10.3 Determining Whether Debt Terms Are Substantially Different
10.3.1 Background
If a debtor modifies or exchanges an outstanding debt instrument with the same
creditor in a transaction that is not a TDR (see Chapter 11), the accounting depends on whether the original and
new debt terms are substantially different. The guidance that applies to
modifications and exchanges is the same because they have the same economic
effect, and in both cases, the debtor continues to have debt outstanding with
the same creditor on revised terms.
Under ASC 470-50, debt terms are considered substantially different in each of
the following circumstances:
-
The 10 percent cash flow test is passed (see Section 10.3.3).
-
The fair value of an embedded conversion option changes by at least 10 percent of the carrying amount of the original debt instrument (see Section 10.3.4.2).
-
A substantive conversion option is added to, or eliminated from, the debt terms (see Section 10.3.4.3).
If the new debt terms are substantially different from the original debt terms,
the original debt is accounted for as being extinguished and a new debt
instrument is recognized (see Section 10.4.2). If the new
debt terms are not substantially different from the original debt terms, the
transaction is accounted for as a modification of the original debt terms (see
Section 10.4.3).
10.3.2 Level of Aggregation
10.3.2.1 Background
A debtor needs to determine the appropriate level of
aggregation for its analysis of any modification or exchange if a particular
debt instrument is held by more than one creditor (see the next section) or
a creditor holds more than one debt instrument (see Section 10.3.2.3).
Special considerations are necessary for loan participations and loan
syndications (see Section
10.3.2.4).
10.3.2.2 Multiple Holders of Identical Debt Instruments
ASC Master Glossary
Public Debt Issuance
A public debt issuance occurs when a debtor issues a
number of identical debt instruments to an
underwriter that sells the debt instruments (in the
form of securities) to various investors.
ASC 470-50
55-3 In a public debt
issuance, for purposes of applying the guidance in
this Subtopic, the debt instrument is the individual
security held by an investor, and the creditor is
the security holder. If an exchange or modification
offer is made to all investors and only some agree
to the exchange or modification, then the guidance
in this Subtopic shall be applied to debt
instruments held by those investors that agree to
the exchange or modification. Debt instruments held
by those investors that do not agree would not be
affected.
When identical debt instruments are held by more than one
creditor (e.g., in a public debt issuance), the debtor applies the
modification and exchange guidance in ASC 470-50 separately to the debt held
by each individual creditor (i.e., on a creditor-by-creditor basis). If all
holders do not participate in the modification or exchange, the debtor
applies ASC 470-50 only to debt held by those creditors that participate. A
debt arrangement involving multiple lenders may be structured as a loan
participation, in which case the debtor has only one creditor (see Section 10.3.2.4).
If a modification or exchange involves multiple
creditors that belong to the same consolidated group or otherwise are
under common control, the debtor should apply judgment and consider the
economic substance of the transaction to determine whether those
creditors should be treated as one or multiple creditors when applying
the guidance in ASC 470-50 (see Section
10.3.2.3). In most cases, multiple creditors that
are controlled by the same parent or entity will be treated as a single
creditor under ASC 470-50.
If a collective assessment would produce the same outcome as an individual
assessment (e.g., all holders that participate in a modification or exchange
of identical debt instruments receive the same new debt terms), a debtor
does not need to perform separate assessments for each individual creditor
that participates in the transaction to determine whether to account for
that creditor’s debt as an extinguishment. However, if different creditors
(or creditor groups) obtain different debt terms under a modification or
exchange, or the effective interest rate on debt held by different creditors
is not the same, the debtor would need to apply ASC 470-50 separately to
each creditor or creditor group.
As discussed in Section 10.2.13, a
debtor is not required to apply ASC 470-50 to certain market issuances of
new debt to replace old debt even if some creditors hold both the original
and new or modified debt.
10.3.2.3 Multiple Debt Instruments Held by the Same Creditor
Sometimes, one creditor (or multiple creditors within a
consolidated group or otherwise under common control) holds multiple debt
instruments issued by the same debtor. If a modification or exchange
involves more than one existing debt instrument (or more than one new debt
instrument), a debtor should apply judgment and consider the economic
substance of the transaction to determine whether the modification or
exchange should be evaluated on the basis of an aggregation of individual
debt instruments. In many cases, the evaluation will be performed on an
aggregated basis because either (1) it is not possible to perform the
evaluation on an individual-instrument basis (e.g., two existing debt
instruments are exchanged for one new instrument) or (2) the transaction was
negotiated as an overall package (e.g., the debtor accepts less favorable
terms on one debt instrument in exchange for more favorable terms on a
different debt instrument). Aggregating debt instruments in the application
of ASC 470-50 is consistent with the accounting for multiple transactions
executed contemporaneously or in contemplation of one another (i.e.,
contingent upon one another). While it would generally be difficult to
establish that contemporaneous transactions between a debtor and a creditor
were not contingent on one another, other relevant facts and circumstances
involving the transactions may suggest otherwise. In performing the 10
percent cash flow test, the debtor would calculate and use a composite
effective interest rate for any debt instruments that are evaluated on an
aggregated basis (see Section 10.3.3.3).
10.3.2.4 Loan Participations and Loan Syndications
ASC Master Glossary
Loan
Participation
A transaction in which a single
lender makes a large loan to a borrower and
subsequently transfers undivided interests in the
loan to groups of banks or other entities.
Loan
Syndication
A transaction in which several
lenders share in lending to a single borrower. Each
lender loans a specific amount to the borrower and
has the right to repayment from the borrower. It is
common for groups of lenders to jointly fund those
loans when the amount borrowed is greater than any
one lender is willing to lend.
ASC 470-50
55-1 Based on the definition
of a loan participation, for purposes of applying
the guidance in this Subtopic, the debt instrument
would be the contract between the debtor and the
lead bank. Participating banks are not direct
creditors but, rather, have an interest represented
by a certificate of participation. In the event of a
modification or exchange between the debtor and lead
bank, the debtor shall apply the guidance in this
Subtopic.
55-2 Based on the definition
of a loan syndication, for purposes of applying the
guidance in this Subtopic, separate debt instruments
exist between the debtor and the individual
creditors participating in the syndication. If an
exchange or modification offer is made to all
members of the syndicate and only some of the
creditors agree to the exchange or modification, the
guidance in this Subtopic would be applied to debt
instruments held by those creditors that agree to
the exchange or modification. Debt instruments held
by those creditors that do not agree would not be
affected.
Loan participations and loan syndications both involve more
than one lender. Legally, however, they are structured differently and
therefore ASC 470-50 does not treat them the same.
-
In a loan participation, the debtor legally has only one loan. That loan is subdivided by a lead lender into multiple undivided interests, which are transferred by the lead lender to individual lenders. Since the arrangement contractually is structured as only one loan, there is only one creditor under ASC 470-50. Therefore, the debtor performs the analysis under ASC 470-50 for the debt arrangement as a whole (i.e., it represents only one unit of account under ASC 470-50) even if new lenders join or existing lenders leave.
