Chapter 4 — Initial Recognition and Measurement of Debt
Chapter 4 — Initial Recognition and Measurement of Debt
4.1 Background
Debt is initially recognized on the settlement date (see Section 4.2). There is a
presumption that debt issued solely in exchange for cash should be initially
recognized at the amount of cash proceeds received (see Section 4.3.4). However, an entity should
evaluate debt that is issued in exchange for property, goods, or services to
determine whether to initially measure it at (1) its face amount or (2) the present
value of the cash flows, discounted by using an imputed interest rate (i.e., at fair
value under ASC 820) (see Section
4.3.5). Any difference between the debt’s initial carrying amount and
stated principal amount represents a discount or premium (see Section 4.3.6). In addition,
any debt for which the issuer elects the fair value option in ASC 815-15 or ASC
825-10 is initially measured at its fair value, with any up-front costs or fees
incurred recognized immediately in earnings (see Section 4.4).
4.2 Recognition Date
In practice, debt liabilities are initially recognized on the settlement date (i.e.,
the date on which the debtor receives the related proceeds such as cash or other
financial or nonfinancial assets) as opposed to the date on which the debt is priced
or the parties enter into a binding agreement to issue it.
The debt’s settlement date may differ from the date on which any related hedging transaction is recognized. In FASB Statement 133 Implementation Issue No. E23 (not
codified), the Basis for Conclusions states, in part:
It is customary for a debtor or investor to enter into an at-market interest
rate swap at the date the issuance or purchase of an interest-bearing asset
or liability is firmly committed to and priced (referred to herein as the
trade date), because at that date the debtor or investor begins to be
exposed to changes in interest rates. The debt obligation often is not
recognized for financial reporting purposes until it is issued several
days later (on the settlement date). Consequently, if a hedging
relationship is designated on the trade date, the hedged item may not yet be
a recognized asset or liability. [Emphasis added]
If an entity enters into an agreement that requires or permits it to issue debt in
the future, it should consider whether it must recognize that agreement as a
derivative under ASC 815-10 until the debt is funded. Usually, such contracts are
not within the scope of the accounting requirements for derivatives because ASC 815
contains a scope exception for loan commitments (see Section 2.3.3), and the contract might not meet the net settlement
characteristic in the definition of a derivative (see Section
8.3.4.4). If an entity incurs costs and fees associated with a future
debt issuance or a commitment that requires or permits it to issue debt in the
future, it may need to capitalize such costs and fees as an asset (see Chapter 5).
4.3 Debt Subject to ASC 835-30
4.3.1 Background
ASC 835-30 provides guidance on the initial measurement of debt
for which the issuer has not elected the fair value option in ASC 815-15 (see
Section 8.5.6)
or ASC 825-10 (see Section
4.4). Certain types of payables are exempt from the scope of this
guidance (see the next section). While debt is initially measured at the present
value of the debt’s contractual cash flows (see Section 4.3.3), the initial measurement
guidance in ASC 835-30 on debt issued in exchange for cash (see Section 4.3.4) is
different from that on debt issued in exchange for property, goods, or services
(see Section
4.3.5). Section
4.3.6 describes the concepts of discount and premium.
4.3.2 Scope
ASC 835-30
15-3 With the exception of
guidance in paragraphs 835-30-45-1A through 45-3
addressing the presentation of discount and premium in
the financial statements, which is applicable in all
circumstances, and the guidance in paragraphs
835-30-55-2 through 55-3 regarding the application of
the interest method, the guidance in this Subtopic does
not apply to the following:
- Payables arising from transactions with suppliers in the normal course of business that are due in customary trade terms not exceeding approximately one year
- Amounts that do not require repayment in the future, but rather will be applied to the purchase price of the property, goods, or service involved . . .
- Amounts intended to provide security for one party to an agreement (for example, security deposits, retainages on contracts)
- The customary cash lending activities and demand or savings deposit activities of financial institutions whose primary business is lending money
- Transactions where interest rates are affected by the tax attributes or legal restrictions prescribed by a governmental agency (for example, industrial revenue bonds, tax exempt obligations, government guaranteed obligations, income tax settlements)
- Transactions between parent and subsidiary entities and between subsidiaries of a common parent
- The application of the present value measurement (valuation) technique to estimates of contractual or other obligations assumed in connection with sales of property, goods, or service, for example, a warranty for product performance
- Receivables, contract assets, and contract liabilities in contracts with customers, see paragraphs 606-10-32-15 through 32-20 for guidance on identifying a significant financing component in a contract with a customer.
The initial measurement guidance in ASC 835-30 applies to both receivables and
payables other than items (1) for which the entity has elected the fair value
option in ASC 815-15 (see Section 8.5.6) or ASC 825-10 (see
Section 4.4) or (2) that meet one or
more of the scope exceptions in ASC 835-30. ASC 835-30-15-3 includes the
following scope exceptions:
-
Payables resulting from the purchase of goods or services from suppliers in the normal course of business on customary terms not exceeding approximately one year (i.e., trade payables).
-
Payables to a parent, subsidiary, or entity under common control.
-
Debt that has an interest rate that is “affected by the tax attributes or legal restrictions prescribed by a governmental agency” such as “industrial revenue bonds, tax exempt obligations, government guaranteed obligations, [and] income tax settlements.”
- Certain obligations associated with sales of property, goods, or services:
-
Amounts that will be applied as a reduction to the price of property, goods, or services, such as deposits, advances, and progress payments (see Deloitte’s Roadmap Revenue Recognition for a discussion of the accounting for revenue contracts with a significant financing component).
