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.
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Bifurcation Condition
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Condition Met?
|
Analysis
|
|---|---|---|
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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)
|
It depends
|
A term extension feature embedded in a debt
host contract often qualifies for the loan commitment scope
exception from the perspective of the issuer (borrower).
However, this scope exception is not
available if the term extension option is held by the
investor (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 (see
Section 6.4) 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
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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.
5.5.5 Scope Exception for Certain Loan Commitments
Because a term extension feature is a legally binding commitment
to extend the term of the debt on the basis of prespecified terms and
conditions, it is economically equivalent to a loan commitment for the term
extension period. Therefore, the loan commitment scope exception in ASC
815-10-15-69 through 15-71 (see Section 2.3.9) can be applied to a term
extension feature that gives the debtor the unilateral option to extend the
maturity of nonconvertible debt. This scope exception could not be applied by an
investor in a debt instrument with a term extension feature.
In a typical loan commitment, a potential creditor agrees to the
terms under which a potential debtor may borrow money. However, the potential
debtor is not legally obligated to borrow money under those terms or even from
that creditor. Therefore, if the creditor has the option to extend the maturity
of the debt, the instrument is not the equivalent of a loan commitment and thus
would not qualify for the exception.