Chapter 3 — Contract Analysis
Chapter 3 — Contract Analysis
3.1 Background
This chapter discusses how an entity should identify and evaluate
contractual terms (see Section
3.2) and units of account (see Section 3.3) as well as the allocation of debt
proceeds and issuance costs to those units of account (see Sections 3.4 and 3.5, respectively).
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.
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:
-
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
-
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:
-
An observable market other than the market for the issuer’s stock
-
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
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).
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:
3.4 Allocation of Proceeds to Units of Account
3.4.1 Background
This section discusses an issuer’s allocation of proceeds among freestanding
financial instruments when those instruments are issued in a single transaction,
including allocation methods (see the next section) and certain application
issues (see Section
3.4.3).
3.4.2 Allocation Methods
3.4.2.1 Background
Generally, an issuer uses one of the following two approaches to allocate
proceeds received upon a debt issuance among freestanding financial
instruments and any other elements that are part of the same transaction:
-
A with-and-without method (also known as a residual method; see Section 3.4.2.2).
-
A relative fair value method (see Section 3.4.2.3).
The appropriate allocation method depends on the accounting
that applies to each freestanding financial instrument issued as part of the
transaction (see Section
3.3.2). The issuer should also consider whether it is
necessary to allocate an amount to any other rights or privileges included
in the transaction (see Section 3.3.3). That is, in the application of these
allocation methods, it is assumed that the proceeds received represent the
aggregate fair value of the instruments issued.
Proceeds are allocated among the freestanding financial
instruments that form part of the same transaction before any amounts are
allocated to component parts of those freestanding financial instruments
(such as an embedded derivative instrument that is bifurcated under ASC
815-15).
After applying the appropriate method for allocating
proceeds among freestanding financial instruments, an entity would evaluate
whether any of those instruments contain embedded derivatives that require
separation under ASC 815-15 (see Chapter 8). If so, it would use the
with-and-without method (see the next section) to separate them from the
host contract (see Section
8.5.3.1).
When a debt issuance involves both the issuance and the receipt of noncash
financial instruments (e.g., an entity issues debt in exchange for cash and
a put option that permits it to sell its own equity shares), the fair value
of the items received represents a component of the proceeds that are
allocated among the financial instruments issued.
3.4.2.2 With-and-Without Method
If one or more, but not all, of the freestanding financial instruments issued
as part of a single transaction must be recognized as assets or liabilities
measured at fair value on a recurring basis (e.g., one of the instruments is
accounted for as a derivative instrument under ASC 815 or at fair value
under the fair value option in ASC 825-10; see Section 4.4), the issuer should use the with-and-without
method to allocate the proceeds among the freestanding financial
instruments. This approach is analogous to the allocation method for
bifurcated embedded derivatives in ASC 815-15-30-2 and 30-3 (see
Section 8.5.3.1).
Under the with-and-without method, a portion of the proceeds equal to the
fair value of the instrument (or instruments) measured at fair value on a
recurring basis is first allocated to that instrument (or instruments) on
the basis of its fair value as of the initial measurement date. The
remaining proceeds are then allocated to the other instrument(s) issued in
the same transaction either on a residual basis, if there is only one
remaining instrument, or by using a relative fair value approach if there
are multiple remaining instruments. The with-and-without allocation approach
avoids the recognition of a “day 1” gain or loss in earnings that is not
associated with a change in the fair value of the instrument(s) subsequently
measured at its fair value. Under this approach, if there is only one
freestanding financial instrument to which the residual proceeds are
allocated, the issuer is not required to estimate that instrument’s fair
value.
Example 3-8
Debt Issued With Liability-Classified
Warrants
Entity C issues debt to Entity B, together with a
detachable and separately transferable warrant, for
total proceeds of $10,000, which is also the par
amount of the debt. The warrant gives the holder the
right to purchase shares issued by C, which are
redeemable for cash at the holder’s option. Entity C
determines that the debt and the warrant represent
separate freestanding financial instruments.
