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 PIK 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, some PIK interest
features may qualify for a scope exception, which is discussed further in the
section below.
6.7.5 Scope Exception for Loan Commitments
ASC 815-10-15-69 through 15-71 contain a scope exception related to the
derivative accounting requirements in ASC 815 for “a commitment to originate a
loan” for the holder of the commitment (i.e., the potential borrower; see
Section 2.3.9). (The investor or potential lender in a
loan commitment is never eligible for this derivative scope exception.)
For the holder of the commitment, this scope exception applies irrespective of
whether (1) the commitment is contingent and (2) the loan is revolving or
nonrevolving. Commitments to issue debt securities (e.g., tranche debt
issuances) also qualify for this scope exception. ASC 310-10-20 defines a loan
as a “contractual right to receive money on demand or on fixed or determinable
dates that is recognized as an asset in the creditor’s statement of financial
position. Examples include but are not limited to accounts receivable (with
terms exceeding one year) and notes receivable.” We informally discussed with
members of the SEC staff the application of this scope exception to commitments
to issue debt securities. The staff concurred that it is appropriate to apply
the loan commitment exception to an entity’s commitment to receive funds in
exchange for the initial issuance of a debt security that will be an obligation
of the entity.
In a typical loan commitment, the potential creditor writes an option to the
potential debtor that permits the potential debtor to obtain debt on
prespecified terms at its request. Therefore, the loan commitment scope
exception does not apply to an option written by the potential debtor to the
potential creditor under which the potential creditor could force the potential
debtor to enter into a loan but does not give the potential debtor a right to
elect to borrow money from the potential creditor.
ASC 815 does not clearly address whether the scope exception for loan commitments
is available if the loan to be funded contains an embedded feature that will
need to be bifurcated as a derivative once the loan is funded. It may therefore
be prudent for an entity to further evaluate whether the loan commitment meets
the definition of a derivative in ASC 815. If the loan commitment does not meet
the net settlement characteristic in the definition of a derivative (e.g., it
requires delivery of an underlying loan that is not RCC and the commitment
cannot otherwise be net settled), the debtor may conclude that the loan
commitment should not be accounted for as a derivative even if the scope
exception for loan commitments is considered inapplicable.