3.5 Allocation of Issuance Costs to Units of Account

3.5.1 Background

This section discusses (1) how an issuer should allocate issuance costs among freestanding financial instruments when those instruments are issued in a single transaction (see the next section) and (2) certain application issues (see Section 3.5.3). For a discussion of what qualifies as a debt issuance cost, see Section 5.2.

3.5.2 Allocation Methods

On the basis of their specific facts and circumstances, entities should consistently apply a systematic and rational method for allocating issuance costs among freestanding financial instruments that form part of the same transaction.

If the proceeds are allocated solely on the basis of the relative fair value method, the related issuance costs should also be allocated on that basis, which is consistent with the guidance in SAB Topic 2.A.6 (see Section 3.5.3.3).

Connecting the Dots

An entity may issue debt and enter into a loan commitment with the same counterparty at the same time. In such a case, the amount of proceeds allocated to the loan commitment may be nominal. When the entity applies the relative fair value method, it would therefore be appropriate to allocate issuance costs on the basis of the relative amount of costs that would have been incurred if the two freestanding financial instruments had been entered into separately. For example, assume that an entity incurs total issuance costs of $10 million for the issuance of $200 million in debt and a commitment to enter into an additional $100 million of debt. The entity estimates that if it had issued the instruments separately, it would have incurred issuance costs of $8 million and $6 million for the debt issuance and loan commitment, respectively. Therefore, it would allocate $5.7 million of issuance costs to the debt (i.e., $10 million × [$8 million ÷ $14 million]) and $4.3 million of issuance costs to the loan commitment (i.e., $10 million × [$6 million ÷ $14 million]).

If an entity allocates the proceeds by using the with-and-without method (including allocation to a freestanding financial instrument that contains an embedded derivative that must be bifurcated from its host contract), one of the following two methods is generally appropriate in the allocation of the related issuance costs:

The relative fair value method — The entity allocates issuance costs on the basis of the relative fair values of the freestanding financial instruments by analogy to ASC 470-20-25-2. SAB Topic 2.A.6 (see Section 3.5.3.3) states that this method should be applied in the allocation of costs between services received “[w]hen an investment banker provides services in connection with a business combination or asset acquisition and also provides underwriting services associated with the issuance of debt or equity securities.” However, if no proceeds are allocated to the debt under the with-and-without method, the entity expenses as incurred any issuance costs allocated to the debt under the relative fair value method because presenting a debt liability as an asset would be inappropriate.
An approach that is consistent with the allocation of proceeds — The entity allocates issuance costs in proportion to the allocation of proceeds between the freestanding financial instruments (see Section 3.4.2).

The method used should be applied consistently to similar transactions. Any issuance costs allocated to a freestanding or an embedded financial instrument that is subsequently measured at fair value through earnings must be expensed as of the issuance date (see, for example, ASC 825-10-25-3). For additional discussion of the allocation of issuance costs, see Section 3.3.4.4 of Deloitte’s Roadmap Distinguishing Liabilities From Equity.

3.5.3 Application Issues

3.5.3.1 Credit Facilities With Both Revolving and Nonrevolving Components

An entity might incur costs and fees to obtain a credit facility that includes both revolving- and nonrevolving-debt components. The portion of the costs and fees that are allocated to the nonrevolving component is deferred as an asset before the issuance of debt and reduces the initial net carrying amount of any debt drawn in proportion to such drawn amount (see Section 5.3). The portion allocated to the revolving component is treated as a cost or fee to obtain a line-of-credit or revolving-debt arrangement (see Section 5.4). If a portion of the costs and fees paid is attributable to services received that are not directly related to the debt arrangement, that portion is allocated to those services (see Section 3.5.3.3).

3.5.3.2 Transactions That Involve the Receipt of Noncash Financial Assets

When a debt issuance transaction involves the receipt of noncash financial assets by the issuing entity (e.g., tranche debt financings that include the issuance of debt and the receipt of loan commitments at inception), the related issuance costs may be allocated in one of two ways:

Only to the financial liability (and any equity instruments) issued. No costs are allocated to the noncash financial assets received since they form part of the proceeds received, which are allocated to the financial instruments issued.
Both to the noncash financial assets received and to the financial liabilities (and any equity instruments) issued, without regard to whether the fair values are positive or negative (i.e., by using absolute values). Costs and fees are allocated to noncash financial assets on the basis that transaction costs would have been incurred in a stand-alone transaction for those assets.

