Chapter 7 — Special Accounting Models for Certain Types of Debt
Chapter 7 — Special Accounting Models for Certain Types of Debt
7.1 Background
This chapter discusses the specialized accounting models that apply
to the following types of debt:
-
Sales of future revenues (see Section 7.2).
-
Participating mortgages (see Section 7.3).
-
Indexed debt (see Section 7.4).
-
Joint-and-several liability arrangements (see Section 7.5).
-
Convertible debt (see Section 7.6).
-
Debt exchangeable into the stock of another entity (see Section 7.7).
7.2 Sales of Future Revenues
7.2.1 Background
A seller of future revenue should evaluate whether the proceeds received should
be accounted for as debt or deferred income under ASC 470-10. Sales of future
revenue that are accounted for as debt are subject to the interest method, as
further discussed below.
7.2.2 Scope
ASC 470-10
25-1 An entity receives cash
from an investor and agrees to pay to the investor for a
defined period a specified percentage or amount of the
revenue or of a measure of income (for example, gross
margin, operating income, or pretax income) of a
particular product line, business segment, trademark,
patent, or contractual right. It is assumed that
immediate income recognition is not appropriate due to
the facts and circumstances. The payment to the investor
and the future revenue or income on which the payment is
based may be denominated in a foreign currency.
In a sale of future revenue (such as a profit-sharing agreement, a securitization
of a participation in a future revenue stream, a celebrity bond, or other
contingent payment obligation that varies on the basis of future revenue or
income), an entity receives an up-front lump sum payment from an investor and,
in return, agrees to pass on a specified percentage or amount of its future
revenue or income to that investor for a specified period. The share of revenue
or income owed to the investor may be graduated (e.g., 50 percent of the first
$1 million of revenue and then 25 percent of the amount in excess of $1 million)
or may be different from year to year. Further, the entity might guarantee a
minimum amount to be paid to the investor or there may be a maximum total amount
payable. The underlying cash flows that the entity will pass on might originate
from its contractual arrangements with third parties (e.g., fees and royalties
that it will receive from the licensing of patents, copyrights, trademarks, or
technology and franchise agreements) or its operations (e.g., a specified
interest in revenue, gross margin, or income of the entity or one of its
subsidiaries, business segments, or product lines).
Example 7-1
Sale of Royalty Income
Company C makes an up-front payment of $60 million to
Company D in exchange for the right to collect five
years of future royalties from specified songs covered
by intellectual property rights owned by D.
Example 7-2
Sale of Patent Infringement Litigation Claims
Company L enters into a patent
litigation funding agreement with Company Y. Company Y
is engaged in the business of investing in commercial
legal claims it believes to be meritorious. Under the
agreement, Y agrees to pay up to $20 million of the
litigation costs that will be incurred by L to pursue
claims against defendants that may be infringing on L’s
patents. In exchange, L assigns to Y the rights to an
amount received in connection with a settlement in a
judgment equal to 100 percent of Y’s invested amount
plus a fixed percentage of consideration received in
excess of 100 percent of Y’s invested amount. Company L
would account for this arrangement as a sale of future
revenue only if the arrangement was not considered a
freestanding derivative or a hybrid instrument with an
embedded derivative that must be bifurcated. Generally,
arrangements such as these that are indexed to
litigation represent derivative instruments that are not
eligible for the scope exception in ASC
815-10-15-59(d).
Example 7-3
Sale of Net Income
Company E enters into an agreement with Company P under
which P makes an up-front cash payment of $10 million in
exchange for a right to 40 percent of E’s net profits
from the operation of a hotel for 72 calendar months.
Company E is responsible for the management of the
financial affairs of the hotel, including the payment of
all expenses of construction, opening, operating,
furnishing, supplying, marketing, maintaining, and
repairing the hotel. Company P does not have any
operational responsibilities or rights related to the
hotel. Further, the arrangement does not create a
partnership or joint venture between the parties.
Company E has the right to terminate the agreement at
any time, provided that it pays P a termination fee in
an amount equal to the net present value of the expected
net profits from the date of the termination until the
end of the term of the agreement.
Typically, an entity is not required to account for a contract for the sale of
future revenues as a derivative instrument because ASC 815-10-15-59(d) contains
a scope exception for non-exchange-traded contracts for which the settlement is
based on a specified volume of sales or service revenues of one of the parties
to the contract (see Section 8.4.10). A FASB staff
publication, The Impact of the Issuance of Statement 133 on Then-Existing
Consensuses for EITF Issues (November 13, 2000), states, in part:
Generally, the contracts to pay a portion of revenue received and other
amounts as described in [ASC 470-10-25-1] would not be subject to the
requirements of [ASC 815] because any related derivative (or embedded
derivative) would meet the exception in [ASC 815-10-15-59(d)] related to
involving an underlying based on specified amounts of sales or service
revenues by one of the parties to the contract.
Sales of future revenues that are addressed by ASC 470-10
represent transactions that are not within the scope of the guidance in ASC
860-10 on transfers of financial assets. ASC 860-10 only applies to transfers of
recognized financial assets (see Section 2.2 of Deloitte’s Roadmap
Transfers and Servicing
of Financial Assets). ASC 860-10-20 defines a financial
asset as follows:
Cash, evidence of an ownership interest in an entity, or
a contract that conveys to one entity a right to do either of the
following:
-
Receive cash or another financial instrument from a second entity
-
Exchange other financial instruments on potentially favorable terms with the second entity.
At the 1997 AICPA Conference on Current SEC Developments, then
SEC Professional Accounting Fellow Armando Pimentel noted that the SEC staff
“has applied this definition very strictly” (i.e., narrowly). Accordingly, a
seller of a right that entitles the holder to a share of receivables that have
not yet been recognized for accounting purposes (e.g., receivables that will be
recognized in the future related to existing or anticipated orders for the
entity’s goods or services) would apply the guidance on sales of future revenue
in ASC 470-10 instead of the guidance on transfers of financial assets in ASC
860-20. (See Deloitte’s Roadmap Revenue Recognition for further
discussion of the point in time at which a receivable should be recorded under a
contract with a customer in accordance with ASC 606.)
A contract to service a financial asset (i.e., a servicing
right) entitles the holder to a stream of future revenue associated with a
financial asset, but that contract is not a financial asset because it depends
on the delivery of future services. The accounting for a transfer of servicing
rights is addressed in ASC 860-50-40 (see Chapter 6 of Deloitte’s Roadmap Transfers and Servicing of
Financial Assets).
7.2.3 Classification
7.2.3.1 Background
ASC 470-10
25-2 While the
classification of the proceeds from the investor as
debt or deferred income depends on the specific
facts and circumstances of the transaction, the
presence of any one of the following factors
independently creates a rebuttable presumption that
classification of the proceeds as debt is
appropriate:
-
The transaction does not purport to be a sale (that is, the form of the transaction is debt).
-
The entity has significant continuing involvement in the generation of the cash flows due the investor (for example, active involvement in the generation of the operating revenues of a product line, subsidiary, or business segment).
-
The transaction is cancelable by either the entity or the investor through payment of a lump sum or other transfer of assets by the entity.
-
The investor’s rate of return is implicitly or explicitly limited by the terms of the transaction.
-
Variations in the entity’s revenue or income underlying the transaction have only a trifling impact on the investor’s rate of return.
-
The investor has any recourse to the entity relating to the payments due the investor.
ASC 470-10 requires a seller of future revenue to evaluate whether the
offsetting entry to the proceeds received should be classified as debt or
deferred income. It is generally inappropriate to record the proceeds
immediately as income, because the seller maintains some continuing
involvement and the earnings process is not completed when the cash is
received.
Further, the proceeds cannot be recorded to equity unless
the contract legally represents an ownership interest that is not required
to be classified as a liability under GAAP (e.g., under ASC 480; see
Deloitte’s Roadmap Distinguishing Liabilities From Equity).
ASC 470-10-25-2 requires an
entity to consider six factors in determining the appropriate classification
of the proceeds:
Factors That Create Rebuttable Presumption of
Debt
|
Factors That Could Help Overcome the Debt
Presumption
|
---|---|
“[T]he form of the transaction is debt” (see
Section 7.2.3.2)
|
The transaction purports to be a sale
|
“The entity has significant continuing involvement in
the generation of the cash flows due the investor”
(see Section 7.2.3.3)
|
The entity is not significantly involved in the
generation of the cash flows owed to the
investors
|
“The transaction is cancelable by either the entity
or the investor through payment of a lump sum or
other transfer of assets by the entity” (see
Section 7.2.3.4)
|
The agreement is not cancelable
|
“The investor’s rate of return is implicitly or
explicitly limited by the terms of the transaction”
(see Section 7.2.3.5)
|
There is no cap on payments to the investor
|
“Variations in the entity’s revenue or income
underlying the transaction have only a trifling
impact on the investor’s rate of return” (see
Section 7.2.3.6)
|
Variations in the level of revenue or income can
produce at least moderate variations in the
investor’s return
|
“The investor has any recourse to the entity relating
to the payments due the investor” (see
Section 7.2.3.7)
|
The agreement includes no guarantees, recourse, or
collateral provisions
|
If any of the six factors in ASC 470-10-25-2 are present, there is a
rebuttable presumption that the proceeds should be classified as debt.
Accounting for the proceeds from the sale of future revenue as debt
highlights that the proceeds received will be repaid in cash, not in goods
or services. Such accounting is appropriate when the transaction is in the
form of debt or any of the factors in ASC 470-10-25-2 are present.
The presumption that the proceeds should be classified as debt can be
overcome, and the proceeds may be accounted for as deferred income, if the
transaction purports to be a sale and none of factors in ASC 470-10-25-2 are
present. Such accounting suggests that the entity has accelerated the
collection of cash from the sales of goods or services in a manner similar
to a nonrefundable advance payment received from a customer.
Example 7-4
Sale of Future Revenue Accounted for as
Debt
On March 31, 20X0, Entity A enters into an agreement
with Entity B under which A agrees to sell $250
million of future receivables associated with its
anticipated sales of a specified product in exchange
for a $175 million up-front cash payment. Entity A
continues to be solely responsible for research and
development, regulatory compliance, intellectual
property protection, manufacturing, marketing,
distribution, sales, product liability, and
reimbursement associated with the product. Under the
agreement, A is required to make quarterly payments
for five years. Quarterly repayment amounts are
subject to both a fixed cap of $25 million each
quarter and a variable cap equal to 10 percent of
quarterly revenues. Any amounts that remain
outstanding after five years are to be paid in
subsequent quarters subject to the 10 percent of
quarterly revenues cap. Entity A has an option to
prepay its obligation at an amount equal to $250
million less amounts already paid at the time of
prepayment. Entity B has a security interest in A’s
rights related to the product and will have a
secured interest in the future receivables once they
come into existence. Entity A concludes that the
transaction should be accounted for as debt under
ASC 470-10 because the factors in ASC
470-10-25-2(b)–(f) are present. Entity A treats the
proceeds of $175 million as the principal amount of
the debt. The additional $75 million that will be
repaid is recognized as interest over the life of
the debt.
7.2.3.2 Legal Form of Debt
A sale of future revenue may have the legal form of a nonrecourse borrowing.
If the transaction’s legal form is that of debt (e.g., a securitization of
future revenue), the issuer should classify the transaction as debt.
Accounting for the transaction as deferred revenue would be inappropriate
since the form of a transaction that is legally debt is respected under U.S.
GAAP.
