Chapter 6 — Subsequent Accounting for Debt

6.2 Interest Method

6.2.1 Background

ASC Master Glossary

Interest Method

The method used to arrive at a periodic interest cost (including amortization) that will represent a level effective rate on the sum of the face amount of the debt and (plus or minus) the unamortized premium or discount and expense at the beginning of each period.

ASC 835-30

25-5 The total amount of interest during the entire period of a cash loan is generally measured by the difference between the actual amount of cash received by the borrower and the total amount agreed to be repaid to the lender. . . .

Under the interest method, an entity uses present value techniques (see Section 4.3.3) to determine the net carrying amount of the debt and the amount of periodic interest cost. The difference between the net amount the debtor receives upon issuing debt and the aggregate undiscounted amount it is required to pay as principal and interest over the debt’s life represents the total interest cost on the debt. The total interest cost over the debt’s life is allocated to individual reporting periods by using the effective yield implicit in the debt’s contractual cash flows (see Section 6.2.3.3). Through this allocation, any premium or discount (see Section 4.3.6) and debt issuance costs (see Section 5.3) are amortized as interest cost over the debt’s life (see Section 6.2.4).

The debt’s net carrying amount at any point in time is the sum of the present values of the debt’s remaining future principal and interest payments, discounted at the debt’s effective interest rate. Other methods of computing periodic interest cost may be used only if the results are not materially different from those calculated under the interest method (see Section 6.2.3.7). The issuer reports interest cost as interest expense unless the cost qualifies for capitalization as borrowing costs under ASC 835-20 (see Section 14.2.4). The scope of the interest method is addressed in the next section.

6.2.2 Scope

ASC 835-30

45-1 The guidance in this Section does not apply to the amortization of premium and discount of assets and liabilities that are reported at fair value and the debt issuance costs of liabilities that are reported at fair value.

55-1 The guidance in the following paragraphs is not subject to the scope limitation in paragraph 835-30-15-3(b).

55-2 Generally accepted accounting principles (GAAP) require use of the interest method. . . .

Unless an issuer elects to account for a particular debt instrument under the fair value option in ASC 815-15 (see Section 8.5.6) or ASC 825-10 (see Section 4.4), it must apply the interest method to that debt, including the amortization of any debt discount or premium and debt issuance costs. The interest method applies irrespective of whether the debt has any stated interest (e.g., the interest method applies to zero-coupon debt).

A debtor should evaluate whether features embedded in a debt contract (e.g., indexation, conversion, redemption, acceleration, extension, exchange, and contingent payment features) must be separately accounted for as derivatives under ASC 815-15 (see Chapter 8). When a derivative has been bifurcated from a debt host contract, the interest method applies to such contract but not to the embedded derivative (see Section 8.5). Further, an entity should evaluate whether it can apply one of the special accounting models within GAAP for certain types of debt, such as those for sales of future revenue, participating mortgages, or indexed debt (see Chapter 7).

6.2.3 Interest Method Mechanics

6.2.3.1 Background

This section addresses the following topics:

The inputs necessary for application of the interest method (see Section 6.2.3.2).
The calculation of the effective interest rate under the interest method (see Section 6.2.3.3).
The calculation of periodic interest cost (see Section 6.2.3.4).
The calculation of the net carrying amount of debt under the interest method (see Section 6.2.3.5).
The accrual of interest cost between interest payment dates (see Section 6.2.3.6).
The use of alternative methods (see Section 6.2.3.7).

Further, Section 6.2.3.8 contains comprehensive examples of the interest method’s application to the issuance of debt at a discount and at a premium.

6.2.3.2 Inputs to the Interest Method

To apply the interest method, an entity must determine the debt’s initial net carrying amount and the timing and amount of the debt’s contractual cash flows:

Initial net carrying amount — Chapter 4 discusses the initial measurement of debt, and Chapter 5 addresses the treatment of debt issuance costs. In the application of the interest method, the amount of proceeds and subsequent cash flows that are used to compute the effective interest rate are based on the amounts allocated to the debt host contract after separation of any embedded derivative (see Chapter 8) and any equity component (see Section 7.6).
Contractual cash flows — The timing and amount of the debt’s contractual cash flows are based on the debt’s contractual terms. The application of the interest method does not depend on whether such cash flows are designated as principal, interest, premium, discount, or fees.

Some debt instruments require the debtor to pay an exit fee or repayment premium at maturity (e.g., 8 percent of the debt’s principal amount). If the payment of such an amount is mandatory upon repayment of the debt, it should be incorporated into the contractual cash flows that are used to apply the interest method. However, an entity should evaluate exit fees and repayment premiums that are contingent or variable to determine whether they must be accounted for separately under ASC 815-15 (see Chapter 8) and, if not, whether special interest recognition guidance applies (see Chapter 7). Special considerations are necessary when the timing or amount of the cash flows on debt is variable (see Sections 6.2.4 and 6.2.5).

The stated interest rate on debt may be fixed over the debt’s life; however, some debt instruments have interest-free periods or different fixed rates during the term of the debt. In these circumstances, proper application of the interest method will result in a constant effective yield throughout the entire term of the debt. Some debt instruments contain interest terms that vary on the basis of a reference rate (e.g., a prime rate or benchmark rate) and a margin. Section 6.2.5.2 discusses the application of the interest method to variable-rate debt.

In the United States, interest on fixed-rate corporate bonds is often paid semiannually in two equal installments. However, other payment frequencies are also common (e.g., monthly, quarterly, or annually). For some debt instruments (e.g., short-term commercial paper and zero-coupon bonds), no periodic interest payments are made. Further, different day-count conventions exist for determining the number of days between interest payments. For example, under the contractual terms, it might be assumed that a year has 360 days consisting of twelve 30-day months. Alternatively, it might be assumed that a year has 365 days (or 366 days in a leap year). To appropriately determine the timing and amount of a debt instrument’s contractual cash flows, an entity should consider such terms and conventions.

Typically, the application of the interest method is based on the contractual cash flows produced until the debt’s contractual maturity date. However, a shorter period may be appropriate for certain debt that is puttable by the creditor before maturity (see Section 6.2.4.2).

6.2.3.3 Effective Interest Rate

The debt’s effective interest rate is the interest rate that is implicit in the terms of the debt (i.e., the internal rate of return of the debt’s initial carrying amount determined on the basis of the contractual cash flows over the debt’s life). The effective interest rate often differs from the debt’s stated interest rate because of premiums, discounts, or debt issuance costs (see the previous section). The effective interest rate would also differ from the stated rate on debt that has an interest-free period or contains an interest rate that increases over the debt’s life.