Example 3-10

Tranche Debt Financing With Warrants

Entity S enters into a tranche debt financing arrangement with an investment firm. On the initial closing date, S issues to the investment firm a note payable with a principal amount of $30 million and warrants on its own stock. In exchange, S receives cash proceeds of $30 million and a loan commitment under which it may draw up to $200 million of additional notes if certain business milestones are met. In addition, S incurs $3.2 million of third-party costs directly attributable to the financing arrangement.

Entity S determines that the note payable, the warrants, and the loan commitment represent separate units of account. It engages a valuation specialist that provides the following fair value estimates:

Note payable — $16,532,595.
Loan commitment — $38,385,821.
Warrants — $51,853,226.

Entity S does not elect to account for the notes by using the fair value option in ASC 825-10 and has a policy of allocating issuance costs on a relative fair value basis under ASC 470-20-25-2 (see Section 3.4.2.3). Entity S can elect to use either of the following approaches to allocate the issuance costs:

Approach 1 — Allocate Third-Party Issuance Costs Only to the Debt and Warrants

Under this approach, the proceeds received after deduction of third-party costs are allocated to the debt and warrants on the basis of their relative fair values. No third-party costs are allocated to the loan commitment asset, since that asset forms part of the proceeds received.

Approach 2 — Allocate Third-Party Issuance Costs to the Debt, Warrants, and Loan Commitment Asset

Under this approach, third-party costs are allocated to the debt, warrants, and loan commitment asset on the basis of their relative fair values without regard to whether the fair values are positive or negative (i.e., by using absolute values). The allocation of some of the third-party costs to the loan commitment asset is also consistent with the treatment of transaction costs associated with financial assets that are not classified as held for trading (i.e., if only a loan commitment had been obtained, there could have been third-party costs that would be capitalizable).

Note that since it would be inappropriate to allocate negative third-party costs to the loan commitment asset, an entity determines the relative fair values on the basis of the absolute amounts of the items. In this example, because the fair value of the proceeds received equals that of the financial instruments issued, the use of the relative fair value allocation method does not affect the allocation of proceeds to the financial instruments issued.

3.5.3.3 Interim Bridge Financing and Other Services

SEC Staff Accounting Bulletins

SAB Topic 2.A.6, Debt Issue Costs in Conjunction With a Business Combination [Reproduced in ASC 340-10-S99-2]

Facts: Company A is to acquire the net assets of Company B in a transaction to be accounted for as a business combination. In connection with the transaction, Company A has retained an investment banker to provide advisory services in structuring the acquisition and to provide the necessary financing. It is expected that the acquisition will be financed on an interim basis using “bridge financing” provided by the investment banker. Permanent financing will be arranged at a later date through a debt offering, which will be underwritten by the investment banker. Fees will be paid to the investment banker for the advisory services, the bridge financing, and the underwriting of the permanent financing. These services may be billed separately or as a single amount.

Question 1: Should total fees paid to the investment banker for acquisition-related services and the issuance of debt securities be allocated between the services received?

Interpretive Response: Yes. Fees paid to an investment banker in connection with a business combination or asset acquisition, when the investment banker is also providing interim financing or underwriting services, must be allocated between acquisition related services and debt issue costs.

When an investment banker provides services in connection with a business combination or asset acquisition and also provides underwriting services associated with the issuance of debt or equity securities, the total fees incurred by an entity should be allocated between the services received on a relative fair value basis. The objective of the allocation is to ascribe the total fees incurred to the actual services provided by the investment banker.

FASB ASC Topic 805, Business Combinations, provides guidance for the portion of the costs that represent acquisition-related services. The portion of the costs pertaining to the issuance of debt or equity securities should be accounted for in accordance with other applicable GAAP.

Question 2: May the debt issue costs of the interim “bridge financing” be amortized over the anticipated combined life of the bridge and permanent financings?