Even if the legal form of a transaction is not that of debt, it may have
debt-like characteristics that suggest that it should be accounted for as
debt. Such characteristics may include the following:
-
The proceeds must be used for a specific purpose (e.g., the purchase of equipment).
-
There are covenants restricting the entity’s level of indebtedness until the initial amount received is repaid.
-
The contract has a predefined prepayment schedule (e.g., periodic repayments and a final repayment).
-
There is a contractual interest charge.
-
The entity pledges its assets as collateral to ensure the repayment of the proceeds received.
-
Any portion of the proceeds received that remain unpaid becomes immediately due and payable on a specified date even if revenue or income is insufficient.
7.2.3.3 Seller’s Involvement in the Generation of the Cash Flows
If the entity has significant continuing involvement in the generation of the
cash flows, it is presumed that the transaction represents debt. Such
involvement might take the following forms:
-
Manufacturing.
-
Marketing.
-
Distribution.
-
Repairs and maintenance.
-
Intellectual property protection.
-
Customer service.
-
Billing and handling of customer accounts.
-
Decisions concerning delivery of service and operations.
The evaluation of whether the entity has significant involvement in the generation of the cash flows depends in part on whether the underlying cash flows originate from the entity’s contractual arrangements or its operations. The September 14, 1988, EITF meeting materials state (in EITF Issue 88-18, Issue Summary 1, Supplement 1), in part:
In a licensing or other contractual arrangement,
continuing involvement by the enterprise will vary based on the
terms of the arrangement. For example, the licensing of a patent
will usually require little ongoing activity by the enterprise
except for protection from patent infringements whereas the
enterprise’s obligations under a franchise arrangement could be
substantial, such as providing inventory, advertisement, and
training. Timing and amount of cash flows generated from the
operations of a subsidiary, business segment, or product line are
normally under the control of the enterprise whose involvement is
continuous.
At the 1997 AICPA Conference on Current SEC Developments,
then SEC Professional Accounting Fellow Armando Pimentel suggested that this
criterion is often “very difficult to overcome . . . because the seller of
the item generally continues to be involved in the marketing, promotion, or
direct generation of the asset’s cash flows. For example, if the seller
continues to market and promote the asset, in order to preserve or improve
the future cash flows to the investor, then the transfer would meet this
rebuttable presumption.”
7.2.3.4 Cancellation Provisions
If either the seller or the investor has the right to cancel the transaction
in exchange for a payment by the seller, the transaction is presumed to be
debt. An agreement that is cancelable by the entity permits the entity to
retain the benefits of revenue or income that exceeds expectations. An
agreement that is cancelable by the investor limits the investor’s exposure
to the risk that revenue or income will not meet expectations. Examples of
cancellation provisions include call or prepayment features held by the
seller and put features held by the buyer.
7.2.3.5 Limited Investor Rate of Return
If the investor’s rate of return is either explicitly or implicitly limited,
the transaction is presumed to be debt. A cap on the rate of return limits
the investor’s potential upside associated with changes in revenue or
income. Examples of contractual limits include fixed repayment amounts or
stated ceilings on total payments or rates of return.
7.2.3.6 Limited Investor Exposure to Variability
If the transaction terms are designed so that variations in the underlying
revenue or income have, as described in ASC 470-10-25-2(e), “only a trifling
impact on the investor’s rate of return,” the transaction is presumed to be
debt. In such a case, the investor is not significantly exposed to the risks
and rewards of changes in revenue or income in the transaction. For
instance, if the entity is required to repay the proceeds received
irrespective of the amounts of revenue generated, this criterion is met.
7.2.3.7 Investor Recourse Rights
If the investor has recourse to the seller (e.g., collateral), the
transaction is presumed to be debt because recourse rights limit the
investor’s exposure to reductions in the amount of revenue or income.
Examples of recourse provisions include:
-
Guaranteed minimum annual cash flows.
-
Guaranteed minimum rates of return.
-
Carryover provisions (if annual cash flows are insufficient, the buyer is entitled to recover any shortfall in the following year).
-
Extensions of the term (the expected term of cash flows to generate the buyer’s return may be five years while the agreement is for eight years with a cap; the additional three years act as a guarantee).
-
Acceleration provisions (if certain negative events occur, payments to the buyer are accelerated).
At the 1997 AICPA Conference on Current SEC Developments, Mr. Pimentel
suggested that this criterion is often “very difficult to overcome,
especially in cases where the transfer of the item is structured as an asset
securitization. Typically, asset securitizations require the transferor to
retain some type of recourse, either by transferring cash or other assets to
the investor, or by subordinating future receipts from a retained
interest.”
7.2.4 Debt Model
7.2.4.1 Initial Accounting
If the proceeds received in a sale of future revenue are
accounted for as debt, the entity makes the following entry upon initial recognition:
Cash (or other consideration received)
Debt
If the transaction includes the exchange of separate freestanding financial
instruments or other rights or privileges (e.g., the buyer obtains a right
to reduced pricing in future purchases of a product), the entity may need to
allocate a portion of the proceeds received to such other units of account
(see Section 3.4) before determining
the initial carrying amount of the debt. Further, the entity should evaluate
whether the amount recognized as debt contains any embedded feature (e.g., a
contingent prepayment option) that must be bifurcated as a derivative
instrument (see Chapter 8).
7.2.4.2 Subsequent Accounting
ASC 470-10
35-3 Amounts recorded as
debt shall be amortized under the interest method
(see Subtopic 835-30) . . . .
After initial recognition, an entity uses the interest method (see Section 6.2) to account for the amount
recorded as debt. Because sales of future revenues typically do not involve
fixed contractual cash flows, the entity must make estimates of the timing
and amount of the cash flows payable. While the effective interest rate is
computed at inception by solving for the constant effective yield that
equates the proceeds received to the future estimated payments (see
Section 6.2.3.3), it would be
inappropriate to apply a negative effective interest rate (see below).
In each period, the net carrying amount is the present value of the estimated
future cash payments, discounted by using the effective interest rate (see
Section 6.2.3.5). However, in the
absence of a TDR, it would be inappropriate to reduce the debt’s net
carrying amount below the initial carrying amount (i.e., the proceeds), less
payments previously made by the borrower to the investor, since ASC
450-30-25-1 precludes the recognition of contingent gains (see Section 6.2.5.5), and a debt obligation
cannot be derecognized unless either of the extinguishment conditions in ASC
405-20-40-1 is met (see Section 9.2). Actual cash
repayments are recorded as either interest expense or a reduction of the
outstanding debt balance, including accrued interest, in accordance with the
interest method.
Interest cost is accrued in each period by applying the
effective interest rate against the debt’s net carrying amount (see
Section
6.2.3.4).
Interest expense
Debt (or accrued interest)
Example 7-5
Application of Interest Method to a Sale of Future
Revenue
Entity R enters into a sale-of-future-revenue
arrangement within the scope of ASC 470-10 and
determines that the arrangement must be accounted
for as debt by applying the interest method in ASC
835-30. Entity R receives initial cash proceeds of
$10 million. It prepares a preliminary amortization
schedule on the basis of the initial proceeds and
the estimated future cash payments shown in the
second column of the table below. The final column
shows the maximum remaining undiscounted cash flows
that the entity could be required to be pay under
the contractual terms (such payments are limited to
a maximum amount of $5 million per year). (The
effective interest rate of this series of cash flows
is approximately 14.9 percent.)
If the timing or amount of the actual or estimated cash
flows changes, the effective interest rate or the net carrying amount (or
both) may need to be updated (see the next section).
7.2.4.3 Changes in Actual or Estimated Cash Flows
7.2.4.3.1 Background
If the timing or amount of the actual or estimated cash flows changes,
the original amortization schedule for the debt should be updated to
reflect the revised cash flows, subject to the limitation on reducing
the net carrying amount discussed in Section 7.2.4.2. An entity generally should apply one of
the methods identified in the table below to account for changes in the
amount or timing of cash flows.
Updated Effective Interest Rate?
|
Updated Net Carrying Amount?
|
Immediate Earnings Effect?
| |
---|---|---|---|
Prospective (see Section
7.2.4.3.2)
|
Yes
|
No
|
No
|
Retrospective (see Section
7.2.4.3.3)
|
Yes
|
Yes
|
Yes
|
Cumulative catch-up (see Section
7.2.4.3.4)
|
No
|
Yes
|
Yes
|
The application of any of these methods is an entity-wide accounting
policy election. Once an accounting policy has been adopted, ASC
250-10-45-11 requires the entity to use it consistently.
7.2.4.3.2 Prospective Interest Method
Under the prospective interest method, the entity recalculates the
effective interest rate on the basis of the current carrying amount and
the revised estimate of remaining future payments as of the date on
which the estimate changes. This method of recognizing interest is
similar to that in (1) ASC 470-50-40-14 related to debt modifications
and exchanges that do not qualify for extinguishment accounting (see
Section 10.4.3) and (2) ASC 470-60-35-5 related
to TDRs in which the net carrying amount is less than the future cash
flows (see Section 11.4.4.2).
Unlike the retrospective and catch-up methods, the prospective method
does not require an entity to immediately adjust the current carrying
amount of the debt or the recognition of a gain or loss in earnings as a
result of the change in estimated cash flows. Instead, the change in the
estimate of remaining future cash flows is recognized prospectively as a
yield adjustment.
A benefit of the prospective interest method is that it is relatively simple to apply. As noted in paragraph 99 of FASB Concepts Statement 7,
a drawback of this method is that it can “[obscure] the impact of
changes in estimated cash flows.” Further, the “interest rate that is
derived . . . is unrelated to the rate at initial recognition or to
current market rates for similar assets and liabilities.”
Connecting the Dots
An entity may determine that because of a
significant unexpected change in circumstances, the remaining
undiscounted cash flows payable on a sale of future revenue that
is accounted for as debt is less than the current net carrying
amount of the debt. For example, assume that on January 1, 20X1,
an entity receives cash proceeds of $25 million in return for
repayment of a specified percentage of sales on a newly
commercialized product. As of December 31, 20X2, the entity had
adjusted the carrying amount of the debt obligation to $27
million, which included the recognition of interest expense of
$5 million less cash payments made of $3 million. Further,
assume that on March 31, 20X2, because of litigation related to
the product that generates the repayments on the debt, the
entity determines that it now expects the total future
undiscounted cash flows payable to be only be $5 million.
On the basis of informal discussions with staff
in the SEC’s Office of the Chief Accountant (OCA), we understand
that in such a situation, an entity that applies the prospective
method could either (1) cease recognizing any interest on the
debt (in which case it would apply the future cash payments to
the net carrying amount of the debt until there is a change in
future cash flow expectations or the debt is legally
extinguished) or (2) amortize the net carrying amount (i.e., $27
million) to the initial carrying amount less the payments made
(i.e., $22 million) on the basis of the interest method. Under
the latter alternative, in the absence of a change in cash flow
expectations, the entity would recognize interest income of $5
million over time (which reflects a reversal of the $5 million
in interest expense previously recognized). The entity could
not, however, reduce the net carrying amount below the initial
amount borrowed less payments previously made since the
conditions for liability extinguishment in ASC 405-20 would not
be met on the basis of the revised expectations of future cash
flows.