Rather than electing to account for
the debt by using the fair value option in ASC
825-10 (see Section 4.4), C
will account for it at amortized cost by using the
interest method in ASC 835-30 (see Section
6.2). In evaluating whether the warrant
is within the scope of ASC 480, C determines that
the warrant is a freestanding financial instrument
that embodies an obligation to repurchase the
issuer’s equity shares and that the issuer may be
required to settle the obligation by transferring
assets. In a manner consistent with the guidance in
ASC 480, C will account for the warrant as a
liability that is measured both initially and
subsequently at fair value, with changes in fair
value recognized in earnings (see Chapter
5 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity). Entity C estimates that
the initial fair value of the warrant is $2,000.
In determining the initial carrying amounts, C
allocates the proceeds received between the debt and
the warrant. Because the warrant, but not the debt,
will be measured at fair value, with changes in fair
value recognized in earnings, C should first measure
the fair value of the warrant ($2,000) and allocate
that amount to the warrant liability. The amount of
proceeds allocated to the debt is the difference
between the total proceeds received ($10,000) and
the fair value of the warrant ($2,000). The
resulting discount from the par amount of the debt
($2,000) is accreted to par by using the
effective-interest method in ASC 835-30 (see
Section
6.2).
3.4.2.3 Relative Fair Value Method
The relative fair value method is appropriate if either of the following
applies: (1) none of the freestanding financial instruments issued as part
of a single transaction are measured at fair value, with changes in fair
value recognized in earnings on a recurring basis, or (2) after the entity
uses the with-and-without method to measure freestanding financial
instruments at fair value, more than one freestanding financial instrument
remains. To apply the relative fair value method, the entity allocates the
proceeds (or remaining proceeds after using the with-and-without method) on
the basis of the fair values of each freestanding financial instrument at
the time of the instrument’s issuance. ASC 470-20-25-2 requires an entity to
use the relative fair value approach to allocate proceeds in certain
transactions involving debt and detachable warrants (see Section 3.4.3.2). The approach is also
appropriate for other transactions that involve freestanding financial
instruments not measured at fair value on a recurring basis.
Under the relative fair value method, the issuer makes separate estimates of
the fair value of each freestanding financial instrument and then allocates
the proceeds in proportion to those fair value amounts (e.g., if the
estimated fair value of one of the instruments is 20 percent of the sum of
the estimated fair values of each of the instruments issued in the
transaction, 20 percent of the proceeds would be allocated to that
instrument). Because the issuer needs to independently measure each
freestanding financial instrument issued as part of the transaction, more
fair value estimates must be made under the relative fair value method than
under the with-and-without method.
In some transactions involving the issuance of more than two freestanding
financial instruments, both the with-and-without method and the relative
fair value method will apply. For example, if one freestanding financial
instrument is measured at fair value on a recurring basis and others are
not, the freestanding financial instrument that is subsequently measured at
fair value on a recurring basis should be initially measured at its fair
value, and the remaining amount of proceeds should be allocated among the
freestanding financial instruments not subsequently measured at fair value
on the basis of their relative fair values.
When a debt transaction involves both the issuance of financial instruments
and the receipt of noncash financial assets (e.g., tranche debt financings
that include the issuance of debt and the receipt of loan commitments), the
fair value of the noncash financial assets received may be treated as part
of the total proceeds received. Under this approach, the sum of the amount
of cash proceeds and the fair value of the noncash financial assets received
is allocated on a relative fair value basis to the financial instruments
issued.
After using the appropriate method(s) to allocate the proceeds to the
freestanding financial instruments, the entity should separate any component
parts from an individual freestanding financial instrument in accordance
with applicable GAAP (e.g., embedded derivatives).
3.4.3 Application Issues
3.4.3.1 Fair Value Exceeds Debt Proceeds
Sometimes the estimated fair value as of the issuance date of the liabilities
that are subsequently accounted for at fair value (e.g., debt that is
accounted for under the fair value option in ASC 825-10 and detachable
warrants that are accounted for as derivatives under ASC 815) exceeds the
amount of net debt proceeds received.