Interpretive Response: No. Debt issue costs should be amortized by the interest method over the life of the debt to which they relate. Debt issue costs related to the bridge financing should be recognized as interest cost during the estimated interim period preceding the placement of the permanent financing with any unamortized amounts charged to expense if the bridge loan is repaid prior to the expiration of the estimated period. Where the bridged financing consists of increasing rate debt, the guidance issued in FASB ASC Topic 470, Debt, should be followed.1

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1 As noted in FASB ASC paragraph 470-10-35-2, the term-extending provisions of the debt instrument should be analyzed to determine whether they constitute an embedded derivative requiring separate accounting in accordance with FASB ASC Topic 815, Derivatives and Hedging.

SAB Topic 2.A.6 (reproduced in ASC 340-10-S99-2) addresses an entity’s accounting for fees paid to an investment bank to obtain interim bridge financing and other services in connection with an acquisition that will be accounted for as a business combination. The fees paid represent consideration for multiple items received, including (1) interim bridge financing to help the entity pay for the acquisition, (2) underwriting services related to a future debt offering to finance the acquisition on a more permanent basis, and (3) acquisition-related advisory services. Under this guidance, an entity must allocate the fees paid between the different components (i.e., the bridge financing, the underwriting services, and the acquisition-related services) on a relative fair value basis.

Although the debtor may anticipate that the interim bridge financing will be replaced by permanent debt financing, the costs allocated to the interim bridge financing are amortized over the estimated life of the interim financing. Any remaining unamortized costs attributed to the interim bridge financing are charged to earnings once the bridge financing is repaid. Those costs cannot be treated as an issuance cost of the subsequent debt offering.

Connecting the Dots

In the SAB Topic 2.A.6 fact pattern, the short-term debt with an investment bank will be replaced by long-term debt with other third parties (i.e., the counterparties of the short- and long-term debt instruments differ). However, an entity can use other types of financing arrangements to complete a business combination, including financing obtained on a short-term basis that contractually extends to long-term financing if the acquisition is consummated. For example, assume that an entity obtains a loan from a third party with a short-term maturity date that, according to its contractual terms, will be replaced with long-term financing from the same counterparty if a business combination is consummated on or before the stated maturity date of the short-term financing. The interest rate on the short-term and long-term components of the financing are the same. The entity issues the short-term financing at a 10 percent discount to its stated principal amount. No additional costs or fees are paid by the entity if the short-term financing is replaced by the long-term financing. The discount paid for the short-term financing represents a fee paid for the overall financing arrangement. In this example, the bridge financing guidance in SAB Topic 2.A.6 does not apply. Rather, the entity has, in substance, obtained long-term financing that is puttable by the holder if a proposed acquisition does not occur by a stated date. Regardless of whether the short-term and long-term components of the overall arrangement legally comprise one loan or two, the entity should account for the financing arrangement as contingently puttable long-term debt. Therefore, the discount incurred at inception is related to the overall arrangement and not just the short-term component.

3.5.3.4 Unit Structures

A unit structure issued with debt represents a combination of (1) a debt instrument and (2) a variable-share forward (VSF) contract to issue common shares or an option to issue common shares to the counterparty. An entity must evaluate the terms of these types of issuances to determine whether the debt instrument and equity-linked instrument constitute a single combined unit of account or two separate units of account. While the specific facts and circumstances of each individual unit structure must be considered, these structures will generally consist of separate units of account for the debt instrument and the equity-linked instrument because the two instruments are legally detachable and separately exercisable. The example below illustrates the accounting for the issuance and redemption of such structures.

Example 3-11

Issuance and Redemption of Unit Structure

Issuance

Entity A issues 10-year, $100 par units for $100 per unit. Each unit consists of the following two securities that were issued together but can be separately transferred by the holders:

A senior note payable that has a 10-year maturity and a principal amount of $100 per unit. The note pays interest at a fixed rate of 8 percent annually (i.e., $8 annually) and is subject to a mandatory remarketing at the end of eight years.
A VSF contract that pays the holder contract adjustment payments and obligates the holder to purchase a variable number of A’s common shares for $100 per unit in eight years, as follows:1
- If the 30-day volume-weighted average share price is equal to or greater than $105, the holder receives 0.95 shares for $100.
- If the 30-day volume-weighted average share price is equal to or less than $90, the holder receives one share for $100.
- If the 30-day volume-weighted average share price is between $90 and $105, the holder receives a variable number of shares equal to $100 divided by the stock price for $100.