7.2.4.3.3 Retrospective Interest Method
Under the retrospective interest method, an entity periodically
recalculates the effective interest rate on the basis of the rate that
would have existed at the debt’s inception and takes into account the
original carrying amount, actual payments to date, and the revised
estimate of remaining future payments. (However, the effective interest
rate should not be reduced to the extent that the net carrying amount in
any period would decline below the initial carrying amount less payments
made to date; see Section 7.2.4.2.) Under this method, the debt’s carrying
amount is adjusted in each period to an amount equal to the present
value of the estimated remaining future payments, discounted by using
the revised effective interest rate. The adjustment to the carrying
amount is recognized in earnings as an adjustment to interest expense in
the period in which it occurs.
This method is similar to the prepayment interest method discussed in ASC 310-20-35-26. Unlike the catch-up and prospective methods, the retrospective method requires an entity to adjust both the current carrying amount and the effective interest rate when the amount or timing of actual or estimated cash flows change. As noted in paragraph 100 of FASB Concepts Statement 7, a drawback of this method is that it
“requires that entities retain a detailed record of all past cash
flows.”
7.2.4.3.4 Cumulative Catch-Up Method
Under the cumulative catch-up method, the effective interest rate is not
revised when actual or estimated cash flows change from those estimated
as of the date on which the debt was issued. Instead, the debt’s
carrying amount is adjusted to an amount equal to the present value of
the estimated remaining future payments, discounted by using the
original effective interest rate as of the date on which the estimate
changes. (However, the net carrying amount cannot be reduced to an
amount less than the initial carrying amount less payments made to date;
see Section 7.2.4.2.) The adjustment to the carrying amount is recognized in earnings as an adjustment to interest expense in the period in which the change in estimate occurred. Paragraph 98 of FASB Concepts Statement 7 suggests that this method is “consistent with the
present value relationships portrayed by the interest method.”
7.2.5 Deferred Income Model
ASC 470-10
35-3 Amounts . . .
recorded as deferred income shall be amortized under the
units-of-revenue method.
ASC Master Glossary
Units-of-Revenue Method
A method of amortizing deferred revenue that arises under
certain sales of future revenues. Under this method,
amortization for a period is calculated by computing a
ratio of the proceeds received from the investor to the
total payments expected to be made to the investor over
the term of the agreement, and then applying that ratio
to the period’s cash payment.
If the proceeds received in a sale of future revenue are
presented as deferred income, the entity makes the following entry on initial recognition:
Cash (or other consideration received)
Deferred income
Subsequently, the entity amortizes the amount of deferred income over time. At
inception, the entity determines a unit-of-revenue method ratio equal to the
fraction of the proceeds received to the total expected cash payments to be made
over the term of the agreement. In each period, the amount of amortization is
calculated by applying the unit-of-revenue method ratio to that period’s cash
payment. Periodically, the ratio is updated to reflect changes in estimated cash
flows. Under the deferred income method, no interest expense is accrued.
7.3 Participating Mortgages
7.3.1 Background
ASC 470-30 addresses a debtor’s accounting for a participating mortgage, which is
a mortgage loan that entitles the investor to share in either (or both) an
increase in the market value of, or the income from, a mortgaged real estate
project. Under ASC 470-30, the accounting depends on whether the participation
involves market value appreciation (see Section 7.3.3) or
the project’s results of operations (see Section
7.3.4).
7.3.2 Scope
ASC 470-30
05-1 This
Subtopic establishes the borrower’s accounting for a
participating mortgage loan if the lender is entitled to
participate in any of the following:
-
Appreciation in the fair value of the mortgaged real estate project
-
The results of operations of the mortgaged real estate project.
05-2 The
desire for instruments in which the return to the
lenders was tied more closely to the performance of the
property led to the introduction of participating
mortgage loans.
05-3
Participating mortgage loans and nonparticipating
mortgage loans share all of the following
characteristics:
-
Debtor-creditor relationships between those who provide initial cash outlays and hold the mortgages, and those who are obligated to make subsequent payments to the mortgage holders
-
Real estate collateral
-
Periodic fixed-rate or floating-rate interest payments
-
Fixed maturity dates for stated principal amounts.
05-4 However,
unlike a nonparticipating mortgage loan arrangement, in
a participating mortgage loan, the lender participates
in appreciation in the fair value of the mortgaged real
estate project or the results of operations of the
mortgaged real estate project, or in both.
05-5 The
terms and economics of participating mortgage loan
agreements vary by agreement. The terms and economics of
one agreement may create a circumstance in which any
participation payment is remote. In another agreement,
the terms and economics may transfer many of the risks
and rewards of property ownership.
05-8 The
participation terms of a participating mortgage loan
agreement usually are negotiated concurrently with the
other terms of the underlying mortgage loan. A borrower
agrees to participation rights generally because of
market conditions, or in exchange for concessions
granted by the lender on some other term(s) of the loan,
such as a lower interest rate or a higher loan-to-value
ratio.
05-9 The
lender’s participation reduces the borrower’s potential
realization of operating results or gain on the sale of
the real estate. However, the participation also may
reduce any of the following:
-
The contract interest the borrower is required to pay
-
The risk that the borrower will be unable to pay interest at the stated or floating rate in the loan agreement and, consequently, the risk that the borrower will default on the loan and need to sell the property
-
The amount of capital the borrower has at risk, because the loan-to-value ratio normally is higher.
Further, the obligation to pay the lender a share of the
property appreciation does not increase the current
exposure of the borrower to loss in its investment,
because the participation payments are made only if the
fair value of the property appreciates.
15-1 The
guidance in this Subtopic applies to the following
entities:
- All borrowers in participating mortgage loan arrangements.
15-2 The
guidance in this Subtopic does not apply to the
following entities:
- Creditors in participating mortgage loan arrangements.
15-3 The
guidance in this Subtopic does not apply to the
following transactions and activities:
-
Participating leases
-
Debt convertible at the option of the lender into equity ownership of the property
-
Participating loans resulting from troubled debt restructurings.
In exchange for allowing the creditor to participate in the real estate project
that is financed by a loan, the debtor might receive a reduced interest rate,
more favorable debt covenants, or other benefits. Paragraph 21 of the Basis for
Conclusions of SOP 97-1 states:
In a participating mortgage loan arrangement, the lender generally grants
certain concessions to the borrower in return for the right to
participate in either the appreciation in the market value of the
mortgaged real estate project or the operations of the mortgaged real
estate project, or in both. A common concession is granting an interest
rate lower than that which would have been included in a comparable
nonparticipating mortgage loan. Another common concession is a higher
loan-to-value ratio than would be allowed at the same interest rate in a
loan that does not include the participation in appreciation. AcSEC
believes that in participating loan arrangements, the borrower has
received something of value (the lower interest rate) in exchange for
something of value (the participation feature) and that such exchanges
should be given accounting recognition.
The guidance in ASC 470-30 does not apply to (1) participating mortgages for
which the borrower has elected the fair value option in ASC 815-15 (see
Section 8.5.6) or ASC 825-10 (see Section 4.4), (2) participating leases, (3) debt
that is convertible into an ownership interest in the mortgaged property, or (4)
participating loans resulting from TDRs under ASC 470-60 (see Chapter 11). If a participation feature in a
debt obligation is contingent on the sale of the property (e.g., a requirement
to pay 20 percent of any sales proceeds) and the borrower has no obligation to
sell the property, ASC 470-30 does not apply because the lender is not entitled
to participate unless the borrower elects to sell the property. Further, the
guidance in ASC 470-30 applies only to debt with a participation feature that
does not represent a separate unit of account (see Section 3.3). If the participation feature is a separate unit of
account that is not subject to other applicable GAAP (e.g., derivative
accounting), the issuer should consider the indexed-debt guidance that applies
to separable contingent payments (see Section
7.4).
Typically, participation features in participating mortgage loans are not
bifurcated as derivative instruments under ASC 815-15. There are scope
exceptions in ASC 815-10-15-59 to the derivative accounting requirements for
non-exchange-traded contracts whose underlying on which the settlement is based
is either (1) the price or value of a nonfinancial asset of one of the parties
of the contract provided that the asset is not readily convertible to cash (if
the nonfinancial asset is unique and the nonfinancial asset is owned by the
party that would not benefit from an increase in the fair value of the
nonfinancial asset; see Section 8.4.9.5) or (2) specified
volumes of sales or service revenues of one of the parties to the contract (see
Section 8.4.10.5). ASC 815-15-55-8 and 55-9 contain the
following illustration of a participation feature that is exempt from the scope
of ASC 815:
ASC 815-15
55-8 Under an example
participating mortgage, the investor receives a
below-market interest rate and is entitled to
participate in the appreciation in the fair value of the
project that is financed by the mortgage upon sale of
the project, at a deemed sale date, or at the maturity
or refinancing of the loan. The mortgagor must continue
to own the project over the term of the mortgage.
55-9 This instrument has a
provision that entitles the investor to participate in
the appreciation of the referenced real estate (the
project). However, a separate contract with the same
terms would be excluded by the exception in paragraph
815-10-15-59(b) because settlement is based on the value
of a nonfinancial asset of one of the parties that is
not readily convertible to cash. (This Subtopic does not
modify the guidance in Subtopic 470-30.)
It may be appropriate for an entity to apply the participating mortgage guidance
by analogy to other financial instruments that pay amounts on the basis of the
issuer’s own operations unless the feature must be bifurcated as a derivative
instrument under ASC 815-15 or other accounting requirements apply.
7.3.3 Participation in Market Value Appreciation
7.3.3.1 Background
ASC 470-30
05-6 A lender may be
entitled to participate in appreciation in the fair
value of a project at any one of the following
times:
-
Upon the sale of the project
-
At a deemed sale date
-
At the maturity or refinancing of the loan.
In exchange for more favorable debt terms, a debtor might permit the creditor
to participate in the appreciation in the value of the mortgaged property
(e.g., 25 percent of any increase in the value of the property in excess of
the initially appraised value). That participation feature might be payable
on earliest of the loan’s maturity date, the sale of the property, or the
refinancing of the loan.
7.3.3.2 Initial Accounting
ASC 470-30
25-1 If a lender is
entitled to participate in the appreciation of the
market value of a mortgaged real estate project, the
borrower shall recognize a participation liability
with a corresponding debit to a debt discount
account.
30-1 If the lender is
entitled to participate in appreciation in the fair
value of the mortgaged real estate project, the
borrower shall determine the fair value (see
Subtopic 820-10) of the participation feature at the
inception of the loan (see paragraph 470-30-25-1 for
guidance on how to recognize the participation
feature).
ASC 470-30 requires that when the lender participates in the appreciation of
the mortgaged real estate project’s market value, the debtor must recognize
a participation liability equal to the fair value of the participation
feature at the inception of the loan. The offsetting entry is recognized as
a discount on the debt, which is amortized as an adjustment to interest cost
over the life of the loan.
For example, the debtor might make the following entry on
initial recognition:
Cash (or other consideration received)
Mortgage loan discount
Mortgage loan
Participation feature (at fair value)
7.3.3.3 Subsequent Accounting
ASC 470-30
35-1 The debt discount
shall be amortized by the interest method, using the
effective interest rate.
35-2 Interest expense on
participating mortgage loans consists of the
following three components:
-
Amounts designated in the mortgage agreement as interest
-
Amounts related to the lender’s participation in results of operations
-
Amortization of debt discount related to the lender’s participation in the fair value appreciation of the mortgaged real estate project.
35-4A If a lender is
entitled to participate in the appreciation of the
market value of a mortgaged real estate project,
both of the following are required at the end of
each reporting period:
-
The balance of the participation liability shall be adjusted to equal the current fair value of the participation feature.
-
The corresponding debit or credit shall be recorded in the related debt-discount account.
