Deloitte's Roadmap: Issuer’s Accounting for Debt
Preface
Preface
We are pleased to present the 2024
edition of Issuer’s Accounting for Debt. This Roadmap provides an overview of
the FASB’s authoritative guidance on the issuer’s accounting for debt arrangements
(including convertible debt) as well as our insights into and interpretations of how
to apply that guidance in practice.
Determining the appropriate
accounting for debt arrangements can be time-consuming and complex. Terms that are
significant to the accounting analysis may be buried deep within a contract’s fine
print. To properly apply the numerous rules in U.S. GAAP, an issuer needs to closely
analyze an instrument’s terms and conditions and the related facts and
circumstances. The outcome of the analysis could significantly affect the
classification, measurement, and earnings impact of the debt arrangement and
associated financial statement ratios. This Roadmap is intended to help issuers
navigate the guidance and arrive at appropriate financial reporting conclusions.
The 2024 edition of the Roadmap
includes updated and expanded guidance on various topics. See Appendix E for details.
Be sure to
check out On the Radar (also available as a stand-alone
publication), which briefly summarizes
emerging issues and trends related to the accounting and
financial reporting topics addressed in the Roadmap.
We hope you find this Roadmap to be
a useful resource, and we welcome your suggestions for improvements. If
you need assistance with applying the guidance or have other questions about this
topic, we encourage you to consult our technical specialists and other professional
advisers.
On the Radar
On the Radar
Entities raising capital by issuing
debt instruments must account for those instruments by applying ASC 470 as well as
other applicable U.S. GAAP. Key questions to consider when determining the
appropriate accounting include:
All entities are capitalized with debt or equity. The nature and mix of debt and
equity securities that comprise an entity’s capital structure, and its decisions
about the types of securities to issue when raising capital, may depend on the stage
of the entity’s life cycle, the cost of capital, the need to comply with regulatory
capital requirements or debt covenants (e.g., capital or leverage ratios), and the
financial reporting implications. The complexity of the terms
and characteristics of debt instruments is often influenced by factors such as the
entity’s size, age, or creditworthiness. For example, early-stage and smaller growth
companies are often financed with capital securities that contain complex and
unusual features, whereas larger, more mature entities often have a mix of debt and
equity securities with largely plain-vanilla characteristics. The complexity of the
accounting for debt generally depends on the intricacy of the instrument’s
terms.
Financial instruments that are debt in legal form must always be
classified by the issuer as liabilities. In addition, some legal form equity shares
also require liability classification under ASC 480. An entity must reach a
conclusion about the classification of an obligation or equity share before it can
appropriately apply U.S. GAAP to account for the instrument.
The SEC staff closely
scrutinizes the manner in which entities classify and
disclose information about debt instruments. For
example, the staff frequently comments on (1) an
entity’s classification of instruments as equity rather
than debt, (2) restrictions in debt agreements that
limit an entity’s ability to pay dividends, and (3) a
registrant’s compliance with debt covenants, including
the impact of any noncompliance on its liquidity and
capital resources and the classification of debt as
current versus long-term.
Financial Reporting Considerations
While ASC 470 applies to an issuer’s accounting for debt, it
does not address the accounting for other freestanding financial instruments
issued in conjunction with debt. In some cases (e.g., debt issued on a
stand-alone basis), it is readily apparent that there is only one unit of
account. However, other financing transactions may involve two or more
components that individually represent separate units of account (e.g., debt
issued with detachable warrants). Instruments that can be legally detached and
exercised independently from the issued debt are separate freestanding financial
instruments, and U.S. GAAP must be applied to them individually.
Debt instruments may also contain embedded
features that must be separately accounted for as derivatives under ASC 815-15.
These may include equity conversion options, put and call options, and interest
payment features. Entities must often use judgment when determining the unit of
account for such embedded features and whether to separately account for them.
Applying the derivative accounting guidance in ASC 815-15 is extremely complex
and often requires the involvement of accounting advisers.
When debt is issued with other freestanding financial
instruments or includes an embedded derivative that requires separate
accounting, the entity must appropriately allocate the proceeds between the debt
instrument and the other features that are separately accounted for. The entity
must also identify which costs and fees qualify as debt issuance costs. Such
amounts that are applicable to the debt instrument must be capitalized into the
initial carrying amount of the debt. If the financing transaction includes other
freestanding financial instruments or if the debt contains an embedded feature
that requires bifurcation as a derivative, those costs and fees must be
appropriately allocated to the various instruments.
While debt is generally initially recognized on the basis of
the proceeds received, special considerations are necessary in certain
situations such as those in which:
-
The stated interest rate on the debt differs from the market rate of interest.
-
Convertible debt is issued at a substantial premium.
-
The debt is subsequently accounted for at fair value under the fair value option.
If an entity issues debt in a cash transaction that does not
include any other elements for which separate accounting recognition is required
(e.g., freestanding financial instruments or other stated or unstated rights or
privileges that warrant separate accounting recognition) and the entity has not
elected the fair value option, a presumption exists that the debt should be
initially measured at the amount of cash proceeds received from the holder,
adjusted for debt issuance costs. Any difference between the stated principal
amount and the amount of the cash proceeds received, net of debt issuance costs,
is presented as a discount or premium. However, this presumption may not always
be appropriate (e.g., debt issued at a substantial premium). Further, when debt
is issued in exchange for property, goods, or services, there is no cash amount
to use as the basis for the initial carrying amount of the debt. In these
circumstances, an entity must initially measure the debt instrument at an amount
that equals the present value of the instrument’s future cash flows, discounted
at an appropriate rate. If, however, the entity elects the fair value option for
the debt, the instrument is instead initially recognized at its fair value and
any difference between the proceeds and the fair value of the debt is recognized
immediately in earnings (e.g., debt issuance costs are expensed as incurred).
Most debt instruments, including
convertible debt instruments, are subsequently accounted for by using the
interest method. Under this approach, an entity uses present value techniques to
determine the net carrying amount of the debt and the amount of periodic
interest cost. The difference between the initial carrying amount of the debt
and the aggregate undiscounted amount of future principal and interest payments
over the debt’s life represents the total interest cost on the debt. The total
interest cost over the debt’s life is allocated to individual reporting periods
by using the effective yield implicit in the debt’s contractual cash flows
(i.e., by recognizing a constant effective interest rate). Through this
allocation, any premium or discount and debt issuance costs are amortized as
interest cost over the debt’s life.
When a debt instrument contains an embedded derivative that
must be bifurcated, the interest method is applied only to the host contract.
The embedded derivative is subsequently measured at fair value, with changes in
fair value reported in earnings. The effective interest rate for the host debt
contract will be affected by the discount created from initially recognizing the
embedded derivative at fair value. Furthermore, any potential cash flows
associated with the bifurcated embedded derivative are excluded from the
undiscounted cash flows used to impute the effective yield on the debt.
It is becoming increasingly common for debt
instruments to contain features that adjust interest
or principal payments if the issuer does not meet
certain ESG targets. Separation of these payment
features as embedded derivatives is typically
required under ASC 815-15.
Special applications of the interest method are used for
sales of future revenues, participating mortgages, and indexed debt instruments,
and there is a separate accounting model for joint and several liability
arrangements.
When the fair value option is elected, the debt instrument
is subsequently measured at fair value, with changes in fair value reported in
earnings and other comprehensive income. Entities that separately present
interest expense must apply the interest method under an assumption that the
debt instrument is not subsequently reported at fair value. The calculations
necessary in these circumstances can be complex.
There is extensive guidance in U.S. GAAP on the accounting
for modifications and settlements of debt instruments. For example, entities
must consider:
-
Extinguishments of debt (1) for cash, noncash financial assets, equity shares, or goods or services or (2) as a result of a legal release (ASC 405-20).
-
Modifications and exchanges of debt (ASC 470-50). Specific guidance applies to convertible debt instruments.
-
Troubled debt restructurings (ASC 470-60).
-
Conversions of debt into equity shares, including induced conversions (ASC 470-20).
The guidance consists of a mix of principles and rules and
can be complex to apply. Significant judgment and consultation with accounting
advisers are often necessary.
