6.10 Other Payment Provisions in Contracts

For example, payment provisions may require the issuer of a debt instrument (i.e., the debtor) to:

• Pay additional interest if the debt is not freely tradable by its holders by a specified date after issuance (e.g., the debtor must pay 0.25 percent of additional interest if the debt is not freely tradable six months after issuance).
• Pay additional interest if it has not filed in a timely manner any report or document that must be filed with the SEC (e.g., 0.25 percent of additional interest).
• Pay additional interest if it fails to meet one or more specified ESG targets (e.g., the debtor must pay additional interest of 0.50 percent if it does not use the debt proceeds to invest in renewable energy projects or fails to achieve 40 percent female representation on the debtor’s board of directors within three years of debt issuance).
• Receive an interest rate reduction if it meets specified ESG targets (e.g., the stated interest rate is reduced by 0.25 percent if the debtor achieves a specified reduction in greenhouse gas emissions within three years of debt issuance).
• Reimburse the creditor for increased costs as result of a specified event (e.g., a change in law or hedge disruption event).
• Reimburse the creditor for taxes on interest payments.

Because payment provisions that are contingent on filing with the SEC on time or on the ability to freely trade an instrument do not pertain to the filing or maintenance of either an effective registration statement or an exchange listing, they do not meet the definition of a registration payment arrangement (see Section 2.3.14).

Generally, payments that are contingent on (or indexed to) an underlying other than (1) interest rates (see Section 5.2), (2) the debtor’s creditworthiness (see Section 5.3), or (3) inflation (see Section 5.4) are considered not clearly and closely related to a debt host.

The following types of payment features are typically considered not clearly and closely related to a debt, equity, or lease host:

• Additional interest features that are triggered if debt or equity is not freely tradeable by a specified date or if the issuer does not file financial statements on time with the SEC.
• Additional interest features in a debt or equity host that are triggered if specified ESG targets are or are not met.
• Interest rate reductions that apply if specified ESG targets are met.
• Reimbursement of creditor-related costs.
• Reimbursement of taxes that the creditor owes to the government on interest paid.

We have observed various other types of contingent payment provisions in different types of host contracts in practice. Such embedded features should be carefully evaluated to determine whether the relevant economic risks and characteristics are clearly and closely related to the economic risks and characteristics of the respective host contract. Given the absence of authoritative guidance on less commonly observed embedded features, we encourage consultation with an entity’s accounting advisers.

As shown in the table above, a payment feature that is contingent on a specified event or indexed to a specified variable typically meets the definition of a derivative.

Specifically, a debt instrument with an ESG-linked feature may indicate that the contractual interest rate will (1) be reduced by a certain amount if the borrower achieves predefined targets, such as reaching carbon neutral by a specified date, (2) be increased if the borrower fails to achieve those targets, or (3) vary on the basis of changes in an index tied to specified environmental metrics. As previously discussed in Section 5.2.3, ASC 815-15-25-26 addresses whether an embedded feature whose only underlying is an interest rate or interest rate index should be considered clearly and closely related to a debt host contract. The guidance does not address features that are indexed to or contingent on something other than an interest rate or interest rate index, including features that are indexed to both an interest rate or interest rate index and other underlyings (e.g., environmental targets or key performance indicators). Under the existing guidance, generally, only certain features that are based on a market interest rate, an entity’s credit risk, or inflation are viewed as clearly and closely related to a debt host contract. Accordingly, an ESG-linked feature that adjusts the contractual interest rate is generally not considered clearly and closely related to the host contract, and bifurcation of that feature may be required unless a specific scope exception is available.

Given the wide variety of environmentally linked terms and the evolving nature of these instruments, entities are strongly encouraged to discuss their accounting analysis with their advisers.

 

Changing Lanes

As of the date of this publication, the FASB’s research agenda includes a project on the “definition of a derivative.” One of the objectives of that research project is to identify potential application guidance specific to certain arrangements, including financial instruments with ESG-linked features. While the timing of any possible standard setting is currently unknown, entities should be aware that future standard setting on this topic could result in new or different accounting for ESG-linked features than what is discussed in this section. Stakeholders should monitor the status of the research project for developments.

The fair value of a payment feature embedded in debt host might be minimal, depending on the likelihood that the feature will be triggered and, if so, on its potential amount (e.g., a feature in which a minor adjustment must be made to the interest rate upon an event whose likelihood of occurring is remote). In practice, therefore, entities sometimes determine and document that they are not required to make accounting entries upon debt issuance to recognize a feature that must be bifurcated as a derivative under ASC 815-15. Any such conclusion must be appropriately supported on the basis of materiality. A determination that a feature has a minimal fair value at inception does not negate the requirement to account for it as a derivative. Accordingly, if an entity makes such a determination, it should also monitor its facts and circumstances in each reporting period to evaluate whether the feature’s fair value or a change to it is significant and therefore must, under U.S. GAAP requirements, be reflected in the entity’s financial statements. For instance, if a feature that must be bifurcated as a derivative liability is determined to have a fair value that is not materially different from zero when the debt is issued and the fair value increases to $50,000 during the next reporting period, the change in fair value from zero to $50,000 should be reflected as a loss during that reporting period; the change cannot be recognized as a debt discount after the issuance of the debt.

The entity should also consider the appropriate level of aggregation in identifying and evaluating embedded features (see Section 4.2.2). The terms of a debt contract might contain a cap on the total amount of additional interest that would be paid under additional interest provisions. For example, the debt terms might specify that in no event will additional interest be paid at a rate in excess of 0.50 percent regardless of the number of events or circumstances giving rise to the requirement to pay such additional interest. This means that the total amount of additional interest that might have to be paid on the debt is not necessarily simply the sum of the additional interest that might need to be paid under each of the provisions that triggers such additional interest payments. For instance, if one or more additional interest features have been triggered such that the total amount of additional interest payable is equal to the cap, there would be no incremental amount payable if another such feature is triggered. In this circumstance, the potential payoff of each additional interest provision and the payoffs under the other provisions to which the cap applies are interdependent. Under the payoff profile approach for identifying embedded features (see Section 4.2.2), it is appropriate to evaluate such additional interest features as one combined embedded feature rather than as separate embedded features for each of the triggers. As a consequence, an additional interest feature that would have been considered clearly and closely related to a debt host if it had been evaluated on a stand-alone basis (e.g., an additional interest feature triggered by a change in the issuer’s creditworthiness; see Section 5.3) might have to be combined with other additional interest features that are not considered clearly and closely related to a debt host in the evaluation of whether the combined feature is clearly and closely related to the debt host.