-
In a loan syndication, the debtor legally has separate loans from each member of the syndicate and each lender has a contractual right to payments from the debtor. Therefore, ASC 470-50 treats this arrangement as having multiple creditors (i.e., a separate unit of account for each lender in the syndicate). If the terms of some or all of the syndicated loans are modified, the debtor must perform separate analyses under ASC 470-50 for each member in the syndicate (see Examples 10-4 and 10-7). If a new lender joins the syndicate and extends amounts to the debtor, the debtor treats those amounts as new debt. If the debtor pays off the debt outstanding to an existing member of the syndicate, that debt is accounted for as being extinguished (see Section 9.3). If one loan is modified, but the loans with other members in the loan syndication are not modified, ASC 470-50 is applied only to the loan that was modified (see Example 10-4).
Often a member of a loan syndication (e.g., an investment
bank) provides services that are not directly attributable to its role as a
lender in the syndication. For example, that member might arrange the
overall set-up of a loan syndication and any modifications to the terms of
each of the syndicated loans. Because the accounting for lender fees and
third-party costs are different under ASC 470-50, the debtor may need to
allocate any fees paid to that member between fees that are appropriately
characterized as creditor fees and costs for services that are not
attributable to that member’s role as a creditor (see Section
10.3.3.2.4).
10.3.3 The 10 Percent Cash Flow Test
10.3.3.1 Background
ASC 470-50
40-10 From the debtor’s
perspective, an exchange of debt instruments between
or a modification of a debt instrument by a debtor
and a creditor in a nontroubled debt situation is
deemed to have been accomplished with debt
instruments that are substantially different if the
present value of the cash flows under the terms of
the new debt instrument is at least 10 percent
different from the present value of the remaining
cash flows under the terms of the original
instrument. . . .
One circumstance in which the terms of two debt instruments
are considered substantially different under ASC 470-50 is when such terms
pass the 10 percent cash flow test. The 10 percent cash flow test involves a
comparison of the following two amounts: (1) the present value of the cash
flows under the terms of the modified or new debt instrument and (2) the
present value of the remaining cash flows under the terms of the original
instrument.1 To perform this test, the debtor must determine the timing and amount
of the future cash flows of both the original debt and the new debt
(Section
10.3.3.2) as well as the interest rate that should be used to
discount those cash flows (see Section 10.3.3.3). Special
considerations are necessary if an entity has made consecutive modifications
or exchanges within a 12-month period (Section 10.3.3.4). A modification or
exchange of a debt instrument passes the 10 percent cash flow test if the
present value of the new cash flows is at least 10 percent different from
the present value of the remaining original cash flows.
An exchange or modification of nontroubled debt that passes the 10 percent
cash flow test is accounted for as an extinguishment (see Section
10.4.2). If the 10 percent cash flow test is not passed, the
debtor should consider the guidance on embedded conversion features (see
Section 10.3.4) before determining whether
extinguishment accounting applies.
10.3.3.2 Cash Flows
10.3.3.2.1 Background
ASC 470-50 contains guidance on how a debtor should determine the cash
flows of the original and new or modified debt, including:
-
The cash flows of the new debt instrument (see Section 10.3.3.2.2).
-
The exercise of contractual provisions in connection with a modification or exchange (see Section 10.3.3.2.3).
-
The treatment of creditor fees and third-party costs (see Section 10.3.3.2.4).
-
The calculation of the cash flows on variable-rate debt (see Section 10.3.3.2.5).
-
The cash flow assumptions when debt contains an embedded put or call option (see Section 10.3.3.2.6).
-
The cash flow assumptions for debt with contingent payment features or unusual payment terms (see Section 10.3.3.2.7).
-
The treatment of sweeteners and other noncash consideration (see Section 10.3.3.2.8).
-
Changes to debt terms that do not directly affect the cash flows (see Section 10.3.3.2.9).
-
A change in the currency in which the cash flows are denominated (see Section 10.3.3.2.10).
-
The treatment of conversion features (see Section 10.3.3.2.11).
10.3.3.2.2 Cash Flows of New Debt
ASC 470-50
40-12 The following guidance
shall be used to calculate the present value of
the cash flows for purposes of applying the 10
percent cash flow test described in paragraph
470-50-40-10:
- The cash flows of the new debt instrument include all cash flows specified by the terms of the new debt instrument plus any amounts paid by the debtor to the creditor less any amounts received by the debtor from the creditor as part of the exchange or modification. For a modification or an exchange of a freestanding equity-classified written call option held by a creditor that is a part of or directly related to a modification or an exchange of an existing debt instrument held by that same creditor (see paragraphs 815-40-35-14 through 35-15 and 815-40-35-17(c)), an entity shall apply the guidance in paragraph 470-50-40-12A. . . .
40-12A
If a modification or an exchange of a freestanding
equity-classified written call option held by a
creditor is a part of or directly related to a
modification or an exchange of an existing debt
instrument held by that same creditor (see
paragraphs 815-40-35-14 through 35-15 and
815-40-35-17(c)), an increase or a decrease in the
fair value of the freestanding equity-classified
written call option held by the creditor,
calculated in accordance with paragraph
815-40-35-16, shall be included in the application
of the 10 percent cash flow test described in
paragraph 470-50-40-10.
ASC 470-50-40-12(a) requires a debtor to include all
contractual cash flows of the new debt instrument (e.g., future
principal and interest payments) as well as any amounts exchanged
between the debtor and the creditor as part of the modification or
exchange (e.g., amounts identified as fees, principal repayments, and
additional borrowings) in the calculation of the present value of the
cash flows of the new debt instrument. Any costs paid to third parties,
however, are excluded from this calculation (see Section
10.3.3.2.4). Special considerations are necessary if the
debtor and creditor exchange amounts in accordance with the contractual
provisions of the original debt in conjunction with a debt modification
or exchange (see Section 10.3.3.2.3). The debt’s fair value is not
relevant to whether the 10 percent cash flow test is passed. However,
the fair value of any noncash consideration exchanged should be
considered (see Section 10.3.3.2.8). Further, special considerations
apply if the original or new debt contains an embedded conversion
feature (see Section
10.3.4). In addition, when performing the 10 percent cash
flow test described in ASC 470-50-40-10, an entity should include any
increase or decrease in the fair value of a freestanding
equity-classified written call option held by the creditor that was
modified in conjunction with the debt modification or exchange,
calculated in accordance with ASC 815-40-35-16.
If a debtor receives cash from a creditor as part of a
modification or exchange (e.g., to increase the debt’s principal
amount), the amount received is treated as an immediate (“day 1”) cash
inflow associated with the new debt (i.e., this amount does not need to
be discounted). Therefore, this amount reduces the net present value of
the future cash flows on the new debt. Conversely, if the debtor pays
cash to the creditor (e.g., to reduce the debt’s principal amount), the
amount paid is treated as an immediate cash outflow associated with the
new debt. Accordingly, this amount increases the net present value of
the future cash flows on the new debt.
Because the calculation of the present value of the cash
flows of the new debt includes all cash flows of the new instrument and
any amounts exchanged as result of the modification or exchange, a
debtor cannot, when performing the 10 percent cash flow test, treat any
increase or decrease in the principal amount as new borrowings or as
extinguishment of a portion of the original debt that is separate from
the modification or exchange. Instead, those cash flows are included in
the 10 percent cash flow test. However, note that a principal payment or
an additional borrowing in excess of 10 percent of the present value of
the debt’s carrying amount immediately before a modification or exchange
would not itself cause the 10 percent cash flow test to be passed.
