Background Hearts ‘R Us (Hearts) is a private early-stage R&D company in the final trial of a medical device that will revolutionize the way heart valve defects are repaired – the Heart Valve System (HVS). Hearts has secured financing by issuing $3.5 million of Series A preferred shares ($1 par value) to Bionic Body (Bionic), an SEC registered company that produces medical devices, one of which could be used as supplement to the HVS. For its considerations, Bionic received a seat on Hearts’ Board of Directors, protective rights for its investment percentage (can limit future equity/debt issuances), and both the right of first refusal to purchase and co-sale on sale of shares by key share-holders. Bionic’s shares will be converted to common stock upon execution of an IPO that generates a minimum of $50 million in proceeds. If Heart has not secured FDA approval for the HVS by the 5th anniversary of the date of purchase of the stock, it will redeem the shares at par value.
Issues
1) Does the host contract contain an embedded derivative that must be accounted for separately, and how does this affect the classification of the contract as a liability or equity?
2) Are accounting changes necessary due to the failure of Hearts to acquire FDA approval of its product?
3) How would the accounting guidelines change, if at all, if Hearts were an SEC registrant?

Analysis ASC 815 and ASC 480 contain a myriad of rules that could apply to a hybrid instrument. The issuance of the preferred stock contains within it the requirement for Hearts to buy back its stock at par value upon the condition that the FDA has not approved its HVS by the 5th anniversary of the stock purchase. This could constitute an embedded derivative, as defined by ASC 815-15-20 (future cash flows are affected). ASC 815-15-25-1 requires an embedded derivative to be separated