The contractual terms of debt instruments that refer
to interbank offered rates (e.g., LIBOR) will be
affected by the transition to alternative reference
rates. ASC 848 permits entities to elect optional
expedients and exceptions related to the application
of certain accounting requirements for such
instruments. Specific guidance applies to contract
modifications that directly result from the
discontinuance of reference rates.
Many entities present classified balance sheets in which
they must categorize each liability as either current or long-term. While ASC
210-20 provides general guidance on the classification of liabilities as current
or long-term, entities must also consider the specific balance sheet
classification guidance in ASC 470-10.
ASC 470-10 does not establish a uniform principle for
classifying debt as current or long-term; instead, it consists of a patchwork of
rules and exceptions. One requirement, which is subject to exceptions, is that
liabilities that are scheduled to mature or that the creditor could force the
debtor to repay within one year (or the operating cycle, if longer) after the
balance sheet date should be treated as short-term obligations even if they are
not expected to be settled within that period. However, some short-term
obligations are classified as long-term liabilities because the debtor has the
ability and intent to refinance those obligations on a long-term basis. Other
debt instruments that are contractually due in more than one year must be
classified as current liabilities because the debtor is in violation of a debt
covenant or the debt instrument contains a subjective acceleration clause. When
determining how to classify debt for which a covenant has been violated as of
the balance sheet date, or after the balance sheet date but before the financial
statements are issued or available to be issued, entities must use significant
judgment and may need to engage accounting advisers to assist in the analysis.
Special considerations are necessary for convertible debt
instruments, revolving-debt arrangements, and increasing-rate debt.
Certain information must be disclosed about all debt
instruments. For example, entities must disclose significant debt terms, the
face amount and effective interest rate, pledged assets and restrictive
covenants, and a five-year table of debt maturities. Additional disclosures are
required for specific types of debt, including:
-
Debt that becomes callable because the debtor fails to comply with a covenant.
-
Convertible debt.
-
Debt that is subsequently measured at fair value.
-
Debt that is designated in a hedging relationship under ASC 815-20.
-
Debt is that is guaranteed or collateralized by an entity other than the primary obligor.
-
Structured trade payable arrangements.
In addition to disclosures, entities must consider the
effect of debt instruments on the calculation of
EPS. Debt instruments that are participating
securities will affect the calculation of basic EPS,
whereas those that may be settled in the issuer’s
stock will affect diluted EPS. Note that if either
the entity or the creditor can elect stock or cash
settlement of a debt instrument, share settlement is
assumed for diluted EPS purposes and the
if-converted calculation must be used to determine
the dilution.
This Roadmap provides a comprehensive
discussion of the classification, initial and subsequent
measurement, and presentation and disclosure of debt,
including convertible debt.
Contacts
Contacts
|
|
Ashley Carpenter
Audit &
Assurance
Partner
Deloitte & Touche
LLP
+1 203 761 3197
|
|
Magnus Orrell
Audit & Assurance
Managing Director
Deloitte & Touche
LLP
+1 203 761 3402
|
For information about Deloitte’s financial instruments service offerings, please
contact:
|
|
Jamie Davis
Audit & Assurance
Partner
Deloitte & Touche
LLP
+1 847 337 2899
|
Chapter 1 — Overview
Chapter 1 — Overview
This Roadmap discusses an entity’s accounting, presentation, and
disclosure of (1) debt obligations, such as bonds, loans, notes, and other payables,
including convertible debt, and (2) commitments to obtain debt financing in the
future, such as delayed-draw loan commitments, lines of credit, and revolving-debt
arrangements. Appendix
A identifies the authoritative guidance discussed in the Roadmap.
An entity that issues debt should determine how to appropriately identify units of
account (see Section 3.3) and, if necessary,
allocate the initial proceeds and transaction costs among those units of account
(see Sections 3.4 and 3.5). The initial measurement of debt depends on
whether it was issued for cash or property, goods, or services and whether the
entity elects to account for the debt at fair value (see Chapter 4). The entity should also determine how to account for any
fees and costs associated with debt arrangements, including commitments to obtain
debt financing (see Chapter 5).
Debt is accounted for at amortized cost, and the interest method is applied (see
Section 6.2), unless the issuer has
elected to account for the debt at fair value (see Section 6.3). Specialized accounting models apply to certain types
of debt (such as sales of future revenue, participating mortgages, indexed debt,
extendable increasing-rate debt, joint-and-several obligations, and convertible
debt) (see Chapter 7), and an entity needs to
analyze whether debt contains any features that must be accounted for separately as
derivatives (see Chapter 8).
When an entity settles, modifies, or exchanges debt, it should consider the
accounting requirements related to extinguishments (see Chapter 9), modifications and exchanges (see Chapter 10), troubled debt restructurings (TDRs)
(see Chapter 11), and conversions (see
Chapter 12).
Most entities classify and present debt as either current or
noncurrent on the face of the balance sheet (see Chapter 13). Chapter 14 discusses other considerations
related to the accounting, presentation, and disclosure of debt and structured trade
payable arrangements.
Some entities are affected by both U.S. GAAP and IFRS®
Accounting Standards. There are significant differences between the guidance on debt
under U.S. GAAP and the equivalent requirements under IFRS Accounting Standards (see
Chapter 15).
Chapter 2 — Scope
Chapter 2 — Scope
2.1 Background
This chapter addresses the scope of the guidance discussed in this
Roadmap, including the types of entities and instruments to which it applies.
2.2 Entities
The guidance in this Roadmap applies to all entities. Generally, FASB Codification
guidance (i.e., ASC guidance) applies to both public business entities (including
SEC registrants) and private companies. SEC guidance applies to (1) SEC registrants
and (2) private companies that either have elected to apply such guidance or are
subject to it for other reasons (e.g., for the preparation of financial statements
that are included or incorporated by reference in an SEC registrant’s filing).
2.3 Instruments
2.3.1 Background
This Roadmap addresses the issuer’s accounting for debt (see the next section)
and the potential borrower’s accounting for commitments to obtain debt financing
(see Section
2.3.3), both of which represent financial instruments (see Section 2.3.4). Debt
obligations are financial liabilities (see Section 2.3.5). Sections 2.3.2.4 and 2.3.6 identify topics
that are beyond the scope of this Roadmap.
2.3.2 Debt
2.3.2.1 General
ASC 835-30
15-2 The guidance in this
Subtopic applies to receivables and payables that
represent contractual rights to receive money or
contractual obligations to pay money on fixed or
determinable dates, whether or not there is any
stated provision for interest, with certain
exceptions noted below. Such receivables and
payables are collectively referred to in this
Subtopic as notes. Some examples are the
following:
-
Secured and unsecured notes
-
Debentures
-
Bonds
-
Mortgage notes
-
Equipment obligations
-
Some accounts receivable and payable.
ASC 470-60
15-4A In this Subtopic, a
receivable or a payable (collectively referred to as
debt) represents a contractual right to receive
money or a contractual obligation to pay money on
demand or on fixed or determinable dates that is
already included as an asset or a liability in the
creditor’s or debtor’s balance sheet at the time of
the restructuring.
The types of debt addressed in this Roadmap include loans,
bonds, notes, and other kinds of debt securities and payables, including
convertible debt. In a manner generally similar to the description of a
“note” in ASC 835-30-15-2 and “debt” in ASC 470-60-15-4A, the Roadmap uses
the term “debt” to describe contractual obligations to pay money on demand
or on fixed or determinable dates irrespective of whether such obligations
contain any stated provision for interest.
The scope of this Roadmap is limited to the accounting by the party that has
a contractual obligation (liability) to pay the debt. The terms that
describe such a party — including issuer, debtor, borrower, or obligor — are
used interchangeably in the Roadmap unless otherwise specified. The Roadmap
does not address the accounting by the party that has a contractual right
(asset) to collect the debt (i.e., the party described as the holder,
creditor, lender, investor, or finance provider).
An issuer should account for an instrument that represents a
legal-form debt obligation as debt even if it has certain economic
characteristics that are similar to those of an equity instrument, such as
perpetual debt. For example, a convertible preferred equity certificate or
another instrument that represents a legal-form debt obligation in the
jurisdiction in which it is issued and carries creditor rights (e.g., an
ability to seek recourse in a bankruptcy court) should be accounted for as
debt even if the issuer has only a de minimis amount of common equity
capital and the instrument (1) is described as an “equity certificate,” (2)
has a long maturity (e.g., 40 years), (3) is subordinated to all other
creditors, (4) contains conversion rights into common equity, and (5)
provides dividend rights that are similar to those of a holder of common
equity (e.g., payable only if declared). If it is not readily apparent
whether a claim on an entity legally represents debt or equity, the entity
may need to seek advice from legal counsel.
