The concept of fractional shares has been around for some time, but has risen in popularity over the past decade. As the popularity and volume of these transactions have increased, so has the discussion among industry participants, regulators, and accounting firms regarding potential accounting and regulatory implications related to these fractional share programs. It is important to fully understand fractional shares and the regulations surrounding them before deciding if they are right for your customers.
A fractional share is less than one full share of stock or exchange-traded funds (ETF). Typically, these shares arise as a result of stock splits or similar corporate actions and historically have not been discussed because fractional shares are not available from the stock market and are difficult to sell. However, some broker-dealers recently began offering their customers the ability to invest in fractions of shares. For these transactions, the customer has the option to invest a specific dollar amount in a particular investment, as opposed to acquiring a specified number of shares. This allows investors the ability to invest in companies with high share prices.
Broker-dealers should consider and perform an analysis of whether these fractional shares need to be included on their balance sheets or can be derecognized under the Accounting Standards Codification (ASC) Topic 860, Transfers and Servicing. The accounting analysis may cause the broker-dealer to record financial assets for the fractional shares held by its customers and corresponding financial liabilities which represent secured borrowings where the standard for derecognition is not met under ASC 860 if the broker-dealer is acting as a principal. The derecognition criteria of ASC 860 is as follows:
- A transfer of an entire financial asset, a group of entire financial assets, or a participating interest in an entire financial asset in which the transferor surrenders control over those financial assets shall be accounted for as a sale if and only if all of the following conditions are met:
- The transferred financial assets have been isolated from the transferor—put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. Transferred financial assets are isolated in bankruptcy or other receivership only if the transferred financial assets would be beyond the reach of the powers of a bankruptcy trustee or other receiver for the transferor or any of its consolidated affiliates included in 11 the financial statements being presented. For multiple step transfers, a bankruptcy-remote entity is not considered a consolidated affiliate for purposes of performing the isolation analysis. Notwithstanding the isolation analysis, each entity involved in the transfer is subject to the applicable guidance on whether it shall be consolidated (see paragraphs 860-10-40-7 through 40-14 and the guidance beginning in paragraph 860-10-55-18). A set-off right is not an impediment to meeting the isolation condition.
- Transferee’s rights to pledge or exchange are met if both of the following conditions are met:
- Each transferee (or, if the transferee is an entity whose sole purpose is to engage in securitization or asset-backed financing activities and that entity is constrained from pledging or exchanging the assets it receives, each third-party holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received.
- No condition does both of the following: 1) constrains the transferee (or third-party holder of its beneficial interests) from taking advantage of its right to pledge or exchange and 2) provides more than a trivial benefit to the transferor (see paragraphs 860-10-40-15 through 40-21). If the transferor, its consolidated affiliates included in the financial statements being presented, and its agents have no continuing involvement with the transferred financial assets, the condition under paragraph 860-10-40-5(b) is met.
- The transferor, its consolidated affiliates included in the financial statements being presented, or its agents do not maintain effective control over the transferred financial assets or third-party beneficial interests related to those transferred assets (see paragraph 860-10-40-22A). A transferor’s effective control over the transferred financial assets includes, but is not limited to, any of the following:
- An agreement that both entitles and obligates the transferor to repurchase or redeem them the transferred financial assets before their maturity (see paragraphs 860-10-40-23 through 40-2540-27)
- An agreement, other than through a cleanup call (see paragraphs 860-10-40-28 through 40-39), that provides the transferor with both 1) the unilateral ability to cause the holder to return specific financial assets and 2) a more-than-trivial benefit attributable to that ability.
- An agreement that permits the transferee to require the transferor to repurchase the transferred financial assets at a price that is so favorable to the transferee that it is probable that the transferee will require the transferor to repurchase them (see paragraph 860-10- 55-42D).
The broker-dealer may also need to consider whether or not income statement accounts are impacted based on the accounting conclusions reached.
At the AICPA & SIFMA National Conference on the Securities Industry in November 2021, FINRA and the SEC’s Division of Trading and Markets announced that as long as the broker-dealer carries the long position and maintains control of the shares purchased for its customers, the aforementioned accounting treatment will not likely impact the net capital computation or the reserve formula.
We Are Here to Help
Our specialists are here to help.
Get in touch with a specialist in your industry today.