35-5 The revised debt
discount shall be amortized prospectively, using the
effective interest rate.
45-1 The amortization of
the debt discount relating to the participation
liability shall be included in interest expense.
After the inception of the loan, the participation liability
is adjusted for any changes in the fair value of the participation feature
so that its measurement equals its current fair value as of the reporting
date, with a corresponding offset to the debt discount. For example, if the
fair value of the participation feature increases, the debtor would make the
following entry:
Mortgage loan discount
Participation feature (increase in fair value)
If the fair value of the participation feature decreases,
the debtor would make the following entry:
Participation feature (decrease in fair value)
Mortgage loan discount
The adjusted debt discount is amortized prospectively to
interest expense by adjusting the debt’s effective interest rate over its
remaining life (see Section 6.2.3.3); that is, by using a prospective interest
method. This means that although changes in the fair value of a market value
participation feature in a participating mortgage are reflected immediately
on the debtor’s balance sheet, they are not recognized immediately in net
income. Instead, they are recognized over time through a prospective yield
adjustment that affects the recognition of interest expense over the debt’s
remaining life.
Generally, both increases and decreases in the fair value of
the participation feature are recognized. However, ASC 470-30-35-3 precludes
subsequent reversals of appreciation if interest amounts have been
capitalized under ASC 835-20 (see Section 14.2.4).
Periodic interest expense for mortgage loans that entitle
the lender to participate in the market value appreciation of the mortgaged
real estate project includes amounts designated in the mortgage agreement as
interest and the periodic amortization of the debt discount created by the
participation liability. These amounts should be recognized by using the
interest method (see Section 6.2). If the investor also participates in the
results of the mortgaged real estate project’s operations, such amounts are
recognized as interest expense as they become due (see Section 7.3.4.3).
7.3.3.4 Example
ASC 470-30
Example 1: Accounting by Participating Mortgage
Loan Borrower
55-1 This Example
illustrates the guidance in this Subtopic.
55-2 Assume that on
January 1, 19X1, Borrower Co. purchased a property
for $10 million. On that date, Borrower paid $1
million cash and entered into a participating
mortgage loan agreement with Lender Co. in the
amount of $9 million.
55-3 The loan agreement
has the following terms:
-
15 year term
-
Interest-only periodic payments, principal to be repaid at end of term
-
5% stated interest rate
-
20% participation in appreciation in the value of the property above $10 million, payable at maturity (or earlier if the asset is sold or the loan is refinanced).
55-4 Assumptions related
to the fair value of the participation feature are
as follows.
55-5 Based on the
preceding assumptions, Borrower Co. should make the
following journal entries for this participating
mortgage loan.
a. On January 1, 19X1, the following journal
entries should be recorded:
b. By the end of 19X1, entries to record
interest expense and amortization of discount
throughout the year would have taken the following
form:
c. At the end of 19X2, entries to record
interest expense and amortization of discount
throughout the year would have taken the following
form:
7.3.4 Participation in Results of Operations
7.3.4.1 Background
ASC 470-30
05-7 In agreements in which
lenders participate in results of operations, the
definition of the results of operations may vary
among agreements. Examples of these definitions
include, but are not limited to, the following:
-
Revenue
-
Income
-
Cash flows before or after debt service.
In exchange for more favorable debt terms, a debtor might allow a creditor to
participate in the results of operations of a real estate project. For
example, the debtor and creditor might agree to share in the revenue, net
income, or net cash flows of a mortgaged office or apartment building.
7.3.4.2 Initial Accounting
ASC 470-30 prescribes an accounting model for mortgage loans for which the
lender participates in the results of operations of the mortgaged real
estate project that is different from the accounting model for market value
participation features. Under ASC 470-30, the borrower recognizes no
liability for the fair value of the participation feature at inception.
Instead, a participation liability is recognized as amounts become
contractually due.
Therefore, the debtor might make the following entry on initial recognition:
Cash (or other consideration received)
Mortgage loan
7.3.4.3 Subsequent Accounting
ASC 470-30
35-2 Interest expense on
participating mortgage loans consists of the
following three components:
-
Amounts designated in the mortgage agreement as interest
-
Amounts related to the lender’s participation in results of operations
-
Amortization of debt discount related to the lender’s participation in the fair value appreciation of the mortgaged real estate project.
35-4 Amounts due to a
lender pursuant to the lender’s participation in the
real estate project’s results of operations (as
defined in the participating mortgage loan
agreement) shall be charged to interest expense in
the borrower’s corresponding financial reporting
period, with a corresponding credit to the
participation liability.
Interest expense on mortgage loans that participate in the results of
operations consist of the amounts designated in the loan agreement as
interest as well as amounts that become due to the creditor related to the
participation feature in the results of operations. The participation
feature in the results of operations is not separately recognized by the
borrower before related amounts become due. When amounts become due, the
debtor recognizes a corresponding charge to the income statement (interest
expense). For example, the debtor might make the following entry when it
becomes legally obligated to pay such amounts:
Interest expense
Mortgage loan (or accrued mortgage
participation liability)
A creditor that participates in both market value
appreciation and results of operations of the mortgaged real estate project
applies the guidance on participation features in market value appreciation
when accounting for the participation in such appreciation (see Section 7.3.3).
7.3.5 Other Considerations
7.3.5.1 Variable-Rate Participating Mortgages
ASC 470-30
35-3 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. Interest recognized pursuant to this
guidance is subject to the requirements of Subtopic
835-20. Once capitalized, amounts shall not be
adjusted for the effects of reversals of
appreciation.
The amount that is reported as interest expense for a
participating mortgage loan includes the stated interest rate, amounts due
to the lender for its participation in the real estate project’s results of
operations (see Section
7.3.4.3), and the amortization of any debt discount
associated with a participation liability in the real estate project’s fair
value appreciation (see Section 7.3.3). For stated interest rates that vary on the
basis of changes in a reference interest rate index (such as a prime rate or
benchmark interest rate), ASC 470-30 requires the debtor to accrue the
amounts designated as interest in accordance with the interest rate in
effect in each period as such rate changes over the debt’s life (see also
Section
6.2.5.2).
7.3.5.2 Extinguishments
ASC 470-30
40-1 If the participating
mortgage loan is extinguished before its due date,
the difference between the recorded amount of the
debt (including the unamortized debt discount and
the participation liability) and the amount
exchanged to extinguish the debt is a debt
extinguishment gain or loss.
45-2 If the participating
mortgage loan is extinguished before its due date,
the debt extinguishment gain or loss shall be
reported as required by paragraph 470-50-40-2.
The borrower should apply the general derecognition guidance for liabilities
in ASC 405-20 (see Chapter 9) and ASC 470-50 (see Chapter 10). The computation of the debt extinguishment gain
or loss is based on a comparison of the reacquisition price with the net
carrying amount of the debt. The net carrying amount includes any related
participation liability and any unamortized debt discount. Because ASC
470-30 requires entities to measure participation liabilities related to the
market value appreciation of the mortgaged real estate project at their fair
value on a recurring basis, the debtor should update its estimate of the
fair value of a participation liability as of the extinguishment date.
7.3.5.3 Disclosure
ASC 470-30
50-1 The borrower’s
financial statements shall disclose both of the
following:
-
The aggregate amount of participating mortgage obligations at the balance sheet date, with separate disclosure of the aggregate participation liabilities and related debt discounts
-
Terms of the participations by the lender in either the appreciation in the fair value of the mortgaged real estate project or the results of operations of the mortgaged real estate project, or both.
ASC 470-30 requires entities to provide additional disclosures beyond those
that otherwise apply to debt instruments.
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. That guidance is based on EITF Issue 86-28, which was published before the FASB’s issuance of the guidance on embedded derivatives that is codified in ASC 815-15. Since the indexation feature in most of the debt instruments originally addressed in Issue 86-28
requires bifurcation under ASC 815-15 as an embedded derivative, the
indexed-debt guidance in ASC 470-10 applies to a limited population of those
instruments. That is, such guidance 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).
7.5 Joint-and-Several Liability Arrangements
7.5.1 Background
ASC 405-40
05-1 This Subtopic addresses
the recognition, measurement, and disclosure of
obligations resulting from joint and several liability
arrangements.
In a joint-and-several liability arrangement, two or more entities are
co-obligors with respect to the same obligation. Because each co-obligor is a
primary obligor, the creditor can demand repayment of the full amount of the
obligation from any of the co-obligors. A co-obligor cannot refuse to pay the
full amount even if it did not borrow that amount. Depending on what the
co-obligors have agreed to among themselves and under any applicable laws,
however, a co-obligor that has paid amounts to the creditor on behalf of other
co-obligors might be able to seek repayment of such amounts from its
co-obligors.
Example 7-6
Joint-and-Several Debt Instrument
Two entities each borrow $200 under a joint-and-several
liability debt arrangement. The creditor can demand
repayment of up to $400 from either of the two
co-obligors when the debt becomes due even though each
of them only received $200 of debt proceeds.
7.5.2 Scope
ASC 405-40
15-1 The guidance in this
Subtopic applies to obligations resulting from joint and
several liability arrangements for which the total
amount under the arrangement is fixed at the reporting
date, except for obligations otherwise accounted for
under the following Topics:
-
Asset Retirement and Environmental Obligations, see Topic 410
-
Contingencies, see Topic 450
-
Guarantees, see Topic 460
-
Compensation — Retirement Benefits, see Topic 715
-
Income Taxes, see Topic 740.
For the total amount of an obligation under an
arrangement to be considered fixed at the reporting date
there can be no measurement uncertainty at the reporting
date relating to the total amount of the obligation
within the scope of this Subtopic. However, the total
amount of the obligation may change subsequently because
of factors that are unrelated to measurement
uncertainty. For example, the amount may be fixed at the
reporting date but change in future periods because an
additional amount was borrowed under a line of credit
for which an entity is jointly and severally liable or
because the interest rate on a joint and several
liability arrangement changed.
15-2 Although the total
amount of the obligation of the entity and its
co-obligors must be fixed at the reporting date to be
within the scope of this Subtopic, the amount that the
entity expects to pay on behalf of its co-obligors may
be uncertain at the reporting date.
25-1 An entity shall
recognize obligations resulting from joint and several
liability arrangements when the arrangement is included
in the scope of this Subtopic. In some circumstances,
the arrangement is included in the scope of this
Subtopic at the inception of the arrangement (for
example, a debt arrangement); in other circumstances,
the arrangement is included in the scope of this
Subtopic after the inception of the arrangement (for
example, when the total amount of the obligation becomes
fixed, consistent with paragraph 405-40-15-1).
ASC 405-40 applies to all entities that have obligations resulting from
joint-and-several liability arrangements regardless of the relationship among
the parties involved in the agreement. Examples of obligations that may be
subject to joint-and-several liability include debt obligations, line-of-credit
arrangements, settled litigation, and judicial rulings. However, ASC 405-40 does
not apply to obligations within the scope of other Codification topics
(including ASC 410, ASC 450, ASC 460, ASC 715, and ASC 740). For example, if an
entity is a guarantor or co-guarantor of a debt arrangement and the creditor can
seek repayment from the entity only if the creditor has been unable to collect
amounts due from the debtor, the entity would apply the guidance on guarantees
in ASC 460, not ASC 405-40. Paragraph BC8 of ASU 2013-04 states, in part:
One of the significant differences between a joint and several liability
arrangement and a guarantee arrangement is that an entity is a primary
obligor under a joint and several liability arrangement and is a
secondary obligor under a guarantee arrangement.