-
Warranties for product performance and other obligations assumed in connection with sales of property, goods, or services.
-
Contract liabilities (i.e., “an entity’s obligation to transfer goods or services to a customer for which the entity has received consideration from the customer”; see Deloitte’s Roadmap Revenue Recognition).
-
- Security deposits.
- Customary cash lending activities and demand or savings deposit activities of financial institutions.
4.3.3 Present Value Concepts
A key concept in ASC 835-30 is that the initial measurement of
debt represents the present value of the debt’s principal and interest cash
flows, discounted by using an appropriate interest rate. As discussed in
Section 2.3.1.1
of Deloitte’s Roadmap Fair
Value Measurements and Disclosures (Including the Fair Value
Option), when a note payable (i.e., debt) is initially
recognized on the basis of a present value technique under ASC 835-30, the
measurement is a fair value measurement subject to the guidance in ASC 820.
If debt is issued solely for cash and no other rights or
privileges are involved, there is a presumption that present value equals the
cash proceeds received (see Section 4.3.4). In this circumstance, the debtor identifies the
appropriate discount rate (i.e., the debt’s effective interest rate) by equating
the cash proceeds received to the debt’s contractual cash flows (see Section 6.2.3.3). If debt
is issued in exchange for property, goods, or services, however, the stated
interest rate may not be an appropriate discount rate (see Section 4.3.5.1).
Consequently, if interest is imputed at an appropriate rate (i.e., the debt’s
contractual cash flows are discounted by using an appropriate imputed discount
rate that differs from the stated interest rate), the debt is recognized at a
discount or premium (see Section 4.3.6). The discount or premium represents the
difference between the principal amount of the debt and the present value of the
contractual cash flows, calculated by using a discount rate that is appropriate
in the circumstances.
ASC 835-30
Example 1:
Illustration of Present Value Concepts
55-4 This Example illustrates
the guidance in paragraphs 835-30-05-2, 835-30-25-3
through 25-4, and 835-30-25-10 through 25-11 that the
coupon or stated rate of interest and the face amount of
a note or bond may not be the appropriate bases for
valuation. The presumption that market values provide
the evidence for valuation must be overcome before using
coupon or stated rates and face or maturity amounts as
the bases for accounting.
55-5 Upon issuance of a note or
bond, the issuer customarily records as a liability the
face or principal amount of the obligation. Ordinarily,
the recorded liability also represents the amount that
is to be repaid upon maturity of the obligation. The
value recorded in the liability account, however, may be
different from the proceeds received or the present
value of the obligation at issuance if the market rate
of interest differs from the coupon rate of interest.
For example, consider the issuance of a $1,000, 20-year
bond that bears interest at 10% annually. If we assume
that 10% is an appropriate market rate of interest for
such a bond, the proceeds at issuance will be $1,000.
The bond payable would be recorded at $1,000, which
represents the amount repayable at maturity and also the
present value at issuance, which is equal to the
proceeds. However, under similar circumstances, if the
prevailing market rate were more (less) than 10%, a
20-year 10% bond with a face amount of $1,000 would
usually have a value at issuance and provide cash
proceeds of less (more) than $1,000. The significant
point is that, upon issuance, a bond is valued at the
present value of the future coupon interest payments
plus the present value of the future principal payments
(face amount). These two sets of future cash payments
are discounted at the prevailing market rate of interest
(for an equivalent security) at the date of issuance of
the debt. As the 8% and 12% columns show, premium or
discount arises when the prevailing market rate of
interest differs from the coupon rate.
55-6 In the case of a $1,000
non-interest-bearing 20-year note, where the prevailing
market rate for comparable credit risks is 10%, the
following valuation should be made.
55-7 Comparison of the two
tables shows the significant impact of interest.
4.3.4 Debt Issued in Exchange For Cash
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.
Nonauthoritative AICPA Guidance
Technical Q&As
Section 5220, “Interest Expense”
.07 Imputed Interest on Note Exchanged for Cash
Only
Inquiry — If an enterprise receives cash in
exchange for a non-interest bearing long-term note
payable with a stated amount equal to the cash received,
must interest be imputed on the note in accordance with
FASB ASC 835, Interest?
Reply — If there are rights or privileges other
than cash attendant to the exchange, the value of such
rights or privileges should be given accounting
recognition pursuant to FASB ASC 835-30-25-6. If the
note is issued solely for cash (that is, the cash
received is equivalent to the face amount of the note)
and no other right or privilege is exchanged, it is
presumed to have a present value at issuance measured by
the cash proceeds exchanged.
When an entity issues debt in a cash transaction that does not
include any other elements for which separate accounting recognition is required
(e.g., freestanding financial instruments or other stated or unstated rights or
privileges that warrant separate accounting recognition; see Section 3.3) and the
entity has not elected the fair value option in ASC 815-15 (see Section 8.5.6) or ASC
825-10 (see Section
4.4), a presumption exists that the debt should be initially
measured at the amount of cash proceeds received from the holder, adjusted for
debt issuance costs (see Chapter 5). Any difference between the stated principal amount
and the amount of the cash proceeds received, net of debt issuance costs, is
presented as a discount or premium (see Section 4.3.6).
If a debt issuance includes other freestanding financial
instruments or other elements that warrant separate accounting recognition (see
Section 3.3),
the cash proceeds should be allocated among the debt and those other units of
account as follows: first to any instrument that must be measured at fair value,
with changes recognized in earnings, and then to items not accounted for at fair
value. If the issuer is required to recognize as an asset any freestanding
financial instrument included in the transaction, the amount attributed to that
asset would be added to the amount of proceeds that is allocated among the
freestanding financial instruments that represent liabilities (and any equity
instruments issued). See Section 3.4 for additional discussion of the allocation of
proceeds and issuance costs.
