3.3 Units of Account

3.3.1 Background

ASC Master Glossary

Unit of Account

The level at which an asset or a liability is aggregated or disaggregated in a Topic for recognition purposes.

In determining the appropriate accounting for a debt transaction, an entity should consider how to identify units of account (i.e., the “level at which an asset or a liability is aggregated or disaggregated”). While many debt contracts represent one unit of account, some legal agreements consist of two or more components that individually represent separate units of account (e.g., debt with detachable warrants). Conversely, two separate agreements might represent one combined unit of account (e.g., debt that was issued with warrants that are not legally detachable or separately exercisable from the debt).

Example 3-1

Debt Issued With Other Financial Instruments

Entity B enters into a credit facility with Entity C under which it receives an initial term loan of $20 million and term loan commitments that permit B to request up to an additional $100 million of term loans on specified dates in the future if certain conditions are met. In addition to the payment of principal and interest on outstanding term loans, the credit facility requires B to make payments to C that are indexed to B’s sales revenue. In conjunction with the transaction, B issues warrants to C on its own stock worth $10 million for no separate consideration.

Entity B must determine whether the transaction consists of one or more units of account, including whether the term loan commitments, the warrants, and the revenue-indexed payment obligation are embedded in the initial term loan or should be treated as units of account that are separate from the initial term loan.

Note that in some financing arrangements, an entity issues warrants to the lender that vest on the basis of debt draws. Example 5-1 in this Roadmap and Example 2-6 in Deloitte’s Roadmap Contracts on an Entity’s Own Equity address these arrangements.

To determine the units of account, an issuer should identify each freestanding financial instrument (see Section 3.3.2) and any other elements that qualify for separate accounting recognition (see Section 3.3.3). A decision to treat a transaction as one rather than multiple units of account can have significant financial statement ramifications. For instance, the separation of a financing transaction into multiple units of account could result in the recognition and subsequent amortization of a debt discount (see Section 4.3.6) even if the transaction involved the issuance of debt for proceeds equal to the debt’s stated principal amount. In turn, the recognition of a debt discount could affect the analysis of whether any put, call, or redemption features in the debt must be separated as derivatives and accounted for at fair value on a recurring basis (see Section 8.4.4).

3.3.2 Freestanding Financial Instruments

3.3.2.1 Framework for Identifying Freestanding Financial Instruments

ASC Master Glossary

Freestanding Financial Instrument

A financial instrument that meets either of the following conditions:

It is entered into separately and apart from any of the entity’s other financial instruments or equity transactions.
It is entered into in conjunction with some other transaction and is legally detachable and separately exercisable.

In identifying units of account, an entity should consider the definition of a freestanding financial instrument in the ASC master glossary. (Note that the definition of a freestanding contract in the ASC master glossary is substantially equivalent to the definition of a freestanding financial instrument.)

A freestanding financial instrument is one that is entered into either “separately and apart from any of the entity’s other financial instruments or equity transactions” or “in conjunction with some other transaction and is legally detachable and separately exercisable.” Therefore, in identifying freestanding financial instruments, an entity should consider the following questions, each of which is discussed in detail in the sections below:

Was the transaction entered into contemporaneously with and in contemplation of another transaction, or was it entered into separately and apart from other transactions?
Is the item legally detachable?
Can the item be exercised separately, or does its exercise result in the termination, redemption, or automatic exercise of a specifically identified item?
Does the transaction involve multiple counterparties?

3.3.2.1.1 Contemporaneous or Separate Transaction

The fact that a transaction was entered into separately and apart from any other transaction suggests that it is a freestanding financial instrument that is separate from any other transaction. If the transaction was entered into contemporaneously with and in contemplation of another transaction, the entity should assess whether the two transactions represent a single freestanding financial instrument. For example, if warrants are issued in conjunction with a debt issuance of the same issuer, the issuer should consider whether to treat them as being embedded in the debt even if they are subject to a separate contractual agreement.

A transaction’s having been entered into contemporaneously or in conjunction with some other transaction, however, would not necessarily result in a conclusion that the two transactions should be viewed on a combined basis as a single freestanding financial instrument. The entity should also consider whether the transactions are legally detachable and separately exercisable (see the next section) and whether the combination guidance in ASC 815-10 applies (see Section 3.3.2.2).

A one-week period between transactions may be good evidence that the transactions are not contemporaneous if the entity is exposed to market fluctuations during this time. Even when transactions occur at different times, entities should consider all available evidence to ensure that no side agreements or other contracts were entered into that suggest that the transactions were entered into in contemplation of one another.

3.3.2.1.2 Legally Detachable

There is no guidance in U.S. GAAP on the meaning of “legally detachable.” In practice, an item is considered legally detachable from another item if it is (1) separately transferable from that item or (2) otherwise capable of being separated from that item. If an item is separately exercisable but not considered legally detachable (e.g., an equity conversion option embedded in debt that permits the holder to convert the debt into the issuer’s equity shares instead of receiving a repayment of the debt’s principal amount on its maturity date), it would not be a separate freestanding financial instrument under item (b) of the definition of a freestanding financial instrument. However, in some cases, the separate exercisability of an item results in a conclusion that an item is legally detachable (see discussion in the last paragraph of this section).