The effective interest rate can be determined by using a software application (e.g., the internal rate of return function in a spreadsheet program), a calculator, present value tables, or iterative numerical techniques. Mathematically, the effective interest rate is calculated by solving for the discount rate that equates the debt’s initial net carrying amount to the contractual cash flows over the debt’s life. Algebraically, this can be expressed as a discounted cash flow equation in which P0 is the debt’s initial net carrying amount, CFt is the debt’s principal and interest cash outflows in each time period t until the final cash outflow in time period T (i.e., t = 1, 2, 3, . . . , T), and r is the effective interest rate that is used to discount those cash flows:

Alternatively, if the initial net carrying amount is treated as a negative cash outflow (i.e., P0 = –CF0), the equation can be simplified as follows:

Example 6-1

Calculation of Effective Interest Rate

In December 20X0, Entity R receives net proceeds of $940,000 for the issuance of a one-year debt instrument with a stated principal amount of $1 million that is repayable at maturity. The debt instrument pays interest in arrears at a stated annual rate of 10 percent of the principal amount, payable quarterly in arrears. Accordingly, R pays $25,000 at the end of each quarter, or ($1 million × 10%) ÷ 4. To determine the periodic (quarterly) effective interest rate, R sets up the following discounted cash flow equation:

As shown above, the quarterly effective interest rate is 4.16 percent, or an uncompounded annual effective rate of 16.64 percent. The difference between the effective rate and the cash interest paid equals the periodic amortization of the discount on the debt.

6.2.3.4 Periodic Interest Cost

ASC 835-30

35-1 This Section provides guidance for the measurement of interest income or expense over the term of a note.

35-2 With respect to a note for which the imputation of interest is required, the difference between the present value and the face amount shall be treated as discount or premium and amortized as interest expense or income over the life of the note in such a way as to result in a constant rate of interest when applied to the amount outstanding at the beginning of any given period. This is the interest method.

35-3 The difference between the periodic interest cost so calculated using the interest method and the nominal interest on the outstanding amount of the debt is the amount of periodic amortization.

35-5 The amount chargeable to interest expense under the guidance in this Subtopic is eligible for inclusion in the amount of interest cost capitalized in accordance with Subtopic 835-20.

45-3 Amortization of discount or premium shall be reported as interest expense in the case of liabilities or as interest income in the case of assets. Amortization of debt issuance costs also shall be reported as interest expense.

55-3 The interest method produces periodic interest income at a constant effective yield on a loan . . . .

Over the life of a debt instrument, the total amount of interest cost equals the difference between the debt’s initial net carrying amount and the total contractual payments owed. As a result of discounts, premiums, or debt issuance costs, the amount that is reported as interest cost differs, both cumulatively and in specific financial reporting periods, from the amount contractually designated as interest cost.

To determine the periodic amount of interest cost and the amortization of any discount, premium, or debt issuance costs, an entity applies the effective interest rate to the net carrying amount of the debt as of the beginning of the period. That is, the amount of reported interest cost equals the product of (1) the net carrying amount at the beginning of the period and (2) the periodic effective interest rate.

In each financial reporting period, any premium or discount (including debt issuance costs) is amortized as an adjustment to interest cost. If the amount of interest actually paid in cash differs from the amount of interest accrued, the difference is used to adjust the amount of the remaining unamortized discount or premium.

The amortization of a debt discount increases reported interest cost relative to the amount of interest paid, whereas the amortization of a debt premium reduces reported interest cost.

Example 6-2

Amortization of Discount

Assume the same facts as in Example 6-1 and that during the period between January 1, 20X1, and March 31, 20X1, Entity R accrues $39,096 ($940,000 × 0.0416) of interest cost even though it pays only $25,000 of cash interest at the end of that quarter. The difference of $14,096 reduces the amount of the remaining unamortized discount (i.e., it increases the net carrying amount of the debt instrument).

The full discount amortization schedule for R’s debt instrument is shown below.

6.2.3.5 Net Carrying Amount

Under the interest method, the debt’s net carrying amount at any point in time equals the sum of the stated principal amount plus any remaining unamortized premium less any remaining unamortized discount (including issuance costs). The debt’s net carrying amount at the end of any financial reporting period can be determined as follows:

Mathematically, the debt’s net carrying amount at any point in time equals the present value of its remaining future cash flows, discounted by using the debt’s effective interest rate. Algebraically, this can be represented as follows (with BV0 denoting the net carrying amount (“book value”) on date t = 0):

Example 6-3

Calculation of Net Carrying Amount

Assume the same facts as in Example 6-2. Immediately after the interest payment on June 30, 20X1, Entity R determines the debt’s net carrying amount by adding the amount of the discount amortized (i.e., the excess of interest expense accrued over interest paid) to the net carrying amount at the beginning of the period (i.e., $954,096 + $14,682 = $968,778).

Alternatively, R can determine the net carrying amount by calculating the present value of the remaining cash flows, discounted by the effective interest rate:

Although the carrying amount of a debt instrument for which the issuer has not elected the fair value option in ASC 825-10 is not remeasured for changes in its fair value, an adjustment to the net carrying amount is required when a debt instrument is designated as a hedged item in a fair value hedge (see Section 14.2.1.2). For a discussion of foreign-denominated debt, see Section 14.2.3.

6.2.3.6 Accrual Between Payment Dates

If an entity issues financial statements between payment dates, it must accrue interest payable and amortize any debt discount or premium and debt issuance costs for the period since the last adjustment. In practice, this allocation is sometimes performed on a straight-line basis. However, if the effect of discounting would be material, the interest method should be strictly applied to the adjustment.

Example 6-4

Accrual of Interest

Entity A issues a 15-year bond on March 31, 20X1, at par for cash proceeds of $40 million. No debt issuance costs were incurred. The stated coupon rate is 5 percent per annum, payable semiannually in arrears. Accordingly, A has an obligation to make semiannual interest payments of $1 million ($40,000,000 × 5% × 0.5). Entity A makes the following entry on March 31:

Because the bond was issued at par and no debt issuance costs were incurred, the stated rate equals the effective interest rate that is used to recognize interest expense for financial reporting purposes. During the period from March 31 to September 30, A accrues interest of $1 million as follows:

On September 30, A makes its first semiannual interest payment of $1 million and the following entry:

On December 31, A issues financial statements. On a straight-line basis, A accrues interest of $500,000 ($1,000,000 × 0.5) for the period from October 1 to December 31:1

Under a time-proportionate application of the interest method, A would have accrued interest of $502,762 for the period from September 30 to December 31, or $1,000,000 × (91 ÷ 181 days). Such an approach is an appropriate application of the interest method since interest compounds only semiannually in this example. If, however, interest compounded daily, the interest rate was not constant throughout the life of the instrument, or the debt was a zero coupon instrument, A would be required to strictly apply the interest method if it differed significantly from the straight-line method or time-proportionate method.