2.3.2.2 Convertible Debt
ASC 470-20
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.
Convertible debt is debt that contains a feature that requires or permits its
conversion into the issuer’s equity shares. Economically, a convertible debt
instrument is similar to the combination of (1) a debt obligation with a
below-market interest coupon and (2) an equity conversion option. Investors
are willing to accept a below-market interest rate on their investment
because they also receive an equity conversion option. Because convertible
debt is usually accounted for entirely as debt (see Section 7.6), it may appear that the issuer
is able to borrow at a below-market rate; however, this ignores the fact
that the issuer has given the investors a valuable equity conversion option
in exchange for the low interest rate. In the absence of a conversion
feature, the issuer would have to pay a higher rate that is commensurate
with its nonconvertible debt borrowing rate.
Convertible debt issued by
public companies often contains CCFs that require or permit the issuer to
settle all or part of the instrument’s conversion value by transferring cash
or other assets upon conversion. In practice, there are four types of such
instruments:
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|
Settlement Provision
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Description
|
|---|---|---|
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Instrument A
|
Cash settlement
|
Upon conversion, the issuer must
fulfill the obligation entirely in cash on the basis
of the fixed number of shares multiplied by the
price of the stock on the conversion date (the
“conversion value”).
|
|
Instrument B
|
Issuer option to elect either cash
or physical share settlement
|
Upon conversion, the issuer may
elect to fulfill the entire obligation by using
either stock or cash equivalent to the conversion
value.
|
|
Instrument C
|
Cash settlement of accreted value
and issuer option to elect either net cash or net
share settlement of conversion spread
|
Upon conversion, the issuer (1) must
use cash to settle the accreted value of the
obligation (the amount accrued to the benefit of the
holder minus the conversion spread) and (2) may use
either cash or stock to settle the conversion spread
(the excess conversion value divided by the accreted
value).
|
|
Instrument X
|
Combination settlement
|
Upon conversion, the issuer may
settle the accreted value and conversion spread in
any combination of cash or shares.
|
Example 2-1
Variants of
Convertible Debt With a CCF
The table below illustrates how
Instruments A, B, C, and X, as described above,
would be settled if they each have an accreted value
of $1 million, are convertible into 10,000 shares,
and the current stock price at the time of
conversion is $125.
|
Type
|
Settlement Upon Conversion
|
|---|---|
|
Instrument A
|
The issuer must pay cash of
$1.25 million (10,000 shares × $125).
|
|
Instrument B
|
The issuer can elect to either
deliver 10,000 equity shares or pay cash of $1.25
million (10,000 shares × $125).
|
|
Instrument C
|
The issuer must pay $1 million
of cash to settle the accreted value of the debt
obligation. To settle the conversion spread, the
issuer can elect to either deliver 2,000 equity
shares ($250,000 ÷ $125) or pay $250,000 of
cash.
|
|
Instrument X
|
The issuer can elect to
deliver any combination of cash and shares whose
aggregate value equals $1.25 million (e.g., 1,000
shares and $1.125 million of cash).
|
Section 7.6 discusses
the issuer’s accounting for convertible debt.
2.3.2.2.1 Convertible Debt Issued for Goods or Services
ASC 470-20
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. . . .
ASC 718 addresses the issuer’s accounting for a
convertible debt instrument that is issued to an employee for services,
to a nonemployee for goods or services, or to a customer. A convertible
debt instrument that is within the scope of the initial recognition and
measurement guidance in ASC 718 because it was granted to an employee or
nonemployee in exchange for goods or services remains within the scope
of that guidance throughout its life unless its terms are modified after
it has been vested and the grantee is no longer providing goods or
services or is no longer a customer. Any interest that is paid or
payable on such instruments is treated as compensation cost rather than
as a financing cost. Under ASC 718, unvested convertible debt
instruments granted in exchange for goods and services are treated as
unissued for accounting purposes until those goods or services have been
received. For more information about the issuer’s accounting for
convertible debt instruments within the scope of ASC 718, see Deloitte’s
Roadmap Share-Based
Payment Awards.
2.3.2.3 Share-Settled Debt
ASC 470-20
15-2C . . . 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.
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.
55-1A An example of a
convertible preferred stock that paragraph
470-20-15-2D requires an entity consider as a
convertible debt instrument for purposes of the
scope application of this Subtopic is a convertible
preferred stock that has a stated redemption date
and also would require the issuer to settle the face
amount of the instrument in cash upon exercise of
the conversion option. Such a convertible preferred
stock is a mandatorily redeemable financial
instrument and is classified as a liability under
Subtopic 480-10 because it embodies an unconditional
obligation to redeem the instrument by transferring
assets at a specified or determinable date (or
dates).
Example 4: Stock-Settled Debt
55-18 This Example
illustrates the guidance in paragraph
470-20-25-14.
55-19 If the conversion
price was described as $1 million divided by the
market price of the common stock on the date of the
conversion, that is, resetting at the date of
conversion, the holder is guaranteed to receive $1
million in value upon conversion and, therefore, the
debt instrument would be considered stock-settled
debt.
ASC 480-10
25-14 A financial instrument
that embodies an unconditional obligation, or a
financial instrument other than an outstanding share
that embodies a conditional obligation, that the
issuer must or may settle by issuing a variable
number of its equity shares shall be classified as a
liability (or an asset in some circumstances) if, at
inception, the monetary value of the obligation is
based solely or predominantly on any one of the
following:
-
A fixed monetary amount known at inception (for example, a payable settleable with a variable number of the issuer’s equity shares)
-
Variations in something other than the fair value of the issuer’s equity shares (for example, a financial instrument indexed to the Standard and Poor’s S&P 500 Index and settleable with a variable number of the issuer’s equity shares)
-
Variations inversely related to changes in the fair value of the issuer’s equity shares (for example, a written put option that could be net share settled). . . .
A financial instrument such as debt or preferred stock may
contain a term that is described as a “conversion” feature but economically
represents a share-settled redemption provision. That is, the number of
equity shares to be delivered upon conversion is variable and is calculated
on the settlement date to be equal in value to a fixed or specified monetary
amount (e.g., the principal amount plus accrued and unpaid interest) or a
monetary amount that is indexed to an unrelated underlying (e.g., the price
of gold). If the conversion price is contractually defined as the current
stock price upon conversion, for example, the monetary value of the shares
delivered will equal the instrument’s principal or stated amount.
Even if the terms of the instrument refer to the
share-settled feature as a conversion feature, the issuer should not analyze
it as such under GAAP since a share-settled feature does not have the
economic payoff profile of an equity conversion feature. Instead, the issuer
should (1) evaluate the feature as a put, call, redemption, or other indexed
feature, as applicable, and (2) determine whether the feature must be
separated as a derivative instrument under ASC 815-15. For a discussion of
the evaluation of whether a share-settled redemption feature embedded in a
debt host contract should be separated as a derivative instrument, see
Sections 8.4.4 and 8.4.7.2.5.
Legal-form debt instruments are always classified as
liabilities under GAAP. If an instrument with a share-settled redemption
provision is issued in the form of an equity share such as preferred stock,
the issuer should evaluate whether the instrument must be classified as a
liability under ASC 480. In addition, the issuer should evaluate whether the
instrument contains a substantive conversion feature, in which case the
issuer would apply ASC 470-20 as well as other relevant guidance.
Under ASC 480, liability classification is required for
outstanding financial instruments that embody an unconditional obligation —
or for outstanding financial instruments other than outstanding shares that
embody a conditional obligation — that the issuer must or may settle by
issuing a variable number of its equity shares if the obligation’s monetary
value is based solely or predominantly on one of the following: (1) a fixed
monetary amount, (2) variations in something other than the fair value of
the issuer’s equity shares, or (3) variations inversely related to changes
in the fair value of the issuer’s equity shares (see Chapter 6 of
Deloitte’s Roadmap Distinguishing Liabilities From Equity).