An item is always considered “legally detachable” if it can be transferred separately from another item in a single contractual agreement (or from another item in multiple contracts entered into at the same time) at the holder’s discretion (i.e., without limitations imposed by the counterparty). The fact that an item can be transferred independently from another item indicates that it is a separate unit of account even if the two items were entered into contemporaneously and have the same counterparty. This view is supported by the guidance in ASC 815-10-25-9, which states, in part:

Derivative instruments that are transferable are, by their nature, separate and distinct contracts.

Similarly, ASC 815-10-15-5 states, in part:

The notion of an embedded derivative . . . does not contemplate features that may be sold or traded separately from the contract in which those rights and obligations are embedded. Assuming they meet [the] definition of a derivative instrument, such features shall be considered attached freestanding derivative instruments rather than embedded derivatives by both the writer and the current holder.

Example 3-2

Debt Issued With Additional Term Loan Commitments

Entity A enters into an agreement with a lender for the issuance of a term loan facility in an aggregate principal amount of up to $65 million. The agreement specifies the issuance of a term loan advance of $15 million at the agreement’s closing. Additional term loan advances are available to A as follows:

Upon achieving a specified milestone target and before six months after closing, A may request an additional term loan advance from the lender of $10 million.
Upon achieving an incremental milestone target and before one year after closing, A may request an additional term loan advance from the lender of $20 million.
Upon achieving another milestone target and before two years after closing, A may request an additional term loan advance from the lender of up to $20 million, in minimum increments of $5 million.

If there is no restriction preventing the lender from selling, to a third party, a term loan tranche that it has already provided to A, and the lender continues to be contingently obligated to provide subsequent tranches of additional term loan advances to A upon A’s request, the future tranches would be analyzed as freestanding financial instruments (e.g., loan commitments) that are separate from the initial tranche. This is the case even though the loan facility is documented in a single agreement. Note that A should therefore allocate a portion of the proceeds received in the initial closing of the agreement to the three future tranches (i.e., some of the $15 million received at closing may be attributable to the three future tranches). For discussions of the allocation of issuance costs, see Section 3.5 and Chapter 5.

However, a scenario in which two items cannot be transferred independently of one another suggests that each item is not a freestanding financial instrument under item (b) in the definition of a freestanding financial instrument. For example, if a warrant “travels with” a bond and cannot be transferred separately from the bond, it may be an embedded feature in the bond.

A contract may be entered into in conjunction with some other item. For such a contract to be considered a freestanding instrument, an assessment must be performed of both the form and substance of the transaction, including the substance of the independent transferability of the item. In some circumstances, an item is unconditionally separately transferable by the holder but would have no economic value if the related item were not held, which would suggest that the separate transferability has no substance and the item is embedded in the related item (see further discussion in Section 3.3.2.1.3). Similarly, the holder of a debt instrument that is not readily obtainable in the market may have a separately transferable put option that it can exercise only by delivering the same specific debt instrument. In this case, the debt and the put option may represent a single, combined unit of account on the basis of an assessment of the substance of the transaction.

In other circumstances, an item may be separately transferred only with the consent of the counterparty. If an item may be separated from a related contract without any modification to the contractual terms (e.g., the contract specifically permits the item to be transferred if the issuer gives its consent and such consent cannot be unreasonably withheld), the legally detachable condition is, in substance, generally met since the counterparty has agreed not to withhold its consent. If, however, the counterparty can always prevent the separate transfer of the item at its discretion, the legally detachable condition is, in substance, most likely not met and therefore the item is not a freestanding financial instrument.

Example 3-3

Bond Issued With Warrants

An entity issues a bond with a warrant. The agreement specifies that the counterparty may not transfer the bond or the warrant without the issuer’s consent. However, the agreement does not preclude the transfer of the warrant separately from the bond if the issuer were to give its consent. Further, the contract specifies that such consent cannot be unreasonably withheld. The exercise of the warrant does not result in the termination of the bond (i.e., the counterparty is not required to tender the bond as payment of the exercise price of the warrant). In these circumstances, the warrant is considered a freestanding financial instrument because it is both independently transferable and separately exercisable. The fact that the warrant contains a restriction that may preclude the counterparty from transferring it does not mean that the warrant is not a freestanding contract since the contract specifies that the issuer’s consent cannot be unreasonably withheld.

The SEC staff has indicated in informal discussions that it is possible for two items that have been entered into contemporaneously with the same counterparty to be considered freestanding financial instruments solely on the basis of the items’ ability to be separately exercised (i.e., even though the contractual terms prevent the items from being transferred separately). This would generally be the case when a reasonable conclusion can be reached that the separate exercisability of one item is sufficient to establish that it is legally detachable from the related item. However, when determining whether an item can be transferred separately, an entity must use significant judgment and consider the transaction’s form and substance. We therefore strongly recommend that an entity consult with its independent accounting advisers when performing this assessment.

Example 3-4

Tranche Debt Financing Agreement

Entity X enters into a debt financing agreement with unrelated investors to sell two tranches of convertible debt. The purchase agreement stipulates the following:

On the first closing date, which is the date of the purchase agreement, the investors will purchase $50 million of convertible debt.
On the second closing date, the investors will purchase $25 million of convertible debt subject to a specified condition. The second closing will occur only if (1) a specific milestone related to X’s operations is achieved two years from the first closing date or (2) the specific milestone related to X’s operations is not achieved two years from the first closing date but the holders waive the milestone requirement and elect to purchase the convertible debt (the “contingent purchase option”).
The holders of convertible debt issued in the first closing cannot transfer their contingent purchase options separately from the convertible debt acquired in the first closing (or vice versa). However, such holders have the right to convert that debt into common stock before the date that is two years from the first closing date.
The holders that convert debt into common stock may sell those common shares, and the only restrictions on selling common stock stem from restrictions under U.S. securities laws.