Rather, the calculation of the present value of the cash flows of the
new debt must take into account the change in the remaining future
principal and interest cash flows on a present value basis.
Example 10-3
Modification
of Debt That Includes an Additional Borrowing or
Partial Repayment
Additional Borrowing
Entity C has outstanding
nonprepayable debt with Entity Z, under which
interest must be paid quarterly at an annual rate
of 10 percent (i.e., $2.25 million per quarter)
and a $90 million principal payment is due on
December 31, 20X5. The net carrying amount of the
debt as of October 1, 20X2, is $86.4 million,
which results in an effective interest rate on the
debt of 11.5 percent. Note that the carrying
amount of the debt includes a $3.6 million
unamortized original issue discount. For
simplicity, it is assumed in this example that
there are no capitalized debt issuance costs.
In a transaction that is not
considered a TDR, C and Z agree to modify the
terms of the outstanding debt on October 1, 20X2,
as follows:
- Entity C issues warrants with a fair value of $1 million to Z to purchase C’s common stock.
- Entity Z lends C an additional $30 million that is due on December 31, 20X5.
- The interest rate on the debt is changed to 10.5 percent.
- Quarterly interest payments on the debt are changed to $2.0 million. As a result, the amount due at maturity increases to $137.5 million (i.e., $90 million originally due + $30 million additional principal + deferred quarterly interest payments of $17.5 million).
Using the effective interest
rate on the original debt of 11.5 percent, C
calculates the net present value of the future
cash flows on the new debt to be $116.6 million.
Therefore, C determines the change in the net
present value of cash flows on the debt as follows
(all amounts rounded in thousands):
Because the change in net
present value of cash flows is less than 10
percent, C should treat the changes to the terms
of the debt as a modification. Note that if C had
not accounted for the additional borrowing in this
manner when it performed the 10 percent cash flow
test, it would have inappropriately concluded that
the change in terms of the debt was an
extinguishment.
Partial
Repayment
Assume the same facts described
above regarding the original terms of the debt
instrument.
In a transaction that is not
considered a TDR, C and Z agree to modify the
terms of the outstanding debt on October 1, 20X2,
as follows:
- Entity C issues warrants a fair value of $1 million to Z to purchase C’s common stock.
- Entity C repays $30 million of the principal amount of the debt.
- The interest rate on the debt is changed to 9.5 percent.
- Quarterly interest payments on the debt are changed to $1.425 million, which represents quarterly payments at the revised stated interest rate (i.e., no deferred interest payments).
Using the effective interest
rate on the original debt of 11.5 percent, C
calculates the net present value of the future
cash flows on the new debt to be $56.788 million.
Therefore, C determines the change in the net
present value of cash flows on the debt as follows
(all amounts rounded in thousands):
Because the change in net
present value of cash flows is less than 10
percent, C should treat the changes to the terms
of the debt as a modification. Note that if C had
not accounted for the partial repayment in this
manner when it performed the 10 percent cash flow
test, it would have inappropriately concluded that
the change in terms of the debt was an
extinguishment. Although the debt is not
considered extinguished under ASC 470-50, C should
nevertheless account for the partial repayment
(see Section
10.4.3.2), which will result in a loss
upon partial extinguishment because C would
derecognize a portion of the unamortized original
discount pertaining to the amount repaid.
Example 10-4
Modification of Loan Syndication That Involves
Changes in Principal Amounts Owed to Individual
Lenders
Entity D has $500 million of outstanding loans
that are held by five creditors. The loans were
originally issued in a loan syndication, and each
loan held by each individual creditor has
identical terms. Before the modification discussed
below, the balances held by each creditor were as
follows:
Entity D modifies the terms of
each outstanding loan issued in the syndication.
The modification involves a change in the interest
rate and maturity date of each loan, but there are
no changes in the aggregate principal amount
outstanding. As part of this modification, no cash
flows passed through D; however, the composition
of the principal balances due to the individual
creditors changed. After the modification, each
loan continued to have identical terms. The
principal amounts owed to individual creditors
before and after the modification are as
follows:
As discussed in Section 10.3.2.4, each individual loan
with each member of a syndication is treated as a
separate unit of account in the application of the
10 percent cash flow test. Although no cash flows
passed through D, the cash flows exchanged among
members of the syndication must be treated as if
they were paid (or received) by D. This is because
D was involved in the transactions among the
creditors since those transactions occurred in
conjunction with a modification of debt (see
Section
10.2.8). Therefore, D should do the
following in evaluating the accounting for this transaction:
- In performing the 10 percent cash flow test, D should (1) treat the increase in the principal amount of the loan due to V as an immediate (“day 1”) cash inflow that reduces the net present value of the future cash flows on the new debt and (2) treat the decrease in principal amount of the loan due to W as an immediate (day 1) cash outflow associated with the new debt that increases the net present value of the future cash flows on the new debt. In essence, D would treat the changes in principal amounts due to V and W as if the cash flows were received by (or paid by) D. Otherwise, D may inappropriately conclude that the debt instruments with V and W were fully extinguished when the terms of those instruments did not substantially change. Note also that because the transactions involving V and W involve changes to principal amounts, if, after performing the 10 percent cash flow test, D determines that an extinguishment has not occurred, it should account for (1) the increase in principal amount of debt owed to V as a new issuance of debt and (2) the decrease in principal amount of debt owed to W as a partial extinguishment of debt.
-
Entity D should (1) treat the repayment of the outstanding amount to X as a debt extinguishment and (2) treat the new debt owed to Z that joined the syndicate in the transaction as the issuance of new debt (see Section 10.3.2.4) even though no cash flows passed through D.
Connecting the Dots
A debtor may repay a portion of the outstanding principal amount
of a debt instrument in conjunction with a modification or
exchange that is not accounted for as an extinguishment.
Although the debtor does not consider the entire original debt
instrument extinguished for accounting purposes, it must still
recognize the principal repayment as a partial extinguishment of
the original debt instrument. That is, the debtor first
considers the principal repayment as an undiscounted increase in
the present value of the cash flows of the new debt instrument
to determine whether the original debt instrument should be
considered extinguished in its entirety as a result of the
modification or exchange. If extinguishment accounting is not
required for the original debt instrument, the debtor still
appropriately accounts for the partial repayment of the original
debt instrument. The accounting for such partial repayment
should include the derecognition of a proportionate amount of
any remaining unamortized debt premiums or discounts (including
debt issuance costs) to reflect the fact that a portion of the
original debt instrument has been repaid (see Section
10.4.3.2).
10.3.3.2.3 Exercise of Contractual Provisions in Connection With a Modification or Exchange
Although prespecified changes to the cash flows of a debt instrument that
result from existing contractual terms (e.g., a partial prepayment of
the principal amount pursuant to a contractual prepayment feature) are
not debt modifications (see Section
10.2.7), special considerations are necessary if a debtor
or creditor exercises a contractual provision in the original debt in
conjunction with a modification or exchange.