Outstanding financial instruments that are classified as
liabilities under ASC 480-10-25-14(a) are often described as share-settled
debt even if they do not represent legal-form debt (e.g., because of an
absence of creditor rights). If the monetary value of such obligations
represents a fixed or predominantly fixed monetary amount known at
inception, the obligations should be accounted for in a manner similar to
legal-form debt as discussed in this Roadmap (i.e., in accordance with the
interest method in ASC 835-30 unless the fair value option in ASC 825-10 is
elected; see Chapter
6). For example, if $100,000 worth of equity shares must be
issued to settle a financial instrument, the association that is established
is more akin to a debtor-creditor relationship than an ownership
relationship.
Other variable-share obligations that are liabilities under
ASC 480-10-25-14(b) and (c) must be accounted for at fair value under ASC
480-10-35-5. However, the last sentence of ASC 480-10-55-22 implicitly
acknowledges that a fixed-monetary-value share-settled debt arrangement does
not need to be measured at fair value through earnings under ASC 480.1 ASC 480-10-55-22 addresses whether an entity should recognize a gain
or loss related to the difference between the average and ending market
price upon the settlement of a share-settled debt arrangement for which the
entity used an average stock price rather than the ending stock price to
determine the number of shares that will be delivered. If the instrument
described in ASC 480-10-55-22 had been measured on an ongoing basis at fair
value (i.e., on the basis of a current stock price), there would have been
no difference to address at settlement after the issuer had updated its
prior fair value estimate. Since these types of liabilities are accounted
for at amortized cost (when the fair value option has not been elected),
they are addressed in this Roadmap.
For a comprehensive discussion of the classification and
measurement requirements in ASC 480, see Deloitte’s Roadmap Distinguishing Liabilities
From Equity.
2.3.2.4 Certain Obligations With Characteristics Similar to Debt
This Roadmap does not directly, comprehensively address all of the accounting
requirements for the following types of liability-classified instruments:
-
Liabilities for product financing arrangements within the scope of ASC 470-40, such as contracts in which an entity arranges for another entity to purchase a product on its behalf and agrees to purchase the product from that other entity (see ASC 470-40-05-2(b)). However, the Roadmap’s guidance would generally be relevant to such liabilities because ASC 470-40 does not provide specific requirements related to their subsequent measurement other than to state that they must be accounted for as borrowings (see ASC 470-40-25-1).
-
Mandatorily redeemable financial instruments that are classified as liabilities under ASC 480-10-25-4. For a discussion of the accounting for such liabilities, see Chapter 4 of Deloitte’s Roadmap Distinguishing Liabilities From Equity.
-
Instruments that embody an obligation to deliver a variable number of shares and are classified as liabilities under ASC 480-10-25-14(b) and (c). For a discussion of the accounting for such liabilities, see Chapter 6 of Deloitte’s Roadmap Distinguishing Liabilities From Equity. The guidance in this Roadmap is relevant to the accounting for share-settled debt that is classified as a liability under ASC 480-10-25-14(a) (see Section 2.3.2.3).
-
Liabilities for repurchase agreements with customers that are within the scope of ASC 606. For a discussion of the accounting guidance for such agreements, see Deloitte’s Roadmap Revenue Recognition. The guidance in this Roadmap may be relevant to financial liabilities recognized under ASC 606-10-55-70.
-
Liabilities of collateralized financing entities, which are addressed in ASC 810 and ASC 825. For a discussion of the accounting for such liabilities, see Sections 10.1.3 and 10.2.2 of Deloitte’s Roadmap Consolidation — Identifying a Controlling Financial Interest and Section 12.4.1.2.2.1.1 of Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the Fair Value Option).
-
Financial liabilities recognized under leases within the scope of ASC 842. For a discussion of that guidance, see Deloitte’s Roadmap Leases.
-
Secured borrowings that are recognized under ASC 860-30-25-2 upon a transfer of financial assets that does not meet the conditions for sale accounting in ASC 860-10-40-5 (see Deloitte’s Roadmap Transfers and Servicing of Financial Assets). However, the Roadmap’s guidance would generally be relevant to such liabilities because ASC 860-30 does not specify the manner in which they are subsequently measured and instead requires entities to measure them in accordance with other relevant accounting guidance (see ASC 860-30-35-3).
-
Deposit liabilities of depository institutions, which are addressed in ASC 942-405 and ASC 942-470.
-
Obligations incurred in short sales, which are addressed in ASC 815-10-55-57 through 55-59 and ASC 942-405-25-1.
2.3.2.5 Pushdown of Parent Debt to a Subsidiary
If a parent entity issues debt to a third party and is the
sole legal obligor under the arrangement but expects to repay the debt by
using a consolidated subsidiary’s assets (e.g., the parent is a shell
company and the plan is for the subsidiary to issue dividends to the parent
so the parent can pay principal and interest), questions may arise about
whether the subsidiary should record the debt in its separate stand-alone
financial statements. Since the parent is the sole legal obligor, the
subsidiary would not need to record the debt in its stand-alone financial
statements. This is because the parent may expand its business or create or
acquire other subsidiaries or operations that generate the cash flows needed
to repay the debt. In addition, the subsidiary would not be required to
record the interest expense on such debt; however, it should adequately
disclose the payment arrangement, including any guarantees of repayment of
the debt.
The above guidance does not address the accounting by securitization
structures that may involve multiple legal entities.
For guidance on joint-and-several liability arrangements
involving related parties, see Section 7.5. For guidance on the
preparation of carve-out financial statements, see Section 2.4 of
Deloitte’s Roadmap Carve-Out Financial Statements.
2.3.3 Loan Commitments
ASC Master Glossary
Line-of-Credit
Arrangement
A line-of-credit or revolving-debt
arrangement is an agreement that provides the borrower
with the option to make multiple borrowings up to a
specified maximum amount, to repay portions of previous
borrowings, and to then reborrow under the same
contract. Line-of-credit and revolving-debt arrangements
may include both amounts drawn by the debtor (a debt
instrument) and a commitment by the creditor to make
additional amounts available to the debtor under
predefined terms (a loan commitment).
Loan
Commitment
Loan commitments are legally binding
commitments to extend credit to a counterparty under
certain prespecified terms and conditions. They have
fixed expiration dates and may either be fixed-rate or
variable-rate. Loan commitments can be either of the
following:
-
Revolving (in which the amount of the overall commitment is reestablished upon repayment of previously drawn amounts)
-
Nonrevolving (in which the amount of the overall commitment is not reestablished upon repayment of previously drawn amounts).
Loan commitments can be distributed
through syndication arrangements, in which one entity
acts as a lead and an agent on behalf of other entities
that will each extend credit to a single borrower. Loan
commitments generally permit the lender to terminate the
arrangement under the terms of covenants negotiated
under the agreement.
In addition to the issuer’s accounting for debt, this Roadmap addresses the
potential borrower’s accounting for loan commitments, including line-of-credit
arrangements, revolving-debt arrangements, delayed-draw term loan commitments,
and commitments to issue debt securities. The contractual terms of loan
commitments may specify the timing and amount of the debt that the entity might
draw, conditions that must be met to draw down committed amounts (e.g.,
financial or operational conditions, such as the satisfaction of business
milestones), the applicable interest rate or index, and repayment terms.
Loan commitments are either revolving or nonrevolving:
-
Nonrevolving loan commitment (including delayed-draw debt and term loan commitments) — Once a funded loan has been repaid, those amounts cannot be reborrowed. Some nonrevolving loan commitments involve multiple tranches. For example, a tranche financing agreement might involve the issuance of an initial tranche of term debt that is funded when the contract is executed and one or more future tranches of committed term debt that will be funded on future closing dates (see Example 3-2).
-
Revolving loan commitment (including line-of-credit or revolving-debt arrangements) — Repaid amounts can be reborrowed. That is, the potential debtor can make multiple borrowings up to a specified maximum amount, repay borrowed amounts, and reborrow.