In this example, the contingent purchase option would be considered a freestanding financial instrument because it meets the “legally detachable and separately exercisable” condition. The holders can “detach” the two instruments because they can convert the debt into common stock and sell those shares while retaining the contingent purchase option (i.e., the two instruments are capable of being separated). This would be the case even if the contingent purchase option may not be separately transferred after the conversion into common stock of the debt obtained in the first closing. It would not be appropriate to consider the debt and the contingent purchase option a single combined financial instrument because the contingent purchase option would not become embedded in the common shares received upon conversion of the debt purchased in the first closing.

Note that the conclusion in this example would not change even if:

The holders could not sell the common shares received upon conversion of the debt purchased in the first closing before satisfaction or expiration of the contingent purchase option. At the inception of the arrangement, the two instruments still meet the legally detachable and separately exercisable condition because the contingent purchase option (1) cannot become embedded in the common shares received upon conversion of the debt purchased in the first closing and (2) does not become freestanding only if the debt purchased in the first closing is converted into common stock (instead, the ability to convert the debt purchased in the first closing is evidence that the contingent purchase option is capable of being separated at the inception of the arrangement).
The debt purchased on the first closing date cannot be transferred or converted before the contingent purchase option is satisfied or expires and the holders have the right to acquire the additional debt related to the contingent purchase option at their option at any time before two years from the closing date. The two instruments still meet the legally detachable and separately exercisable condition because the investor can separate the two components by early exercising the contingent purchase option while retaining the debt acquired on the first closing date.

As this example illustrates, and in a manner consistent with practice, an option or commitment to issue additional debt is almost always a freestanding financial instrument because the separate exercisability of the option or commitment is sufficient to demonstrate that the feature is capable of being separated.

3.3.2.1.3 Separate Exercise Versus Termination, Redemption, or Automatic Exercise

If an item can be freely exercised without terminating the other item (e.g., through redemption, automatic exercise, or expiration), it is considered to be “separately exercisable.” The fact that a warrant remains outstanding if a bond to which it is attached is redeemed, for example, suggests that the warrant is a freestanding financial instrument that is separate from the bond. Similarly, if a bond may remain outstanding after a net-share-settled conversion feature included in the bond is exercised, the conversion feature may be a freestanding financial instrument.

Conversely, if the exercise of an item results in the termination of a specifically identified item, the first item would not be considered separately exercisable from the other item. For example, if a warrant can be exercised only by the tendering of a specific bond in a physical settlement, the warrant may be a feature embedded in the bond rather than a freestanding financial instrument. ASC 470-20-25-3 states, in part:

[I]f stock purchase warrants are not detachable from [a] debt instrument and the debt instrument must be surrendered to exercise the warrant, the two instruments taken together are substantially equivalent to a convertible debt instrument.

Similarly, if a specifically identified debt instrument is subject to a redemption requirement, the debt instrument and the redemption requirement may represent one single freestanding financial instrument even if they are documented in separate agreements (see ASC 480-10-15-7C). After a debt instrument’s issuance, the addition of a redemption requirement should be evaluated as a modification of the terms of the debt (see Chapter 10).

3.3.2.1.4 Multiple Counterparties

Contracts with different counterparties are treated as separate freestanding financial instruments even if they were issued contemporaneously or were transacted as a package. Thus, ASC 815-10-15-6 suggests that an option added or attached to an existing debt instrument by another party is not an embedded derivative because it does not have the same counterparty. Similarly, ASC 815-15-25-2 indicates that the notion of an embedded derivative in a hybrid instrument does not refer to provisions in separate contracts between separate counterparties.

Example 3-5

Issuance of a Bond and a Warrant

An entity delivers a bond and a warrant on its own equity to an underwriter for cash. The underwriter is a party to the warrant but holds the bond merely as an agent for a third-party investor. The terms and pricing of the bond sold to the third-party investor are not affected by the sale of the warrant to the underwriter. Because they involve different counterparties, the bond and the warrant are two separate freestanding financial instruments.

Under ASC 815-10-25-10, transactions that are entered into with a single party are treated as having the same counterparty even if some of them are structured through an intermediary (see Section 10.5.2). In consolidated financial statements, the reporting entity is the consolidated group. Therefore, the parent and its subsidiary would not be considered different parties in the consolidated financial statements. For example, if a parent entity writes a put option on debt issued by the subsidiary, it may be acceptable to view the option as being embedded in the debt in the consolidated financial statements even though the subsidiary technically is not a party to the option.

3.3.2.2 Combination Guidance

ASC 815-10 contains additional guidance to help an entity determine whether two or more separate transactions should be viewed as separate units of account or combined for accounting purposes. ASC 815-10-15-8 states, in part:

In some circumstances, an entity could enter into two or more legally separate transactions that, if combined, would generate a result that is economically similar to entering into a single transaction that would be accounted for as a derivative instrument under this Subtopic.