Example 3-9
Fair Value of
Instruments Exceeds Proceeds Received
Entity Y issues debt and detachable
warrants for $100 million of cash proceeds. It
elects to account for the debt at fair value under
the fair value option in ASC 825-10, and it accounts
for the warrants as derivatives at fair value under
ASC 815. The total estimated fair value of the debt
and the warrants is $120 million as of the issuance
date.
At the 2014 AICPA Conference on Current SEC and PCAOB
Developments, then SEC Professional Accounting Fellow Hillary Salo stated,
in part:
[T]he staff understands that there are substantive
reasons reporting entities may enter into these types of
arrangements, including circumstances in which alignment with a
particular investor is viewed as beneficial to the reporting entity
or because a reporting entity is in financial distress and requires
financing. For example, assume a reporting entity that wants to
align itself with a specific investor issues $10 million of
convertible debt at par and is required to bifurcate an in the money
conversion option with a fair value of $12 million. In this case,
the fair value of the financial liability required to be measured at
fair value (that is, the embedded derivative) exceeds the net
proceeds received under the transaction.
Ms. Salo advised entities to apply judgment and perform the following steps
in determining the appropriate accounting for “these types of unique fact
patterns”:
-
“[V]erify that the fair values of the financial liabilities required to be measured at fair value are appropriate under Topic 820.”Connecting the DotsAn entity must apply the fair value measurement requirements in ASC 820 when calculating estimated values. For a detailed discussion of the requirements in ASC 820, see Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the Fair Value Option).
-
“[E]valuate whether the transaction was conducted on an arm’s length basis, including an assessment as to whether the parties involved are related parties under Topic 850.”Connecting the DotsAs noted in ASC 820-10-35-3, a “fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date under current market conditions.” Under ASC 820-10-20, market participants are parties that are independent of each other (i.e., not related parties). Circumstances in which the transaction price may not represent fair value include transactions between related parties and those taking place under duress or in which the entity was forced to accept the transaction price because of financial difficulties.In practice, pro rata distributions to equity owners are recognized as equity transactions (i.e., as a deemed dividend with a debit to retained earnings or other applicable equity account), whereas non-pro-rata distributions are recognized as a charge to earnings in the period in which the distribution is declared. Accordingly, if a wholly owned subsidiary issues debt to its parent, any excess of the fair value of the instruments issued over the proceeds received might represent a deemed dividend from the subsidiary to the parent. If a related-party transaction represents a non-pro-rata distribution, however, expense recognition may be appropriate.In her speech, Ms. Salo emphasized that transactions that are not at arm’s length or are entered into with a related party “require significant judgment; therefore, [the SEC staff] would encourage consultation with OCA in those circumstances.”
-
“[E]valuate all elements of the transaction to determine if there are any other rights or privileges received that meet the definition of an asset under other applicable guidance.”Connecting the DotsIf a transaction is conducted on an arm’s-length basis and the total fair value of the liabilities measured at fair value exceeds the proceeds received, an entity should carefully evaluate whether the difference is attributable to some other transaction element that qualifies for accounting recognition (e.g., separate freestanding financial instruments, other rights or privileges, or transaction costs; see Section 3.3.3). If so, those elements should be recognized separately (e.g., as an asset or expense in accordance with other applicable GAAP). Under ASC 505-30, there is a presumption that a purchase of shares at a price significantly in excess of the open market price includes other elements for which separate accounting is required.
If an entity, after performing these steps, determines that no other
transaction elements can be identified, the excess of the fair value over
the proceeds is recognized as an expense (an up-front loss). Ms. Salo
indicated that the SEC staff expects “clear and robust disclosure of the
nature of the transaction, including reasons why the entity entered into the
transaction and the benefits received.”
Connecting the Dots
The above guidance may also be relevant when the aggregate fair value
of the debt and other instruments issued exceeds the proceeds and
some of the instruments issued are not subsequently accounted for at
fair value.
