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
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.
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 interest to be satisfied through the issuance of an
equivalent principal amount of additional debt instruments with the same
terms as the original debt instrument. The following are two types of such
PIK interest payment features:
-
On each interest payment date, the issuer satisfies the interest payment 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).
-
On each interest payment date, the issuer increases the principal amount of the original debt instrument to reflect the interest accrued to the benefit of the holder. 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. Economically, other than with respect to potential differences attributable to the compounding terms of an instrument, the PIK feature has the same effect as delivering additional debt instruments with the same terms as the original debt instrument.
Certain PIK interest rate features must be separated as
derivatives under ASC 815 (see Section 8.4.6). Otherwise, the
accounting for PIK features depends on whether they are discretionary or
nondiscretionary. A PIK feature in a nonconvertible debt instrument is
considered nondiscretionary if neither the issuer nor the holder can elect
other forms of payment for the interest (e.g., the interest must be paid in
kind and neither party can elect another form of payment before the debt is
repaid). Such a feature is considered discretionary if either the issuer or
the holder can elect a form of payment other than PIK instruments (e.g., the
issuer has the option to settle interest payment obligations by either
delivering cash or issuing PIK instruments).
The table below describes the accounting for PIK interest
features on nonconvertible debt instruments (for such features that are not
bifurcated as embedded derivatives).
Effective Interest Rate of the
Original Debt Instrument
|
Initial Measurement of PIK
Instruments Issued
| |
---|---|---|
Nondiscretionary PIK interest
|
The contractual cash flows of the
PIK instruments that will be issued are incorporated
into the computation of the effective interest rate
of the original debt instrument. Unless some portion
of interest must be paid in cash (e.g., 5 percent in
cash and 5 percent in kind), an entity treats the
original debt instrument as a zero-coupon instrument
when applying the interest method.
|
When PIK interest is recognized, the
debtor measures the PIK instruments issued at the
present value of their contractual cash flows,
discounted by using the effective interest rate of
the original debt instrument.
|
Discretionary PIK interest
|
The effective interest rate of the
original debt instrument may be computed on the
basis of an assumption that the debtor will elect to
pay interest in the form of cash. Alternatively, the
debtor may assume that it will elect to pay interest
in the form of either PIK instruments or cash,
depending on which option is expected to be most
economical (e.g., by considering the fair value of
the PIK instruments in relation to the amount of
cash interest that would be paid). If interest is
expected to be paid in the form of PIK instruments,
the fair value of those PIK instruments is
incorporated into the computation of the effective
interest rate of the original debt instrument as an
assumed cash flow on each interest payment date.
|
When PIK interest is recognized, the
debtor initially measures any debt instrument issued
as PIK interest at its fair value as of its interest
cost recognition date. This initial measurement
approach is consistent with the accounting for stock
dividends in ASC 505-20-30-3.
If there is a difference between the cash flow
assumed in the application of the interest method as
of an interest payment date and the fair value of
the PIK instrument issued, the debtor makes a
corresponding adjustment to the amount of interest
cost recognized. An entity should consider the
frequency with which it recognizes accrued interest
and the compounding terms of the debt, among other
factors, to arrive at a reasonable and practical
approach to recognizing the initial fair value of
debt instruments issued as PIK interest. For
example, an entity may determine that the
contractual interest payment dates are the dates on
which the fair value of PIK instruments should be
measured.
|
The accounting approach for PIK interest on nonconvertible debt
instruments is also appropriate for convertible debt instruments; however,
entities need to consider additional factors when determining whether a
convertible instrument should be viewed as discretionary or nondiscretionary.
The terms of some convertible debt instruments include a PIK interest payment
feature that requires or permits the issuer to satisfy any interest payment
obligations by issuing the same convertible debt instrument. The following are
two types of such PIK interest payment features:
- On the interest payment date, the issuer satisfies the interest payment obligation by issuing additional convertible debt securities to the holder(s). That is, additional fungible securities are issued.
- On each interest payment date, the issuer increases the principal amount of the original debt security to reflect the interest accrued to the benefit of the holder, which results in a proportionate increase in the number of equity shares that will be issued upon exercise of the conversion feature. For example, some convertible debt securities contain a requirement for the issuer to pay accrued interest by increasing the security’s principal amount while maintaining the same conversion price (although the conversion rate per security increases). Upon conversion, the holders will receive additional common shares on the basis of the increased principal amount. Economically, other than with respect to potential differences attributable to the compounding terms of an instrument, such a PIK feature has the same effect as delivering additional instruments.
As further discussed below, the commitment date for the issuance of a convertible
debt instrument as interest affects the initial measurement of such PIK interest
payment (i.e., whether the PIK interest is initially recognized on the basis of
the commitment date for the original convertible debt instrument or the fair
value of the convertible debt instrument issued as PIK interest on the PIK
interest payment date).