The potential debtor’s accounting for loan commitments tends to center on (1) the
treatment of any costs and fees that an entity has incurred to obtain such
commitments (see Chapter 5), (2) the
accounting for modifications and exchanges of commitments (see Section 10.6), and (3) the impact of the
existence of commitments on the classification of debt as current or noncurrent
in a classified balance sheet (see Section
13.7). Further, the potential debtor should consider whether to
account for a freestanding loan commitment as a derivative (see below). When a
credit facility or tranche debt financing arrangement includes both drawn and
undrawn components, the debtor should also appropriately identify the units of
account (e.g., whether commitments to obtain additional term loans on future
closing dates represent freestanding financial instruments or features embedded
in a debt host contract; see Section 3.3).
If a term loan commitment is embedded in a debt host contract, the debtor should
evaluate whether the commitment should be separated as a derivative (see
Section 8.4.6).
In many cases, a commitment to obtain debt financing is exempt from derivative
accounting under ASC 815, even if it meets the characteristics of a derivative
in ASC 815-10-15-83, because ASC 815-10-15-69 specifies that ASC 815-10 does not
apply to the holder’s (i.e., potential borrower’s) accounting for “a commitment
to originate a loan.” This scope exception applies irrespective of whether (1)
the commitment is conditional or (2) the loan is revolving or nonrevolving.
Further, it applies even if the funding will be in the form of a debt security.
ASC 310-10-20 defines a loan as “[a] contractual right to receive money on
demand or on fixed or determinable dates that is recognized as an asset in the
creditor’s statement of financial position. Examples include but are not limited
to accounts receivable (with terms exceeding one year) and notes receivable.”
The application of this scope exception to commitments to issue debt securities
was informally discussed with members of the SEC staff, who concurred that it
may be applied to an entity’s commitment to receive funds in exchange for the
initial issuance of a debt security that will be an obligation of the
entity.
Example 2-2
Application of Loan Commitment Scope Exception to
Issuance of Debt Securities
On July 1, 20X1, Entity E enters into an
agreement to issue medium term note debt securities to
Purchaser P. On that date, all terms of the securities
are negotiated with P, including the settlement date of
August 1, 20X1. Once the medium term note debt
securities are issued, it is expected that they will be
actively traded in a liquid market. Although the
commitment to issue the securities meets the
characteristics of a derivative in ASC 815-10-15-83, it
qualifies for the scope exception in ASC 815-10-15-69.
Accordingly, E will not account for its commitment as a
derivative.
In a typical loan commitment, the potential creditor writes an
option to the potential debtor that permits the potential debtor to obtain debt
on prespecified terms at its request. Therefore, the loan commitment scope
exception does not apply to an option written by the potential debtor to the
potential creditor under which the potential debtor (1) could be forced by the
potential creditor to enter into a loan but (2) is not given a right to elect to
borrow money from the potential creditor. In this scenario, it may be
appropriate to account for the loan commitment at fair value on a recurring
basis even if it does not meet the definition of derivative. As stated in ASC
815-10-S99-4, the “SEC staff’s longstanding position is that written options
that do not qualify for equity classification initially should be reported at
fair value and subsequently marked to fair value through earnings.”
ASC 815 does not clearly address whether the scope exception for loan commitments
is available if the loan to be funded contains an embedded feature that will
require bifurcation as a derivative once the funding takes place (see Chapter 8). It may therefore be prudent to
further evaluate whether the commitment for such loans meets the definition of a
derivative in ASC 815. If the loan commitment does not meet the net settlement
characteristic in the definition of a derivative (e.g., it requires delivery of
an underlying loan that is not readily convertible to cash, and the commitment
cannot otherwise be net settled), the debtor may conclude that the loan
commitment should not be accounted for as a derivative even if the scope
exception for loan commitments is considered inapplicable.
Sometimes loan commitments involve the delivery of debt that is
convertible into equity shares that contain redemption requirements (e.g.,
preferred stock that is redeemable for cash or other assets at the holder’s
option or upon the occurrence of an event that is not solely within the issuer’s
control). If the potential debtor could be forced to issue such convertible debt
(e.g., the potential creditor has the right to waive any funding conditions),
the entity should consider whether the loan commitment has the characteristics
described in ASC 480-10-25-8 (see Chapter
5 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity).
2.3.4 Financial Instruments
ASC Master Glossary
Financial
Instrument
Cash, evidence of an ownership interest
in an entity, or a contract that both:
- Imposes on one entity a
contractual obligation either:
-
To deliver cash or another financial instrument to a second entity
-
To exchange other financial instruments on potentially unfavorable terms with the second entity.
-
- Conveys to that second entity a
contractual right either:
-
To receive cash or another financial instrument from the first entity
-
To exchange other financial instruments on potentially favorable terms with the first entity.
-
The use of the term financial instrument
in this definition is recursive (because the term
financial instrument is included in it), though it is
not circular. The definition requires a chain of
contractual obligations that ends with the delivery of
cash or an ownership interest in an entity. Any number
of obligations to deliver financial instruments can be
links in a chain that qualifies a particular contract as
a financial instrument.
Contractual rights and contractual
obligations encompass both those that are conditioned on
the occurrence of a specified event and those that are
not. All contractual rights (contractual obligations)
that are financial instruments meet the definition of
asset (liability) set forth in FASB Concepts Statement
No. 6, Elements of Financial Statements, although some
may not be recognized as assets (liabilities) in
financial statements — that is, they may be
off-balance-sheet — because they fail to meet some other
criterion for recognition.
For some financial instruments, the
right is held by or the obligation is due from (or the
obligation is owed to or by) a group of entities rather
than a single entity.
Both outstanding debt and loan commitments meet the FASB’s
definition of a financial instrument. They each represent a contract that
“[i]mposes on one entity a contractual obligation . . . [t]o deliver cash or
another financial instrument to a second entity [and] [c]onveys to that second
entity a contractual right . . . [t]o receive cash or another financial
instrument from the first entity.” Accordingly, both debt and loan commitments
are included within the scope of Codification guidance that specifies that it
applies to financial instruments (e.g., the fair value measurement disclosure
requirements in ASC 825-10; see Section 14.4.10) unless that guidance
specifically exempts them.
The definition of a financial instrument contemplates that contractual rights and
contractual obligations may be “conditioned on the occurrence of a specified
event.” Therefore, a loan commitment meets the definition of a financial
instrument even if the funding of the loan is elective or conditional (e.g.,
upon the achievement of specified business milestones).
This Roadmap does not address the accounting for items that do not meet the
definition of a financial instrument, including:
-
Noncontractual rights or obligations, such as an obligation to pay taxes imposed by a government.
-
Contractual rights or obligations that involve the receipt or delivery of nonfinancial items (e.g., an obligation to deliver goods or services, property, plant, equipment, or intangible assets).
2.3.5 Financial Liabilities
ASC Master Glossary
Financial
Liability
A contract that imposes on one entity an
obligation to do either of the following:
-
Deliver cash or another financial instrument to a second entity
-
Exchange other financial instruments on potentially unfavorable terms with the second entity.
From the issuer’s perspective, debt meets the FASB’s definition
of a financial liability because it is a “contract that imposes on one entity an
obligation to . . . [d]eliver cash or another financial instrument to a second
entity.” Accordingly, debt is included within the scope of Codification guidance
that specifies that it applies to financial liabilities (e.g., the presentation
of changes in fair value attributable to instrument-specific credit risk of
liabilities for which the fair value option in ASC 825-10 has been elected; see
Section 6.3.2)
unless that guidance provides a specific exemption. A loan commitment that gives
the holder a right but does not obligate it to obtain a loan does not meet the
definition of a financial liability. This Roadmap does not address the
accounting for (1) financial liabilities other than debt or (2) obligations that
do not meet the definition of a financial liability.
2.3.6 Topics That Are Beyond the Scope of This Roadmap
While an entity may need to consider guidance on the following topics when it
accounts for debt, a detailed discussion of them is beyond the scope of this Roadmap:
-
Hedge accounting (see Section 14.2.1 and Deloitte’s Roadmap Hedge Accounting).
-
Fair value measurements (see Section 14.2.2 and Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the Fair Value Option)).
-
Foreign currency matters (see Section 14.2.3 and Deloitte’s Roadmap Foreign Currency Matters).
-
Capitalization of interest (see Section 14.2.4).
-
Reference rate reform (see Section 14.2.5).
-
Balance sheet offsetting (see Section 14.3.1.1).
-
The preparation of the statement of cash flows (see Section 14.3.2 and Deloitte’s Roadmap Statement of Cash Flows).