If a transaction occurs that involves both the exercise of a contractual
feature in the original debt and a modification to the debt terms, the
debtor’s or creditor’s decision to exercise the contractual feature may
be influenced by the modification of the other contractual terms. If the
interest rate on the debt is below current market rates, for example,
the debtor might agree to exercise a contractual prepayment feature that
is out-of-the-money in exchange for a reduction in the interest rate on
the remaining debt balance. Therefore, it is typically appropriate to
treat all cash flows exchanged between the debtor and the creditor,
including cash flows associated with the exercise of a contractual
feature in the original debt in conjunction with a debt modification or
exchange, as being part of the debt modification or exchange under ASC
470-50-40-12(a). In this circumstance, a partial prepayment is treated
as an immediate cash outflow associated with the new debt under the 10
percent cash flow test (see Section
10.3.3.2.2).
10.3.3.2.4 Fees and Costs
ASC 470-50
05-4 When debtors undergo
a modification or exchange of a debt instrument,
the resulting cash flows can be affected by
changes in principal amounts, interest rates, or
maturity. They can also be affected by fees
exchanged between the debtor and creditor to
effect changes in any of the following:
-
Recourse or nonrecourse features
-
Priority of the obligation
-
Collateralized (including changes in collateral) or noncollateralized features
-
Debt covenants or waivers
-
The guarantor (or elimination of the guarantor)
-
Option features.
Amounts the debtor pays to or receives from the creditor
as part of a modification or exchange, as well as other noncash
consideration exchanged in accordance with Sections 10.3.3.2.2 and 10.3.3.2.8, are included in the cash flows of the new
debt instrument as an immediate (day 1) cash flow. This includes any
fees exchanged between the debtor and the creditor as part of the
modification or exchange, such as fees paid by the debtor to obtain a
waiver of a debt covenant, fees paid by a creditor to remove a call
option, or fees related to changes in recourse provisions, collateral,
or other debt terms. However, under the 10 percent cash flow test, any
third-party fees or costs are excluded, such as fees paid to
accountants, attorneys, or financial advisers.
If a debtor pays the creditor’s advisers on behalf of
the creditor for legal, due diligence, or other costs as part of a
modification or exchange of debt, those costs should be treated
similarly to fees paid directly to the creditor. For example, if a
debtor pays a fee to an attorney that represents a group of bondholders,
the amount paid should be treated as a payment to the bondholders even
though the payment was made directly to a third party. Similarly, if a
debtor reimburses a creditor for costs related to a covenant waiver, the
debtor should treat those costs as it would any other fees paid by the
debtor to the creditor even if the debtor paid such amounts directly to
the creditor’s advisers. In other words, the costs of a creditor that
are paid by the debtor directly to a third party that performed services
for the creditor should be treated as if they were paid to the creditor
in the determination of whether a modification or exchange constitutes
an extinguishment.
In some modifications or exchanges, a counterparty may simultaneously
serve as both creditor and underwriter of debt with other creditors. For
example, in a loan syndication arrangement, the underwriter may hold a
portion of the total loan facility after the syndication. In such
circumstances, the debtor may need to allocate amounts paid to the
underwriter between fees paid to the underwriter in its capacity as a
creditor (for the portion of the debt agreement that the underwriter
receives in the syndication) and fees paid to the underwriter in its
capacity as a third party underwriting the loan facility with other
creditors. Fees paid to the creditor are included in the 10 percent cash
flow test, whereas fees paid to third parties, such as attorneys and
accountants, are excluded from it.
If a debtor pays a lead creditor an administrative fee
as compensation for serving as an administrative agent for multiple
creditors in a loan syndication and the creditor does not own a
significant portion of the entity’s outstanding debt, the administrative
fee is considered an amount paid to a third party rather than an amount
paid to a creditor. If a creditor serves as an administrative agent and
owns a significant portion of the outstanding debt that is being
modified or exchanged, the determination of whether the administrative
fee represents an amount paid to a third party, an amount paid to the
creditor, or contains elements of both will depend on the particular
facts and circumstances. A payment to an entity in its capacity as an
administrative agent is considered an amount paid to a third party
rather than an amount paid to a creditor even if the administrative
agent is also a creditor. Entities should also be mindful that a lead
creditor may be receiving fees for performing services other than
administrative agent services, so it is important to understand whether
the fees need to be allocated between costs attributable to the debt
modification or exchange and costs attributable to other services.
10.3.3.2.5 Variable-Rate Debt
ASC 470-50
40-12 The following
guidance shall be used to calculate the present
value of the cash flows for purposes of applying
the 10 percent cash flow test described in
paragraph 470-50-40-10: . . .
b. If the original debt instrument or the new
debt instrument has a floating interest rate, then
the variable rate in effect at the date of the
exchange or modification shall be used to
calculate the cash flows of the variable-rate
instrument. . . .
If debt has a variable interest rate either before or after a
modification or exchange, ASC 470-50 requires the variable rate in
effect on the date of the exchange or modification (i.e., the spot
interest rate for the applicable interest period) to be used to estimate
the future cash flows of the variable-rate instrument. The guidance does
not permit a debtor to use a yield curve of forward rates to project
future interest payments. Section 10.3.3.3
discusses the discount rate that should be used in determining the
present value of the cash flows of variable-rate debt.
10.3.3.2.6 Puttable or Callable Debt
ASC 470-50
40-12 The following
guidance shall be used to calculate the present
value of the cash flows for purposes of applying
the 10 percent cash flow test described in
paragraph 470-50-40-10: . . .
c. If either the new debt instrument or the
original debt instrument is callable or puttable,
then separate cash flow analyses shall be
performed assuming exercise and nonexercise of the
call or put. The cash flow assumptions that
generate the smaller change would be the basis for
determining whether the 10 percent threshold is
met. . . .
If the terms of the original or new debt or both permit the debtor to
prepay (call) or the creditor to demand early repayment (put) or both,
ASC 470-50 requires the debtor to perform the 10 percent cash flow test
in each possible scenario, irrespective of the intentions or
expectations of the parties regarding exercise of the options. In one
scenario, the test is applied to the cash flows that would exist if no
put or call option is exercised. In other scenarios, the test is applied
to the cash flows that would result if each option is exercised in a
manner consistent with its contractual terms (e.g., if an option can
only be exercised on a specified date, the timing of the assumed cash
flows would reflect that). The debtor should consider all possible
contractual scenarios, including by varying the prepayment date, related
penalties or premiums (if any), and other relevant terms.
In determining whether the 10 percent threshold is passed, the debtor
should use the cash flow assumptions that generate the smaller (or, if
there are more than two scenarios, smallest) change in the present
value. If there is at least one scenario in which the present value of
cash flows under the new debt instrument is less than 10 percent
different from the present value of the remaining cash flows under the
original terms, the 10 percent cash flow test is not passed.
If a debtor concludes that the difference in the present value of the
cash flows is less than 10 percent in at least one scenario, the debtor
is not required to apply the 10 percent cash flow test to the remaining
scenarios. If both the original debt and the new debt are immediately
prepayable for the same amount and no cash flows were exchanged as part
of the modification or exchange, the 10 percent cash flow test would not
be passed since the present values would be the same.
An entity should carefully consider the terms of a call or put feature
when performing the 10 percent cash flow test. For example, an entity
may need to consider the following:
-
The specific terms of prepayment provisions under the original debt instrument may differ from those under the new debt instrument. In the calculation of the present value of cash flows, a debtor should use the specific terms of the original prepayment provision to calculate the remaining cash flows under the original debt instrument and use the new prepayment terms for the new debt instrument.