PIK Feature
|
Description
|
Commitment Date for PIK Interest
|
---|---|---|
Discretionary
|
A PIK feature is discretionary if
either of the following conditions exist:
|
The date that interest is accrued (i.e.,
the interest cost recognition date).
|
Nondiscretionary
|
A PIK feature is nondiscretionary if
both of the following conditions exist:
|
The commitment date for the original
convertible debt instrument.
|
There are two acceptable views on how to interpret the condition
that for PIK dividend payments to be nondiscretionary, the holder must always
receive the number of equity shares upon conversion as if all dividends have
been paid in kind if the original instrument (or part of it) is converted before
accumulated dividends are declared or accrued. An entity should select one view
and apply it consistently as an accounting policy election:
-
View A — Regardless of when during the security’s term the holder converts the instrument into equity shares, the holder must always receive upon conversion all of the interest that would have accrued during the entire life of the security (i.e., to the contractual maturity date).Under this view, the issuer must know at the inception of the original convertible debt instrument, regardless of the ultimate conversion date, the exact number of equity shares that will be issued to the holder upon full conversion (i.e., conversion of the original instrument at its principal amount adjusted for PIK interest or, if PIK interest is paid through the issuance of additional convertible debt instruments, conversion of both the original convertible debt instrument at its principal amount and any additional convertible debt instruments — potential contingent adjustments to the conversion rate for other reasons do not necessarily need to be considered). If the issuer cannot quantify the number of equity shares that will be issued or if the number of equity shares will differ depending on when the instrument is converted, the PIK feature is discretionary under this view. Accordingly, most PIK interest payments would be discretionary under View A since entities typically do not issue convertible debt instruments that allow the holder to effectively earn future interest that would not have accrued on an early conversion (i.e., instruments with make-whole equivalents to all future interest on an undiscounted basis).
-
View B — Regardless of when during the security’s term the holder converts the instrument into equity shares, the holder must always receive upon conversion all of the interest that has accrued during the entire period in which the security has been outstanding (i.e., to the conversion date).Under this view, the holder always receives upon conversion the number of equity shares as if all interest that has been earned to date is paid in equity shares (i.e., no interest amounts are paid in cash). If the conversion date falls between periodic contractual interest dates (i.e., accrual or payment dates) and the holder forfeits any interest that would have accrued from the last interest date, this forfeiture does not prevent the interest from being nondiscretionary since it is not payable in cash.
The view selected will not affect the conclusion that PIK interest is
discretionary in cases in which a convertible debt instrument allows either the
holder or issuer to choose to pay interest in cash or in kind. In these
circumstances, the PIK interest would be considered discretionary regardless of
whether the entity adopted View A or View B.
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. Therefore, the initial measurement
amount of any PIK debt securities is their fair
value on the interest cost accrual date.
Example 6-15
Debt With
Discretionary and Nondiscretionary PIK Interest
Payments
On March 31, 20X0, Entity A issued
100,000 convertible debt securities, with a
principal amount of $1,000, for total proceeds of
$100 million. The securities’ original maturity date
is six years from the issuance date, and they earn
interest at an annual rate of 10 percent per annum
of the principal amount per security, compounded
annually. During the first three years, A is
required to pay interest in kind by delivering
additional debt securities. During years 4–6, A has
the option to pay interest either in cash or in
kind. If interest is paid in kind, the number of
additional debt securities is determined on the
basis of the initial purchase price (i.e., A will
deliver one-tenth of a debt security for each
outstanding debt security). The debt securities do
not contain any put, call, or redemption features.
Thus, at the end of year 3, after payment of
interest in kind, there will be a total of 133,100
debt securities outstanding (100,000 ×
1.103).
This example presents a unique fact
pattern in which the PIK interest payments could be
considered to contain both a discretionary and
nondiscretionary element. Debt securities issued
after March 31, 20X3, should be initially measured
as discretionary PIK instruments at their fair value
as of the interest accrual dates. However, debt
securities issued during the first three years may
be treated as nondiscretionary PIK instruments. That
is, A would treat the original instrument as paying
no interest during years 1–3 and, when applying the
interest method, would assume that the PIK
instruments that will be issued during those years
are instead paid in cash at the end of the original
instrument’s life.
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 6-16
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:
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The expected-effective-yield method (see the next section).
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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 6-17
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 6-18
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 three-month LIBOR
and meet certain other criteria. In addition, T
has issued three classes of 10-year nonrecourse
beneficial interests in the assets it holds:
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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 three-month LIBOR 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.
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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.
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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 three-month
LIBOR 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
1
Note that there are 91 days
between October 1, 20X1, and December 31, 20X1, as
compared with 181 total days in this interest
period.