3.4.3.2 Debt With Detachable Warrants
ASC 470-20
25-2 Proceeds from the
sale of a debt instrument with stock purchase
warrants (detachable call options) shall be
allocated to the two elements based on the relative
fair values of the debt instrument without the
warrants and of the warrants themselves at time of
issuance. The portion of the proceeds so allocated
to the warrants shall be accounted for as paid-in
capital. The remainder of the proceeds shall be
allocated to the debt instrument portion of the
transaction. This usually results in a discount (or,
occasionally, a reduced premium), which shall be
accounted for under Topic 835.
25-3 The same accounting
treatment applies to issues of debt instruments
(issued with detachable warrants) that may be
surrendered in settlement of the exercise price of
the warrant. However, if 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 and the accounting specified in paragraph
470-20-25-12 shall apply.
30-1 The allocation of
proceeds under paragraph 470-20-25-2 shall be based
on the relative fair values of the two instruments
at time of issuance.
30-2 When detachable warrants
(detachable call options) are issued in conjunction
with a debt instrument as consideration in purchase
transactions, the amounts attributable to each class
of instrument issued shall be determined separately,
based on values at time of issuance. The debt
discount or premium shall be determined by comparing
the value attributed to the debt instrument with the
face amount thereof.
When an entity issues debt together with detachable stock
purchase warrants that represent separate freestanding financial instruments
(see Section
3.3.2), the proceeds received must be allocated between the
debt and the warrants. Although ASC 470-20-25-2 may appear to suggest that
the relative fair value method should always be applied to debt issued
together with detachable warrants, the scope of this guidance is limited to
situations in which (1) the warrants are classified as equity and the debt
is not subsequently measured at fair value on a recurring basis and (2)
there are no other transaction elements that must be accounted for
separately (e.g., other stated or unstated rights or privileges). While ASC
470-20-25-2 suggests that the amounts allocated to detachable warrants
should be accounted for as paid-in capital, that guidance conflicts with
other GAAP under which entities must classify certain contracts on the
entity’s own equity as assets or liabilities (e.g., ASC 480 and ASC 815).
Neither ASC 480 nor ASC 815 exempts detachable warrants on the issuer’s
equity shares that are classified as assets or liabilities from the initial
recognition guidance within those topics.
An entity should account for the portion of the proceeds
allocated to the warrants as paid-in capital only if the warrants qualify
for classification as equity instruments. If warrants must be classified as
a liability under ASC 480, ASC 815-40, or other GAAP, the entity should
account for the amount attributable to them under that guidance.
Accordingly, an entity should not rely solely on the guidance in ASC
470-20-25-2 and 25-3 when classifying detachable warrants as liabilities or
equity or when allocating proceeds between debt and detachable warrants. For
a discussion of how to determine the appropriate classification and
measurement of a detachable warrant, see Deloitte’s Roadmaps Contracts on an Entity’s Own
Equity and Distinguishing Liabilities From
Equity.
The following table provides
an overview of the appropriate allocation of proceeds between debt and
detachable warrants at initial recognition:
Warrant Accounted for at Fair Value, With Fair Value
Changes Recognized in Earnings
|
Warrant Classified as Equity
| |
---|---|---|
Debt accounted for at amortized cost
|
With-and-without method (i.e.,
warrant is measured initially at fair value and debt
is measured as the residual; see Section
3.4.2.2). If it is determined that the
transaction price for the debt and warrants does not
represent fair value, special considerations are
necessary.
|
Relative fair value method (see
Section 3.4.2.3). If it is determined
that the transaction price for the debt and warrants
does not represent fair value, special
considerations are necessary.
|
Debt accounted for at fair value, with changes in
fair value recognized in earnings
|
Debt is measured initially at fair
value. If the initial fair values of the debt and
warrants, in the aggregate, exceed the proceeds
received, special considerations are necessary (see
Section 3.4.3.1).
|
With-and-without method (i.e., debt
is measured initially at fair value and warrant is
measured as the residual; see Section
3.4.2.2). If it is determined that the
transaction price for the debt and warrants does not
represent fair value, special considerations are
necessary.
|
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
____________________
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 entries would be
as follows:
Footnotes
1
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.