Chapter 7 — Special Accounting Models for Certain Types of Debt

7.4 Indexed Debt

7.4.1 Background

ASC 470-10 includes guidance on the issuer’s accounting for certain debt instruments that require the issuer to make both guaranteed and contingent payments that are linked to a specific price or index. However, since the indexation feature in most of the debt instruments must be bifurcated under ASC 815-15 as an embedded derivative, the indexed-debt guidance in ASC 470-10 applies only to certain contingent payment obligations that do not need to be separated as embedded derivatives under ASC 815-15 (see Chapter 8) and are not subject to other GAAP.

7.4.2 Scope

ASC 470-10

25-3 Debt instruments may be issued with both guaranteed and contingent payments. The contingent payments may be linked to the price of a specific commodity (for example, oil) or a specific index (for example, the S&P 500). In some instances, the investor’s right to receive the contingent payment (an indexing feature) is separable from the debt instrument. If the indexing feature does not warrant separate accounting under Topic 815 or the instrument does not meet the definition of a derivative under Topic 815, the entire instrument shall be accounted for in accordance with paragraphs 470-10-25-4 and 470-10-35-4.

The guidance on indexed debt instruments in ASC 470-10 applies to debt instruments that are issued with both guaranteed (fixed) and contingent (indexed) payments. The contingent payment obligation might be embedded in the debt (see the next section) or legally separable from it (see Section 7.4.4). However, the indexed-debt guidance does not apply if (1) the contingent payment obligation is subject to derivative accounting under ASC 815 (see Chapter 8), (2) the issuer has elected the fair value option under ASC 815-15 (see Section 8.5.6) or ASC 825-10 (see Section 4.4), or (3) the indexed debt is within the scope of guidance on sales of future revenue in ASC 470-10 (see Section 7.2) or participating mortgages in ASC 470-30 (see Section 7.3).

In many cases, indexation features must be accounted for as derivatives under ASC 815-15 because (1) changes in a commodity price or index (e.g., the price of gold) or in an equity price or index (e.g., S&P 500) are not considered clearly and closely related to a debt host contract (see Sections 8.4.9.3 and 8.4.7.3.2) and (2) contingent features that are explicitly cash settled meet the net settlement characteristic in the definition of a derivative (see Section 8.3.4.4). If the indexation feature is accounted for as a derivative, the indexed-debt guidance in ASC 470-10 does not apply; if the feature is not subject to derivative accounting, the issuer should evaluate whether to apply the indexed-debt guidance.

Examples of debt instruments that could be within the scope of the indexed-debt guidance include debt securities whose principal or interest payments vary on the basis of:

An inflation index, such as CPI, that is considered clearly and closely related to the debt host (see Section 8.4.3.3).
A nonfinancial asset if the indexation feature does not have to be separated as a derivative under ASC 815-15 (e.g., the nonfinancial asset is unique, not readily convertible to cash, and owned by a party to the contract; see Section 8.4.9.5).

7.4.3 Embedded Indexation Feature

Upon initial recognition of a debt instrument within the scope of the indexed-debt guidance in ASC 470-10, no proceeds are allocated to an indexation feature that is embedded in the debt. However, subsequent changes in the intrinsic value of the feature must be recognized (see Section 7.4.5).

7.4.4 Separate Indexation Features

ASC 470-10

25-4 If the investor’s right to receive the contingent payment is separable, the proceeds shall be allocated between the debt instrument and the investor’s stated right to receive the contingent payment. The premium or discount on the debt resulting from the allocation shall be accounted for in accordance with Subtopic 835-30.

If a contingent payment obligation within the scope of the indexed-debt guidance in ASC 470-10 is legally separable from the related debt instrument (i.e., it is a freestanding financial instrument; see Section 3.3), the proceeds received for the debt should be allocated between the debt and the investor’s right to receive contingent payments upon initial recognition. The discount (or reduced premium) on the debt instrument from such allocation should be accounted for in accordance with the interest method (see Section 6.2).