Nevertheless, because it is transaction-based, ASC 815 ordinarily does not permit an entity to treat two or more freestanding financial instruments as a single combined unit of account. ASC 815-10-25-6 states, in part:

[ASC 815-10] generally does not provide for the combination of separate financial instruments to be evaluated as a unit.

However, if two or more freestanding financial instruments have characteristics suggesting that they were structured to circumvent GAAP, they may need to be combined and treated as a single unit of account. Specifically, ASC 815-10 requires two or more separate transactions to be combined and viewed in combination as a single unit of account if they were entered into in an attempt to circumvent the accounting requirements for derivatives (i.e., measured at fair value, with subsequent changes in fair value recognized in earnings except for qualifying hedging instruments in cash flow or net investment hedges). ASC 815-10-15-9 states that such combination is required if the transactions have all of the following characteristics:

They “were entered into contemporaneously and in contemplation of one another.”
They “were executed with the same counterparty (or structured through an intermediary).”
They “relate to the same risk” (e.g., the fair value of the issuer’s equity shares).
“There is no apparent economic need or substantive business purpose for structuring the transactions separately that could not also have been accomplished in a single transaction.”

ASC 815-10-25-6 identifies characteristics similar to those listed above from ASC 815-10-15-98 and adds the following commentary:

If separate derivative instruments have all of [these] characteristics, judgment shall be applied to determine whether the separate derivative instruments have been entered into in lieu of a structured transaction in an effort to circumvent GAAP: . . . If such a determination is made, the derivative instruments shall be viewed as a unit.

ASC 815 does not specify a period of separation between transactions (e.g., one day, one week) that would disqualify them from being treated as contemporaneous. A one-week period between transactions may be sufficient evidence that the transactions are not contemporaneous if the entity is exposed to market fluctuations during this time. Thus, even when transactions occur at different times, entities must consider all available evidence to ensure that no side agreements or other contracts were entered into that call into question whether the transactions were contemporaneous (e.g., there are no earlier agreements for trades to be entered into simultaneously).

ASC 815-10 contains the example below of two offsetting loans that would be combined and accounted for as one unit of account as an interest rate swap.

ASC 815-10

Example 19: Recognition — Viewing Separate Transactions as a Unit for Purposes of Evaluating Net Settlement

Case B: Borrowing and Lending Transactions Viewed as a Unit

55-179 Entity C loans $100 to Entity B. The loan has a 5-year bullet maturity and an 8 percent fixed interest rate, payable semiannually. Entity B simultaneously loans $100 to Entity C. The loan has a five-year bullet maturity and a variable interest of LIBOR, payable semiannually and reset semiannually. Entity B and Entity C enter into a netting arrangement that permits each party to offset its rights and obligations under the agreements. The netting arrangement meets the criteria for offsetting in Subtopic 210-20. The net effect of offsetting the contracts for both Entity B and Entity C is the economic equivalent of an interest rate swap arrangement, that is, one party receives a fixed interest rate from, and pays a variable interest rate to, the other.

55-180 In this Case, based on the facts presented, there is no clear business purpose for the separate transactions, and they should be accounted for as an interest rate swap under this Subtopic. However, in other instances, a clear substantive business purpose for entering into two separate loan transactions may exist (for example, as a means to overcome foreign currency expatriation restrictions).

Note that the SEC staff will challenge the accounting for transactions for which it appears that multiple contracts have been used to circumvent GAAP.

3.3.2.3 Application to Debt With Detachable Warrants

ASC 470-20

05-2 Unlike convertible debt, debt with detachable warrants (detachable call options) to purchase stock is usually issued with the expectation that the debt will be repaid when it matures. The provisions of the debt agreement are usually more restrictive on the issuer and more protective of the investor than those for convertible debt. The terms of the warrants are influenced by the desire for a successful debt financing. Detachable warrants often trade separately from the debt instrument. Thus, the two elements of the security exist independently and may be treated as separate securities.

05-3 From the point of view of the issuer, the sale of a debt security with warrants results in a lower cash interest cost than would otherwise be possible or permits financing not otherwise practicable. The issuer usually cannot force the holders of the warrants to exercise them and purchase the stock. The issuer may, however, be required to issue shares of stock at some future date at a price lower than the market price existing at that time, as is true in the case of the conversion option of convertible debt. Under different conditions the warrants may expire without exercise. The outcome of the warrant feature thus cannot be determined at time of issuance. In either case the debt must generally be paid at maturity or earlier redemption date whether or not the warrants are exercised.

25-3 . . . [I]f stock purchase warrants are not detachable from the debt instrument and the debt instrument must be surrendered to exercise the warrant, the two instruments taken together are substantially equivalent to a convertible debt instrument . . . .

As indicated in ASC 470-20-05-2 and 05-3, as long as both of the following apply, a transaction that includes the issuance of both a debt instrument and a warrant on the issuer’s equity shares should be treated as if it contains two separate freestanding financial instruments:

The “warrants . . . trade separately from the debt instrument.”
The “warrants may expire without exercise,” whereas “the debt must . . . be paid at maturity or [an] earlier redemption date whether or not the warrants are exercised.”

Satisfying these two conditions is equivalent to meeting condition (b) in the ASC master glossary definition of a freestanding financial instrument (see Section 3.3.2.1).