The scope of ASC 405-40 is limited to arrangements for which the total amount is
fixed as of the reporting date. For the total amount to be considered fixed, it
cannot be subject to measurement uncertainty (such as uncertainty associated
with ongoing litigation). As noted in paragraph BC6 of ASU 2013-04, liabilities
that are subject to measurement uncertainty are accounted for under ASC 450 or
other GAAP. If the measurement uncertainty is resolved after the inception of
the arrangement (e.g., settled litigation), ASC 405-40 applies when the total
amount becomes fixed. The total amount would be considered fixed as of the
reporting date even if (1) the portion the entity expects to pay among its
co-obligors is subject to measurement uncertainty or (2) the total amount varies
over time because of factors unrelated to measurement uncertainty (e.g., an
additional amount was borrowed or the interest rate changed).
7.5.3 Measurement
ASC 405-40
30-1 Obligations resulting
from joint and several liability arrangements included
in the scope of this Subtopic initially shall be
measured as the sum of the following:
-
The amount the reporting entity agreed to pay on the basis of its arrangement among its co-obligors.
-
Any additional amount the reporting entity expects to pay on behalf of its co-obligors. If some amount within a range of the additional amount the reporting entity expects to pay is a better estimate than any other amount within the range, that amount shall be the additional amount included in the measurement of the obligation. If no amount within the range is a better estimate than any other amount, then the minimum amount in the range shall be the additional amount included in the measurement of the obligation.
35-1 Obligations resulting
from joint and several liability arrangements included
in the scope of this Subtopic subsequently shall be
measured using the guidance in Section 405-40-30.
Upon initial recognition and on each subsequent measurement date, obligations
within the scope of ASC 405-40 are measured as the sum of (1) the amount the
entity has agreed to pay under the arrangement among the co-obligors (i.e., the
amount the entity has agreed to be ultimately liable for; not the full amount)
and (2) any additional amount the entity expects to pay on behalf of its
co-obligors (e.g., because a co-obligor is expected to be unable to pay some or
all of the amount it has agreed to be liable for among its co-obligors).
In determining how much it has agreed to pay under the arrangement among the
co-obligors, the entity should consider any written agreements among the
co-obligors as well as other facts and circumstances. In the absence of a
written agreement between the parties, factors that could result in a conclusion
that there is an implicit agreement include information about how the parties
have acted in the past, which party received the proceeds, and which party has
made principal repayments or interest settlements.
In determining any additional amount it expects to pay on behalf
of its co-obligors, the entity applies a measurement approach similar to that
for loss contingencies in ASC 450-20 (see Deloitte’s Roadmap Contingencies, Loss Recoveries,
and Guarantees). That is, if a best estimate of the
additional amount is available, the entity should record that amount. If there
is a range of potential estimates and some amount within the range is a better
estimate than any other amount within the range, the best estimate should be
recorded. If no amount within the range is a better estimate than any other
amount, the minimum amount within the range should be recorded.
Example 7-7
Initial Recognition of Joint-and-Several Debt
Instrument
Company A and Company B co-issue and are jointly and
severally liable for $400 of debt. The total amount of
the obligation for the debt is fixed as of the reporting
date. The joint-and-several obligation is within the
scope of ASC 405-40. The arrangement between A and B
states that A agrees to pay the full $400 obligation,
and B does not expect to pay additional amounts on
behalf of A.
Accordingly, A would record a liability of $400, and B
would not record any liability because it has not agreed
to pay any amount and does not expect to pay additional
amounts on behalf of A.
Example 7-8
Initial Recognition of Joint-and-Several Debt
Instrument — Allocation Among Obligors
Assume the same facts as in the example
above, except that the arrangement between Company A and
Company B states that each party will pay $200. In this
scenario, A and B would record a liability of $200
because each has agreed to pay that amount and neither
expects to pay additional amounts on behalf of the other
party.
Example 7-9
Initial Recognition of Joint-and-Several Debt
Instrument — Total Amount Recognized by Parties
Exceeds Total Amount of Obligation
Assume the same facts as in the previous
example, except that Company A expects to pay between
$100 and $200 on behalf of Company B. In this scenario,
A would record $300 and B would record $200 of
liabilities for the debt. Each would record the amount
it agreed to pay on the basis of the arrangement with
its co-obligor (i.e., $200). In addition, A would record
$100 of liabilities, which represents the minimum amount
in the range of $100 to $200 that A expects to pay on
behalf of B (its co-obligor) because no other amount in
the range is a better estimate of what A expects it
would pay (see ASC 405-40-30-1(b)).
7.5.4 Offsetting Entry
ASC 405-40
25-2 The corresponding entry or
entries shall depend on facts and circumstances of the
obligation. Examples of corresponding entries include
the following:
-
Cash for proceeds from a debt arrangement
-
An expense for a legal settlement
-
A receivable (that is assessed for impairment) for a contractual right
-
An equity transaction with an entity under common control.
30-2 The corresponding entry or
entries shall depend on the facts and circumstances of
the obligation.
ASC 405-40 does not prescribe the specific offsetting entry or entries an entity
should make when recognizing or remeasuring the liability in a joint-and-several
liability arrangement. Accordingly, an entity must use judgment and consider the
facts and circumstances.
To the extent that an entity has received cash for amounts it
has borrowed under a joint-and-several liability arrangement, the appropriate
offsetting entry would be to cash. If the entity expects to pay amounts on
behalf of co-obligors, the offsetting entry for such amounts depends on whether
the entity has a contractual right to recover those amounts from its co-obligors
(e.g., under a side agreement). If it has such a right, it should record a
receivable and evaluate it for impairment under ASC 310 or ASC 326 (see
Deloitte’s Roadmap Current
Expected Credit Losses), as applicable. If the entity has
no such right, the appropriate offsetting entry might be an expense. Any
expected recoveries (e.g., if the entity sues its co-obligors) would be
evaluated as a contingency under ASC 450-20 and ASC 450-30 (see Deloitte’s
Roadmap Contingencies, Loss
Recoveries, and Guarantees). Paragraph BC12 of ASU
2013-04 states, in part:
In instances in which a legal or contractual arrangement
exists to recover amounts funded under a joint and several obligation
from the co-obligors, the Task Force noted that a receivable could be
recognized at the time the corresponding liability is established. That
receivable would need to be assessed for impairment. When no legal or
contractual arrangement exists to recover the funded amounts from the
co-obligors, the Task Force noted that an entity should consider all
relevant facts and circumstances to determine whether the gain
contingencies guidance in Subtopic 450-30 or other guidance would apply
in recognizing a receivable for potential recoveries.
If the co-obligors are related parties, an entity should consider the reasons
for, and substance of, the arrangement among the co-obligors in determining the
corresponding entry or entries for any amounts that it has agreed or expects to
pay on behalf of its co-obligors. For an amount owed from a shareholder or
related party (such as a sister company) to be classified as an asset (a
receivable), the terms of the transaction generally should be comparable to the
terms that would be expected to be available from external sources (e.g.,
interest rates, payment terms and maturities, evidence of the ability and intent
of repayment, and nature and sufficiency of collateral). If an entity has agreed
or expects to pay an amount on behalf of a co-obligor that is a related party
and receivable classification is not appropriate, the appropriate corresponding
entry might be to equity. For example, if a subsidiary expects to pay an amount
on behalf of its parent, the substance of the subsidiary’s payment might be that
of an equity distribution from the subsidiary to the parent.
7.5.5 Disclosure
ASC 405-40
50-1 An entity shall
disclose the following information about each
obligation, or each group of similar obligations,
resulting from joint and several liability arrangements
included in the scope of this Subtopic:
- The nature of the arrangement, including:
-
How the liability arose
-
The relationship with other co-obligors
-
The terms and conditions of the arrangement.
-
-
The total outstanding amount under the arrangement, which shall not be reduced by the effect of any amounts that may be recoverable from other entities
-
The carrying amount, if any, of an entity’s liability and the carrying amount of a receivable recognized, if any
-
The nature of any recourse provisions that would enable recovery from other entities of the amounts paid, including any limitations on the amounts that might be recovered
-
In the period the liability is initially recognized and measured or in a period the measurement changes significantly:
-
The corresponding entry
-
Where the entry was recorded in the financial statements.
-
50-2 The disclosures
required by this Section do not affect the related-party
disclosure requirements in Topic 850. The disclosure
requirements in this Section are incremental to those
requirements.
An entity must disclose information about the nature and amount of each
obligation (or each group of similar obligations) within the scope of ASC
405-40, including how the liability arose, the relationship with other
co-obligors, and any other relevant terms and conditions of the explicit or
implicit agreement between them.
7.6 Convertible Debt
7.6.1 Background
ASC 470-20
Convertible Debt
Instruments
05-4 A convertible debt
instrument is a complex hybrid instrument bearing an
option, the alternative choices of which cannot exist
independently of one another. The holder ordinarily does
not sell one right and retain the other. Furthermore,
the two choices are mutually exclusive; they cannot both
be consummated. Thus, the instrument will either be
converted or be redeemed. The holder cannot exercise the
option to convert unless he forgoes the right to
redemption, and vice versa.
05-5 A convertible debt
instrument may offer advantages to both the issuer and
the purchaser. From the point of view of the issuer,
convertible debt has a lower interest rate than does
nonconvertible debt. Furthermore, the issuer of
convertible debt instruments, in planning its long-range
financing, may view convertible debt as essentially a
means of raising equity capital. Thus, if the fair value
of the underlying common stock increases sufficiently in
the future, the issuer can force conversion of the
convertible debt into common stock by calling the issue
for redemption. Under these market conditions, the
issuer can effectively terminate the conversion option
and eliminate the debt. If the fair value of the stock
does not increase sufficiently to result in conversion
of the debt, the issuer will have received the benefit
of the cash proceeds to the scheduled maturity dates at
a relatively low cash interest cost.
05-6 On the other hand, the
purchaser obtains an option to receive either the face
or redemption amount of the instrument or the number of
common shares into which the instrument is convertible.
If the fair value of the underlying common stock
increases above the conversion price, the purchaser
(either through conversion or through holding the
convertible debt containing the conversion option)
benefits through appreciation. The purchaser may at that
time require the issuance of the common stock at a price
lower than the fair value. However, should the fair
value of the underlying common stock not increase in the
future, the purchaser has the protection of a debt
security. Thus, in the absence of default by the issuer,
the purchaser would receive the principal and interest
if the conversion option is not exercised.
05-7 Entities may issue
convertible debt instruments that may be convertible
into common stock at the lower of a conversion rate
fixed at time of issuance and a
fixed discount to the market price of the common stock
at the date of conversion.
05-7A Entities also may
issue convertible debt instruments that, by their stated
terms, may be settled in cash (or other assets) upon
conversion, including partial cash settlement.
05-8 Certain convertible
debt instruments may have a contingently adjustable
conversion ratio; that is, a conversion price that is
variable based on future events such as any of the
following:
- A liquidation or a change in control of an entity
- A subsequent round of financing at a price lower than the convertible security’s original conversion price
- An initial public offering at a share price lower than an agreed-upon amount.
05-8A Certain convertible
debt instruments may become convertible only upon the
occurrence of a future event that is outside the control
of the issuer or holder.
Instruments
15-2A The guidance on
convertible debt instruments in this Subtopic shall be
considered after considering the guidance in the Fair
Value Option Subsections of Subtopic 825-10 on financial
instruments.