Factors to consider in the determination of whether a transaction includes other
elements that should be recognized separately include (1) whether the effective
interest rate calculated on the basis of the proceeds allocated to the debt
would be unreasonable given the general level of interest rates, (2) the
issuer’s creditworthiness, and (3) the debt’s initial fair value. If the
transaction conveys rights or privileges unrelated to the debt, the issuer
should recognize such rights or privileges separately from the debt. If the
amount attributed to such rights or privileges represents an asset or expense,
such amount is added to the proceeds that are allocated to the debt and any
other freestanding financial liabilities or equity instruments issued. If the
transaction includes terms that meet the definition of a registration payment
arrangement, the issuer should also consider whether any amount should be
allocated to that arrangement. See Section 3.3.3 for additional discussion.
If the terms of a debt instrument include embedded features or other components
that must be recognized separately from the debt (e.g., any bifurcated embedded
derivative under ASC 815-15 or equity component under ASC 470-20), the amount
attributable to such features or components is allocated from the amount of
proceeds allocated to the debt after allocation to any other freestanding
financial instruments.
4.3.5 Debt Issued in Exchange for Property, Goods, or Services
4.3.5.1 General
ASC 835-30
05-2 Business transactions
often involve the exchange of cash or property,
goods, or service for a note or similar instrument.
When a note is exchanged for property, goods, or
service in a bargained transaction entered into at
arm’s length, there should be a general presumption
that the rate of interest stipulated by the parties
to the transaction represents fair and adequate
compensation to the supplier for the use of the
related funds. That presumption, however, must not
permit the form of the transaction to prevail over
its economic substance and thus would not apply if
interest is not stated, the stated interest rate is
unreasonable, or the stated face amount of the note
is materially different from the current cash sales
price for the same or similar items or from the fair
value of the note at the date of the transaction.
The use of an interest rate that varies from
prevailing interest rates warrants evaluation of
whether the face amount and the stated interest rate
of a note or obligation provide reliable evidence
for properly recording the exchange and subsequent
related interest.
25-7 A note exchanged for
property, goods, or service represents the following
two elements, which may or may not be stipulated in
the note:
-
The principal amount, equivalent to the bargained exchange price of the property, goods, or service as established between the supplier and the purchaser
-
An interest factor to compensate the supplier over the life of the note for the use of funds that would have been received in a cash transaction at the time of the exchange.
25-8 Notes exchanged for
property, goods, or services are valued and
accounted for at the present value of the
consideration exchanged between the contracting
parties at the date of the transaction in a manner
similar to that followed for a cash transaction.
When an entity issues debt in exchange for property, goods,
or services in a bargained transaction entered into at arm’s length (i.e.,
the debtor is the purchaser of property, goods, or services), and there are
no other separate elements in the transaction, there is a general
presumption that the debt’s stated rate of interest represents fair and
adequate compensation for the debtor’s use of the funds. In such cases, the
debt is initially measured at the present value of the contractual cash
flows, discounted by using the stated interest rate (i.e., typically the
stated principal amount) and adjusted for debt issuance costs (see Chapter 5), unless the issuer elects the
fair value option in ASC 815-15 (see Section 8.5.6) or ASC 825-10 (see
Section
4.4).
This presumption does not apply if (1) the debt has no
stated interest; (2) the stated interest rate is unreasonable (e.g., it does
not reflect the general level of interest rates or the issuer’s
creditworthiness); (3) the debt’s stated amount is materially different from
the current cash sales price for the same or similar items of property,
goods, or services; or (4) the debt’s stated amount is materially different
from the debt’s fair value on the date of the transaction. If the
presumption is inapplicable, the issuer must use other methods to determine
the debt’s initial measurement (see Section
4.3.5.2).
If the terms of a debt instrument include embedded features
or components that must be recognized separately from the debt (e.g., any
bifurcated embedded derivative under ASC 815-15), the amount attributed to
such features or components is allocated out of the initial measurement
amount.
4.3.5.2 Circumstances in Which the Presumption Does Not Apply
ASC 835-30
05-3 This Subtopic provides
guidance for the appropriate accounting when the
face amount of a note does not reasonably represent
the present value of the consideration given or
received in the exchange. This circumstance may
arise if the note is non-interest-bearing or has a
stated interest rate that is different from the rate
of interest appropriate for the debt at the date of
the transaction. Unless the note is recorded at its
present value in this circumstance, the sales price
and profit to a seller in the year of the
transaction and the purchase price and cost to the
buyer are misstated, and interest income and
interest expense in subsequent periods are also
misstated.
25-2 If determinable, the
established exchange price (which, presumably, is
the same as the price for a cash sale) of property,
goods, or service acquired or sold in consideration
for a note may be used to establish the present
value of the note. When notes are traded in an open
market, the market rate of interest and quoted
prices of the notes provide the evidence of the
present value. These methods are preferable means of
establishing the present value of the note.
25-10 In circumstances where
interest is not stated, the stated amount is
unreasonable, or the stated face amount of the note
is materially different from the current cash sales
price for the same or similar items or from the fair
value of the note at the date of the transaction,
the note, the sales price, and the cost of the
property, goods, or service exchanged for the note
shall be recorded at the fair value of the property,
goods, or service or at an amount that reasonably
approximates the fair value of the note, whichever
is the more clearly determinable. That amount may or
may not be the same as its face amount, and any
resulting discount or premium shall be accounted for
as an element of interest over the life of the
note.