6.2.3.7 Use of Alternative Methods

6.2.3.7.1 General

ASC 835-30

35-4 Other methods of amortization may be used if the results obtained are not materially different from those that would result from the interest method.

55-1 The guidance in the following paragraphs is not subject to the scope limitation in paragraph 835-30-15-3(b).

55-2 . . . There is no basis for using an alternative to the interest method except if the results of alternative methods do not differ materially from those obtained by using the interest method. Therefore, methods other than the interest method, such as the rule of 78s, sum of the years’ digits, and straight-line methods shall not be used if their results materially differ from the interest method.

55-3 The interest method produces periodic interest income at a constant effective yield on a loan; therefore, in a lending arrangement in which interest collected in earlier periods will be greater than that computed using the interest method, the excess interest collected shall be deferred and recognized as interest income in later periods so as to produce a constant yield. For example, the interest method would be applied in this way to loans for which interest is collected by the sum of the years’ digits method.

In determining the amount of interest to be recognized in each financial reporting period, an entity may use an approach other than the interest method (e.g., straight-line amortization) only if the results would not be materially different from those calculated by using the interest method. The interest method must be applied even if the contractual terms of the debt instrument require the use of a different means of allocating payments between amounts designated as principal repayments and those designated as interest payments.

Generally, the total amount of interest reported over the entire life of a debt instrument should not differ on the basis of the method used to recognize interest in individual periods, but the amounts reported in each individual period may be different. For example, straight-line amortization of a debt discount results in greater amortization in earlier periods and lower amortization in later periods than the interest method. If an entity uses an approach other than the interest method, it must assess whether the results are materially different in each individual period. If the results are materially different in any individual period, the interest method must be applied.

6.2.3.7.2 Straight-Line Amortization

Under the straight-line method, any debt discount or premium and debt issuance costs for a nonamortizing loan are amortized in equal periodic amounts over the life of the debt instrument. For example, if the debt discount for a five-year $1,000 loan is $25, a fifth of that amount ($5) is amortized to interest expense each year. This differs from the interest method, which typically requires entities to amortize discounts at an increasing amount over time and amortize premiums at a decreasing amount over time. Under the interest method, the amount of discounts or premiums amortized in each period differs because a constant effective interest rate is applied to a changing net carrying amount that is updated over time for the amortization of discounts or premiums. As discussed in Section 6.2.3.7.1, use of the straight-line method for amortizing debt discounts and debt premiums is acceptable only if the results are not materially different from those calculated under the interest method.

Example 6-5

Interest Method Compared With Straight-Line Method

Under the straight-line method, the discount amortization schedule is as follows for a two-and-a-half year $100,000 debt instrument that was issued for net proceeds of $95,000 and has a stated coupon rate of 12 percent per annum, payable semiannually in arrears:

Under the interest method, the discount amortization schedule for the same debt instrument is as follows:

6.2.3.7.3 Rule of 78s

Another alternative method identified in ASC 835-30-55-2 for calculating principal and interest portions of debt is the rule of 78s. Under this method, an entity first calculates the sum of the digits (SD) for the number of remaining payments scheduled to be made by the debtor over the debt’s life. For example, for a six-month loan that will be repaid in six equal monthly installments, the SD is 21 (1 + 2 + 3 + 4 + 5 + 6 = 21). The SD can also be determined by using the following formula in which N is the total number of payments:

The method is called the rule of 78s because the SD for a loan that will be repaid in 12 monthly payments is 78, or [12 × (12 + 1)] ÷ 2 = 78.

Next, the entity determines the total amount of interest to be paid over the life of the instrument by calculating the difference between the original principal amount and the total amount to be repaid over the life of the instrument. For example, if an entity borrows $12,000 and the total amount to be repaid is $12,600, the total amount of interest to be paid over the life of the loan is $600.

The amount of interest attributable to each period is determined by multiplying the total amount of interest over the life of the instrument by the fraction of the SD that is attributable to each period. For example, the fraction of the SD that is attributable to the first month of a six-month loan is 0.285 (6 ÷ 21 = 0.285).

As discussed in Section 6.2.3.7.1, use of the rule of 78s for amortizing debt discounts and debt premiums is acceptable only if the results are not materially different from those calculated under the interest method.

Example 6-6

Interest Method Compared With Rule of 78s Method

Under the rule of 78s, the computation of interest for a six-month loan of $12,000 that will be repaid in six equal monthly installments totaling $12,600 is as follows:

Under the interest method, the entity would compute the amount of interest on the basis of the effective interest rate, which is approximately 1.41 percent per month. This results in the following amortization schedule:

6.2.3.7.4 Sum-of-the-Years’-Digits Method

Another alternative method identified in ASC 835-30-55-2 is the sum-of-the-years’-digits (SYD) method. The SYD method is similar to the rule of 78s except that the digits used to allocate total interest cost over the debt’s life do not represent the number of remaining payments but rather the number of remaining years. The amount of interest attributable to each year is calculated by multiplying the total amount of interest over the instrument’s life by the fraction of the SYD that is attributable to each year of the debt’s life. Although ASC 835-30 refers to the SYD method as a potential alternative to the interest method for determining the amount of interest expense, it is more commonly known as an accelerated method for the depreciation of the deductible cost of a nonfinancial asset over its useful life for tax purposes. As discussed in Section 6.2.3.7.1, use of the SYD method is acceptable only if the results are not materially different from those calculated under the interest method.

6.2.3.8 Comprehensive Examples

Example 6-7

Debt Issued at Discount

Entity D issues a 10-year $100 million bond on March 31, 20X1, at a 4 percent discount for proceeds of $96 million. Further, D incurs debt issuance costs of $1 million. The stated coupon rate is 10 percent per annum, payable semiannually in arrears. Accordingly, D has an obligation to make semiannual interest payments of $5 million. It makes the following entry on March 31, 20X1:

Because the bond was issued at a discount and debt issuance costs were incurred, the stated interest rate differs from the effective interest rate. By solving for the rate that equates the initial net proceeds to the future contractual interest and principal cash flows (see Section 6.2.3.3), D determines that the periodic (semiannual) effective interest rate equals 5.42 percent. During the period from March 31 to September 30, A accrues interest of $5,144,694 ($95,000,000 × 5.42% = $5,144,694) and makes the following journal entry:

On September 30, 20X1, D makes its first semiannual interest payment and recognizes the following entry:

During the period from September 30, 20X1, to March 31, 20X2, D accrues interest of $5,152,530 [($95,000,000 + $144,694) × 5.42% = $5,152,530] and makes the following entry:

On March 31, 20X2, D makes its second semiannual interest payment and recognizes the following entry:

The full discount amortization schedule for D’s bond is shown below.