Conversely, in accordance with ASC 470-20-25-3, if a warrant on an issuer’s equity shares is not detachable from a debt instrument and the warrant cannot be exercised unless the debt is surrendered, the debt and warrant are treated as a single combined freestanding financial instrument since they “are substantially equivalent to a convertible debt instrument.”

3.3.3 Other Elements That Warrant Separate Accounting Recognition

3.3.3.1 Background

ASC 835-30

25-4 . . . If cash and some other rights or privileges are exchanged for a note, the value of the rights or privileges shall be given accounting recognition . . . .

ASC 470-20

25-15 If the issuance transaction for a convertible debt instrument within the scope of this Subtopic includes other unstated (or stated) rights or privileges in addition to the convertible debt instrument, a portion of the initial proceeds shall be attributed to those rights and privileges based on the guidance in other applicable U.S. generally accepted accounting principles (GAAP).

In addition to any freestanding financial instruments (see Section 3.3.2), a debt issuer should consider whether a debt transaction contains any other elements that warrant accounting recognition separately from the debt. For example:

Contractual terms that are within the scope of the guidance on registration payment arrangements in ASC 825-20 must be treated as a separate unit of account (see Section 3.3.3.2).
When an entity elects to account for debt by applying the fair value option in ASC 815-15 or ASC 825-10, the unit of account for the debt excludes any inseparable third-party guarantee (see Section 3.3.3.3).
If debt is issued in exchange for cash and other rights or privileges that do not form part of the debt, those other rights or privileges should be recognized separately (see Section 3.3.3.4).
Sometimes a debt transaction involves the exchange of nonfinancial items (see Section 4.3.5).
A debt issuer should evaluate features embedded in hybrid debt instruments to determine whether such features must be separated as derivatives under ASC 815 (see Chapter 8). (Note that the transaction proceeds are first allocated among the hybrid debt instrument and any other freestanding financial instruments before the embedded derivative is bifurcated from the hybrid debt instrument.)
A debt issuer should evaluate convertible debt to determine whether it includes a separable equity component under the guidance in ASC 470-20-25-13 on substantial premiums (see Section 7.6).

To identify transaction elements that warrant separate accounting recognition, the debt issuer must sometimes perform a more careful evaluation of the transaction and apply professional judgment (e.g., if the effective interest rate that would be computed on the basis of the initially ascribed debt proceeds is unreasonable; see Section 3.3.3.4). If separate accounting recognition is required, a portion of the debt proceeds may need to be allocated to the other transaction elements. Alternatively, the value of other transaction elements might represent an addition to the debt proceeds if they benefit the debtor (e.g., a valuable right that qualifies as an asset).

3.3.3.2 Registration Payment Arrangements

ASC Master Glossary

Registration Payment Arrangement

An arrangement with both of the following characteristics:

It specifies that the issuer will endeavor to do either of the following:
1. File a registration statement for the resale of specified financial instruments and/or for the resale of equity shares that are issuable upon exercise or conversion of specified financial instruments and for that registration statement to be declared effective by the U.S. Securities and Exchange Commission (SEC) (or other applicable securities regulator if the registration statement will be filed in a foreign jurisdiction) within a specified grace period
2. Maintain the effectiveness of the registration statement for a specified period of time (or in perpetuity).
It requires the issuer to transfer consideration to the counterparty if the registration statement for the resale of the financial instrument or instruments subject to the arrangement is not declared effective or if effectiveness of the registration statement is not maintained. That consideration may be payable in a lump sum or it may be payable periodically, and the form of the consideration may vary. For example, the consideration may be in the form of cash, equity instruments, or adjustments to the terms of the financial instrument or instruments that are subject to the registration payment arrangement (such as an increased interest rate on a debt instrument).

ASC 825-20

15-1 The guidance in this Subtopic applies to all entities that issue a registration payment arrangement.

15-2 The guidance in this Subtopic applies to the following transactions and activities:

A registration payment arrangement regardless of whether it is issued as a separate agreement or included as a provision of a financial instrument or other agreement. An arrangement that requires the issuer to obtain and/or maintain a listing on a stock exchange, instead of, or in addition to, obtaining and/or maintaining an effective registration statement, is within the scope of this Subtopic if the remaining characteristics of the definition of the term registration payment arrangement are met.

15-4 The guidance in this Subtopic does not apply to any of the following:

Arrangements that require registration or listing of convertible debt instruments or convertible preferred stock if the form of consideration that would be transferred to the counterparty is an adjustment to the conversion ratio. See Subtopic 470-20 on debt with conversion and other options or Subtopic 505-10 on equity for related guidance.
Arrangements in which the amount of consideration transferred is determined by reference to either of the following:
1. An observable market other than the market for the issuer’s stock
2. An observable index.
For example, if the consideration to be transferred if the issuer is unable to obtain an effective registration statement is determined by reference to the price of a commodity. See Subtopic 815-15 for related guidance.
Arrangements in which the financial instrument or instruments subject to the arrangement are settled when the consideration is transferred (for example, a warrant that is contingently puttable if an effective registration statement for the resale of the equity shares that are issuable upon exercise of the warrant is not declared effective by the SEC within a specified grace period).