-
Debt often has more than one potential prepayment date. The debtor’s scenario analysis should take into account the potential cash flows that would result on any potential prepayment date. If a put or call option is only exercisable on a specified date (or dates), the debtor would assume that it is exercised on that date (or those dates).
-
Prepayment may be prohibited for a specified period. The 10 percent cash flow test is only applied to prepayment scenarios that could occur in accordance with the debt’s contractual terms.
-
Prepayment may carry a penalty or premium, and that penalty or premium may change over time. Prepayment penalties or premiums are treated as part of the debt’s cash flows in the potential scenarios in which those penalties or premiums would apply.
-
Sometimes put or call options are contingent. The debtor should consider the facts and circumstances as of the date of the modification or exchange in evaluating whether the 10 percent cash flow test should take into account scenarios in which a contingent put or call option is exercised (see Section 10.3.3.2.7).
Note that the debtor should not consider (1) the likelihood that a
noncontingent option will be exercised or (2) its intent and ability to
exercise an option.
Example 10-5
Application of 10 Percent Cash Flow
Test
On January 1, 20X0, Entity E
entered into a 10-year $500,000 senior secured
loan agreement with Bank B that requires E to make
quarterly principal and interest payments to B.
The quarterly compounded contractual interest rate
is 10 percent per annum, and the loan matures on
January 1, 20Y0. Entity E determines that the
effective interest rate equals the contractual
interest rate. Under the terms of the loan, E can
prepay the loan in full at any time for an amount
equal to the unpaid principal and accrued interest
on the date of prepayment without any penalty. On
July 1, 20X5, E and B agree to amend the loan
agreement to ease certain financial covenants. In
return, E agrees to an increase in the contractual
interest rate to 15 percent, which reflects
changes in market rates and the modified
covenants. Entity E determines that the
modification is not a TDR (see Chapter
11). After the modification, E can
still prepay the loan at any time with no
penalty.
In applying the 10 percent cash
flow test to the loan modification, E calculates
the following amounts:
-
The present value of remaining cash flows under the original terms, assuming (1) exercise of the prepayment option and (2) nonexercise of the prepayment option.
-
The present value of the cash flows under the terms of the modified debt instrument, assuming (1) exercise of the prepayment option and (2) nonexercise of the prepayment option.
Because prepayment can occur at
any time without a penalty, E assumes in the
present value calculations that the prepayment
occurs on the earliest possible date (i.e.,
immediately after the modification). On July 1,
20X5, the unpaid principal amount of the original
debt instrument is $285,892. Entity E performs the
following steps as part of the 10 percent cash
flow test:
- Determine the present value
of the cash flows of the original debt
instrument:
-
Assuming exercise of the prepayment option on July 1, 20X5, which results in a present value of remaining cash flows equal to an outflow of $285,892 (unpaid principal with no accrued interest).
-
Assuming nonexercise of the prepayment option:
-
Entity E makes quarterly payments of $19,918 through January 1, 20Y0, on the basis of the original terms ($500,000 loan, maturing on January 1, 20Y0, with quarterly payments of principal and interest at 10 percent).
-
The discount rate is the effective interest rate, for accounting purposes, of the original debt instrument (i.e., 10 percent).
-
Accordingly, the present value of the cash flows of the original debt instrument is $285,892.
-
-
- Determine the present value
of the cash flows of the modified debt
instrument:
-
Assuming exercise of the prepayment option on July 1, 20X5, which also results in a present value of $285,892.
-
Assuming nonexercise of the prepayment option:
-
Entity E makes quarterly payments of $22,127 through maturity on January 1, 20Y0, calculated by using the contractual interest rate on the modified debt instrument of 15 percent and face amount of $285,892.
-
The discount rate is the effective interest rate, for accounting purposes, of the original debt instrument (i.e., 10 percent).
-
The present value of the interest and principal payments on the modified debt instrument at 10 percent is $317,598.
-
-
- Determine the percentage of
change in the present value of the debt:
-
Assuming exercise of the prepayment option for both the original and modified debt instrument, for which the percentage change in present value is 0 percent.
-
Assuming nonexercise of the prepayment option for the original debt instrument but exercise of the prepayment option for the modified debt instrument, for which the percentage change in present value is 0 percent.
-
Assuming exercise of the prepayment option for the original debt instrument but nonexercise on the modified debt instrument, for which the percentage change in present value is 11.1 percent.
-
Assuming nonexercise of the prepayment option on both the original and modified debt instrument, for which the percentage change in present value is 11.1 percent.
-
In E’s calculation, the present
value of the cash flows under the modified terms
is not substantially different from the present
value of the remaining cash flows under the
original terms when prepayment is assumed for both
the original and modified loan at the earliest
possible time or when prepayment is assumed on the
modified loan, but not the original loan. If no
prepayment is assumed for the original loan and
the modified loan, or when prepayment is assumed
only for the original loan, the present value of
the cash flows is substantially different. Because
a debtor uses the cash flow assumptions that
generate the smallest change to determine whether
the 10 percent threshold is passed, A concludes
that the 10 percent cash flow test in ASC 470-50
is not passed. Therefore, if neither the original
nor the modified debt contains a conversion
feature that meets the conditions in Section
10.3.4.2 or 10.3.4.3, the
terms of the modified debt are not considered
substantially different from the terms of the
original debt and the accounting treatment in
Section 10.4.3 applies.
10.3.3.2.7 Contingent or Unusual Payment Terms
ASC 470-50
40-12 The following
guidance shall be used to calculate the present
value of the cash flows for purposes of applying
the 10 percent cash flow test described in
paragraph 470-50-40-10: . . .
d. If the debt instruments contain contingent
payment terms or unusual interest rate terms,
judgment shall be used to determine the
appropriate cash flows. . . .
If debt has contingent payment terms or unusual interest rate features
before or after a modification or exchange, the debtor should consider
the facts and circumstances and use judgment to estimate the cash flows
of the instrument that has those terms. If debt contains a contingently
exercisable put or call option, the debtor should include a separate
cash flow scenario in which it is assumed that the option is exercised
as of the date (or dates) that it is contractually permitted to be
exercised if either (1) the contingency is met as of the date of the
modification or exchange or (2) it is probable that the contingency will
be met. If the likelihood that the contingency will be met is remote, it
should not be assumed under the 10 percent cash flow test that the put
or call option was exercised.
10.3.3.2.8 Sweeteners and Other Noncash Consideration Exchanged
ASC 470-60
55-12 When determining the
effect of any new or revised sweeteners (options,
warrants, guarantees, letters of credit, and so
forth), the current fair value of the new
sweetener or change in fair value of the revised
sweetener would be included in day-one cash flows.
If such sweeteners are not exercisable for a
period of time, that delay is typically considered
within the estimation of the initial fair value as
of the debt’s modification date.
Sometimes, a debt modification or exchange involves the transfer of
noncash consideration, such as the receipt, delivery, or modification of
freestanding financial instruments (e.g., warrants, options, or equity
shares), between the debtor and creditor. When performing the 10 percent
cash flow test, the debtor should treat the fair value of such noncash
consideration as an amount paid or received under ASC 470-50-40-12(a);
that is, as a day 1 cash flow. This is analogous to a debtor’s
requirement to treat the current fair value of any new sweetener (e.g.,
warrants, options, guarantees, or letters of credit) as an immediate day
1 cash flow in determining whether a creditor has granted a concession
under ASC 470-60-55-10 and ASC 470-60-55-12 (see Section
11.3.3.4). However, any noncash consideration paid to
third parties (e.g., attorneys, accountants, or financial advisers)
should not be reflected in the 10 percent cash flow test (see Section 10.3.3.2.4).
