable fair value, where the security does not qualify for the practical expedient to estimate fair value, at cost minus impairment plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer, and an election to measure a security that way is made for each investment separately (FASB Accounting Standards Update 2016-01, paragraph 321-10-35-2). Two holdings in the same private company can therefore sit on different measurement bases, and neither one is wrong.
Once made, the election runs until the security stops qualifying. The entity continues applying that guidance until the investment no longer qualifies for it, for example because it acquires a readily determinable fair value or becomes eligible for the practical expedient, and it reassesses at each reporting period whether the investment still qualifies (FASB Accounting Standards Update 2016-01, paragraph 321-10-35-2). The reassessment is periodic work, not a one-time entry, and the test that decides whether a price counts as readily determinable is set out in marketable security.
Impairment on an elected security starts qualitative. At each reporting period an entity holding one considers impairment indicators, among them a significant deterioration in the earnings performance, credit rating, asset quality or business prospects of the investee, and where that assessment indicates impairment and fair value is below carrying value, the security is written down to fair value (FASB Accounting Standards Update 2016-01, paragraph 321-10-35-3). Nothing requires a valuation until the qualitative screen says one is needed.
The Securities Law Definition Reaches Wider
Two rulebooks use the same two words and neither one is a paraphrase of the other. Under the Securities Exchange Act, an equity security means any stock or similar security, any security future on such a security, any security convertible into one or carrying a warrant or right to subscribe to or purchase one, any such warrant or right, and any other security the Commission deems of similar nature and appropriate to treat as an equity security (15 U.S.C. 78c(a)(11)).
The Commission then used that last limb. Its rule defines the term to include any stock or similar security, a certificate of interest or participation in any profit sharing agreement, a preorganization certificate or subscription, a transferable share, a voting trust certificate or certificate of deposit for an equity security, a limited partnership interest, an interest in a joint venture, a certificate of interest in a business trust, a security future on any such security, convertibles and warrants and the rights themselves, and any put, call, straddle, or other option or privilege of buying such a security from or selling such a security to another without being bound to do so (17 CFR 240.3a11-1).
That last clause is where the two definitions visibly part. The securities rule describes the option contract itself, so a put or a call is an equity security under it either way. The accounting glossary asks which side of the same contract the reporting entity is on, and puts the written side outside the class. A firm reading one definition into the other will classify a written option wrongly, and the two answers are both correct in their own rulebook. Where the statutory enumeration of security itself sits, and how it differs from the accounting test, is worked through in financial instruments.
Common Questions
Common stock, preferred stock and other capital stock are the plain cases, and the definition adds the rights that sit on top of them: warrants, rights and purchased call options to acquire an ownership interest, and put options to dispose of one, at fixed or determinable prices (FASB Accounting Standards Update 2016-01, Master Glossary). For accounting purposes the list also takes in interests in partnerships, unincorporated joint ventures and limited liability companies, which are treated as if they are equity securities (FASB Accounting Standards Update 2016-01, paragraph 321-10-15-4).
An equity security is a stake in the issuer, a debt security is a claim on the issuer, and the two are measured under different Topics. The debt side still turns on what the holder intends: investments in debt securities are classified as held-to-maturity and measured at amortized cost only if the reporting entity has the positive intent and ability to hold those securities to maturity (FASB Statement of Financial Accounting Standards No. 115, paragraph 7). No comparable intent question is asked about an equity security, and where each one’s unrealized mark ends up is set out in mark to market.
Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm can put a block of its own investment classification and measurement work through a trial task before any client file depends on it.