Example 6-8

Debt Issued at a Premium

Entity P issues a five-year $10 million bond on March 31, 20X1, at a 4 percent premium for proceeds of $10.4 million. Further, P incurs debt issuance costs of $100,000. The stated coupon rate is 12 percent per annum, payable semiannually in arrears. Accordingly, P has an obligation to make semiannual interest payments of $600,000. Entity P makes the following entry on March 31, 20X1:

Because the bond was issued at net premium, the stated interest rate differs from the effective interest rate. By solving for the rate that equates the initial net proceeds to the future contractual interest and principal cash flows, P determines that the periodic (semiannual) effective interest rate equals 5.6 percent. During the period from March 31 to September 30, P accrues interest of $576,809 ($10,300,000 × 5.6% = $576,809) as follows:

On September 30, 20X1, P makes its first semiannual interest payment and recognizes the following entry:

During the period from September 30, 20X1, to March 31, 20X2, P accrues interest of $575,510 [($10,300,000 – $23,191) × 5.6% = $575,510] as follows:

On March 31, 20X2, P makes its second semiannual interest payment and recognizes the following entry:

The full premium amortization schedule for P’s bond is shown below.

6.2.4 Amortization Period

6.2.4.1 General

ASC 835-30

Although ASC 835-30-35-2 specifies that a discount or premium should be amortized over the debt’s “life,” it does not explicitly address whether life refers to the contractual term or some shorter period. In practice, life has been interpreted to mean the debt’s full stated contractual term unless the debt is puttable by the creditor at an amount in excess of its accreted value before its stated maturity date (see the next section). Special amortization guidance applies to extendable increasing-rate debt (see Section 6.2.4.5).

6.2.4.2 Puttable Debt Involving a Discount

For debt issued at a discount that is puttable by the creditor at an amount in excess of its accreted value (e.g., at an amount equal to or in excess of its stated principal amount), the debtor should amortize any debt discount and issuance costs from the date of issuance to the earliest stated date on which the creditor has a noncontingent right to exercise its put option. This means that in the calculation of the effective interest rate, it should be assumed that the debtor exercises the put option. From the debtor’s perspective, this is the highest possible yield that it could be forced to pay if the circumstances do not change. This guidance is supported by analogy to the requirement in ASC 480-10-S99-3A(15)(a) to accrete changes in the redemption value of redeemable securities classified in temporary equity to the earliest redemption date (see Section 9.5.2.3 of Deloitte’s Roadmap Distinguishing Liabilities From Equity).

If debt becomes immediately due and payable because a mandatory redemption feature is triggered, any remaining unamortized debt discount and debt issuance costs should be recognized immediately as an expense. If a contingent put right is triggered (or it becomes probable that it will be triggered) so that the creditor obtains the right to exercise it (e.g., a creditor’s right to accelerate the repayment of debt upon a debt covenant violation), the debtor should assess whether it is necessary to accelerate the amortization of any remaining unamortized debt discount and issuance costs. If there is a reasonable likelihood that the creditor will not exercise the put feature (e.g., because the creditor has waived the debt covenant violation), continued amortization over the debt’s full contractual term may be appropriate.

If the holder’s ability to exercise a put option is contingent on circumstances beyond its control but the holder is expected to obtain the unilateral ability to exercise it, it is acceptable to amortize discounts and issuance costs over the period until the holder is expected to obtain such unilateral ability. If the creditor does not have a unilateral right to put the debt back to the company as of a specified date or on specified dates (e.g., the exercise of the put is contingent on an uncertain future event outside the creditor’s control) and it is not probable that the put right will become exercisable by the creditor, any debt discount and debt issuance costs should be amortized over the debt’s full contractual term. If debt is puttable at an amount less than its accreted value (e.g., a put option with a strike price that is less than the amount of net proceeds received), amortization of the discount over the full contractual term would also be appropriate since the debtor would not be paying the creditor for any discount or issuance costs upon the exercise of the put.

Example 6-9

Puttable Debt Issued at a Discount

Entity D issues a 10-year $60 million debt instrument on March 31, 20X1, at a 6 percent discount for net cash proceeds of $56.4 million. The stated coupon rate is 8 percent per annum, payable semiannually in arrears. Accordingly, D has an obligation to make semiannual interest payments of $2.4 million.

The holder has the unconditional right to put the debt back to D at par at any time after five years; therefore, the debt discount should be amortized over five years to ensure that its carrying amount is equal to the redemption amount on the earliest redemption date. Entity D computes the effective interest rate on the basis of a five-year life and determines that the periodic effective interest rate is 4.77 percent. The discount amortization schedule for D’s debt is shown below:

6.2.4.3 Puttable Debt Involving a Premium

For debt that is issued at a premium to par and puttable by the creditor at an amount less than its accreted value (e.g., par), the debt premium should be amortized over the contractual life of the debt. It would not be appropriate to recognize the debt premium as a reduction of interest expense from the date of issuance to the earliest stated redemption date. ASC 450-30-25-1 provides analogous guidance:

A contingency that might result in a gain usually should not be reflected in the financial statements because to do so might be to recognize revenue before its realization.

Example 6-10

Puttable Debt Issued at a Premium

Entity R issued debt at a premium with a 10-year term. The holder has the unconditional right to put the debt back to the company at par at any time after five years. Entity R should amortize the debt premium over the 10-year contractual life of the debt.

6.2.4.4 Callable Debt

Any discount or premium for debt that is prepayable or callable by the debtor (but is not puttable by the creditor) should be amortized over the contractual term of the debt (i.e., the debtor should not assume that it will exercise its call option).

Example 6-11

Callable Debt Issued at a Discount

Entity C issued two nonconvertible debt instruments. Both instruments have a 10-year term and were issued at a discount. The entity can call each debt instrument at par at any time after five years. The first debt instrument has an interest rate that “steps up” during the contractual term of the debt from 6 percent to 12 percent. The second debt instrument has an interest rate that is variable for five years and then becomes fixed for the remaining term. Neither of the debt instruments is puttable by the investor. For each instrument, C should amortize the related debt discount and any issuance cost over the full contractual term to the debt’s maturity. Note that the application of the interest method to the debt with the interest rate step-up must take into account the contractual interest rate terms throughout the contractual life of the instrument.

6.2.4.5 Extendable Increasing-Rate Debt

ASC 470-10

35-1 A debt instrument may have a maturity date that can be extended at the option of the borrower at each maturity date until final maturity. In such cases, the interest rate on the note increases a specified amount each time the note is renewed. For guidance on accounting for interest, see Subtopic 835-30.