If the stated rate of interest on debt issued in exchange for property, goods, or services does not represent fair and adequate compensation for the debtor’s use of funds, the issuer should determine whether price information is available for the property, goods, services, or debt. Such information would include current cash sales prices for the same or similar items of property, goods, or services or, if the debt is traded in an open market, the debt’s quoted price or market rate of interest. Paragraph 28 of FASB Concepts Statement 7 states, in part:
In the absence of a cash transaction, accountants turn to other
techniques for the initial measurement of an asset or liability, but
the measurement objective remains the same. The process begins by
determining whether others have bought or sold the same or similar
items in recent cash transactions.
If price information exists, the debt is initially measured
at whichever amount more clearly represents the fair value of the property,
goods, services, or debt. Any difference between the stated principal amount
and the initial measurement amount is presented as a discount or premium
(see Section
4.3.6). If there is no price information, the debt is
initially measured at the present value of its principal and interest
payments, discounted by using an imputed interest rate (see the next
section).
4.3.5.3 Imputed Interest Rate
ASC Master Glossary
Imputed Interest Rate
The interest rate that results from a process of
approximation (or imputation) required when the
present value of a note must be estimated because an
established exchange price is not determinable and
the note has no ready market.
ASC 835-30
10-1 The objective of the
guidance in this Subtopic is to approximate the rate
for a note that would have resulted if an
independent borrower and an independent lender had
negotiated a similar transaction under comparable
terms and conditions with the option to pay the cash
price upon purchase or to give a note for the amount
of the purchase that bears the prevailing rate of
interest to maturity.
25-3 If an established
exchange price is not determinable and if the note
has no ready market, the problem of determining
present value is more difficult. To estimate the
present value of a note under such circumstances, an
applicable interest rate is approximated that may
differ from the stated or coupon rate. This process
of approximation is called imputation, and the
resulting rate is called an imputed interest rate.
Nonrecognition of an apparently small difference
between the stated rate of interest and the
applicable current rate may have a material effect
on the financial statements if the face amount of
the note is large and its term is relatively
long.
25-11 In the absence of
established exchange prices for the related
property, goods, or service or evidence of the fair
value of the note (as described in paragraph
835-30-25-2), the present value of a note that
stipulates either no interest or a rate of interest
that is clearly unreasonable shall be determined by
discounting all future payments on the notes using
an imputed rate of interest. This determination
shall be made at the time the note is issued,
assumed, or acquired; any subsequent changes in
prevailing interest rates shall be ignored.
25-12 Paragraph 835-30-10-1
identifies the objective of the guidance in this
Subtopic for approximating an interest rate. The
variety of transactions encountered precludes any
specific interest rate from being applicable in all
circumstances. However, this paragraph provides the
following general guidelines:
-
The choice of a rate may be affected by the credit standing of the issuer, restrictive covenants, the collateral, payment and other terms pertaining to the debt, and, if appropriate, the tax consequences to the buyer and seller.
-
The prevailing rates for similar instruments of issuers with similar credit ratings will normally help determine the appropriate interest rate for determining the present value of a specific note at its date of issuance.
-
In any event, the rate used for valuation purposes shall be the rate at which the debtor can obtain financing of a similar nature from other sources at the date of the transaction.
25-13 The selection of a rate
may be affected by many considerations. For
instance, where applicable, the choice of a rate may
be influenced by the following:
-
An approximation of the prevailing market rates for the source of credit that would provide a market for sale or assignment of the note
-
The prime or higher rate for notes that are discounted with banks, giving due weight to the credit standing of the maker
-
Published market rates for similar-quality bonds
-
Current rates for debentures with substantially identical terms and risks that are traded in open markets
-
The current rate charged by investors for first or second mortgage loans on similar property.
In determining the initial measurement of debt, an entity uses an imputed
interest rate if all of the following conditions are met:
-
The debt was issued in exchange for property, goods, or services and does not represent a trade payable or other obligation that is exempt from ASC 835-30 (see Section 4.3.2).
-
Any of the following apply: (1) the debt has no stated interest; (2) the stated interest rate is unreasonable (e.g., it does not reflect the general level of interest rates or the issuer’s creditworthiness); (3) the debt’s stated amount is materially different from the current cash sales price for the same or similar items of property, goods, or services; or (4) the debt’s stated amount is materially different from the debt’s fair value on the date of the transaction.
-
There are no established exchange prices for the property, goods, or services.
-
The debt is not quoted in the open market.
The imputed rate represents an estimate of the interest rate at which the
issuer could obtain financing of a similar nature from other sources. In
other words, it is the rate that an independent borrower and lender would
negotiate on the issuance date in a cash transaction under comparable terms
and conditions.
Although ASC 835-30 does not explicitly describe how an entity uses an imputed rate to determine the debt’s present value as a fair value measurement, the FASB has affirmed that the fair value measurement guidance in ASC 820 related to the application of present value techniques applies to such measurements. Paragraphs C19 and C20 of the Basis for Conclusions of FASB Statement 157 state, in part:
[T]he Board affirmed that the measurement for
receivables and payables in [ASC 835-30] determined using a present
value technique, is a fair value measurement. The discount rate for
contractual (promised) cash flows described in [ASC 835-30] (rate
commensurate with the risk) embodies the same notion as the discount
rate used in the traditional approach (or discount rate adjustment
technique) described in FASB Concepts Statement No. 7, Using Cash
Flow Information and Present Value in Accounting
Measurements, and clarified in [ASC 820-10]. . . .
