Chapter 5 — Common Embedded Features Unique to Debt Host Contracts

5.5 Term Extension Features in a Debt Host

5.5.1 Background

Term extension features embedded in a debt host contract include those that give either party the right to extend the debt’s remaining term or automatically extend the term upon the occurrence of a specified event.

5.5.2 Bifurcation Analysis

The table below presents an overview of the bifurcation analysis of a term extension feature embedded in a debt host contract. However, an entity should always consider the terms and conditions of a specific feature in light of all the relevant accounting guidance before reaching a conclusion.

Bifurcation Condition	Condition Met?	Analysis
Not clearly and closely related (see Section 4.3.2)	It depends	A term extension feature is not clearly and closely related to a debt host unless the interest rate is concurrently reset to a current market rate and the debt initially did not involve a significant discount.
Hybrid instrument not measured at fair value through earnings on a recurring basis (see Section 4.3.3)	It depends	From the issuer’s perspective, debt is not measured at fair value on a recurring basis unless the issuer elects the fair value option in ASC 815-15 or ASC 825-10. The fair value option cannot be elected for debt that contains a separately recognized equity component at inception. From the holder’s perspective, if a loan or debt security is remeasured at fair value, with changes in fair value recorded in earnings, any derivative embedded in the interest would not need to be accounted for separately since the accounting for the interest would already be the same as that of a freestanding derivative.
Meets the definition of a derivative (see Section 4.3.4)	It depends	The evaluation of whether a term extension feature meets the definition of a derivative depends on whether it meets the net settlement characteristic in the definition of a derivative.
Meets a scope exception (see Chapter 2 and Section 4.3.5)	Generally, yes	A term extension feature embedded in a debt host contract often qualifies for the loan commitment scope exception. However, this scope exception is not available if the term extension option is held by the creditor.

As shown in the table above, a term extension feature in a debt host would not be bifurcated if (1) the feature is considered clearly and closely related to the debt host contract (see the next section), (2) the entity is remeasuring the hybrid instrument at fair value on a recurring basis through earnings, (3) the feature does not meet the definition of a derivative, or (4) the feature meets the scope exception for loan commitments.

5.5.3 Clearly-and-Closely-Related Analysis

ASC 815-15

25-44 An embedded derivative that either (a) unilaterally enables one party to extend significantly the remaining term to maturity or (b) automatically extends significantly the remaining term triggered by specific events or conditions is not clearly and closely related to the interest rate on a debt instrument unless the interest rate is concurrently reset to the approximate current market rate for the extended term and the debt instrument initially involved no significant discount. Thus, if there is no reset of interest rates, the embedded derivative is not clearly and closely related to the host contract. That is, a term-extending option cannot be used to circumvent the restriction in paragraph 815-15-25-26 regarding the investor’s not recovering substantially all of its initial recorded investment.

Under ASC 815-15-25-44, a term extension feature is clearly and closely related to a debt host only if (1) the interest rate is adjusted to the approximate current market rate of interest for the extended term at the time the term is extended and (2) the debt did not initially involve a significant discount.

Example 5-11

Debt With Extension Option

Company XYZ issues five-year, variable-rate debt that pays three-month SOFR plus 250 basis points on a quarterly basis. At the end of five years, XYZ has an option to extend the debt for another three years and, if the option is exercised, XYZ will continue to pay three-month SOFR plus 250 basis points for the extended term.

Although the debt continues to vary on the basis of three-month SOFR if the term of the debt is extended, the interest rate does not reset to current market rates because the credit spread is not adjusted. At the end of the original five-year term, the current market rate for an issuer with the creditworthiness of XYZ may be different than three-month SOFR plus 250 basis points (e.g., the current market rate for XYZ debt could be SOFR plus 750 basis points), even if the creditworthiness of XYZ has not changed. Therefore, because XYZ has the option to extend the maturity of the debt significantly and the interest rate in its entirety does not reset to market, the term-extending option is not clearly and closely related to the debt host.

The analysis of whether a term extension feature is clearly and closely related to a debt host is different from the analysis of whether an embedded prepayment (or call) option is clearly and closely related to a debt host even though economically such features may be similar.

Example 5-12

Bonds With Extension Options

Entity ABC issues two series of bonds that are publicly traded. One bond has a five-year term and a 6 percent fixed coupon rate and grants the bondholder an option to extend the debt for another three years at a 6 percent fixed interest rate. The second bond has an eight-year term and a 6 percent fixed coupon rate and grants the bondholder an option to put the debt back to ABC at the end of five years. Although these two bonds are economically similar, they are analyzed differently under ASC 815. The first bond is analyzed as a five-year debt host contract with an embedded term extension feature; the second bond is analyzed as an eight-year debt host contract with an embedded put option.

The term-extending option in the first bond extends the maturity of the debt significantly but does not reset the interest rate to a market rate. The term-extending option, therefore, is not clearly and closely related to the debt host and may need to be bifurcated from the host contract and accounted for separately if it meets the other criteria in ASC 815-15-25-1. The embedded put option in the second bond would not be evaluated under the guidance on term extension options. Instead, it would be evaluated under the guidance on embedded put options (see Section 6.4).

5.5.4 Derivative Analysis

The table below presents an analysis of whether a term extension feature embedded in a debt host contract meets the definition of a derivative (see Section 4.3.4). Note, however, that an entity should always consider the terms and conditions of a specific feature in light of the applicable accounting guidance before reaching a conclusion.

Characteristics of a Derivative	Characteristic Present?	Analysis
Underlying and notional amount or payment provision (see Section 1.4.1)	Yes	A term extension feature in a debt host contract has both an underlying (interest rates and, if applicable, the occurrence or nonoccurrence of any exercise contingency) and a notional amount (the principal amount subject to extension) or payment provision.
Initial net investment (see Section 1.4.2)	Yes	The initial net investment in an embedded feature is its fair value (i.e., the amount that would need to be paid to acquire the term extension feature on a stand-alone basis without the debt host contract). Generally, a term extension feature has an initial net investment that is smaller than would be required for a direct investment in the amount of debt that is subject to the term extension (since the investment in the debt host contract does not form part of the initial net investment for the embedded feature).
Net settlement (see Section 1.4.3)	It depends	Typically, the entity would evaluate whether the debt contract that will be extended is RCC (see below).

Generally, the analysis of whether an embedded term extension feature meets the definition of a derivative focuses on whether the feature meets the net settlement characteristic. If a term extension feature does not contain an explicit net settlement provision or a market mechanism to facilitate net settlement (both of which would be uncommon), the evaluation depends on whether the instrument whose maturity is being extended is RCC (e.g., publicly traded debt that may be sold in increments that can be rapidly absorbed by the market without significantly affecting the price). If the underlying debt is not RCC, the embedded term extension feature should not be bifurcated as a derivative because it does not permit net settlement and therefore does not meet the definition of a derivative.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.