35-2 The borrower’s periodic interest cost shall be determined using the interest method based on the estimated outstanding term of the debt. In estimating the term of the debt, the borrower shall consider its plans, ability, and intent to service the debt. Debt issue costs shall be amortized over the same period used in the interest cost determination. The term-extending provisions of the debt instrument should be analyzed to determine whether those provisions constitute an embedded derivative that warrants separate accounting as a derivative under Subtopic 815-10.

45-8 If the debt is paid at par before its estimated maturity, any excess interest accrued shall be an adjustment of interest expense.

An exception to the requirement to amortize discounts and premiums over the contractual term applies to certain extendable increasing-rate debt instruments. (This guidance does not apply to debt with a term extension option that must be bifurcated as a derivative instrument under ASC 815-15; see Section 8.4.5.) In accordance with ASC 470-10-35-2, if a debt instrument has a contractual maturity date that can be extended at the issuer’s option at an increasing interest rate, the debt discounts and issuance costs must be amortized over the period in which the debt is estimated to be outstanding even if that period extends beyond the debt’s original contractual maturity date. That is, the effective interest rate is calculated on the basis of the estimated term of the debt.

If extendable increasing-rate debt is repaid at par before its estimated maturity, the issuer should not recognize a debt extinguishment gain for any excess interest accrued. Instead, ASC 470-10-45-8 requires the debtor to derecognize the excess interest accrued by adjusting the amount of reported interest expense.

Example 6-12

Increasing-Rate Debt

Entity E issues a 90-day debt instrument at par for proceeds of $100 million. The interest rate is 5 percent per annum. Entity E has an option to extend the term for 90 days in each quarter at an increasing interest rate. If the term is extended, the interest rate increases by 0.5 percent in each quarter during the first year and 0.25 percent in each quarter after the first year. The estimated outstanding term of the debt is two years. Entity E determines that, if a two-year life is assumed, the effective (quarterly) interest rate under ASC 470-10-35-2 is 1.6 percent. The interest recognition schedule for this debt instrument is as follows:

Even though debt with a borrower extension option (at an increased interest rate) is economically similar to a debt instrument with an interest rate that steps up over time and that the borrower may call before maturity, the guidance in ASC 470-10-35 does not apply to such callable debt. The guidance in ASC 470-10-35 on extendable increasing-rate debt represents an exception to the general interest recognition guidance in ASC 835-30. Discounts, premiums, and issuance costs related to callable, increasing-rate debt are amortized over the contractual term to maturity (see Section 6.2.4.4).

Example 6-13

Callable Increasing-Rate Debt

Entity C issues a note that is economically similar to Entity E’s note in Example 6-12. However, C structures the note as a callable five-year increasing-rate note instead of a three-month instrument extendable at an increasing interest rate. Entity C issues the note at par for proceeds of $100 million. The initial interest rate is 5 percent per annum, payable quarterly. The interest rate increases by 0.5 percent in each quarter during the first year and 0.25 percent in each quarter after the first year. Under the call option, C has the right to prepay the debt at any time at par. The estimated outstanding term of the debt is two years. Entity C determines that the effective (quarterly) interest rate computed under ASC 835-30 is approximately 1.97 percent. The interest recognition schedule for this note is as follows:

Connecting the Dots

ASC 470-10 does not specifically address whether an issuer of extendable increasing-rate debt that uses the interest method should periodically update the debt’s estimated life. However, since ASC 470-10-45-8 acknowledges that there could be excess accrued interest as of the date such debt is repaid, we believe that there is no requirement for entities to reassess the estimated life that was determined on the debt’s issuance date. However, it would also be appropriate for an entity that uses the interest method to elect, as an accounting policy, to continually update the estimated life of extendable increasing-rate debt provided that the entity makes any necessary adjustments to periodic interest expense by applying a retrospective method (i.e., the cumulative interest cost reported in any financial reporting period-end is based on the updated effective yield).

6.2.5 Debt With Contingent or Variable Cash Flows or Other Unique Features

6.2.5.1 Background

Some debt instruments contain contractual features that could affect the timing or amount of the contractual cash flows or the settlement method (e.g., cash or equity shares). Such adjustments may be at the option of the counterparty (e.g., a put or redemption feature) or contingent on the occurrence or nonoccurrence of an event (e.g., noncompliance with a debt covenant). They may also be based on a price (e.g., a commodity or equity price), appraised value (e.g., mortgaged real estate), index (e.g., a stock market index), rate (e.g., consumer price index [CPI]), or other measure (e.g., the issuer’s revenue, the cash flows from a mortgaged real estate project, or the cash flows from a pool of receivables). An entity should evaluate these types of features to determine whether they must be separated from the instrument as derivatives under ASC 815-15 (see Chapter 8).

If ASC 815-15 does not require the separation of such a feature and the issuer has not elected to account for the debt at fair value under ASC 815-15 (see Section 8.5.6) or ASC 825-10 (see Section 4.4), the application of the interest method may need to be altered. Special accounting models apply to certain types of debt such as puttable debt (see Section 6.2.4.2), extendable increasing-rate debt (see Section 6.2.4.5), sales of future revenue (see Section 7.2), participating mortgages (see Section 7.3), indexed debt (see Section 7.4), and convertible debt (see Section 7.6). The application of the interest method to variable-rate debt is addressed in Section 6.2.5.2 and to paid-in-kind (PIK) interest in Section 6.2.5.3. If no other accounting literature is applicable, the debtor should consider the guidance on loss contingencies in ASC 450-20 (see Section 6.2.5.4) and gain contingencies in ASC 450-30 (see Section 6.2.5.5) to determine whether any accounting is required before a payment occurs. However, a debtor should accrue interest on the basis of the amounts that are contractually due even if the debtor is unable, or expects to be unable, to pay some or all of those amounts (see Section 6.2.5.6). Special considerations related to the application of the interest method to nonrecourse beneficial interest obligations are addressed in Section 6.2.5.7.

6.2.5.2 Variable-Rate Debt

If the stated interest rate of a debt instrument varies on the basis of changes in a reference interest rate index (such as the prime rate or benchmark interest rate), the debtor generally should accrue amounts designated in the debt agreement as interest in accordance with the interest rate in effect in each period as it changes over the debt’s life. ASC 470-30-35-3, which addresses participating mortgages (see Section 7.3.5), states, in part:

Amounts designated in the mortgage agreement as interest shall be charged to income in the period in which the interest is incurred. If the loan’s stated interest rate varies based on changes in an independent factor, such as an index or rate (for example, the prime rate, the London Interbank Offered Rate [LIBOR], or the U.S. Treasury bill weekly average rate), the calculation of the interest shall be based on the factor (the index or the rate) as it changes over the life of the loan.