-
The presentation and disclosure of earnings per share (EPS) (see Section 14.3.3 and Deloitte’s Roadmap Earnings per Share).
-
Business combinations (see Deloitte’s Roadmap Business Combinations).
-
Consolidation (see Deloitte’s Roadmap Consolidation — Identifying a Controlling Financial Interest).
-
Specialized industry guidance.
Further, the guidance in this Roadmap does not apply to the accounting for the
following liabilities or equity items:
-
Asset retirement and environmental obligations within the scope of ASC 410 (see Deloitte’s Roadmap Environmental Obligations and Asset Retirement Obligations).
-
Exit or disposal cost obligations within the scope of ASC 420.
-
Deferred revenue within the scope of ASC 430.
-
Unconditional purchase obligations and certain other commitments issued within the scope of ASC 440.
-
Loss contingencies within the scope of ASC 450 (see Deloitte’s Roadmap Contingencies, Loss Recoveries, and Guarantees).
-
Guarantee obligations within the scope of ASC 460 (see Deloitte’s Roadmap Contingencies, Loss Recoveries, and Guarantees).
-
Equity-classified items within the scope of ASC 505.
-
Contract liabilities within the scope of ASC 606 (see Deloitte’s Roadmap Revenue Recognition).
-
Employee benefit obligations within the scope of ASC 712, ASC 715, ASC 960, or ASC 962.
-
Share-based payments for goods or services within the scope of ASC 718 (see Deloitte’s Roadmap Share-Based Payment Awards).
-
Tax obligations within the scope of ASC 740 (see Deloitte’s Roadmap Income Taxes).
-
Freestanding derivative contracts within the scope of ASC 815 (see Deloitte’s Roadmap Derivatives).
-
Servicing liabilities within the scope of ASC 860-50 (see Deloitte’s Roadmap Transfers and Servicing of Financial Assets).
-
Insurance liabilities within the scope of ASC 944.
Footnotes
Chapter 3 — Contract Analysis
Chapter 3 — Contract Analysis
3.1 Background
This chapter discusses how an entity should identify and evaluate
contractual terms (see Section
3.2) and units of account (see Section 3.3) as well as the allocation of debt
proceeds and issuance costs to those units of account (see Sections 3.4 and 3.5, respectively).
3.2 Identifying and Evaluating Contractual Terms
When determining the appropriate accounting for a debt transaction, an entity should
carefully review the underlying legal documents and consider all relevant facts and
circumstances. It also needs to consider the numerous rules and exceptions that
exist under GAAP and that might apply to the transaction. Sometimes seemingly simple
debt transactions raise complex accounting issues.
Since the details of debt transactions tend to be unique, an entity cannot assume
that it can use the same accounting that it or other entities used for other similar
transactions. For example, the allocation of proceeds to other contemporaneous
transactions could affect the analysis of whether any embedded features need to be
bifurcated (see Chapter 8). Likewise, the
analysis of the appropriate accounting for a debt modification depends on whether
the issuer is experiencing financial difficulties and has received a concession from
the creditor (see Chapter 11).
Further, contractual terms that may be significant to the accounting analysis could
be buried deep within a contract’s fine print, or they may have been overridden or
modified in separate legal documents (e.g., confidential side letters). Even minor
variations in the way contractual terms are defined could have a material effect on
the accounting for a debt arrangement. For example, the accounting analysis of a
provision that requires an increase to the interest rate of a debt instrument upon
the debtor’s event of default depends on how the contractual terms define an event
of default (see Section 8.4.2).
In forming a view on the appropriate accounting, an entity should not rely solely on
the name given to a transaction or how it is described in summary term sheets,
slideshow presentations, or marketing materials. Products with similar economics
sometimes go by different names in the marketplace (e.g., products marketed by
different banks), while products subject to different accounting may go by the same
or similar names.
An entity should also be mindful that the names given to contractual provisions in
legal documents (e.g., conversion, exchange, share settlement, or redemption
provisions) do not necessarily reflect their economics or how they would be
identified and analyzed for accounting purposes. For example, an equity conversion
feature that is embedded in a debt arrangement and economically represents a
share-settled redemption feature might need to be analyzed as a redemption feature
even though its form is that of a conversion feature (see Section
8.4.7.2.5).
The determination of the appropriate accounting for a debt arrangement can be
time-consuming and complex. The outcome of the analysis could significantly affect
the arrangement’s classification, measurement, and earnings impact as well as its
associated financial statement ratios. To arrive at appropriate accounting
conclusions, an entity should work with its auditors and consider involving
technical specialists.
3.3 Units of Account
3.3.1 Background
ASC Master Glossary
Unit of Account
The level at which an asset or a liability is aggregated
or disaggregated in a Topic for recognition
purposes.
In determining the appropriate accounting for a debt transaction, an entity
should consider how to identify units of account (i.e., the “level at which an
asset or a liability is aggregated or disaggregated”). While many debt contracts
represent one unit of account, some legal agreements consist of two or more
components that individually represent separate units of account (e.g., debt
with detachable warrants). Conversely, two separate agreements might represent
one combined unit of account (e.g., debt that was issued with warrants that are
not legally detachable or separately exercisable from the debt).
Example 3-1
Debt Issued With Other Financial Instruments
Entity B enters into a credit facility with Entity C
under which it receives an initial term loan of $20
million and term loan commitments that permit B to
request up to an additional $100 million of term loans
on specified dates in the future if certain conditions
are met. In addition to the payment of principal and
interest on outstanding term loans, the credit facility
requires B to make payments to C that are indexed to B’s
sales revenue. In conjunction with the transaction, B
issues warrants to C on its own stock worth $10 million
for no separate consideration.
Entity B must determine whether the transaction consists
of one or more units of account, including whether the
term loan commitments, the warrants, and the
revenue-indexed payment obligation are embedded in the
initial term loan or should be treated as units of
account that are separate from the initial term
loan.
Note that in some financing
arrangements, an entity issues warrants to the lender
that vest on the basis of debt draws. Example
5-1 in this Roadmap and Example
2-6 in Deloitte’s Roadmap Contracts
on an Entity’s Own Equity address
these arrangements.
To determine the units of account, an issuer should identify
each freestanding financial instrument (see Section
3.3.2) and any other elements that qualify for separate
accounting recognition (see Section
3.3.3). A decision to treat a transaction as one rather than multiple
units of account can have significant financial statement ramifications. For
instance, the separation of a financing transaction into multiple units of
account could result in the recognition and subsequent amortization of a debt
discount (see Section 4.3.6) even if the
transaction involved the issuance of debt for proceeds equal to the debt’s
stated principal amount. In turn, the recognition of a debt discount could
affect the analysis of whether any put, call, or redemption features in the debt
must be separated as derivatives and accounted for at fair value on a recurring
basis (see Section 8.4.4).
3.3.2 Freestanding Financial Instruments
3.3.2.1 Framework for Identifying Freestanding Financial Instruments
ASC Master Glossary
Freestanding Financial Instrument
A financial instrument that meets either of the
following conditions:
-
It is entered into separately and apart from any of the entity’s other financial instruments or equity transactions.
-
It is entered into in conjunction with some other transaction and is legally detachable and separately exercisable.
In identifying units of account, an entity should consider
the definition of a freestanding financial instrument in the ASC master
glossary. (Note that the definition of a freestanding contract in the ASC
master glossary is substantially equivalent to the definition of a
freestanding financial instrument.)
A freestanding financial instrument is one that is entered
into either “separately and apart from any of the entity’s other financial
instruments or equity transactions” or “in conjunction with some other
transaction and is legally detachable and separately exercisable.”
Therefore, in identifying freestanding financial instruments, an entity
should consider the following questions, each of which is discussed in
detail in the sections below:
-
Was the transaction entered into contemporaneously with and in contemplation of another transaction, or was it entered into separately and apart from other transactions?
-
Is the item legally detachable?
-
Can the item be exercised separately, or does its exercise result in the termination, redemption, or automatic exercise of a specifically identified item?
-
Does the transaction involve multiple counterparties?
