3.2 Identifying and Evaluating Contractual Terms

When determining the appropriate accounting for a debt transaction, an entity should carefully review the underlying legal documents and consider all relevant facts and circumstances. It also needs to consider the numerous rules and exceptions that exist under GAAP and that might apply to the transaction. Sometimes seemingly simple debt transactions raise complex accounting issues.

Since the details of debt transactions tend to be unique, an entity cannot assume that it can use the same accounting that it or other entities used for other similar transactions. For example, the allocation of proceeds to other contemporaneous transactions could affect the analysis of whether any embedded features need to be bifurcated (see Chapter 8). Likewise, the analysis of the appropriate accounting for a debt modification depends on whether the issuer is experiencing financial difficulties and has received a concession from the creditor (see Chapter 11).

Further, contractual terms that may be significant to the accounting analysis could be buried deep within a contract’s fine print, or they may have been overridden or modified in separate legal documents (e.g., confidential side letters). Even minor variations in the way contractual terms are defined could have a material effect on the accounting for a debt arrangement. For example, the accounting analysis of a provision that requires an increase to the interest rate of a debt instrument upon the debtor’s event of default depends on how the contractual terms define an event of default (see Section 8.4.2).

In forming a view on the appropriate accounting, an entity should not rely solely on the name given to a transaction or how it is described in summary term sheets, slideshow presentations, or marketing materials. Products with similar economics sometimes go by different names in the marketplace (e.g., products marketed by different banks), while products subject to different accounting may go by the same or similar names.

An entity should also be mindful that the names given to contractual provisions in legal documents (e.g., conversion, exchange, share settlement, or redemption provisions) do not necessarily reflect their economics or how they would be identified and analyzed for accounting purposes. For example, an equity conversion feature that is embedded in a debt arrangement and economically represents a share-settled redemption feature might need to be analyzed as a redemption feature even though its form is that of a conversion feature (see Section 8.4.7.2.5).

The determination of the appropriate accounting for a debt arrangement can be time-consuming and complex. The outcome of the analysis could significantly affect the arrangement’s classification, measurement, and earnings impact as well as its associated financial statement ratios. To arrive at appropriate accounting conclusions, an entity should work with its auditors and consider involving technical specialists.