15-2B The guidance on
convertible debt instruments in this Subtopic shall be
considered after considering the guidance in Subtopic
815-15 on bifurcation of embedded derivatives for an
embedded conversion option or other embedded feature
(for example, an embedded prepayment option) as
applicable (see paragraph 815-15-55-76A). The relevant
guidance in this Subtopic does not affect an issuer’s
determination under Subtopic 815-15 of whether an
embedded conversion option or other embedded feature
shall be separately accounted for as a derivative
instrument.
15-2C The guidance in this
Subtopic does not apply to a convertible debt instrument
award issued to a grantee that is subject to the
guidance in Topic 718 on stock compensation unless the
instrument is modified as described in and no longer
subject to the guidance in that Topic. The guidance in
this Subtopic does not apply to stock-settled debt that
is subject to the guidance in Subtopic 480-10 on
distinguishing liabilities from equity or other
Subtopics (see paragraph 470-20-25-14), unless the
stock-settled debt also contains a substantive
conversion feature (as discussed in paragraphs
470-20-40-7 through 40-10) for which all relevant
guidance in this Subtopic shall be considered in
addition to the relevant guidance in other
Subtopics.
15-2D For purposes of
determining whether an instrument is within the scope of
this Subtopic, a convertible preferred stock shall be
considered a convertible debt instrument if it has both
of the following characteristics:
- It is a mandatorily redeemable financial instrument.
- It is classified as a liability under Subtopic 480-10.
For related implementation guidance, see paragraph
470-20-55-1A.
Debt Instruments With Detachable Warrants
25-3 . . . [I]f stock purchase
warrants are not detachable from the debt instrument and
the debt instrument must be surrendered to exercise the
warrant, the two instruments taken together are
substantially equivalent to a convertible debt
instrument and the accounting specified in paragraph
470-20-25-12 shall apply.
Convertible Debt Instruments
25-14 If a debt instrument
has a conversion option that continuously resets as the
underlying stock price increases or decreases so as to
provide a fixed value of common stock to the holder at
any conversion date, the instrument shall be considered
stock-settled debt that is subject to the guidance in
Subtopic 480-10 or other Subtopics (such as Subtopic
718-10, 815-15, or 825-10). Example 4 (see paragraph
470-20-55-18) illustrates application of the guidance in
this paragraph.
ASC 470-20 applies to an issuer’s accounting for convertible
debt unless (1) the issuer has elected the fair value option1 or (2) the embedded conversion option must be bifurcated under ASC 815-15.
If an issuer elects to account for convertible debt at fair value on a recurring
basis under the fair value option in ASC 815-15 (see Section 8.5.6) or ASC 825-10 (see Section 4.4), no embedded derivative features would be
bifurcated and any issuance costs would be expensed at inception (see Section 5.5). The convertible debt instrument
would be subsequently remeasured to its fair value on each reporting date, with
such changes in fair value reflected in earnings except for the portion of the
changes attributable to the change in instrument-specific credit risk, which
would be reported in OCI (see Section
6.3).
If the fair value option has not been elected, an issuer of convertible debt
applies the following steps in ASC 815-15-55-76A to account for the debt instrument:
- “Step 1. Identify embedded features, including the embedded conversion option that must be evaluated under Subtopic 815-15.”
- “Step 2. Apply the guidance in Subtopic 815-15 to determine whether any of the embedded features identified in Step 1 must be separately accounted for as derivative instruments.”
- “Step 3. Apply the guidance in Subtopic 470-20 to account for the convertible debt instrument (including the embedded conversion option and any other embedded features, which are not separately accounted for as a derivative instrument in Step 2) as a liability.”
- “Step 4. If one or more embedded features are required to be separately accounted for as a derivative instrument based on the analysis performed in Step 2, that embedded derivative shall be separated from the host contract in accordance with the guidance in this Subtopic.”
If the embedded conversion option must be bifurcated as a derivative liability
under ASC 815-15, the recognition and measurement guidance in ASC 470-20 does
not apply. However, if the embedded conversion option does not have to be
bifurcated under ASC 815-15 but there are other embedded features that must be
bifurcated (e.g., redemption options or interest features), the guidance in ASC
470-20 applies. See Chapter 8 for
discussion of the evaluation of embedded derivative features in convertible debt
instruments.
In the remaining discussion below, it is assumed that the issuer has not elected
the fair value option and that the embedded conversion option is not bifurcated
under ASC 815-15.
7.6.2 Convertible Debt Not Issued at a Substantial Premium
ASC 470-20
25-12 A debt with an embedded
conversion feature shall be accounted for in its
entirety as a liability and no portion of the proceeds
from the issuance of the convertible debt instrument
shall be accounted for as attributable to the conversion
feature unless the conversion feature is required to be
accounted for separately as an embedded derivative under
Subtopic 815-15 or the conversion feature results in a
premium that is subject to the guidance in paragraph
470-20-25-13.
25-15 If the issuance
transaction for a convertible debt instrument within the
scope of this Subtopic includes other unstated (or
stated) rights or privileges in addition to the
convertible debt instrument, a portion of the initial
proceeds shall be attributed to those rights and
privileges based on the guidance in other applicable
U.S. generally accepted accounting principles
(GAAP).
Upon the initial recognition of convertible debt, the issuer presents the entire
amount attributable to the debt as a liability. The initial carrying amount of
the convertible debt liability is reduced by any direct and incremental issuance
costs paid to third parties that are associated with the convertible debt
issuance (see Section 5.3). No amount
attributable to the debt is initially recognized within equity unless the
instrument is issued at a substantial premium (see Section 7.6.3). In determining the amount attributable to the
convertible debt instrument, the issuer should allocate the proceeds to other
unstated (or stated) rights and privileges on the basis of the guidance in other
U.S. GAAP (see Section 3.4). For example,
if convertible debt is issued with detachable warrants, the issuer should
allocate the proceeds received to the two instruments in accordance with ASC
470-20-25-2.
Example 7-10
Issuance of
Convertible Debt Instrument Without Any Other
Instruments
Entity A issues a five-year convertible
debt instrument at par for net cash proceeds of $8
million, which is its principal amount. The instrument
has a stated interest rate of 1.5 percent per annum and
an embedded conversion option that gives the holder the
right to convert the debt on its maturity date into a
fixed number of A’s shares of common stock subject to
standard antidilution adjustments. The interest rate on
the convertible debt is lower than that on similar
nonconvertible debt issued by A, since investors are
willing to accept a lower rate because of the value of
the embedded conversion option. Entity A estimates that
if the embedded conversion option had been issued
separately as a freestanding financial instrument, its
fair value at inception would have been $1 million.
Further, A has determined that it does not have to
bifurcate the conversion option as a derivative under
ASC 815-15. Therefore, A makes the following journal
entry at issuance:
Convertible debt is subsequently accounted for at amortized cost
in accordance with the interest method described in ASC 835-30 (see Section 6.2). Reported
interest expense on convertible debt to which ASC 470-20-25-12 applies is
generally lower than that on similar nonconvertible debt, since the issuer is
“paying” for the low interest rate by providing an equity conversion feature
that is not recognized for accounting purposes.
In GAAP, there are several exceptions to the prohibition in ASC
470-20-25-12 against separately recognizing a conversion feature embedded in a
convertible debt instrument:
-
If the conversion feature meets the bifurcation criteria in ASC 815-15 (see Section 8.4.7), it is accounted for separately from the debt host contract as a derivative at fair value, with changes in fair value recognized in earnings.
-
If the conversion feature was bifurcated as a derivative but no longer meets the bifurcation criteria, ASC 815-15-35-4 requires the issuer to reclassify the previously bifurcated conversion option into equity (see Section 8.5.4.3).
-
If the convertible debt is modified or exchanged and the modification or exchange is not accounted for as an extinguishment, the amount of any increase in the fair value of the conversion feature associated with the modification or exchange reduces the carrying amount of the debt, with a corresponding increase in equity (see Section 10.4.3).
-
If the convertible debt is issued at a substantial premium to its face amount, it is presumed that the premium should be accounted for in equity (see the next section) unless the conversion feature requires bifurcation as a derivative under ASC 815-15-25-1 (see Section 8.4.7).
7.6.3 Convertible Debt Issued at a Substantial Premium
ASC 470-20
25-13 If a convertible debt
instrument is issued at a substantial premium, there is
a presumption that such premium represents paid-in
capital.
25-15 If the issuance
transaction for a convertible debt instrument within the
scope of this Subtopic includes other unstated (or
stated) rights or privileges in addition to the
convertible debt instrument, a portion of the initial
proceeds shall be attributed to those rights and
privileges based on the guidance in other applicable
U.S. generally accepted accounting principles
(GAAP).
Sometimes, convertible debt is sold or initially recognized at a substantial
premium over the principal amount to be repaid at maturity. In this
circumstance, there is a presumption that the premium should be recognized in
equity as paid-in capital if it is substantial.
ASC 470-20-25-13 applies only to convertible debt instruments that are not
specifically addressed in other GAAP; therefore, it does not apply to:
-
Convertible debt instruments with a conversion feature that must be bifurcated as a derivative under ASC 815-15 (see Section 8.4.7).
-
Debt instruments that contain a conversion feature that economically represents a share-settled redemption feature (see Section 8.4.7.2.5).
The guidance on allocating a substantial premium to paid-in capital may apply in
circumstances in which, for example:
-
An acquirer assumes an acquiree’s outstanding convertible debt in a business combination.
-
Convertible debt is issued upon the exercise of a physically settled liability-classified warrant.
While ASC 470-20 does not define substantial, in practice, a premium of 10
percent or more is considered substantial. In certain circumstances, however, a
premium of less than 10 percent may also be considered substantial (e.g., for a
zero-coupon convertible debt instrument that is initially recognized at a
premium because of the value of the conversion feature and for which negative
interest expense would be reported if the premium was not allocated to
equity).
Although ASC 470-20 does not specifically address such cases, an entity may be
able to overcome the presumption that it should record a substantial premium in
APIC if the premium is not attributable to the value of the equity conversion
feature. For example, the presumption may be overcome if:
-
The convertible debt was issued or assumed at a premium because it pays a higher coupon rate than similar nonconvertible debt.
-
The convertible debt includes an embedded feature other than the conversion feature that significantly increased the proceeds received for the debt.
When convertible debt is initially recognized under ASC 470-20-25-13, the
principal amount of the debt is recognized as a liability, and the premium is
recognized in APIC. The issuer should also determine whether the instrument
contains any other embedded features that must be bifurcated as derivatives
under ASC 815-15 (e.g., a put, call, redemption, or indexation feature; see
Chapter 8). While the issuer should
reduce the initial carrying amount of the convertible debt by any direct or
incremental issuance costs paid to third parties that are associated with the
debt’s issuance, the guidance in U.S. GAAP does not explicitly address whether
or, if so, how to allocate such costs between an instrument’s debt and equity
components (see Section 3.5).
Because a separated equity component (a premium) is contained
within the convertible debt to which the guidance on substantial premiums in ASC
470-20-25-13 applies, the issuer cannot elect the fair value option in ASC
815-15 (see Section
8.5.6) or ASC 825-10 (see Section 4.4). Therefore, except for any
bifurcated embedded derivatives, the liability-classified portion of the
convertible debt instrument is subsequently measured at amortized cost, which
the issuer determines by using the interest method described in ASC 835-30 (see
Section 6.2).
The issuer does not subsequently remeasure the amount initially recognized for
the premium in equity.