15-5 The guidance in this Subtopic shall not be applied by analogy to the accounting for contracts that are not registration payment arrangements meeting the criteria in paragraphs 825-20-15-2 through 15-3. For example, a building contract that includes a provision requiring the contractor to obtain a certificate of occupancy by a certain date or pay a penalty every month until the certificate of occupancy is obtained is not addressed by this Subtopic.

25-1 An entity shall recognize a registration payment arrangement as a separate unit of account from the financial instrument(s) subject to that arrangement.

25-2 The financial instrument(s) subject to the registration payment arrangement shall be recognized in accordance with other applicable generally accepted accounting principles (GAAP) (for example, Subtopics 815-10; 815-40; and 835-30) without regard to the contingent obligation to transfer consideration pursuant to the registration payment arrangement.

25-3 The contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement shall be recognized separately in accordance with Subtopic 450-20.

30-1 An entity shall measure a registration payment arrangement as a separate unit of account from the financial instrument(s) subject to that arrangement.

30-2 The financial instrument(s) subject to the registration payment arrangement shall be measured in accordance with other applicable generally accepted accounting principles (GAAP) (for example, Subtopics 815-10; 815-40; and 835-30) without regard to the contingent obligation to transfer consideration pursuant to the registration payment arrangement.

30-3 The contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement shall be measured separately in accordance with Subtopic 450-20.

30-4 If the transfer of consideration under a registration payment arrangement is probable and can be reasonably estimated at inception, the contingent liability under the registration payment arrangement shall be included in the allocation of proceeds from the related financing transaction using the measurement guidance in Subtopic 450-20. The remaining proceeds shall be allocated to the financial instrument(s) issued in conjunction with the registration payment arrangement based on the provisions of other applicable GAAP. A financial instrument issued concurrently with a registration payment arrangement might be initially measured at a discount to its principal amount under this allocation methodology. For example, if the financial instruments issued concurrently with the registration payment arrangement are a debt instrument and an equity-classified warrant, the remaining proceeds after recognizing and measuring a liability for the registration payment arrangement under that Subtopic would be allocated on a relative fair value basis between the debt and the warrant pursuant to paragraph 470-20-25-3.

30-5 If all of the following criteria are met, the issuer’s share price at the reporting date shall be used to measure the contingent liability under Subtopic 450-20:

An entity would be required to deliver shares under a registration payment arrangement.
The transfer of that consideration is probable.
The number of shares to be delivered can be reasonably estimated.

35-1 If the transfer of consideration under a registration payment arrangement becomes probable and can be reasonably estimated after the inception of the arrangement or if the measurement of a previously recognized contingent liability increases or decreases in a subsequent period, the initial recognition of the contingent liability or the change in the measurement of the previously recognized contingent liability (in accordance with Subtopic 450-20) shall be recognized in earnings.

ASC 825-20 contains special unit-of-account guidance on registration payment arrangements. An issuer of a debt instrument may agree to pay specified amounts if a registration statement for the resale of the instrument or other instruments subject to the arrangement (e.g., shares that might be delivered upon conversion of the debt) is not declared effective or if effectiveness of the registration statement is not maintained. For example, a convertible debt instrument may require the issuer to:

Use its “best efforts” to file a registration statement for the resale of shares and have the registration statement declared effective by the end of a specified grace period (e.g., within 90 to 180 days).
Maintain the effectiveness of a registration statement for a period.

If the issuer fails to meet these conditions, the contract may require it to make cash payments to the counterparty unless or until a registration statement is declared effective. For example, the contract may require that after the 180-day grace period, the entity must pay the investor 2 percent of the contract purchase price for each month in which there is no registration statement in effect.

A registration payment arrangement is treated as a unit of account that is separate from the related debt instrument even if such payment arrangement is included in the terms of the debt instrument. However, a payment arrangement that does not meet the definition of a registration payment arrangement is not within the scope of the ASC 825-20 guidance on registration payment arrangements; ASC 825-20-15-5 specifically states that the guidance in ASC 825-20 “shall not be applied by analogy to the accounting for contracts that are not registration payment arrangements” under ASC 825-20. For example, some debt instruments issued in accordance with an exemption from registration under the Securities Act of 1933 require the issuing entity to pay additional interest at a specified time after the issuance date if (1) the debt instrument is not freely tradable by its holders or (2) the issuer has not filed in a timely manner any report or document that must be submitted to the SEC under Section 13 or Section 15(d) of the Securities Exchange Act of 1934. Because these payment provisions do not pertain to the filing or maintenance of either an effective registration statement or an exchange listing, they do not meet the definition of a registration payment arrangement. Instead, they must be evaluated under the embedded derivative requirements in ASC 815-15 (see Section 8.4.11).

A registration payment arrangement that is within the scope of ASC 825-20 is treated as a contingent liability (see Deloitte’s Roadmap Contingencies, Loss Recoveries, and Guarantees). This means that proceeds from the related financing transaction are allocated to the registration payment arrangement upon initial recognition only if there is a probable obligation to make payments under the arrangement that can be reasonably estimated (see ASC 825-20-30-4). If the obligation becomes probable and can be reasonably estimated after inception, a contingent liability is then recognized, with an offset to earnings. Any subsequent change in the amount of the contingent liability is also recognized in earnings (see ASC 825-20-35-1). If the entity is required to deliver shares under the arrangement, the number of shares can be reasonably estimated, and the transfer is probable, the entity measures the contingent liability by using the issuer’s stock price as of the reporting date (see ASC 825-20-30-5).