Accordingly, the guidance for using present value techniques to
measure fair value in [ASC 820-10] applies for the measurements
required under [ASC 835-30].
In estimating the imputed rate, the issuer would consider
information about observed rates of interest for comparable debt as of the
transaction date. Whether debt for which observable data are available can
be compared depends on the debt’s characteristics such as the amount and
timing of the contractual cash flows, the issuer’s creditworthiness (e.g.,
published credit rating), the seniority or subordination of the debt,
collateral and other credit enhancements, restrictive covenants, tax
treatment for the issuer and the holder, and any embedded features (e.g.,
put or call options).
If there is no debt instrument with substantially the same characteristics as
the debt, the issuer might determine the imputed rate by using a build-up
method that takes into account observable data related to the risk-free
yield curve and credit spreads for similar debt, adjusted as appropriate for
differences in the debt’s characteristics. In a manner similar to the
objective of a fair value measurement, the issuer should maximize the use of
observable inputs (e.g., quoted prices or rates in active markets for
similar debt and inputs that are derived principally or corroborated by
observable market data) and minimize the use of unobservable inputs.
Entities that determine the present value of debt by using
an imputed rate may need to apply the guidance in ASC 820 related to
discount rate adjustment techniques (ASC 820-10-55-10 through 55-12), the
build-up method (ASC 820-10-55-33 and 55-34), the effect of an entity’s
credit standing (ASC 820-10-55-57 and 55-57A), and the application of
present value techniques to debt obligations (ASC 820-10-55-85 through
55-89). For additional discussion of the application of fair value
measurement techniques, see Deloitte’s Roadmap Fair Value Measurements and Disclosures
(Including the Fair Value Option).
Once the imputed rate has been determined, the issuer
discounts the debt’s contractual cash flows by using that rate and
recognizes the debt at its present value. Any difference between the debt’s
present value and stated amount is presented as a discount or premium (see
the next section).
4.3.6 Discounts and Premiums
ASC Master Glossary
Discount
The difference between the net proceeds, after expense,
received upon issuance of debt and the amount repayable
at its maturity. See Premium.
Premium
The excess of the net proceeds, after expense, received
upon issuance of debt over the amount repayable at its
maturity. See Discount.
ASC 835-30
25-5 . . . The difference
between the face amount and the proceeds upon issuance
is shown as either discount or premium. For example, if
a bond is issued at a discount or premium, such discount
or premium is recognized in accounting for the original
issue. The coupon or stated interest rate is not
regarded as the effective yield or market rate.
Moreover, if a long-term non-interest-bearing note or
bond is issued, its net proceeds are less than face
amount and an effective interest rate is based on its
fair value upon issuance.
25-9 The difference between
the face amount and the present value upon issuance is
shown as either discount or premium.
45-1A The discount or
premium resulting from the determination of present
value in cash or noncash transactions is not an asset or
liability separable from the note that gives rise to it.
Therefore, the discount or premium shall be reported in
the balance sheet as a direct deduction from or addition
to the face amount of the note. Similarly, debt issuance
costs related to a note shall be reported in the balance
sheet as a direct deduction from the face amount of that
note. The discount, premium, or debt issuance costs
shall not be classified as a deferred charge or deferred
credit.
When the stated principal or face amount of a debt instrument differs from its
initial carrying amount, a discount or premium arises. Under the interest
method, a discount or premium is amortized over the debt’s life, typically to
interest expense (see Sections 6.2 and
14.2.4).
Example 4-1
Issuance of Debt at a Discount
Entity D issues long-term debt with a principal amount of
$100 million at a 2 percent discount to par for cash
proceeds of $98 million. It makes the following
entries:
Conceptually, premiums and discounts are valuation accounts that do not exist
separately from the related debt (i.e., they are not separate units of account).
Therefore, an entity is not permitted to present premiums and discounts as
assets or liabilities that are separate from the debt. Instead, debt discounts
are treated as deductions from, and debt premiums are treated as additions to,
the carrying amount of the debt to which they are related.
Economically, reasons for the existence of a discount or premium may include the following:
-
The debt’s stated interest rate differs from the market rate of interest for the instrument upon issuance. For example, if debt with a coupon rate of 6 percent is issued when the market rate of interest for similar debt is 5 percent, issuance of the debt at a premium to par would be expected since investors would be willing to invest an amount in excess of the principal amount to compensate for the above-market coupon rate. Conversely, if the market rate of interest exceeds the stated coupon rate upon issuance, issuance of the debt at a discount to par would be expected.
-
The debt is a zero-coupon instrument that pays no interest during its life. Zero-coupon instruments are generally issued at a discount to par; the discount represents compensation for the time value of money over the debt’s life.
-
The debt was issued with other freestanding financial instruments. For instance, ASC 470-20 requires the proceeds received for debt issued with detachable warrants (see Section 3.4.3.2) to be allocated between the debt and the warrants, resulting in a discount on the debt even if the transaction proceeds were equal to the principal amount of the debt.
-
The debt contains an embedded component that must be separated, such as an embedded derivative under ASC 815-15 (e.g., a bifurcated put, call, or conversion feature; see Chapter 8). For example, if debt was issued at par and contains an embedded redemption feature that must be bifurcated as a derivative liability under ASC 815-15, a debt discount would arise for accounting purposes.
-
The debt contains an embedded feature that is not accounted for separately from the debt. For instance, if the stated interest rate equals the market rate of interest for nonconvertible debt, but the debt contains a conversion feature that is not required to be accounted for separately from the debt, an investor should be willing to purchase the debt at a premium to par. (Note, however, that a substantial premium to par may need to be recognized in equity under ASC 470-20-25-13; see Section 7.6.)