Example 7-11
Assumption of Convertible Debt in a Business
Combination
Entity A acquires Entity B and assumes
B’s outstanding convertible debt. The convertible debt’s
fair value ($1.2 million) is significantly higher than
its principal amount ($1 million). Entity A determines
that it does not have to bifurcate the conversion option
as a derivative under ASC 815-15. In accordance with ASC
805-20-30-1, the acquirer in a business combination
measures liabilities assumed at their acquisition-date
fair values. Because the difference between the
convertible debt’s fair value and face amount is
substantial, A allocates a portion of the initial
carrying amount equal to the excess of the fair value
over the face amount (i.e., $200,000) to equity (APIC)
under ASC 470-20-25-13.
Example 7-12
Liability-Classified Physically Settled
Warrant
In EITF Issue 00-27 (superseded), the following tentative
guidance illustrated the application of ASC 470-20-25-13
to convertible debt issued upon the exercise of a
liability-classified physically settled warrant:
Assume Company A issues a freestanding warrant to
Company B on January 15, 20X0, for its fair value,
$20. . . . The warrant provides Company B with the
right during the next 2 years to exercise the
warrant for $100 in cash and receive Company A
$100 par value convertible debt. The debt is
convertible into 10 shares of Company A common
stock. The fair value of Company A stock on
January 15, 20X0, is $11 per share. Company B
exercises the warrant on February 15, 20X1, when
the fair value of Company A stock is $20 per share
and the fair value and carrying amount of the
warrant is $105. [The] warrant terms require
physical settlement upon exercise and Company A
has determined that the warrant is classified as a
liability. . . . The exercise of the warrant and
resulting issuance of the convertible debt would
be recorded as follows:
7.6.4 Own-Share Lending Arrangements in Connection With Convertible Debt Issuance
7.6.4.1 Overview
ASC 470-20
05-12A An entity for which
the cost to an investment banking firm (investment
bank) or third-party investors (investors) of
borrowing its shares is prohibitive (for example,
due to a lack of liquidity or extensive open short
positions in the shares) may enter into
share-lending arrangements that are executed
separately but in connection with a convertible debt
offering. Although the convertible debt instrument
is ultimately sold to investors, the share-lending
arrangement is an agreement between the entity
(share lender) and an investment bank (share
borrower) and is intended to facilitate the ability
of the investors to hedge the conversion option in
the entity’s convertible debt.
05-12B The terms of a
share-lending arrangement require the entity to
issue shares (loaned shares) to the investment bank
in exchange for a nominal loan processing fee.
Although the loaned shares are legally outstanding,
the nominal loan processing fee is typically equal
to the par value of the common stock, which is
significantly less than the fair value of the loaned
shares or the share-lending arrangement. Generally,
upon maturity or conversion of the convertible debt,
the investment bank is required to return the loaned
shares to the entity for no additional
consideration.
05-12C Other terms of a
share-lending arrangement typically require the
investment bank to reimburse the entity for any
dividends paid on the loaned shares. Typically, the
arrangement precludes the investment bank from
voting on any matters submitted to a vote of the
entity’s shareholders to the extent the investment
bank is the owner of the shares.
ASC 470-20 provides guidance on an issuer’s accounting for
equity-classified share-lending arrangements on its own shares that are
executed in contemplation of a convertible debt issuance. In practice, an
issuer may enter into such an arrangement to help ensure the successful
completion of the convertible debt offering by facilitating investors’
ability to economically hedge their exposure to the share price risk
associated with the issuer’s stock that is inherent in the convertible
instrument.
Example 7-13
Own-Share
Lending in Conjunction With Convertible Debt
Issuance
Issuer A is issuing convertible debt. However, before
agreeing to buy the debt, certain prospective
investors would like to ensure that they can
economically hedge their exposure to the share price
risk related to A’s stock that is associated with
the embedded conversion option. Accordingly, the
prospective investors enter into derivative
contracts on the underlying shares (e.g., options,
forwards, or total return swaps) with Bank B that
offset the exposure related to the “long” position
in A’s stock that would result from the convertible
debt investment. To economically hedge its own
exposure from writing such derivatives, B borrows
the underlying shares and sells them short in the
market.
Because B cannot secure a sufficient number of
underlying shares in the market (i.e., they are not
readily available to market participants) or the
price is too high, it borrows the underlying shares
by entering into a share-lending arrangement
directly with A. The terms of the arrangement
require B to pay a nominal processing fee to A
(e.g., the par value of the shares) that is
significantly less than the agreement’s fair
value.
Issuer A is motivated to enter into the agreement
because the pricing and successful completion of the
convertible debt offering depend on the investors’
ability to enter into derivative contracts to hedge
their equity price exposure, which in turn depends
on B’s ability to borrow the shares.
During the period in which the shares are on “loan,”
they are legally outstanding and the holder is
legally entitled to any dividends paid on them,
although it must reimburse A for such payments. Upon
the conversion or maturity of the convertible debt,
B must physically return the loaned shares to A for
no consideration. If B defaults in returning the
loaned shares, A is contractually entitled to a cash
payment equal to the shares’ fair value.
7.6.4.2 Scope
The guidance on the issuer’s accounting for own-share lending arrangements in
ASC 470-20 applies to arrangements that have the following terms and characteristics:
-
The issuer is lending its equity shares to the counterparty (i.e., it has issued its equity shares on loan).
-
The issuer receives a nominal fee that is significantly less than the fair value of the shares and of the arrangement.
-
The counterparty will return the loaned shares to the issuer on the arrangement’s maturity date for no additional consideration. If the counterparty is unable to return the loaned shares, it may be required to reimburse the issuer in cash.
-
The arrangement qualifies as equity under GAAP.
-
The arrangement was executed in contemplation of a convertible debt issuance or other financing.
In evaluating whether the contract qualifies as equity under GAAP, the issuer
should consider the requirements in ASC 480-10 and ASC 815-40.
Connecting the Dots
For a discussion of the evaluation of whether an own-share lending
arrangement qualifies as equity under ASC 815-40, see Deloitte’s
Roadmap Contracts on an Entity’s Own
Equity, in particular Sections 2.9, 4.3.5.11, and 5.2.3.6.
7.6.4.3 Initial Accounting
ASC 470-20
25-20A At the date of
issuance, a share-lending arrangement entered into
on an entity’s own shares in contemplation of a
convertible debt offering or other financing shall
be measured at fair value (in accordance with Topic
820) and recognized as an issuance cost, with an
offset to additional paid-in capital in the
financial statements of the entity.
30-26A At the date of
issuance, a share-lending arrangement entered into
on an entity’s own shares in contemplation of a
convertible debt offering or other financing shall
be measured at fair value in accordance with Topic
820.
Own-share lending arrangements within the scope of this
guidance are initially recorded at fair value and recognized as a debt
issuance cost with an offset to APIC in the issuer’s financial statement
(i.e., Dr: Debt; Cr: Equity — APIC).
The terms of a share-lending arrangement entered into in contemplation of a
convertible debt issuance typically require an entity to issue its common
shares to a counterparty (e.g., the bank) in exchange for a nominal
processing fee. The processing fee is significantly less than the fair value
of the shares and is typically less than a market fee that would be charged
in a share-lending arrangement that was not entered into in contemplation of
a convertible debt issuance. To promote the issuance of the debt, the issuer
may sometimes accept less than the market rate on the share-lending
arrangement. The fair value of the share-lending arrangement will be
determined on the basis of the difference between the contractual processing
fee and a market-based fee that would typically be charged for lending such
shares, adjusted as necessary to reflect the nonperformance risk of the
share borrower.
Example 7-14
Initial Accounting for Own-Share Lending
Arrangement
Issuer A issues convertible debt at
par for cash proceeds of $250 million. The stated
interest rate on the debt is 2.5 percent per annum.
The debt is due five years from the issuance date
and is convertible into A’s equity shares at the
holder’s option. Issuer A determines that the
convertible debt should be accounted for under ASC
470-20-25-12. Accordingly, the equity conversion
option is not separately recognized as an equity
component under ASC 470-20.
In contemplation of the convertible debt issuance, A
executes a share-lending arrangement with Bank B to
help ensure the successful completion of the debt
offering, and A receives $100,000 for the
arrangement (which is also the par amount of the
shares issued). However, the fair value of the
arrangement is $15 million. Issuer A evaluates the
share-lending arrangement under ASC 470-20 and ASC
815-40 and determines that it qualifies as
equity.
On the date that both the debt issuance and the
share-lending arrangement occur, A makes the
following journal entry:
7.6.4.4 Subsequent Accounting
ASC 470-20
35-11A If it becomes probable
that the counterparty to a share-lending arrangement
will default, the issuer of the share-lending
arrangement shall recognize an expense equal to the
then fair value of the unreturned shares, net of the
fair value of probable recoveries, with an offset to
additional paid-in capital. The issuer of the
share-lending arrangement shall remeasure the fair
value of the unreturned shares each reporting period
through earnings until the arrangement consideration
payable by the counterparty becomes fixed.
Subsequent changes in the amount of the probable
recoveries should also be recognized in
earnings.
Unless an issuer elects to account for debt arising from an
own-share lending arrangement at fair value under the fair value option in
ASC 825-10, it uses the effective interest method to amortize any debt
discount (or reduced premium) that is created by recognizing the
arrangement. The amount recognized in equity is not remeasured as long as
(1) the share-lending arrangement qualifies as equity under ASC 815-40 and
(2) it is not probable that the counterparty to the share-lending
arrangement will default in returning the loaned shares (or an equivalent
amount of consideration).
If it becomes probable that the counterparty to the share-lending arrangement will default in returning the loaned shares (or an equivalent amount of consideration), the issuer must recognize an expense equal to the fair value of the unreturned shares adjusted for the fair value of any probable recoveries. The offsetting entry for the expense is to APIC (i.e., Dr: Loss; Cr: Equity — APIC). The EITF stated the following related to Issue 09-1 at
its June 18, 2009, meeting:
Some Task Force members observed that equity-classified instruments
do not generally result in expense charges. However, the Task Force
concluded that an expense was appropriate in this situation because
it relates to a counterparty default and not changes in the entity’s
share price.
In other words, the EITF determined that even though the share-lending
arrangement is classified in equity, it is appropriate to record an expense
because the issuer incurs a loss from the counterparty’s failure to satisfy
its obligation to return the loaned shares. Under the contractual terms of
the instrument, the issuer should have received the shares back (or an
equivalent amount of consideration), but instead it received no value or
something of lesser value because of the counterparty’s default.
The amount of the loss (i.e., the fair value of the unreturned shares
adjusted for probable recoveries) is remeasured each period (e.g., for
changes in the fair value of the unreturned shares) until the consideration
payable becomes fixed. The issuer recognizes changes in the amount of the
loss in earnings with an offset to APIC.
7.6.5 Temporary Equity
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of
Redeemable Securities
2. ASR 268 requires preferred securities that are
redeemable for cash or other assets to be classified
outside of permanent equity if they are redeemable (1)
at a fixed or determinable price on a fixed or
determinable date, (2) at the option of the holder, or
(3) upon the occurrence of an event that is not solely
within the control of the issuer. As noted in ASR 268,
the Commission reasoned that “[t]here is a significant
difference between a security with mandatory redemption
requirements or whose redemption is outside the control
of the issuer and conventional equity capital. The
Commission believes that it is necessary to highlight
the future cash obligations attached to this type of
security so as to distinguish it from permanent
capital.”