Example 10-6
Warrants Issued in Exchange for Maturity
Extension
An entity issues warrants to its
creditors in exchange for an extension of the
maturity date of a debt obligation. The warrants
are considered an amount paid to the creditors as
part of the modification; therefore, the entity
should include their fair value when performing
the 10 percent cash flow test under ASC
470-50-40-12(a). Irrespective of whether
extinguishment or modification accounting applies,
the warrants are recorded initially at fair value
with a credit to equity (APIC) or liabilities
depending on how they are classified (see
Deloitte’s Roadmaps Distinguishing
Liabilities From Equity and
Contracts on an Entity’s Own
Equity).
ASC 470-50 does not address how the addition, removal,
or modification of an embedded derivative that has been separated from a
debt instrument under ASC 815-15 should be reflected in the 10 percent
cash flow test. The debtor may treat such changes as the transfer of
noncash consideration (i.e., by imputing an immediate day 1 cash flow
for any change in the fair value of the embedded derivative in
connection with the modification or exchange). However, the 10 percent
cash flow test should not incorporate an imputed cash flow for the
change in the fair value of an embedded conversion feature. Instead,
conversion features are evaluated separately (see Section 10.3.3.2.11).
10.3.3.2.9 Changes to Debt Terms That Do Not Directly Affect the Cash Flows
A debt modification may involve changes to contractual terms that do not
directly affect the cash flows of the instrument (e.g., seniority in
liquidation or collateral). Typically, such changes would not by
themselves cause the amended debt terms to be considered substantially
different from the original debt terms, except for certain conversion
features (see Section 10.3.4).
10.3.3.2.10 Change in Currency
The new debt instrument might be denominated in a currency different from
that of the original debt instrument (e.g., USD debt that is modified to
become GBP debt). If the currency in which a debt instrument’s cash
flows is denominated has changed, the debtor needs to convert the cash
flows of the original or new debt so that the same currency is used to
perform the 10 percent cash flow test. The cash flows should be
converted by using an appropriate foreign currency exchange rate. For
example, the debtor might convert the cash flows by using the foreign
currency spot exchange rate as of the date of the modification or
exchange or it might use foreign currency forward exchange rates
applicable to each cash flow.
10.3.3.2.11 Conversion Features
ASC 470-50
40-12 The following
guidance shall be used to calculate the present
value of the cash flows for purposes of applying
the 10 percent cash flow test described in
paragraph 470-50-40-10: . . .
g. The change in the fair value of an
embedded conversion option resulting from an
exchange of debt instruments or a modification in
the terms of an existing debt instrument shall not
be included in the 10 percent cash flow test.
Rather, a separate test shall be performed by
comparing the change in the fair value of the
embedded conversion option to the carrying amount
of the original debt instrument immediately before
the modification, as specified in paragraph
470-50-40-10(a).
When a debtor performs the 10 percent cash flow test, it should not
impute any cash flows related to the modification of an embedded
conversion feature or the addition or removal of such a feature.
Instead, it should perform a separate analysis of such changes (see
Section 10.3.4). Note, however, that a
conversion feature that in substance represents a share-settled
redemption feature should be analyzed as a put or call option, not as a
conversion feature (see Sections
8.4.7.2.5 and 10.3.3.2.6).
10.3.3.3 Discount Rate
10.3.3.3.1 Background
ASC 470-50
40-12 The following
guidance shall be used to calculate the present
value of the cash flows for purposes of applying
the 10 percent cash flow test described in
paragraph 470-50-40-10: . . .
e. The discount rate to be used to calculate
the present value of the cash flows is the
effective interest rate, for accounting purposes,
of the original debt instrument. . . .
The discount rate used to calculate the present value of cash flows
before and after a modification or exchange is the effective interest
rate of the original debt instrument. In performing the 10 percent cash
flow test, an issuer is not permitted to use different interest rates to
discount the cash flows before and after the modification or exchange.
For example, an issuer could not apply the original effective interest
rate to discount the cash flows before a modification of a fixed-rate
debt instrument and a current market rate to discount the cash flows
after the modification.
10.3.3.3.2 Variable-Rate Debt
ASC 470-50 does not specifically address how the discount rate should be
determined for a variable-rate instrument (e.g., whether to use a
current spot rate or forward rates). Generally, the issuer should use
the effective interest rate immediately before the modification or
exchange to discount both the remaining cash flows of the original debt
and the cash flows of the new debt. This is analogous to the debtor’s
requirement in ASC 470-50-40-12(b) to use the variable rate in effect on
the date of the modification or exchange to project the cash flows of a
variable-rate instrument when performing the 10 percent cash flow test
(see Section 10.3.3.2.5). If the
interest rate on the original debt instrument was fixed and the interest
rate on the new debt instrument is variable, the debtor should use the
original effective interest rate to discount both the remaining cash
flows of the original debt and the cash flows of the new debt.
10.3.3.3.3 Debt Issuance Costs
ASC 470-50 does not specifically address whether the discount rate used
to perform the 10 percent cash flow test should reflect the effect of
third-party debt issuance costs that were incurred when the original
debt instrument was first issued and deducted from the debt’s initial
carrying amount. Third-party costs do not affect the cash flows between
the debtor and the creditor and must be excluded from the cash flows
used to perform the 10 percent cash flow test. Therefore, the discount
rate used in the 10 percent cash flow test should exclude the effect of
third party-debt issuance costs since such amounts have no bearing on
the relationship between the debtor and creditor and the objective of
ASC 470-50 is to determine whether a modification or exchange has
resulted in a significant change in the debtor-creditor
relationship.
10.3.3.3.4 Fair Value Hedge Adjustments
ASC 470-50 does not specifically address whether the discount rate used
to perform the 10 percent cash flow test should reflect the effect of
any fair value hedge adjustments that have been made to the debt’s
carrying amount (see Section 14.2.1.2). Fair value
hedging adjustments do not affect the cash flows between the debtor and
the creditor. In addition, ASC 470-60-55-11 suggests that hedging
effects should not be reflected in the calculation of the effective
borrowing rate used to determine whether a debt modification or exchange
involves a concession under the TDR guidance in ASC 470-60. Therefore, a
debtor should exclude the effect of a fair value hedge adjustment from
the discount rate used to perform the 10 percent cash flow test since
such amounts have no bearing on the relationship between the debtor and
creditor and the objective of ASC 470-50 is to determine whether a
modification or exchange has resulted in a significant change in the
debtor-creditor relationship.
10.3.3.3.5 Convertible Debt With a Separately Recognized Equity Component
While ASC 470-50 does not specifically address how the
separation of an equity component (see Section 7.6) affects the discount
rate used to perform the 10 percent cash flow test, it is acceptable to
discount the cash flows by using an original effective interest rate
that reflects the equity component’s separation.