An arrangement would not be accounted for as a separate unit of account under ASC 825-20 if it contains any of the following provisions:

The form of consideration transferred is a contingently adjustable conversion ratio in a convertible instrument.
The payment is adjusted by reference either to an observable market other than the issuer’s stock (e.g., a commodity price) or to an observable index.
The payment is made when the contract subject to the arrangement is settled (e.g., a payment that is made upon the exercise of an option on own stock that is subject to the arrangement).

Accordingly, an entity would consider such provisions in its analysis of whether an equity conversion option or other embedded feature must be bifurcated from the debt as a derivative instrument under ASC 815-15 (see Chapter 8).

3.3.3.3 Debt Issued With Third-Party Guarantee

ASC 825-10

25-13 For the issuer of a liability issued with an inseparable third-party credit enhancement (for example, debt that is issued with a contractual third-party guarantee), the unit of accounting for the liability measured or disclosed at fair value does not include the third-party credit enhancement. This paragraph does not apply to the holder of the issuer’s credit-enhanced liability or to any of the following financial instruments or transactions:

A credit enhancement granted to the issuer of the liability (for example, deposit insurance provided by a government or government agency)
A credit enhancement provided between reporting entities within a consolidated or combined group (for example, between a parent and its subsidiary or between entities under common control).

An issuer of a debt security might purchase a financial guarantee from a third party that guarantees that it will pay its debt obligation. The issuer incorporates the guarantee into the terms of the debt such that it transfers with the security in transactions among investors. By packaging the debt with a third-party guarantee, the issuer is able to reduce the debt’s stated interest rate or receive higher debt proceeds.

If third-party guaranteed debt is accounted for at fair value (e.g., under the fair value option in ASC 815-15 or ASC 825-10; see Sections 4.4 and 8.5.6), the debt’s fair value is determined as if it was not guaranteed (see ASC 820-10-35-18A and ASC 825-10-25-13). Upon debt issuance, therefore, the debt proceeds would be allocated between the debt and the third-party guarantee (see the example below). This treatment differs if the guaranteed debt is not accounted for or disclosed at fair value. When debt is accounted for at amortized cost, it is acceptable not to allocate any amount of the debt proceeds to the guarantee (i.e., a guarantee asset is not recognized). Nevertheless, the payment to the guarantor represents a debt issuance cost that should be deducted from the debt proceeds under ASC 835-30-45-1A (see the example below and Section 5.3).

Example 3-6

Debt Issued With Third-Party Guarantee

In connection with a debt issuance, Entity A agrees to pay $2.5 million to Entity C in exchange for C’s guarantee to pay the holder of A’s debt any outstanding principal or interest payments that become due if A were to default on such payments. The guarantee is incorporated into the debt terms, and it transfers with the debt. Entity A receives $100 million of debt proceeds. Without the guarantee, the fair value of the debt is estimated to be $97.5 million. Entity A elects to apply the fair value option to the debt. It treats the payment to the guarantor for the guarantee as an up-front cost or fee, which is expensed under ASC 825-10-25-3, and the amount allocated to the guarantee from the debt proceeds as a reimbursement of its payment to the guarantor. At inception, A makes the following accounting entries:

Note that in this example, the amount paid to purchase the guarantee equals the difference between the principal amount and initial fair value of the issued debt without the guarantee; if this was not the case, the issuer would recognize an inception gain or loss for the difference.

If A did not elect to apply the fair value option to the debt, it would recognize the following accounting entries at inception:

3.3.3.4 Other Transaction Elements

ASC 835-30

25-4 When a note is received or issued solely for cash and no other right or privilege is exchanged, it is presumed to have a present value at issuance measured by the cash proceeds exchanged. If cash and some other rights or privileges are exchanged for a note, the value of the rights or privileges shall be given accounting recognition as described in paragraph 835-30-25-6.

25-6 A note issued solely for cash equal to its face amount is presumed to earn the stated rate of interest. However, in some cases the parties may also exchange unstated (or stated) rights or privileges, which are given accounting recognition by establishing a note discount or premium account. In such instances, the effective interest rate differs from the stated rate. For example, an entity may lend a supplier cash that is to be repaid five years hence with no stated interest. Such a non-interest-bearing loan may be partial consideration under a purchase contract for supplier products at lower than the prevailing market prices. In this circumstance, the difference between the present value of the receivable and the cash loaned to the supplier is appropriately regarded as an addition to the cost of products purchased during the contract term. The note discount shall be amortized as interest income over the five-year life of the note, as required by Section 835-30-35.

ASC 470-20

If a debt transaction involves other stated or unstated rights or privileges, an issuer must recognize those rights or privileges separately from the debt by allocating or attributing an amount to them upon initial recognition of the debt. For example, ASC 835-30-25-6 specifies that if an issuer extends a three-year loan that pays no interest to a supplier in exchange for cash equal to the face amount of the loan and a right to purchase products from the supplier at a below-market price, a portion of the amount lent equal to the difference between the cash paid and the present value of the receivable must be attributed to the right and added to the cost of the products purchased during the contract term (i.e., the right is accounted for as an asset that is separate from the loan). Although that example applies to the creditor’s accounting, the requirement in ASC 835-30-25-6 to separately recognize other stated or unstated rights or privileges separately from a debt instrument also applies to the debtor (see Section 4.3.4).

