6.7 Embedded Commitments (Including PIK Interest/Dividend Features)
6.7.1 Background
A credit facility or tranche debt financing might include both an initial term
loan and commitments to obtain additional term loans on specified future dates.
Further, some debt and preferred stock instruments contain a paid-in-kind (PIK)
interest or dividend feature, respectively, which requires or permits the issuer
to pay interest or dividends in the form of additional debt or stock that has
the same terms as the original instrument. In substance, a PIK interest feature
in a debt host is a loan commitment since it permits or requires the issuer to
issue additional debt with specified terms to settle future interest payments.
Similarly, a PIK dividend feature in an equity host is a commitment to issue
additional equity interests.
Note that the discussion in this section only applies if the entity has
determined that the host contract and the PIK commitments represent one combined
unit of account (see Section 3.3 of
Deloitte’s Roadmap Distinguishing Liabilities From
Equity for further discussion of unit of account
considerations). If the commitments represent separate units of account (e.g.,
the commitments are legally detachable and separately exercisable from the host
contract), they should be evaluated as freestanding commitments and would be
subject to other guidance.
6.7.2 Bifurcation Analysis
The table below presents an overview of the bifurcation analysis of a PIK
commitment embedded in a debt or equity 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 loan commitment is not clearly and closely related to a
debt host contract if it includes features that are not
clearly and closely related to a debt instrument.
Similarly, a commitment to issue additional equity
shares would not be clearly and closely related to an
equity host contract if it includes features that are
not clearly and closely related to an equity instrument.
|
|
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, legal form 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. In the case of (1) an outstanding share
that qualifies for equity presentation but was
determined to have a debt host contract or (2) an equity
host contract, the issuer would not measure the
instrument at fair value, with changes in fair value
recorded through earnings, on a recurring basis.
From the perspective of a holder of a debt or equity host
contract, the determination of whether the hybrid
instrument is measured at fair value, with changes in
fair value recorded through earnings, depends on whether
the instrument is considered a debt security within the
scope of ASC 320 (and the related classification of the
debt security) or an equity security within the scope of
ASC 321.
|
|
Meets the definition of a derivative (see Section 4.3.4)
|
It depends
|
The evaluation of whether a PIK commitment 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 Section 4.3.5)
|
It depends
|
A debtor should evaluate whether the commitment qualifies
for the loan commitment scope exception (see Section 2.3.9). This
scope exception is not available if the commitment is
held by the potential creditor or investor, nor would it
be available for a PIK dividend feature embedded in an
equity instrument.
|
6.7.3 Clearly-and-Closely-Related Analysis
A loan commitment is not clearly and closely related to a debt host contract if
it includes features that are not clearly and closely related to a debt
instrument. For example, if a commitment requires an entity to issue (1) debt
that is convertible into the debtor’s equity shares or (2) both debt and
warrants on the debtor’s equity shares, the commitment would not be clearly and
closely related to a debt host contract since the debtor’s stock price is not
clearly and closely related to a debt host. Similarly, a commitment to issue
term debt would not be clearly and closely related to a preferred stock
agreement with an equity host since the risks and rewards of holding debt are
not consistent with those of an equity holder. However, a commitment to issue
additional equity shares could be clearly and closely related to an equity host
contract. The clearly-and-closely-related analysis will depend on the specifics
of the embedded loan commitment features and the nature of the host contract.
6.7.4 Derivative Analysis
The table below presents an analysis of whether a loan or equity
commitment meets the definition of a derivative (see Section 4.3.4). 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 loan commitment has both an underlying
(interest rates and, if applicable, the occurrence or
nonoccurrence of any exercise contingency and other
underlyings) and a notional amount (the committed amount
of debt/equity) 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 commitment on
a stand-alone basis).
Generally, an embedded loan commitment
feature has an initial net investment that is smaller
than the committed amount of debt or equity.
|
|
Net settlement (see Section
1.4.3)
|
It depends
|
The entity should evaluate whether the
debt or equity that would be issued upon settlement of
the PIK feature is RCC or whether the PIK feature
explicitly provides for net settlement on the basis of
contractual terms.
|
Generally, an analysis of whether an embedded PIK commitment meets the definition
of a derivative focuses on whether it meets the net settlement characteristic in
the definition of a derivative (see Section
1.4.3). If the PIK 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 of whether the feature meets the net
settlement characteristic depends on whether the debt or equity that would be
funded is RCC (e.g., publicly traded instruments that may be sold in increments
that can be rapidly absorbed by the market without significantly affecting the
price). If the underlying debt or equity shares are not RCC, the embedded PIK
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.
If the net settlement criterion is met, a PIK interest feature embedded in a debt
contract may qualify for the loan commitment scope exception, which is discussed
further in Section 2.3.9; however, such
scope exception would not be applicable to a PIK dividend feature embedded in an
equity contract. Further, an investor in a debt instrument that contains a PIK
interest feature may be ineligible to apply the loan commitment scope exception
if the loans are mortgage loans that are expected to be held for sale once
funded (see Section 2.3.9 for further
details).