-
The debtor paid a fee to the creditor as part of the debt issuance.
-
The debt is designated as a hedged item in a fair value hedging relationship under ASC 815-25, and the carrying amount has been adjusted for changes in fair value as a result of the application of fair value hedge accounting (see Section 14.2.1.2).
If the stated interest rate on a debt instrument is fixed at different levels
during the life of the debt or includes an interest-free period, a discount or
premium to the principal amount could arise after the initial recognition of the
debt even if the debt was issued at par. For example, if a debt instrument has
an increasing interest rate (or an initial interest-free period), the
application of the interest method (see Chapter 6) by using a constant effective interest rate would be
expected to result in the creation of a premium during the term of the debt.
4.4 Debt Subject to the Fair Value Option
4.4.1 Background
ASC 825-10
05-5 The Fair Value Option
Subsections of this Subtopic address both of the
following:
-
Circumstances in which entities may choose, at specified election dates, to measure eligible items at fair value (the fair value option)
-
Presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities.
Under ASC 825-10, entities can elect the fair value option to
account for certain financial assets and financial liabilities at fair value.
For a comprehensive discussion of this guidance, see Chapter 12 of Deloitte’s Roadmap Fair Value Measurements and
Disclosures (Including the Fair Value Option). The
sections below summarize the fair value option requirements that apply to items
within the scope of this Roadmap.
4.4.2 Scope
ASC 825-10
15-4 All entities may elect
the fair value option for any of the following eligible
items:
-
A recognized financial asset and financial liability, except any listed in the following paragraph
-
A firm commitment that would otherwise not be recognized at inception and that involves only financial instruments (for example, a forward purchase contract for a loan that is not readily convertible to cash — that commitment involves only financial instruments — a loan and cash — and would not otherwise be recognized because it is not a derivative instrument)
-
A written loan commitment . . . .
15-5 No entity may elect the
fair value option for any of the following financial
assets and financial liabilities: . . .
e. Deposit liabilities, withdrawable on demand,
of banks, savings and loan associations, credit
unions, and other similar depository
institutions.
f. Financial instruments that are, in whole or
in part, classified by the issuer as a component
of shareholders’ equity (including temporary
equity).
An entity may elect the fair value option for any eligible item
within the scope of ASC 825-10. Unless a specific scope exception applies, debt
represents an eligible item for which the issuer may elect the fair value
option. Under ASC 825-10-15-4(b), the fair value option is available to a holder
of an unrecognized loan commitment provided that the commitment (1) meets the
definition of a firm commitment (e.g., the terms include a disincentive for
nonperformance that is sufficiently large to make performance probable) and (2)
involves only financial instruments (see Section 2.3.4). A loan commitment does not
meet the definition of a firm commitment if it includes subjective provisions
that permit either party to rescind it (e.g., it permits the potential lender to
rescind its commitment in the event of a material adverse change in the holder’s
financial condition or performance).
The ability to elect the fair value option does not depend on whether (1) its
application serves to mitigate volatility in reported earnings that would
otherwise arise as a result of measuring items on different bases or (2) the
entity manages and monitors performance of an item on a fair value basis. The
ability to elect the fair value option for a debt instrument is also not
predicated on the reliability of the fair value measurement; however, the inputs
used for such measurement must reflect market participant assumptions (including
adjustments that market participants demand for the risk associated with
unobservable inputs or the valuation technique used to determine fair value). In
addition, entities are required to disclose the categorization of fair value
measurements within the fair value hierarchy, including whether significant
inputs to those measurements are observable or unobservable.
The fair value option is not available for financial instruments
that are, in whole or in part, classified by the issuer as a component of
shareholders’ equity (including temporary equity). Thus, the fair value option
cannot be elected for convertible debt for which the issuer has recognized an
equity component on the debt as of an election date (see Section 7.6), such as
convertible debt issued at a substantial premium to par for which an equity
component has been recognized under ASC 470-20-25-13. An entity also cannot
elect the fair value option for deposit liabilities, withdrawable on demand, of
banks, savings and loan associations, credit unions, and other similar
depository institutions. Instead, such liabilities are accounted for under ASC
942-405.
4.4.3 Election Dates
ASC 825-10
25-1 This Subtopic permits all
entities to choose, at specified election dates, to
measure eligible items at fair value (the fair value
option).
25-2 The decision about whether
to elect the fair value option:
-
Shall be applied instrument by instrument, except as discussed in paragraph 825-10-25-7
-
Shall be irrevocable (unless a new election date occurs, as discussed in paragraph 825-10-25-4)
-
Shall be applied only to an entire instrument and not to only specified risks, specific cash flows, or portions of that instrument.
An entity may decide whether to elect
the fair value option for each eligible item on its
election date. Alternatively, an entity may elect the
fair value option according to a preexisting policy for
specified types of eligible items.
25-4 An entity may choose to
elect the fair value option for an eligible item only on
the date that one of the following occurs:
a. The entity first recognizes the eligible
item.
b. The entity enters into an eligible firm
commitment. . . .
e. An event that requires an eligible item to
be measured at fair value at the time of the event
but does not require fair value measurement at
each reporting date after that . . . .
25-5 Some of the events that
require remeasurement of eligible items at fair value,
initial recognition of eligible items, or both, and
thereby create an election date for the fair value
option as discussed in paragraph 825-10-25-4(e) are:
-
Business combinations, as defined in Subtopic 805-10
-
Consolidation or deconsolidation of a subsidiary or VIE
-
Significant modifications of debt, as defined in Subtopic 470-50.