The contract payment obligation requires A to make a cash payment each year for 10 years equal to 3 percent times the stated amount of $100 per unit (i.e., $3 annually). Such obligation represents a financing of the net premium that A would have otherwise had to pay to enter into the VSF contract.

Assume that A has evaluated the unit structure and determined that the senior note payable and VSF contract are separate units of account. Furthermore, assume that the VSF contract meets the conditions in ASC 815-40 to be classified within equity and that A has not elected to apply the fair value option to the senior note payable.

Entity A should allocate the proceeds received between the senior note payable and the VSF contract (including the contract payment obligation) in proportion to their relative fair values at issuance. If the net fair value of the VSF contract (including the contract payment obligation) is zero, A would allocate the entire $100 proceeds per unit to the liability associated with the senior note payable.

In addition, A should determine the fair value of the contract payment obligation at issuance (e.g., by using a discounted cash flow technique in accordance with ASC 820) and classify that amount as a liability with an offsetting reduction in stockholders’ equity. Assuming that the fair value of the contract payment obligation is $20, A would recognize the following journal entry upon issuance of the units (per unit):

After issuance, A should (1) accrue interest on the contract payment obligation (i.e., the difference between the $20 initial carrying amount and the undiscounted amount of the contract payments) by using the interest method and (2) report that amount as interest expense. Because the VSF contract is classified in equity, A should not remeasure it after issuance (see ASC 815-40-35-2).

Redemption

If A subsequently repurchases the units for cash before their settlement dates, it should recognize an extinguishment of debt for the two liabilities (i.e., the senior note payable and the contract payment obligation) and a settlement of the equity-classified VSF contract (i.e., excluding the contract payment obligation). The calculation of the debt extinguishment gain or loss will depend on whether the equity-classified VSF contract has a positive or negative fair value to A.

If the equity-classified VSF contract has a positive fair value to A, the reacquisition price paid by A to extinguish the two liabilities equals the sum of the cash paid and the fair value of the equity-classified VSF contract at settlement. In this circumstance, A effectively is using both cash and the fair value of the VSF contract as consideration to extinguish its two liabilities. If the equity-classified VSF contract has a negative fair value to A, the reacquisition price paid by A to extinguish the two liabilities equals the cash paid less the fair value of the equity-classified VSF contract at settlement. In this circumstance, part of the cash paid by A effectively is consideration to settle the negative fair value of the equity-classified VSF contract. The difference between the reacquisition price calculated as described above and the aggregate carrying amount of the two liabilities should be recognized as a debt extinguishment gain or loss in accordance with ASC 470-50-40-2.

If the equity-classified VSF contract has a positive fair value to A, its fair value would be credited to equity upon settlement (and, as described above, result in an increase in the reacquisition price paid to extinguish the two liabilities). If the equity-classified VSF contract has a negative fair value to A, its fair value would be debited to equity upon settlement (and, as described above, result in a decrease in the reacquisition price paid to extinguish the two liabilities).

Assume that A repurchases the units before maturity by making a cash payment of $105 per unit to each unitholder. At the time of the repurchase, the carrying amounts are as follows (per unit):

Senior note payable: $100.
Contract payment obligation: $14.

The fair value of the VSF contract (i.e., excluding the contract payment obligation) on the date of repurchase is $3 and is positive to A.

Entity A would recognize a $6 debt extinguishment gain as a result of the settlement of the equity unit structure. The debt extinguishment gain is calculated as follows: aggregate carrying amount of the debt of $114 ($100 and $14), less the reacquisition price paid of $108 (i.e., the $105 in cash consideration plus the $3 fair value of the equity-classified derivative component of the VSF). The fair value of the equity-classified VSF contract (excluding the contract payment obligation) is included in the reacquisition price paid because the holder would have had to pay A $3 to settle the contract if it had been settled separately. In other words, A is using the settlement of the equity-classified VSF contract as partial consideration for the repurchase of the two liabilities.

Entity A’s journal entry would be as follows:

Footnotes

Economically, the VSF contract’s payoffs are structured as if A had purchased a put option and written a call option on its own common shares.

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.