Chapter 10 — Debt Modifications and Exchanges

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. 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.

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 R 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, R and Z agree to modify the terms of the outstanding debt on October 1, 20X2, as follows:

Entity R issues warrants with a fair value of $1 million to Z to purchase R’s common stock.
Entity Z lends R 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, R calculates the net present value of the future cash flows on the new debt to be $116.6 million. Therefore, R determines the change in the net present value of cash flows on the debt as follows (all amounts rounded in thousands):

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, R and Z agree to modify the terms of the outstanding debt on October 1, 20X2, as follows:

Entity R issues warrants a fair value of $1 million to Z to purchase R’s common stock.
Entity R 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, R calculates the net present value of the future cash flows on the new debt to be $56.788 million. Therefore, R 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, R should treat the changes to the terms of the debt as a modification. Note that if R 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, R should nevertheless account for the partial repayment (see Section 10.4.3.2), which will result in a loss upon partial extinguishment because R would derecognize a portion of the unamortized original discount pertaining to the amount repaid.

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 10-4

Application of 10 Percent Cash Flow Test

On January 1, 20X0, Company A entered into a 10-year $500,000 senior secured loan agreement with Bank B that requires A 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. Company A determines that the effective interest rate equals the contractual interest rate. Under the terms of the loan, A 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, A and B agree to amend the loan agreement to ease certain financial covenants. In return, A agrees to an increase in the contractual interest rate to 15 percent, which reflects changes in market rates and the modified covenants. Company A determines that the modification is not a TDR (see Chapter 11). After the modification, A can still prepay the loan at any time with no penalty.

In applying the 10 percent cash flow test to the loan modification, A 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, A 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. Company A 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:
1. 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).
2. Assuming nonexercise of the prepayment option:
  1. Company A 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).
  2. The discount rate is the effective interest rate, for accounting purposes, of the original debt instrument (i.e., 10 percent).
  3. 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:
1. Assuming exercise of the prepayment option on July 1, 20X5, which also results in a present value of $285,892.
2. Assuming nonexercise of the prepayment option:
  1. Company A 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.
  2. The discount rate is the effective interest rate, for accounting purposes, of the original debt instrument (i.e., 10 percent).
  3. 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:
1. 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.
2. 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.
3. 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.
4. 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 A’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 10-5

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.

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 10-6

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

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 10-7

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. If an embedded conversion feature requires bifurcation as a derivative under ASC 815-15 before and after a modification or exchange, the guidance in ASC 470-50-40-10 does not apply since the conversion feature is accounted for separately from the debt both before and after the modification or exchange. 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.

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.

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

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.

Confidential and Proprietary — for Use Solely by Authorized Personnel

This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.