10.3.3.4 Consecutive Modifications or Exchanges
ASC 470-50
40-12 The following
guidance shall be used to calculate the present
value of the cash flows for purposes of applying the
10 percent cash flow test described in paragraph
470-50-40-10: . . .
f. If within a year of the current
transaction the debt has been exchanged or
modified without being deemed to be substantially
different, then the debt terms that existed a year
ago shall be used to determine whether the current
exchange or modification is substantially
different. . . .
If debt was previously modified or exchanged within one year of the current
modification or exchange and the earlier transaction was not accounted for
as an extinguishment, the debtor is required to use the debt terms that
existed before the earliest modification or exchange within that 12-month
period to determine the present value of the remaining cash flows of the
original debt instrument. In that case, the cash flows of the new debt
instrument would include all cash flows exchanged with the creditor (e.g.,
modification fees) since the earliest modification or exchange within that
12-month period.
In some transactions, such as loan syndications, multiple creditors hold
loans with identical terms (see Section
10.3.2.4). The individual loans may be transferred among
creditors but these transfers do not result in modification or
extinguishment accounting if the debtor is not involved in the
transaction(s) (see Section 10.2.8).
Such transfers among debt holders also do not affect the contractual terms
of debt that has been modified more than once during a one-year period.
Therefore, when performing the 10 percent cash flow test in accordance with
the one-year lookback guidance in ASC 470-50-40-12(f), an entity should not
consider the cash flows related to these types of transfers as cash flows
between the debtor and an individual creditor. This concept is best
illustrated through an example.
Example 10-7
Multiple Modifications and Transfer of Debt Among
Holders
Entity F has $500 million of
outstanding loans that are held by multiple
creditors. The loans were originally issued in a
loan syndication, and each loan held by each
individual creditor has identical terms. Debtor Y
initially acquired $100 million of the loans, and
Debtor Z initially acquired $60 million of the
loans.
During 20X5, the following transactions occurred:
- March 20X5 — Entity F modified the terms of each outstanding loan issued in the syndication. This modification, which applied equally to each outstanding loan, did not involve any principal repayment, principal forgiveness, or additional borrowing. After this modification, each outstanding loan continued to have identical terms. This modification was not accounted for as an extinguishment.
- June 20X5 — Debtor Y sold $20 million of its total investment in F’s loan to Z. This transaction was a transfer among creditors for which no accounting was required by F. After this transfer, Y and Z each held $80 million of the loans issued by F.
- December 20X5 — Entity F further modified the terms of each outstanding loan issued in the syndication. This modification, which applied equally to each outstanding loan, did not involve any principal repayment, principal forgiveness, or additional borrowing. After this modification, each outstanding loan continued to have identical terms.
Because F modified the terms of the outstanding loans
twice during 20X5 (i.e., in March and December), it
must use the terms of the loans that existed before
the first modification to determine the appropriate
accounting for the second modification. ASC 470-50
requires F to perform the 10 percent cash flow test
on an individual creditor basis (see Section 10.3.2.4).
However, if F were to perform this test on the debt
held by Y by comparing the present value of the cash
flows on (1) a $100 million outstanding amount
immediately before the first modification and (2) a
$60 million outstanding amount on the date of the
second modification, it may conclude that it must
account for this modification as an extinguishment
solely because of the $40 million change in
principal amount. However, this treatment would not
be appropriate because the change in principal
amount was not part of either modification. In a
manner consistent with the guidance on additional
borrowings and principal repayments discussed in
Section
10.3.3.2.2, the transfer between Y and
Z should have no impact on F’s accounting for the
second modification. Rather, F should focus on the
changes to the contractual terms of the outstanding
debt, which did not involve any change to the total
outstanding principal amount. Therefore, in the
performance of the 10 percent cash flow test on the
debt held by Y, it is appropriate to treat the
transfer between Y and Z as having occurred
immediately before the first modification in such a
way that the outstanding principal amount for both
the original debt and the new debt (after the second
modification) held by Y is $80 million. Similarly, F
would also use $80 million as the outstanding
principal amount for both the original debt and the
new debt (after the second modification) held by Z.
The accounting result would be the same if F
performed a single 10 percent cash flow test on the
entire $500 million of outstanding debt, which would
be appropriate in this example since the terms of
each individual debt instrument were identical
before and after the two modifications.
10.3.4 Evaluation of Embedded Conversion Features
10.3.4.1 Background
The terms of the original and new debt instruments are
considered substantially different under ASC 470-50 even if the 10 percent
cash flow test is not passed if either of the following apply:
-
The change in the fair value of an embedded conversion option due to a modification or exchange is at least 10 percent of the carrying amount of the original debt instrument immediately before the modification or exchange (see Section 10.3.4.2).
-
A substantive conversion option is added to, or eliminated from, the debt terms (see Section 10.3.4.3).
Special considerations are necessary if:
-
The embedded conversion feature must be bifurcated as an embedded derivative before or after the modification or exchange or both (see Section 10.3.4.4).
-
The convertible debt contains a separately recognized equity component (see Section 10.3.4.5).
10.3.4.2 A 10 Percent Change in Embedded Conversion Feature’s Fair Value
ASC 470-50
40-10 . . . If the terms
of a debt instrument are changed or modified and the
cash flow effect on a present value basis is less
than 10 percent, the debt instruments are not
considered to be substantially different, except in
the following two circumstances:
- A modification or an exchange affects the terms of an embedded conversion option, from which the change in the fair value of the embedded conversion option (calculated as the difference between the fair value of the embedded conversion option immediately before and after the modification or exchange) is at least 10 percent of the carrying amount of the original debt instrument immediately before the modification or exchange. . . .
The terms of two debt instruments are considered substantially different
under ASC 470-50 if the change in the fair value of an embedded conversion
option due to a modification or exchange is at least 10 percent of the
carrying amount of the original debt instrument immediately before the
modification or exchange. The change in the embedded conversion option’s
fair value is calculated by comparing its fair value immediately before and
after the modification or exchange. A share-settled redemption feature (see
Section 8.4.7.2.5) should be
evaluated as a put or call option (see Section
10.3.3.2.6) and not as a conversion feature.
Example 10-8
Modification of Conversion Option in Debt
A long-term debt instrument with a
carrying amount of $100 million contains a
conversion option that is currently
out-of-the-money. The conversion feature is not
required to be bifurcated as an embedded derivative
under ASC 815-15 and the debt does not contain a
separately recognized equity component. The debtor
and creditor agree to reduce the strike price of the
conversion option to increase the likelihood that
the creditor will elect to exercise it when the debt
matures in a few years. The reduction is not within
the scope of the guidance on induced conversions.
The fair value of the conversion option immediately
before the reduction is $2 million. Immediately
after the modification, the fair value is $16
million. Accordingly, the change in the fair value
of the conversion feature is $14 million, which
exceeds 10 percent of the carrying amount of the
original debt instrument immediately before the
modification ($14 million ÷ $100 million = 14%).
Accordingly, the debt terms are considered
substantially different, and extinguishment
accounting applies (see Section
10.4.2).
If the change in fair value of an embedded conversion
feature is less than 10 percent, the debtor must also consider whether (1)
the 10 percent cash flow test is passed (see Section 10.3.3) or (2) a substantive
conversion feature was added or removed (see Section 10.3.4.3) before determining
whether the debt terms should be considered substantially different under
ASC 470-50.