3.3.2.1.1 Contemporaneous or Separate Transaction
The fact that a transaction was entered into separately
and apart from any other transaction suggests that it is a freestanding
financial instrument that is separate from any other transaction. If the
transaction was entered into contemporaneously with and in contemplation
of another transaction, the entity should assess whether the two
transactions represent a single freestanding financial instrument. For
example, if warrants are issued in conjunction with a debt issuance of
the same issuer, the issuer should consider whether to treat them as
being embedded in the debt even if they are subject to a separate
contractual agreement.
A transaction’s having been entered into
contemporaneously or in conjunction with some other transaction,
however, would not necessarily result in a conclusion that the two
transactions should be viewed on a combined basis as a single
freestanding financial instrument. The entity should also consider
whether the transactions are legally detachable and separately
exercisable (see the next section) and whether the combination guidance
in ASC 815-10 applies (see Section 3.3.2.2).
A one-week period between transactions may be good
evidence that the transactions are not contemporaneous if the entity is
exposed to market fluctuations during this time. Even when transactions
occur at different times, entities should consider all available
evidence to ensure that no side agreements or other contracts were
entered into that suggest that the transactions were entered into in
contemplation of one another.
3.3.2.1.2 Legally Detachable
There is no guidance in U.S. GAAP on the meaning of
“legally detachable.” In practice, an item is considered legally
detachable from another item if it is (1) separately transferable from
that item or (2) otherwise capable of being separated from that item. If
an item is separately exercisable but not considered legally detachable
(e.g., an equity conversion option embedded in debt that permits the
holder to convert the debt into the issuer’s equity shares instead of
receiving a repayment of the debt’s principal amount on its maturity
date), it would not be a separate freestanding financial instrument
under item (b) of the definition of a freestanding financial instrument.
However, in some cases, the separate exercisability of an item results
in a conclusion that an item is legally detachable (see discussion in
the last
paragraph of this section).
An item is always considered “legally detachable” if it
can be transferred separately from another item in a single contractual
agreement (or from another item in multiple contracts entered into at
the same time) at the holder’s discretion (i.e., without limitations
imposed by the counterparty). The fact that an item can be transferred
independently from another item indicates that it is a separate unit of
account even if the two items were entered into contemporaneously and
have the same counterparty. This view is supported by the guidance in
ASC 815-10-25-9, which states, in part:
Derivative instruments that are transferable
are, by their nature, separate and distinct contracts.
Similarly, ASC 815-10-15-5 states, in part:
The notion of an embedded derivative . . . does not contemplate
features that may be sold or traded separately from the contract
in which those rights and obligations are embedded. Assuming
they meet [the] definition of a derivative instrument, such
features shall be considered attached freestanding derivative
instruments rather than embedded derivatives by both the writer
and the current holder.
Example 3-2
Debt Issued With Additional Term Loan
Commitments
Entity A enters into an agreement with a lender
for the issuance of a term loan facility in an
aggregate principal amount of up to $65 million.
The agreement specifies the issuance of a term
loan advance of $15 million at the agreement’s
closing. Additional term loan advances are
available to A as follows:
-
Upon achieving a specified milestone target and before six months after closing, A may request an additional term loan advance from the lender of $10 million.
-
Upon achieving an incremental milestone target and before one year after closing, A may request an additional term loan advance from the lender of $20 million.
-
Upon achieving another milestone target and before two years after closing, A may request an additional term loan advance from the lender of up to $20 million, in minimum increments of $5 million.
If there is no restriction
preventing the lender from selling, to a third
party, a term loan tranche that it has already
provided to A, and the lender continues to be
contingently obligated to provide subsequent
tranches of additional term loan advances to A
upon A’s request, the future tranches would be
analyzed as freestanding financial instruments
(e.g., loan commitments) that are separate from
the initial tranche. This is the case even though
the loan facility is documented in a single
agreement. Note that A should therefore allocate a
portion of the proceeds received in the initial
closing of the agreement to the three future
tranches (i.e., some of the $15 million received
at closing may be attributable to the three future
tranches). For discussions of the allocation of
issuance costs, see Section 3.5 and Chapter 5.
However, a scenario in which two items cannot be
transferred independently of one another suggests that each item is not
a freestanding financial instrument under item (b) in the definition of
a freestanding financial instrument. For example, if a warrant “travels
with” a bond and cannot be transferred separately from the bond, it may
be an embedded feature in the bond.
A contract may be entered into in conjunction with some
other item. For such a contract to be considered a freestanding
instrument, an assessment must be performed of both the form and
substance of the transaction, including the substance of the independent
transferability of the item. In some circumstances, an item is
unconditionally separately transferable by the holder but would have no
economic value if the related item were not held, which would suggest
that the separate transferability has no substance and the item is
embedded in the related item (see further discussion in Section
3.3.2.1.3). Similarly, the holder of a debt instrument that
is not readily obtainable in the market may have a separately
transferable put option that it can exercise only by delivering the same
specific debt instrument. In this case, the debt and the put option may
represent a single, combined unit of account on the basis of an
assessment of the substance of the transaction.
In other circumstances, an item may be separately transferred only with
the consent of the counterparty. If an item may be separated from a
related contract without any modification to the contractual terms
(e.g., the contract specifically permits the item to be transferred if
the issuer gives its consent and such consent cannot be unreasonably
withheld), the legally detachable condition is, in substance, generally
met since the counterparty has agreed not to withhold its consent. If,
however, the counterparty can always prevent the separate transfer of
the item at its discretion, the legally detachable condition is, in
substance, most likely not met and therefore the item is not a
freestanding financial instrument.
Example 3-3
Bond Issued
With Warrants
An entity issues a bond with a
warrant. The agreement specifies that the
counterparty may not transfer the bond or the
warrant without the issuer’s consent. However, the
agreement does not preclude the transfer of the
warrant separately from the bond if the issuer
were to give its consent. Further, the contract
specifies that such consent cannot be unreasonably
withheld. The exercise of the warrant does not
result in the termination of the bond (i.e., the
counterparty is not required to tender the bond as
payment of the exercise price of the warrant). In
these circumstances, the warrant is considered a
freestanding financial instrument because it is
both independently transferable and separately
exercisable. The fact that the warrant contains a
restriction that may preclude the counterparty
from transferring it does not mean that the
warrant is not a freestanding contract since the
contract specifies that the issuer’s consent
cannot be unreasonably withheld.
The SEC staff has indicated in informal discussions that
it is possible for two items that have been entered into
contemporaneously with the same counterparty to be considered
freestanding financial instruments solely on the basis of the items’
ability to be separately exercised (i.e., even though the contractual
terms prevent the items from being transferred separately). This would
generally be the case when a reasonable conclusion can be reached that
the separate exercisability of one item is sufficient to establish that
it is legally detachable from the related item. However, when
determining whether an item can be transferred separately, an entity
must use significant judgment and consider the transaction’s form and
substance. We therefore strongly recommend that an entity consult with
its independent accounting advisers when performing this assessment.
Example 3-4
Tranche Debt Financing
Agreement
Entity X enters into a debt
financing agreement with unrelated investors to
sell two tranches of convertible debt. The
purchase agreement stipulates the following:
-
On the first closing date, which is the date of the purchase agreement, the investors will purchase $50 million of convertible debt.
-
On the second closing date, the investors will purchase $25 million of convertible debt subject to a specified condition. The second closing will occur only if (1) a specific milestone related to X’s operations is achieved two years from the first closing date or (2) the specific milestone related to X’s operations is not achieved two years from the first closing date but the holders waive the milestone requirement and elect to purchase the convertible debt (the “contingent purchase option”).
-
The holders of convertible debt issued in the first closing cannot transfer their contingent purchase options separately from the convertible debt acquired in the first closing (or vice versa). However, such holders have the right to convert that debt into common stock before the date that is two years from the first closing date.
-
The holders that convert debt into common stock may sell those common shares, and the only restrictions on selling common stock stem from restrictions under U.S. securities laws.
In this example, the contingent
purchase option would be considered a freestanding
financial instrument because it meets the “legally
detachable and separately exercisable” condition.
The holders can “detach” the two instruments
because they can convert the debt into common
stock and sell those shares while retaining the
contingent purchase option (i.e., the two
instruments are capable of being separated). This
would be the case even if the contingent purchase
option may not be separately transferred after the
conversion into common stock of the debt obtained
in the first closing. It would not be appropriate
to consider the debt and the contingent purchase
option a single combined financial instrument
because the contingent purchase option would not
become embedded in the common shares received upon
conversion of the debt purchased in the first
closing.