The definition of the interest method suggests that periodic interest cost is determined on the basis of a level effective rate (see Section 6.2.1). Because the interest cash flows of variable-rate debt vary in accordance with changes in a reference rate, however, the application of a constant discount rate to the remaining estimated cash flows could result in the recognition of significant gains and losses that do not reflect changes in the debt’s outstanding amount. Therefore, it is not appropriate to recognize interest payments that vary on the basis of a reference interest rate by using an effective interest rate that is frozen at inception (although a frozen effective yield may be used to amortize a discount, a premium, or debt issuance costs, as discussed below).

If variable-rate debt has an associated discount or premium or debt issuance costs, an entity may amortize such amounts by using an amortization schedule that is fixed at inception on the basis of the reference rate that was in effect when the debt was first recognized. ASC 310-20 contains analogous guidance on the application of the interest method to the recognition of net fees and costs associated with the origination or acquisition of a loan asset that has a stated interest rate that varies on the basis of changes in an independent factor such as the prime rate. That guidance permits an entity to either freeze the effective interest rate at inception or continually update it as the factor changes over the loan’s life as long as the method selected is applied consistently over the loan’s life. ASC 310-20-35-18(c) and ASC 310-20-35-19 state, in part:

If the loan’s stated interest rate varies based on future changes in an independent factor, such as an index or rate (for example, the prime rate, the London Interbank Offered Rate [LIBOR], or the U.S. Treasury bill weekly average rate), the calculation of the constant effective yield necessary to recognize fees and costs shall be based either on the factor (the index or rate) that is in effect at the inception of the loan or on the factor as it changes over the life of the loan.

[The] lender may not change from one alternative to the other during the life of the loan. The lender must select one of the two alternatives and apply the method consistently throughout the life of the loan.

6.2.5.3 PIK Interest

ASC Master Glossary

Payment-in-Kind Bonds

Bonds in which the issuer has the option at each interest payment date of making interest payments in cash or in additional debt securities. Those additional debt securities are referred to as baby or bunny bonds. Baby bonds generally have the same terms, including maturity dates and interest rates, as the original bonds (parent payment-in-kind bonds). Interest on baby bonds may also be paid in cash or in additional like-kind debt securities at the option of the issuer.

Some debt instruments include a PIK interest feature that requires or permits the issuer to fulfill its interest payment requirements by issuing an equivalent principal amount of additional debt instruments with the same terms as the original debt instrument. That is, on each interest payment date, the issuer satisfies its obligation by issuing to the holder(s) additional debt instruments that have the same terms as the original debt instrument (i.e., additional fungible securities). Alternatively, interest payment obligations may be capitalized into the principal amount of the original debt instrument.2 Generally, both types of PIK interest features are economically the same.

While some PIK interest features must be separated as derivatives under ASC 815 (see Section 8.4.6), most will be subject to the scope exception in ASC 815-10-15-69 through 15-71 for certain loan commitments. If PIK interest features are not accounted for as derivatives, it is generally appropriate to use the interest method to recognize the interest payments that are paid in kind.

If an issuer has discretion to satisfy interest payment obligations in cash or in kind and the interest rate differs depending on the form of payment, the effective interest rate of the debt instrument should be determined on the basis of whether the issuer expects interest to be paid in cash or in kind. Generally, the issuer will conclude that it will make periodic interest payments by using the option (i.e., cash or in kind) that is most economically favorable to it.

Example 6-14

Discretionary PIK Interest Feature — Interest May Be Paid in Cash or in Kind

Company R issued debt securities with interest coupons that may be paid in cash or additional debt securities at R’s option. The original debt security pays interest at an 8 percent per annum rate. Company R elects the form of interest payments immediately before each payment date. This PIK feature is considered discretionary since R can choose the form of payment of the interest coupons. It is acceptable for R to use the interest method to account for interest payments that are paid in kind.

6.2.5.4 Loss Contingencies

ASC 450-20

25-2 An estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met:

Information available before the financial statements are issued or are available to be issued (as discussed in Section 855-10-25) indicates that it is probable that . . . a liability had been incurred at the date of the financial statements. Date of the financial statements means the end of the most recent accounting period for which financial statements are being presented. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.
The amount of loss can be reasonably estimated.

The purpose of those conditions is to require accrual of losses when they are reasonably estimable and relate to the current or a prior period. . . . As discussed in paragraph 450-20-50-5, disclosure is preferable to accrual when a reasonable estimate of loss cannot be made. Further, even losses that are reasonably estimable shall not be accrued if it is not probable that an asset has been impaired or a liability has been incurred at the date of an entity’s financial statements because those losses relate to a future period rather than the current or a prior period. Attribution of a loss to events or activities of the current or prior periods is an element of . . . liability incurrence.

Sometimes, debt instruments require the issuer to make one or more payments upon the occurrence or nonoccurrence of specified events. For example, a debt instrument might require the debtor to pay a fixed amount on the basis of a condition linked to the issuer’s creditworthiness. If no other accounting literature applies (e.g., the provision does not need to be separated as a derivative under ASC 815-15 and is not subject to the indexed-debt guidance in ASC 470-10), the issuer should evaluate whether it must accrue a probable loss under the loss contingency guidance in ASC 450-20. Under that guidance, an expense must be accrued if it is probable that a payment will be required and the amount of the payment can be reasonably estimated (see Deloitte’s Roadmap Contingencies, Loss Recoveries, and Guarantees). Note, however, that if the payment varies on the basis of a price or an index (e.g., it varies on the basis of a measure of inflation) and no other accounting literature applies, the debtor should generally apply the guidance on indexed debt in ASC 470-10 (see Section 7.4) instead of the loss contingency guidance in ASC 450-20.

Example 6-15

Contingent Payment on Debt Instrument

Entity A has issued 10-year notes that include a provision that requires A to maintain a leverage ratio of 8:1 or lower as of each quarterly reporting date. The leverage ratio is expressed as A’s total consolidated indebtedness as of the date of determination to its most recently reported annualized EBITDA. If A fails to maintain the specified leverage ratio, the notes become immediately due and payable unless A makes a cash payment of $20 million to the notes’ holders. Entity A has determined that it is not required to separate the contingent penalty provision as an embedded derivative. In this circumstance, the contingent payment represents a loss contingency that should be evaluated under ASC 450-20-25-2. If it becomes probable that A will be required to make the payment, A should record an immediate charge to earnings for the amount of the loss.

6.2.5.5 Gain Contingencies

ASC 450-30

25-1 A contingency that might result in a gain usually should not be reflected in the financial statements because to do so might be to recognize revenue before its realization.