3(e). Convertible debt instruments that contain a
separately classified equity component. Other
applicable GAAP may require a convertible debt
instrument to be separated into a liability component
and an equity component.FN8 In these
situations, the equity-classified component of the
convertible debt instrument should be considered
redeemable if at the balance sheet date the issuer can
be required to settle the convertible debt instrument
for cash or other assets (that is, the instrument is
currently redeemable or convertible for cash or other
assets). For these instruments, an assessment of whether
the convertible debt instrument will become redeemable
or convertible for cash or other assets at a future date
should not be made. For example, a convertible debt
instrument that is not redeemable at the balance sheet
date but could become redeemable by the holder of the
instrument in the future based on the passage of time or
upon the occurrence of a contingent event is not
considered currently redeemable at the balance sheet
date.
12. Initial measurement. The SEC staff believes
the initial carrying amount of a redeemable equity
instrument that is subject to ASR 268 should be its
issuance date fair value, except as follows: . . .
d. For convertible debt instruments that
contain a separately classified equity component,
an amount should initially be presented in
temporary equity only if the instrument is
currently redeemable or convertible at the
issuance date for cash or other assets (see
paragraph 3(e)). The portion of the
equity-classified component that is presented in
temporary equity (if any) is measured as the
excess of (1) the amount of cash or other assets
that would be required to be paid to the holder
upon a redemption or conversion at the issuance
date over (2) the carrying amount of the
liability-classified component of the convertible
debt instrument at the issuance date.
16. [Subsequent measurement.] The
following additional guidance is relevant to the
application of the SEC staff’s views in paragraphs 14
and 15: . . .
d. For convertible debt instruments that
contain a separately classified equity component,
an amount should be presented in temporary equity
only if the instrument is currently redeemable or
convertible at the balance sheet date for cash or
other assets (see paragraph 3(e)). The portion of
the equity-classified component that is presented
in temporary equity (if any) is measured as the
excess of (1) the amount of cash or other assets
that would be required to be paid to the holder
upon a redemption or conversion at the balance
sheet date over (2) the carrying amount of the
liability-classified component of the convertible
debt instrument at the balance sheet
date.FN15
23. Convertible debt instruments that contain a
separately classified equity component. For
convertible debt instruments subject to ASR 268 (see
paragraph 3(e)), there should be no incremental earnings
per share accounting from the application of this SEC
staff announcement. Subtopic 260-10 addresses the
earnings per share accounting.
_____________________
FN8 See Subtopics 470-20 and
470-50; and Paragraph 815-15-35-4.
FN15 ASR 268 does not impact
the application of other applicable GAAP to the
accounting for the liability component or the accounting
upon derecognition of the liability and/or equity
component.
In financial statements filed with the SEC under Regulation S-X, issuers of
equity-classified instruments that are redeemable for cash or other assets in
circumstances that are not under the issuers’ sole control must (1) present such
instruments on the face of the balance sheet in a caption that is separate from
both liabilities and stockholders’ equity (i.e., as “temporary equity”) and (2)
apply specific measurement, disclosure, and EPS guidance to them. In addition,
an issuer that is subject to the SEC’s requirements should consider whether it
must classify as temporary equity all or a portion of the equity component of a
convertible debt instrument that contains such a component, including each of
the following:
-
Convertible debt instruments that contain a separately recognized equity component as a result of a previous modification or exchange involving the instrument that (1) was not accounted for as an extinguishment and (2) increased the fair value of the conversion option (see Section 10.4.3).
-
Convertible debt instruments that contain a separately recognized equity component as a result of the reclassification of a previously bifurcated embedded conversion feature (see Section 8.5.4.3).
Terms and features that could trigger classification as temporary equity are not
limited to those that are explicitly described as redemption or put features but
also include, for example, certain call, conversion, and liquidation features
that could force the issuer to redeem an instrument for cash or assets in
circumstances that are not solely within its control.
For convertible debt instruments that contain a separately
recognized equity component, ASC 480-10-S99-3A(3)(e) limits the scope of the
application of the guidance on temporary equity to scenarios in which the
convertible instrument is currently redeemable or convertible by the investor
for cash or other assets. Unlike its application to other redeemable equity
instruments, the guidance on classifying a convertible debt instrument with a
separately recognized equity component as temporary equity must be applied only
at the ends of reporting periods in which the instrument is currently redeemable
for cash or other assets. Thus, the guidance does not apply in reporting periods
in which the instrument will become redeemable or convertible only on a future
date. As a result of this guidance, an entity that has an outstanding
convertible debt instrument with a separately recognized equity component must
assess, in each financial reporting period, whether the equity component (or a
portion thereof) must be classified in temporary equity. As indicated in ASC
480-10-S99-3A(12)(d) and ASC 480-10-S99-3A(16)(d), the amount that must be
classified in temporary equity is limited to the excess (if any) of “(1) the
amount of cash or other assets that would be required to be paid to the holder
upon a redemption or conversion . . . over (2) the carrying amount of the
liability-classified component of the convertible debt instrument” both at
initial measurement and on subsequent balance sheet dates.
For a comprehensive discussion of the SEC’s temporary equity
guidance, see Chapter
9 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity.
Example 7-15
Convertible Debt
With Separated Equity Component
Entity A issued a convertible debt
instrument for net proceeds of $100. Upon the
instrument’s issuance, A was required to separate the
conversion feature as a derivative under ASC 815-15.
After issuance, however, the conversion feature no
longer met the bifurcation criteria in ASC 815-15-25-1.
Accordingly, A reclassified the carrying amount of the
conversion feature as equity under ASC 815-15-35-4.
As of the reporting date, the current carrying amount of
the debt is $90 and the carrying amount of the
equity-classified conversion feature is $10. The
instrument also includes a cash-settled put option that
permits the investor to put the instrument back to A at
any time for $97. Entity A is not required to bifurcate
the put option and account for it as a derivative under
ASC 815-15. In this case, A would present $3 of the
equity component in permanent equity and $7 in temporary
equity because $7 of the equity component is currently
redeemable (i.e., the excess of the current redemption
amount over the carrying amount of the debt’s liability
component).
If, instead, the put option was contingent and the
contingency was not met as of the reporting date, no
amount would be presented in temporary equity
(irrespective of whether it was probable that the
contingency would be met in the future) because the
SEC’s guidance on redeemable securities in ASC
480-10-S99-3A only applies to convertible debt
instruments with a separately classified equity
component if the instrument is currently redeemable or
convertible as of the reporting date.
Footnotes
1
The fair value option cannot be applied to a convertible
debt instrument issued at a substantial premium. Such an instrument must
be accounted for in accordance with the guidance in Section 7.6.3.
7.7 Debt Exchangeable Into the Stock of Another Entity
ASC 470-20 — SEC Materials — SEC Staff Guidance
Comments Made by SEC Observer at Emerging Issues Task
Force (EITF) Meetings
SEC Observer Comment: Debt Exchangeable for the Stock of
Another Entity
S99-1 The following is the text of
the SEC Observer Comment: Debt Exchangeable for the Stock of
Another Entity.
An issue has been discussed involving an
enterprise that holds investments in common stock of other
enterprises and issues debt securities that permit the
holder to acquire a fixed number of shares of such common
stock. These types of transactions are commonly affected
through the sale of either debt with detachable warrants
that can be exchanged for the stock investment or debt
without detachable warrants (the debt itself must be
exchanged for the stock investment — also referred to as
“exchangeable” debt). Those debt issues differ from
traditional warrants or convertible instruments because the
traditional instruments involve exchanges for the equity
securities of the issuer. There have been questions as to
whether the exchangeable debt should be treated similar to
traditional convertibles as specified in Subtopic 470-20 or
whether the transaction requires separate accounting for the
exchangeability feature. The SEC staff believes that
Subtopic 470-20 does not apply to the accounting for debt
that is exchangeable for the stock of another entity and
therefore separation of the debt element and exchangeability
feature is required.
A debt instrument may contain a feature that requires or permits its exchange into
the shares of a third party rather than the issuer’s equity shares (“exchangeable
debt”). For example, the terms of a debt instrument may include an option for the
holder to require the issuer to deliver a fixed number of shares of common stock of
a third party in lieu of repaying the debt’s principal amount at maturity. From the
issuer’s perspective, exchangeable debt is substantially different from convertible
debt because the embedded exchange feature is not settled in the issuer’s equity
shares but in third-party stock.
In EITF Issue 85-9 (superseded), the SEC staff observer indicated that “he believes
that [ASC 470-20-25-12] does not apply and that separation of the debt element and the exchangeability feature is required.” After the publication of Issue 85-9, the FASB issued Statement 133 (codified in ASC 815). The status section of EITF Issue
85-9 notes that a “nondetachable (thus embedded) warrant to exchange debt into
another entity’s stock is not clearly and closely related to the debt instrument
and, if it meets the definition of a derivative, shall be separated from the debt
and accounted for as a derivative instrument.”
Accordingly, the issuer of exchangeable debt should not analyze such debt as
convertible debt under ASC 470-20. Instead the issuer should evaluate whether the
exchange feature must be separated as a derivative under ASC 815-15 (see
Section 8.4.7) and, if not, whether the SEC staff observer
comments in ASC 470-20-S99-1 apply. Under ASC 470-20-S99-1, the exchange feature
would be accounted for separately from the debt even if it is not required to be
separated as a derivative under ASC 815 (e.g., the feature might not need to be
separated as a derivative if it does not meet the net settlement characteristic in
the definition of a derivative; see Section 8.4.7).
ASC 470-20-S99-1 does not address the measurement of an exchange feature that does
not have to be accounted for as a derivative. An entity might analogize to the
guidance on embedded features that are accounted for as derivatives and account for
the exchange feature at fair value, with changes in fair value recognized in net
income. Alternatively, an entity might look to the indexed-debt guidance in ASC
470-10 and account for the exchange feature on the basis of an intrinsic value
approach under which changes in intrinsic value are recognized in net income. Under
that approach, the exchange feature is measured on the basis of the excess, if any,
of the current value of the third-party stock over the debt’s net carrying amount,
without regard to the time value inherent in the option to exchange the debt for
third-party stock (see Section 7.4.5).
In consolidated financial statements, a contract exchangeable into
the equity shares of a consolidated subsidiary is analyzed in a manner similar to a
contract convertible into the parent’s equity shares provided that the subsidiary is
a substantive entity (see Section
2.6.1 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity).
This is the case irrespective of whether the debt instrument is issued by the parent
or subsidiary. Accordingly, if a parent issues a debt instrument that is
exchangeable into the equity shares of a consolidated subsidiary and the subsidiary
is a substantive entity, the exchange feature would be analyzed as a conversion
feature under ASC 470-20 unless it has to be accounted for as a derivative
instrument under ASC 815 (e.g., if it can be net settled and does not qualify for
the scope exception in ASC 815-10-15-74(a) for certain contracts on the entity’s own
equity). Equity shares issued by an equity-method investee, however, are not
considered part of the entity’s own equity.
In the subsidiary’s separate financial statements, the equity of its
parent is not considered part of the subsidiary’s equity. Therefore, a debt
instrument that is issued by a subsidiary and exchangeable into the parent’s equity
shares would not be analyzed in a manner similar to a contract that is convertible
into the subsidiary’s equity shares in the subsidiary’s separate financial
statements (see Section
2.6.2 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity).
In the parent’s consolidated financial statements, however, the same debt instrument
would be analyzed as a debt instrument that is convertible into the issuer’s equity
shares.