10.3.4.3 Addition or Removal of Substantive Conversion Feature
ASC 470-50
40-10 . . . If the terms
of a debt instrument are changed or modified and the
cash flow effect on a present value basis is less
than 10 percent, the debt instruments are not
considered to be substantially different, except in
the following two circumstances: . . .
b. A modification or an exchange of debt
instruments adds a substantive conversion option
or eliminates a conversion option that was
substantive at the date of the modification or
exchange. (For purposes of evaluating whether an
embedded conversion option was substantive on the
date it was added to or eliminated from a debt
instrument, see paragraphs 470-20-40-7 through
40-9.)
The terms of two debt instruments are considered substantially different
under ASC 470-50 if a substantive conversion option is added to, or
eliminated from, a debt instrument. The debtor determines whether the new or
eliminated conversion option is substantive as of the date of the
modification or exchange. In determining whether a conversion feature is
substantive, the debtor applies ASC 470-20-40-7 through 40-9 (see
Section 12.3.3.2). Under that guidance, a
conversion feature is considered substantive if it is at least reasonably
possible that it will be exercised in the future. The conversion feature
would not be considered substantive in any of the following circumstances:
-
The holder has no ability to exercise the conversion feature (i.e., it is not exercisable) unless the issuer exercises its call option.
-
It is not reasonably possible for the holder to obtain the ability to exercise the conversion feature (i.e., it is not reasonably possible that the feature will become exercisable) unless the issuer exercises its call option. For example, this would be the case if the only circumstance in which the holder can obtain a right to convert the instrument (other than the issuer’s exercise of the call option) is a specified event that does not have a reasonable possibility of occurring.
-
It is not reasonably possible that the holder will exercise the conversion feature (e.g., the conversion price is extremely high relative to the current share price as of the modification or exchange date).
A share-settled redemption feature (see Section
8.4.7.2.5) should be evaluated as a put or call option (see
Section 10.3.3.2.6) and not as a
conversion feature.
Example 10-9
Modification of Conversion Option in Debt
A long-term debt instrument with a
carrying amount of $100 million contains a
conversion option that is currently deep
out-of-the-money. The conversion option is not
required to be bifurcated as an embedded derivative
under ASC 815-15 and the debt does not contain a
separately recognized equity component. Because it
is unlikely that the creditor will elect to exercise
the conversion option, the debtor and creditor agree
to reduce the strike price of the conversion option
to make it at least reasonably possible that the
creditor will elect to exercise it in the future.
The reduction is not within the scope of the
guidance on induced conversions (see Section
12.3.4). The conversion option in the
original debt instrument is considered
nonsubstantive since it was not reasonably possible
that the creditor would exercise it. However, the
new conversion option is substantive since it is
reasonably possible that the creditor will exercise
it. Accordingly, the debt terms are considered
substantially different, and extinguishment
accounting applies (see Section
10.4.2).
If no substantive conversion feature was added or removed, the debtor must
also consider whether (1) the 10 percent cash flow test is passed (see
Section 10.3.3) or (2) the change
in fair value of an embedded conversion feature is at least 10 percent (see
Section 10.3.4.2) before
determining whether the debt terms should be considered substantially
different.
10.3.4.4 Conversion Feature That Is Bifurcated Under ASC 815-15
ASC 470-50
40-11 With respect to the
conditions in (a) and (b) in the preceding
paragraph, this guidance does not address
modifications or exchanges of debt instruments in
circumstances in which the embedded conversion
option is separately accounted for as a derivative
under Topic 815 before the modification, after the
modification, or both before and after the
modification.
ASC 470-50 does not specifically address a modification or
exchange of debt instruments that affects a conversion feature that has been
bifurcated as an embedded derivative. Therefore, the approach to accounting
for such a modification or exchange will depend on the facts and
circumstances.
10.3.4.4.1 Embedded Conversion Option Bifurcated Before and After Modification or Exchange
An embedded conversion feature that must be bifurcated as a derivative
under ASC 815-15 before and after a modification or exchange is always
recognized at fair value in accordance with ASC 815-15. However, a
debtor must apply judgment on the basis of its particular facts and
circumstances to determine whether the modification or exchange results
in an extinguishment of the debt instrument.
In some situations, it is appropriate for a debtor to treat the host debt
instrument and bifurcated conversion feature separately to determine
whether a modification or extinguishment has occurred. That is, the
debtor would use the following approach:
- Apply the 10 percent cash flow test to the host debt instrument (excluding the terms of the bifurcated conversion feature).
- Recognize the change in fair value of the bifurcated conversion feature directly in earnings.
Under this approach, the guidance in ASC 470-50-40-10(a) does not apply
since the conversion feature is considered to be accounted for
separately from the debt both before and after the modification or
exchange.
In other situations, the appropriate accounting for the modification or
exchange must take into account the interrelationship between changes
made to the terms of the host debt instrument and the bifurcated
conversion feature. For example, assume that a modification involves an
increase to both the conversion price and the interest rate on the host
debt instrument. The result of these modifications is a 15 percent
decrease in the fair value of the bifurcated conversion feature and an
offsetting 15 percent increase in the fair value of the host debt
instrument. However, the changes to the terms of the debt instrument are
less than 10 percent (i.e., the changes in the present value of future
cash flows are less than 10 percent). In this example, the debtor
determines that it is not appropriate to recognize the decrease in the
fair value of the bifurcated conversion feature directly in earnings and
separately apply the 10 percent present value test to the host debt
instrument (without the conversion feature) because to do so would
result in an immediate positive impact to earnings that would be offset
by future interest on the host debt instrument (i.e., the carrying
amount of the host debt instrument does not change under modification
accounting). Rather, the debtor adjusts the carrying amount of the host
debt instrument by the decrease in the fair value of the bifurcated
conversion feature, with no immediate impact to earnings. This
accounting is similar to the accounting that would result if both the
host debt instrument (without the conversion feature) and the bifurcated
conversion feature were accounted for as being extinguished.
10.3.4.4.2 Embedded Conversion Option Bifurcated Before or After the Modification or Exchange, But Not Both
If the conversion feature was not bifurcated as a derivative before the
modification or exchange, but requires bifurcation after the
modification or exchange, the debtor may analogize to the guidance in
ASC 470-50-40-10(a). Similarly, if the conversion feature was bifurcated
as a derivative before the modification or exchange, but does not
require bifurcation after the modification or exchange, the debtor may
also analogize to the guidance in ASC 470-50-40-10(a).
10.3.4.5 Convertible Debt With a Separately Recognized Equity Component
ASC 470-50 does not specifically address how the separation
of an equity component (see Section 7.6) affects an issuer’s
assessment of an embedded conversion feature under ASC 470-50-40-10. In the
determination of whether the change in the fair value of an embedded
conversion option is at least 10 percent of the carrying amount of the
original debt instrument immediately before the modification or exchange, it
is reasonable to add back any discount created by the equity component since
the purpose is to assess the significance of the change in fair value
compared with the carrying amount of the instrument as a whole. In other
words, this test is performed as if the convertible debt instrument had
never been separated into component parts (i.e., it requires the use of a
pro forma net carrying amount of the convertible debt instrument as if
separation had not occurred).
Footnotes
1
In the absence of unamortized debt issuance costs
(see Section
10.3.3.3.3) or fair value hedge accounting
adjustments (see Section 10.3.3.3.4), this amount equals the carrying
amount of the original debt.