To appropriately identify all accounting elements that warrant separate accounting recognition, an issuer may sometimes need to more carefully examine the nature, purpose, and economic substance of a transaction and apply professional judgment. If the effective interest rate that would be computed on the basis of the debt proceeds is unreasonable (e.g., it does not reflect the general level of interest rates, the issuer’s creditworthiness, or an embedded equity conversion feature), the debt’s initial fair value is materially different from the amount of debt proceeds received, or the accounting otherwise appears misleading, the transaction presumptively includes other elements that should be identified and recognized separately from the debt, and appropriate disclosures should be provided. Entities are strongly encouraged to consult with their independent accountants in these circumstances.

At the 2014 AICPA Conference on Current SEC and PCAOB Developments, then SEC Professional Accounting Fellow Hillary Salo noted that entities need to closely evaluate a transaction in which the fair value of the financial liabilities issued exceeds the net proceeds received to determine whether (1) the fair value measurements are appropriate, (2) the transaction is with a related party, or (3) any other identifiable transaction elements exist (see Section 3.4.3.1). She indicated that if no other transaction element can be identified, the difference should be recognized as an expense. Although her remarks focused on liabilities that are accounted for at fair value on a recurring basis, they are also relevant in other situations in which the amount of proceeds initially attributed to a debt issuance (1) would result in an unreasonable effective interest rate or (2) is clearly different from the debt’s fair value at issuance.

Debt transactions with related parties might include a distribution or contribution component (see Section 9.3.7 for a discussion of the accounting for debt extinguishments with related parties). In practice, a pro rata distribution to current equity owners is recognized as an equity transaction (i.e., as a deemed dividend with a debit to retained earnings or other applicable equity account; see Section 9.5.5 of Deloitte’s Roadmap Distinguishing Liabilities From Equity), whereas a non-pro-rata distribution is recognized as a charge to earnings in the period in which the distribution is declared. Accordingly, if a debt transaction involves a payment to a related party that is not attributable to the debt, the recognition of an expense might be required upon issuance unless the payment represents a pro rata distribution to all holders of common stock or equivalent current ownership interests, in which case it may be treated as an equity distribution. Examples of rights or privileges for which separate accounting recognition might be required as an expense in a transaction with a related party include:

A selling shareholder’s agreement to abandon certain acquisition plans, forgo other transactions, settle litigation, settle employment contracts, or voluntarily restrict its ability to purchase shares of the issuer in exchange for consideration from the issuer.
A shareholder or former shareholder’s agreement not to purchase additional shares of the issuer in exchange for a payment (i.e., a “standstill agreement”).

Example 3-7

Debt Issued With Loan Commitment and Warrants

Entity B enters into a credit facility arrangement with a lender for the issuance of a term loan facility in the aggregate principal amount of up to $150 million. The contractual terms specify the issuance of a term loan advance of $5 million at the closing of the agreement. Additional term loan advances are available to B under the arrangement as follows:

Six months after closing, B may request an additional term loan advance from the lender of $45 million if certain financial and operational conditions are met.
One year after closing, B may request an additional term loan advance from the lender of $50 million if certain financial and operational conditions are met.
Two years after closing, B may request an additional term loan advance from the lender of up to $50 million if certain financial and operational conditions are met.

The drawn components of the debt arrangement can be separately transferred by the lender. (Note that the conclusion in this example would not change if the drawn and undrawn components of the debt arrangement represented a single freestanding financial instrument because the additional term loans potentially issuable by B do not have to be recognized as derivatives under ASC 815.)

At the arrangement’s inception, the lender pays $5 million in cash to B, and B gives the lender net-cash settleable warrants on its own stock that have an initial fair value of $7 million. The warrants represent freestanding financial instruments, meet the definition of a derivative in ASC 815, and do not qualify for any scope exception from derivative accounting. Accordingly, they are required to be accounted for at fair value, with changes in fair value recognized in earnings. The initial term loan advance is on market terms for a similar borrower for debt with similar terms (i.e., its fair value is $5 million) and does not meet the definition of a derivative in ASC 815. Further, the fair value of the commitments B has received from the lender to obtain additional term loan advances in the future is $7 million. (This component does not meet the definition of a derivative in ASC 815, but if it did, it would qualify for the scope exception for loan commitments.) The transaction is on arm’s-length terms; economically, B has received cash and loan commitments with an aggregate fair value of $12 million and has issued debt and warrants with an aggregate fair value of $12 million.

If the rights and privileges associated with the loan commitments given by the lender were not separately recognized, the accounting would be misleading. That is, B would need to either (1) reduce the initial carrying amount of the advance to zero and recognize an up-front loss of $2 million even though B has not incurred any economic loss and has an obligation to repay the advance or (2) recognize the advance as an asset of $2 million even though it represents an obligation, since that is the net fair value of the advance and commitments. By analogy to Ms. Salo’s remarks at the 2014 AICPA Conference on Current SEC and PCAOB Developments (see Section 3.4.3.1), it would be appropriate in this example for B to recognize the loan commitments as a component of the proceeds it has received for the advance (i.e., as an asset) separately from the advance. Entity B would make the following accounting entries:

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.