Sometimes, debt instruments include contractual terms under which some or all of the principal or interest payments will be forgiven upon the occurrence or nonoccurrence of specified events. For example, some debt securities include bail-in provisions under which a regulatory authority has the power to write down or cancel the debt. In the absence of the occurrence or nonoccurrence of the specified events, however, the full stated amount of principal and interest is payable. If no other accounting literature applies (e.g., the provision does not need to be separated as a derivative under ASC 815-15), it is generally not appropriate for the issuer to anticipate that some or all of its obligation might be canceled in the future. Such an expectation is akin to a contingent gain that should be recognized only if or when the gain is realized or realizable under the guidance on gain contingencies in ASC 450-30 (see Chapter 3 of Deloitte’s Roadmap Contingencies, Loss Recoveries, and Guarantees). Further, under ASC 405-20, a debtor generally is not permitted to derecognize a debt obligation before it has been extinguished (see Section 9.2).

Connecting the Dots

There is no guidance in U.S. GAAP that specifically addresses whether an entity is permitted to account for a forgivable loan from a government entity as an in-substance government grant. However, in all situations in which a debtor expects to repay a forgivable loan, it must account for that amount as debt.

6.2.5.6 Actual or Expected Payment Defaults

Under the interest method, a debtor accrues interest on the basis of the amounts that are contractually due even if the debtor is unable, or expects to be unable, to pay some or all of those amounts. In the absence of a debt modification or exchange that qualifies as a debt extinguishment (see Chapter 10) or TDR (see Chapter 11), it is not appropriate for a debtor to adjust or write off debt discounts, premiums, or debt issuance costs even if it has defaulted or is expected to default or violate covenants of the underlying debt. Further, an entity is not permitted to anticipate that the creditor will forgive some or all of the outstanding amount of principal and interest in the future. The expectation of full or partial forgiveness is akin to a contingent gain that should be given accounting recognition only if or when the gain is realized or realizable under the guidance on gain contingencies in ASC 450-30 (see the previous section). Further, in accordance with ASC 405-20, a debtor generally is not permitted to derecognize a debt obligation before it has been extinguished (see Section 9.2).

However, an adjustment to the debt’s net carrying amount and the related amounts of any debt discount, premium, or debt issuance costs may become necessary if the debtor is subject to reorganization proceedings under the U.S. Bankruptcy Code. ASC 852-10-45-6 states:

Debt discounts or premiums as well as debt issue costs shall be viewed as valuations of the related debt. When the debt has become an allowed claim and the allowed claim differs from the net carrying amount of the debt, the recorded amount shall be adjusted to the amount of the allowed claim (thereby adjusting existing discounts or premiums, and deferred issue costs to the extent necessary to report the debt at this allowed amount). The gain or loss resulting from the entries to record the adjustment shall be classified as reorganization items, as discussed in paragraph 852-10-45-9. Premiums and discounts as well as debt issuance cost on debts that are not subject to compromise, such as fully secured claims, shall not be adjusted.

If the recorded amount is adjusted under ASC 852, discounts, premiums, and issuance costs should continue to be amortized over the life of the debt that was assumed when the obligation was originally recorded.

6.2.5.7 Nonrecourse Beneficial Interests

6.2.5.7.1 Background

For nonrecourse beneficial interest liabilities (i.e., obligations indexed to a pool of financial assets) for which both fixed and contingent payments are required, special methods of recognizing interest expense may be acceptable if (1) the contingent payment obligation is not subject to derivative accounting under ASC 815 (see Chapter 8) and (2) the issuer has not elected the fair value option for the instrument under ASC 815-15 (see Section 8.5.6) or ASC 825-10 (see Section 4.4). Such special methods include:

The expected-effective-yield method (see the next section).
The hypothetical liquidation at fair value (HLFV) method (see Section 6.2.5.7.3).

6.2.5.7.2 Expected-Effective-Yield Method

Under the expected-effective-yield method, the debtor recognizes interest expense in each reporting period by using an effective interest rate that is determined on the basis of expected cash flows over the life of the debt.

Example 6-16

Liability Secured by Receivables

Entity A obtains a five-year loan from Bank B. The loan has a fixed, stated interest rate of 12 percent and is collateralized by a pool of revolving credit card receivables that A holds. When A receives payments from the underlying receivables, it is required under the terms of the loan to use a specified portion of those cash flows to pay the fixed interest and repay a portion of the principal amount to B on the basis of a waterfall schedule. If the projected cash flows from the underlying receivables at any time are insufficient to repay the principal amount and to pay the fixed interest to B, A is required to fund the deficit by using other assets. Further, B is entitled to participate in any residual cash flows generated by the pool once A has made its required principal and fixed interest payments. Because this participation is contingent on the performance of the receivables, it represents a contingent payment obligation of A. At inception of the loan, there is an expectation that contingent payments will be payable to B.

In this scenario, A may apply either (1) a contingent interest expense recognition model that is similar to the guidance on indexed debt instruments (see Section 7.4) or on participating mortgages (see Section 7.3), such as the HLFV method (see Section 6.2.5.7.3), or (2) an effective-yield interest expense recognition approach on the basis of the effective interest rate expected to be paid over the life of the loan by analogy to the method that may be elected for anticipated prepayments on a large number of similar loans under ASC 310-20-35-26 through 35-33.

If A elects to apply an effective-yield interest expense recognition approach, it should reflect in its determination of the effective interest rate the amount and timing of all cash flows expected to be paid on the loan, which would be affected by the expected performance of the pool of receivables. However, A cannot anticipate nonpayment of the principal amount or the fixed-interest cash flows because those payments are contractual. Although those amounts must be paid even if the cash flows from the pool of receivables are insufficient, this conclusion would not change if this were not the case.

If the expected timing or amount of the cash flows change, A applies a retrospective interest method (see ASC 310-20-35-26). That is, it recalculates the effective interest rate by determining the effective interest rate that would have existed when the debt was first recognized on the basis of the original net carrying amount, actual payments to date, and the revised estimate of remaining future payments. Entity A then adjusts the debt’s current net carrying amount to an amount equal to the present value of the estimated remaining future payments, discounted by using the revised effective interest rate, with an offsetting adjustment to interest expense.

6.2.5.7.3 HLFV Method

An entity uses the HLFV method to measure interest expense for a nonrecourse beneficial interest liability (i.e., an obligation indexed to a pool of financial assets) as of each reporting date on the basis of an assumption that the pool was liquidated, the assets held were sold at fair value, and the proceeds on sale were distributed in accordance with the waterfall provisions that govern the distribution of the cash flows generated by the pool of assets.