ASC 470-10 does not specify the method for allocating the proceeds between the debt liability and the separable contingent payment obligation. As a result, various allocation approaches for separating the contingent payment feature may be acceptable, including the following:

Relative fair value — The proceeds are allocated between the debt and the contingent payment obligation on the basis of the relative fair values of each component.
Fair value of debt component — The proceeds are allocated between the debt and the contingent payment obligation by first recognizing the carrying amount of the debt on the basis of the fair value of a similar debt instrument without the contingent payment obligation. The contingent payment obligation is then recognized as the difference between the proceeds received upon issuance and the carrying amount of the debt (i.e., a residual amount).
Fair value of contingent payment obligation — The proceeds are allocated between the debt and the contingent payment obligation by first recognizing the carrying amount of the contingent payment obligation on the basis of the fair value of such component. The debt is then recognized as the difference between the proceeds received upon issuance and the carrying amount of the contingent payment obligation (i.e., a residual amount).

Even though the separable contingent payment obligation is subsequently remeasured on the basis of its intrinsic value (see the next section), entities would generally not allocate the proceeds on the basis of the intrinsic value of the contingent payment obligation as of the issuance date of the debt because to do so would generally result in the allocation of no amount to the contingent payment obligation (i.e., the obligation has no intrinsic value at inception).

7.4.5 Intrinsic Value Method

ASC 470-10

35-4 As the applicable index value increases such that an issuer would be required to pay an investor a contingent payment at maturity, the issuer shall recognize a liability for the amount that the contingent payment exceeds the amount, if any, originally attributed to the contingent payment feature. The liability for the contingent payment feature shall be based on the applicable index value at the balance sheet date and shall not anticipate any future changes in the index value. When no proceeds are allocated originally to the contingent payment, the additional liability resulting from the fluctuating index value shall be accounted for as an adjustment of the carrying amount of the debt obligation.

ASC 470-10 requires the issuer to apply an intrinsic value approach to the measurement of contingent payment obligations in indexed debt instruments. The intrinsic value is determined on the basis of the applicable index value as of the balance sheet date and does not take into account future changes in the index value (e.g., on the basis of projections or forward market prices). In other words, the liability measurement is based on the settlement amount that would be payable on the basis of the conditions as of the reporting date.

Changes in the index value of an indexed debt instrument are accounted for as adjustments to the carrying amount of the (1) debt obligation (if embedded) or (2) contingent payment liability (if separable). Such changes should be recognized in the income statement as they occur (e.g., as interest expense).

At the 1997 AICPA Conference on Current SEC Developments, then SEC Professional Accounting Fellow Russell Mallett stated, in part:

While accounting practice typically recognizes changes in a debt obligation in the income statement, the [EITF] . . . did not reach a consensus on this point, although a majority of the Task Force believed expense treatment was appropriate.

Further, Mr. Mallett provided an example of an indexed debt instrument with a floor on the settlement amount equal to the original principal amount and suggested that such an index feature essentially is an embedded written option. He further noted that “generally, the staff believes that the obligations resulting from written options should be recognized in the balance sheet and changes in those obligations should be recognized immediately in the income statement. Therefore, consistent with the [indexed-debt] guidance in [ASC 470-10], the staff concluded that the indexed debt obligation should be adjusted based on the changes in the [index value] at each balance sheet date and that any changes in the obligation should be recognized in the income statement.”

The cumulative amount of additional expense recognized for the contingent payment obligation should not be less than zero. That is, while previously recognized additional expense may potentially be reversed in a subsequent financial reporting period if the index value declines, the cumulative total expense recognized should not be less than zero. An expectation that the issuer will not be required to repay the initial amount of the obligation is akin to a contingent gain that should be recognized only if or when the payment obligation is legally extinguished under ASC 405-20 (see Section 9.2).

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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.