An issuer is permitted to elect the fair value option for a debt instrument on
the date on which (1) the debt is first recognized, or (2) an event occurs that
causes the debt to be remeasured at fair value under GAAP at the time of the
event but does not result in a requirement to apply subsequent fair value
measurement (e.g., a business combination). Once an entity elects the fair value
option, it may not revoke fair value accounting unless a new election date
occurs.
The determination of whether a debt modification or exchange
qualifies as a remeasurement event for the borrower depends on whether the debt
is treated as a new debt instrument under ASC 470-50 (see Section 10.4.2). If
modification accounting is applied, the debt is considered to reflect the
continuation of the original contract and a new election date is not available.
If extinguishment accounting applies, the new debt instrument is eligible to be
elected under the fair value option at its initial recognition. If a debt
modification or exchange represents a TDR (see Chapter 11), the debt instrument is not
considered a new instrument and, therefore, a new election date for the fair
value option is not available. For additional discussion of election dates, see
Section 12.3.2
of Deloitte’s Roadmap Fair
Value Measurements and Disclosures (Including the Fair Value
Option).
While ASC 825 provides little guidance on the documentation an entity must
maintain to support its election of the fair value option, it indicates that the
decision to elect the fair value option should be made as of the election date
for each eligible item. Entities also have the flexibility to establish an
automatic election policy for certain eligible items of an identical or similar
nature. In deciding to permit entities to elect the fair value option, the FASB
noted that maintaining evidence of compliance with the election requirements of
ASC 825 is a matter of internal control. In all scenarios, an entity must
support its fair value option election under ASC 825 with appropriate concurrent
documentation that eliminates any question regarding whether the entity elected
to apply fair value measurement to a particular instrument.
4.4.4 Level of Aggregation
ASC 825-10
25-7 The fair value option
may be elected for a single eligible item without
electing it for other identical items with the following
four exceptions:
-
If multiple advances are made to one borrower pursuant to a single contract (such as a line of credit or a construction loan) and the individual advances lose their identity and become part of a larger loan balance, the fair value option shall be applied only to the larger balance and not to each advance individually. . . .
25-10 The fair value option
need not be applied to all instruments issued or
acquired in a single transaction (except as required by
paragraph 825-10-25-7(a) through (b)). For example,
investors in shares of stock and registered bonds might
apply the fair value option to only some of the shares
or bonds issued or acquired in a single transaction. For
this purpose, an individual bond is considered to be the
minimum denomination of that debt security.
25-11 A financial instrument
that is legally a single contract may not be separated
into parts for purposes of applying the fair value
option. In contrast, a loan syndication arrangement may
result in multiple loans to the same borrower by
different lenders. Each of those loans is a separate
instrument, and the fair value option may be elected for
some of those loans but not others.
Generally, an entity can elect the fair value option on an
instrument-by-instrument basis. Thus, an entity can elect it for a debt
instrument without doing so for other separate but identical debt instruments if
they represent separate units of account (see Section
3.3). Further, ASC 825-10-25-10 specifies that an entity might
elect the fair value option for only some of the bonds issued in a single
transaction and that, “[f]or this purpose, an individual bond is considered to
be the minimum denomination of that debt security.”
If a group of lenders jointly fund a loan to a single borrower and each lender
loans a specific amount to the borrower and has the right to demand repayment
from the borrower, the loan from each lender is considered separate and distinct
from the loans from other lenders even if each of the loans forms part of the
same overall loan syndication agreement (see Section
10.3.2.4). Thus, ASC 825-10-25-11 permits election of the fair
value option for each loan in a loan syndication arrangement in which the loans
are made to the same borrower by different lenders.
However, under ASC 825-10-25-11, a “financial instrument that is legally a single
contract may not be separated into parts for purposes of applying the fair value
option.” For example, a debt host contract that remains after the separation of
an embedded financial derivative under ASC 815-15 (e.g., convertible debt with a
bifurcated conversion feature) is not eligible for the fair value option.
Nevertheless, the entire hybrid financial instrument is eligible for the fair
value option provided that no specific exception applies to the instrument.
Example 4-2
Unit of Account for Fair Value Option Election
Purposes — Debt
Entity E enters into, and documents in the same contract,
a debt instrument with a $1 million principal amount and
a warrant on 100,000 shares of common stock with a
single investor. Since the warrant is legally detachable
and separately exercisable, the debt instrument and
warrant individually represent freestanding financial
instruments (i.e., the debt instrument is considered an
individual contract under ASC 825-10-25-11).
Accordingly, E could apply the fair value option to its
liability related to the $1 million debt instrument
provided that it is not subject to any of the fair value
option exceptions in ASC 825-10-15-5. The warrant would
be separately evaluated as a liability or equity
instrument under other applicable U.S. GAAP (e.g., ASC
480, ASC 815, and ASC 815-40).
However, E could not apply the fair value option to only
$500,000 of the $1 million principal amount of debt
because the entire principal amount represents a single
unit of account and ASC 825-10-25-11 prohibits the
election of the fair value option for only a portion of
the amount of an individual bond. If, however, E had
entered into the contract with 10 different investors,
it could individually make the fair value option
election for the $1 million principal amount of the debt
component of each of the 10 different contracts (e.g.,
it could elect the fair value option for the $1 million
debt component related to five investors and not elect
the fair value option for the $1 million debt component
for the other five investors).
An entity that can make multiple debt draws under a single credit facility (e.g.,
a line of credit or tranche debt financing) cannot apply the fair value option
to each draw individually if, as described in ASC 825-10-25-7(a), such draws
“lose their identity and become part of a larger loan balance.”