Example 6-17

Nonrecourse Beneficial Interest Liability

Entity E consolidates Trust T, which is a collateralized loan obligation entity. Trust T holds investments in variable-rate debt instruments that pay interest at the three-month U.S. Treasury (UST) rate and meet certain other criteria. In addition, T has issued three classes of 10-year nonrecourse beneficial interests in the assets it holds:

Class A notes — The principal amount of such notes is $500 million, they are the most senior interests issued by T, and they have a first-priority security interest in each asset T holds. The class A notes accrue interest at the three-month UST rate plus 50 basis points per annum, payable quarterly. No distributions of excess cash flows received on the assets held may be paid on the other notes issued by T until all principal and interest on the class A notes have been paid in full. If an event of default occurs (e.g., T fails to pay any required principal or interest payments on the class A notes when due), holders of a majority of the notes have the right to declare them immediately due and payable.
Class B notes — The principal amount of such notes is $50 million and they have a subordinated priority security interest in each asset held by T. Available cash flows received from the assets held by T are paid quarterly on the class B notes until a 15 percent annual internal rate of return is achieved. Trust T’s inability to make payments to holders of the class B notes does not constitute an event of default. At T’s inception, there was an expectation that the class B notes would achieve at least a 15 percent return.
Income notes — The principal amount of such notes is $25 million, they are the most subordinated beneficial interests issued by T, and they have no stated interest rate. The inability of T to make payments to holders of the income notes does not constitute an event of default. The income notes are held by E.

If certain coverage tests are met, any excess cash flows received on the assets held by T after required principal and interest payments have been made on the class A notes and class B notes are distributed quarterly to holders of the class B notes and income notes on a 50:50 basis. Under the coverage tests, (1) the class A notes’ overcollateralization ratio (i.e., the ratio of the aggregate principal amount of debt instruments held by T to the aggregate principal amount of class A notes) must exceed 105 percent and (2) the class A notes’ interest coverage ratio (i.e., the ratio of the interest proceeds received on the assets held by T [net of expenses and fees] to the accrued and unpaid interest on the class A notes) must exceed 115 percent on the applicable quarterly payment date before distributions of excess cash flows can be made to holders of class B notes and income notes. If the coverage tests are not met on a quarterly payment date, any excess cash flows are used to pay down the principal amount of the class A notes.

Entity E has determined that the beneficial interests issued do not contain any features that must be accounted for separately as derivatives (see Chapter 8). Further, E has not elected to apply the fair value option in ASC 815-15 (see Section 8.5.6) or ASC 825-10 (see Section 4.4) to the beneficial interests.

There are two interest elements related to the class B notes: (1) interest up to a 15 percent annual internal rate of return and (2) excess interest determined on the basis of the excess cash flows on the assets held by T.

Irrespective of T’s performance (e.g., the level of credit losses), E should recognize interest expense on the class B notes on the basis of a 15 percent effective yield. Although the class B notes may not receive interest equal to a 15 percent annual return if certain levels of credit or other losses occur, the class B notes have a stated interest rate of 15 percent. In substance, the stipulated interest rate on the class B notes is similar to the stipulated interest rate on the class A notes because both are nonrecourse debt obligations that will receive the stated return only if the assets held by T generate sufficient cash flows. Further, it would be inappropriate for E to reduce the carrying amount of the class B notes below the unpaid principal amount plus accrued and unpaid interest at a 15 percent annual internal rate of return because the extinguishment criteria in ASC 405-20-40-1 (see Section 9.2) are not met (i.e., T is not legally released from its role as primary obligor under the class B notes until the principal amount and accrued and unpaid interest is repaid in full or T liquidates.

Because the excess interest that will be paid on the class B notes is contingent on the performance of T’s assets, it would be appropriate for E to apply the contingent payment obligation guidance related to indexed-debt instruments in ASC 470-10 (see Section 7.4) or participating mortgages in ASC 470-30 (see Section 7.3). In the calculation of the amount of excess interest expense under this guidance, it would be acceptable for E to apply the hypothetical liquidation at book value method (as described in ASC 323-10-55-54 through 55-57), except that the fair value of the assets held by T should be used in the hypothetical liquidation analysis (i.e., the HLFV method).

Under the HLFV method, as of each financial reporting date, excess interest expense on the class B notes is measured on the basis of the assumption that T was liquidated, the assets held were sold at fair value, and the proceeds on sale were distributed in accordance with the terms of the beneficial interests. This method has the effect of recognizing excess interest expense on the class B notes on the basis of the “applicable index” (the fair value of T’s assets) in accordance with the guidance on indexed-debt instruments in ASC 470-10 (see Section 7.4).

At the end of the first annual reporting period, the aggregate fair value of the assets held by T is $600 million and the three-month UST rate is 2.0 percent. If these assets were to be sold at fair value, $512 million would be allocated to the class A notes (which includes the repayment of principal of $500 million and the payment of $12 million of interest). Further, $57.5 million would be allocated to the class B notes (which includes the repayment of principal of $50 million and $7.5 million of interest at 15 percent). After these distributions, $30.5 million would remain. Fifty percent of this residual cash flow ($15.25 million) would be allocated to the class B notes as additional interest. As a result, at the end of the reporting period, E should recognize total interest expense on the class B notes of $22.75 million.

When applying the HLFV method in subsequent financial reporting periods, E should recognize excess interest expense amounts on the basis of the excess of (1) the cumulative amounts that would be paid to the class B notes (which consist of (a) the 15 percent annual yield, (b) the amount of excess interest above the 15 percent yield that has been previously paid in cash, and (c) the excess interest that results from the current-period application of the HLFV method) over (2) the total interest expense recognized in prior periods. This could involve the reversal of previously recognized excess interest, but in no circumstance should the total interest expense recognized, on a cumulative basis, be less than a 15 percent effective yield on the principal amounts outstanding, plus the amount of any excess interest above the 15 percent yield that has been previously paid in cash. Therefore, the total carrying amount related to the class B notes will always equal the excess of (1) the initial principal amount invested ($50 million), plus interest accrued at a 15 percent annual effective yield on the unpaid principal amount, plus excess interest accrued over (2) principal and interest amounts paid on the class B notes.

Also, the determination of whether cash distributions are (would be) reflected as repayments of principal or as a return (and the associated impact such decision has on the calculation of the 15 percent annual yield) should be consistent with the contractual terms of the beneficial interests. Reflecting payments as a reduction of principal in accordance with such terms is consistent with the legal extinguishment concept in ASC 405-20-40-1 (see Section 9.2) as long as under the terms, interest no longer accrues at a 15 percent annual yield for amounts that are considered principal repayments.

Footnotes

Note that there are 91 days between October 1, 20X1, and December 31, 20X1, as compared with 181 total days in this interest period.

If the debt is convertible into equity shares, there is a proportionate increase in the number of such shares that will be issued upon exercise of the conversion feature.

Confidential and Proprietary — for Use Solely by Authorized Personnel

This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.