Example 4-3
Unit of Account for Fair Value Option Election
Purposes — Line of Credit
Entity F has a $5 million line-of-credit agreement with
Bank A. On March 1, 20X7, F draws $500,000 on its line
of credit and chooses not to elect the fair value
option. On April 1, 20X7, F draws another $1 million.
Because the $1 million is added to the $500,000 and
becomes part of the larger balance, the fair value
option may not be elected for the $1 million. When F
chose not to elect the fair value option for the
$500,000, it also chose not to elect the fair value
option for any subsequent draws on that line of credit.
Under ASC 825-10-25-4, that election is irrevocable
unless a new election date occurs.
An entity cannot separately elect the fair value option for the accrued interest
on a debt instrument, nor can it elect the fair value option and exclude the
accrued interest component. (Accrued interest simply represents one or more
future interest cash flows of the debt.) Rather, in accordance with ASC
825-10-25-2(c), the entity must either (1) elect the fair value option for an
interest-bearing financial asset or financial liability that includes any
accrued interest or (2) not elect the fair value option for any component of an
interest-bearing financial asset or financial liability.
Section 3.3.3.3 discusses the unit of
account for a liability issued with an inseparable third-party credit
enhancement.
4.4.5 Initial Measurement
ASC 820-10
30-1 The fair value
measurement framework, which applies at both initial and
subsequent measurement if fair value is required or
permitted by other Topics, is discussed primarily in
Section 820-10-35. This Section sets out additional
guidance specific to applying the framework at initial
measurement.
30-2 When an asset is
acquired or a liability is assumed in an exchange
transaction for that asset or liability, the transaction
price is the price paid to acquire the asset or received
to assume the liability (an entry price). In contrast,
the fair value of the asset or liability is the price
that would be received to sell the asset or paid to
transfer the liability (an exit price). Entities do not
necessarily sell assets at the prices paid to acquire
them. Similarly, entities do not necessarily transfer
liabilities at the prices received to assume them.
30-3 In many cases, the
transaction price will equal the fair value (for
example, that might be the case when on the transaction
date the transaction to buy an asset takes place in the
market in which the asset would be sold). . . .
30-3A When determining
whether fair value at initial recognition equals the
transaction price, a reporting entity shall take into
account factors specific to the transaction and to the
asset or liability. For example, the transaction price
might not represent the fair value of an asset or a
liability at initial recognition if any of the following
conditions exist:
-
The transaction is between related parties, although the price in a related party transaction may be used as an input into a fair value measurement if the reporting entity has evidence that the transaction was entered into at market terms.
-
The transaction takes place under duress or the seller is forced to accept the price in the transaction. For example, that might be the case if the seller is experiencing financial difficulty.
-
The unit of account represented by the transaction price is different from the unit of account for the asset or liability measured at fair value. For example, that might be the case if the asset or liability measured at fair value is only one of the elements in the transaction (for example, in a business combination), the transaction includes unstated rights and privileges that are measured separately, in accordance with another Topic, or the transaction price includes transaction costs.
-
The market in which the transaction takes place is different from the principal market (or most advantageous market). For example, those markets might be different if the reporting entity is a dealer that enters into transactions with customers in the retail market, but the principal (or most advantageous) market for the exit transaction is with other dealers in the dealer market.
30-6 If another Topic
requires or permits a reporting entity to measure an
asset or a liability initially at fair value and the
transaction price differs from fair value, the reporting
entity shall recognize the resulting gain or loss in
earnings unless that Topic specifies otherwise.
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.
When an entity elects to measure debt (or another eligible item)
under the fair value option, it initially measures it at fair value in
accordance with ASC 820. That guidance stipulates that the fair value represents
an exit price under the assumption that an asset is sold or a liability or
equity instrument is transferred (assumed) in an orderly transaction between
unrelated market participants under current market conditions. In many cases,
the transaction price for an asset, liability, or equity instrument equals its
fair value upon initial recognition. However, in certain situations, it is not
appropriate to assume that the transaction price (which is an entry price) is
the initial fair value (which is an exit price) of an asset, liability, or
equity instrument.
Accordingly, if an issuer elects to measure debt at fair value, it needs to
assess whether the debt proceeds represent the fair value at inception and
consider whether one or more of the factors in ASC 820-10-30-3A are present.
Section 3.3 addresses situations in
which the unit of account for the transaction price of debt differs from the
unit of account for fair value accounting purposes.
In many cases, it is inappropriate to record an inception gain
or loss as of the date of initial recognition. At the 2006 AICPA Conference on
Current SEC and PCAOB Developments, then SEC Professional Accounting Fellow
Joseph McGrath stated the following:
[W]e have heard that some believe that it is “open
season” on inception gains. I would caution those constituents that
there continue to be many instances in which day one gains are not
appropriate. [ASC 820] does not allow the practice of “marking to model”
when the transaction occurs in the entity’s principal market. Rather,
transaction prices would generally be used in such a circumstance, and
the model would be calibrated to match transaction price.
Mr. McGrath’s remarks indicate that if none of the factors in ASC 820-10-30-3A
are present, the transaction price is most likely the best estimate of fair
value. However, if any of the criteria in ASC 820-10-30-3A are met, there may be
a difference between the transaction price and fair value. For example, ASC
820-10-30-3A(c) indicates that the transaction price might not represent fair
value at initial recognition if “the transaction price includes transaction
costs.” That might be the case in a transaction that includes a structuring
fee.
For a discussion of the evaluation of situations in which the fair value exceeds
the debt proceeds received, see Section
3.4.3.1.