Note that the conclusion in this
example would not change even if:
- The holders could not sell the common shares received upon conversion of the debt purchased in the first closing before satisfaction or expiration of the contingent purchase option. At the inception of the arrangement, the two instruments still meet the legally detachable and separately exercisable condition because the contingent purchase option (1) cannot become embedded in the common shares received upon conversion of the debt purchased in the first closing and (2) does not become freestanding only if the debt purchased in the first closing is converted into common stock (instead, the ability to convert the debt purchased in the first closing is evidence that the contingent purchase option is capable of being separated at the inception of the arrangement).
- The debt purchased on the first closing date cannot be transferred or converted before the contingent purchase option is satisfied or expires and the holders have the right to acquire the additional debt related to the contingent purchase option at their option at any time before two years from the closing date. The two instruments still meet the legally detachable and separately exercisable condition because the investor can separate the two components by early exercising the contingent purchase option while retaining the debt acquired on the first closing date.
As this example illustrates, and in a manner
consistent with practice, an option or commitment
to issue additional debt is almost always a
freestanding financial instrument because the
separate exercisability of the option or
commitment is sufficient to demonstrate that the
feature is capable of being separated.
3.3.2.1.3 Separate Exercise Versus Termination, Redemption, or Automatic Exercise
If an item can be freely exercised without terminating
the other item (e.g., through redemption, automatic exercise, or
expiration), it is considered to be “separately exercisable.” The fact
that a warrant remains outstanding if a bond to which it is attached is
redeemed, for example, suggests that the warrant is a freestanding
financial instrument that is separate from the bond. Similarly, if a
bond may remain outstanding after a net-share-settled conversion feature
included in the bond is exercised, the conversion feature may be a
freestanding financial instrument.
Conversely, if the exercise of an item results in the termination of a
specifically identified item, the first item would not be considered
separately exercisable from the other item. For example, if a warrant
can be exercised only by the tendering of a specific bond in a physical
settlement, the warrant may be a feature embedded in the bond rather
than a freestanding financial instrument. ASC 470-20-25-3 states, in part:
[I]f stock purchase warrants are not detachable from [a] 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.
Similarly, if a specifically identified debt instrument
is subject to a redemption requirement, the debt instrument and the
redemption requirement may represent one single freestanding financial
instrument even if they are documented in separate agreements (see ASC
480-10-15-7C). After a debt instrument’s issuance, the addition of a
redemption requirement should be evaluated as a modification of the
terms of the debt (see Chapter
10).
3.3.2.1.4 Multiple Counterparties
Contracts with different counterparties are treated as
separate freestanding financial instruments even if they were issued
contemporaneously or were transacted as a package. Thus, ASC 815-10-15-6
suggests that an option added or attached to an existing debt instrument
by another party is not an embedded derivative because it does not have
the same counterparty. Similarly, ASC 815-15-25-2 indicates that the
notion of an embedded derivative in a hybrid instrument does not refer
to provisions in separate contracts between separate counterparties.
Example 3-5
Issuance of
a Bond and a Warrant
An entity delivers a bond and a warrant on its
own equity to an underwriter for cash. The
underwriter is a party to the warrant but holds
the bond merely as an agent for a third-party
investor. The terms and pricing of the bond sold
to the third-party investor are not affected by
the sale of the warrant to the underwriter.
Because they involve different counterparties, the
bond and the warrant are two separate freestanding
financial instruments.
Under ASC 815-10-25-10, transactions that are entered
into with a single party are treated as having the same counterparty
even if some of them are structured through an intermediary (see
Section
10.5.2). In consolidated financial statements, the
reporting entity is the consolidated group. Therefore, the parent and
its subsidiary would not be considered different parties in the
consolidated financial statements. For example, if a parent entity
writes a put option on debt issued by the subsidiary, it may be
acceptable to view the option as being embedded in the debt in the
consolidated financial statements even though the subsidiary technically
is not a party to the option.
3.3.2.2 Combination Guidance
ASC 815-10 contains additional guidance to help an entity determine whether
two or more separate transactions should be viewed as separate units of
account or combined for accounting purposes. ASC 815-10-15-8 states, in part:
In some circumstances, an entity could enter into two or more legally
separate transactions that, if combined, would generate a result
that is economically similar to entering into a single transaction
that would be accounted for as a derivative instrument under this
Subtopic.
Nevertheless, because it is transaction-based, ASC 815
ordinarily does not permit an entity to treat two or more freestanding
financial instruments as a single combined unit of account. ASC 815-10-25-6
states, in part:
[ASC 815-10] generally does not provide for the
combination of separate financial instruments to be evaluated as a
unit.
However, if two or more freestanding financial instruments
have characteristics suggesting that they were structured to circumvent
GAAP, they may need to be combined and treated as a single unit of account.
Specifically, ASC 815-10 requires two or more separate transactions to be
combined and viewed in combination as a single unit of account if they were
entered into in an attempt to circumvent the accounting requirements for
derivatives (i.e., measured at fair value, with subsequent changes in fair
value recognized in earnings except for qualifying hedging instruments in
cash flow or net investment hedges). ASC 815-10-15-9 states that such
combination is required if the transactions have all of the following
characteristics:
-
They “were entered into contemporaneously and in contemplation of one another.”
-
They “were executed with the same counterparty (or structured through an intermediary).”
-
They “relate to the same risk” (e.g., the fair value of the issuer’s equity shares).
-
“There is no apparent economic need or substantive business purpose for structuring the transactions separately that could not also have been accomplished in a single transaction.”
ASC 815-10-25-6 identifies characteristics similar to those
listed above from ASC 815-10-15-98 and adds the following commentary:
If separate derivative instruments have all of
[these] characteristics, judgment shall be applied to determine
whether the separate derivative instruments have been entered into
in lieu of a structured transaction in an effort to circumvent GAAP:
. . . If such a determination is made, the derivative instruments
shall be viewed as a unit.
ASC 815 does not specify a period of separation between transactions (e.g.,
one day, one week) that would disqualify them from being treated as
contemporaneous. A one-week period between transactions may be sufficient
evidence that the transactions are not contemporaneous if the entity is
exposed to market fluctuations during this time. Thus, even when
transactions occur at different times, entities must consider all available
evidence to ensure that no side agreements or other contracts were entered
into that call into question whether the transactions were contemporaneous
(e.g., there are no earlier agreements for trades to be entered into
simultaneously).
ASC 815-10 contains the example below of two offsetting
loans that would be combined and accounted for as one unit of account as an
interest rate swap.
ASC 815-10
Example 19:
Recognition — Viewing Separate Transactions as a
Unit for Purposes of Evaluating Net
Settlement
Case B: Borrowing and Lending
Transactions Viewed as a Unit
55-179 Entity C loans $100 to
Entity B. The loan has a 5-year bullet maturity and
an 8 percent fixed interest rate, payable
semiannually. Entity B simultaneously loans $100 to
Entity C. The loan has a five-year bullet maturity
and a variable interest of LIBOR, payable
semiannually and reset semiannually. Entity B and
Entity C enter into a netting arrangement that
permits each party to offset its rights and
obligations under the agreements. The netting
arrangement meets the criteria for offsetting in
Subtopic 210-20. The net effect of offsetting the
contracts for both Entity B and Entity C is the
economic equivalent of an interest rate swap
arrangement, that is, one party receives a fixed
interest rate from, and pays a variable interest
rate to, the other.
55-180 In this Case, based on
the facts presented, there is no clear business
purpose for the separate transactions, and they
should be accounted for as an interest rate swap
under this Subtopic. However, in other instances, a
clear substantive business purpose for entering into
two separate loan transactions may exist (for
example, as a means to overcome foreign currency
expatriation restrictions).
Note that the SEC staff will challenge the accounting for
transactions for which it appears that multiple contracts have been used to
circumvent GAAP.
3.3.2.3 Application to Debt With Detachable Warrants
ASC 470-20
05-2 Unlike convertible
debt, debt with detachable warrants (detachable call
options) to purchase stock is usually issued with
the expectation that the debt will be repaid when it
matures. The provisions of the debt agreement are
usually more restrictive on the issuer and more
protective of the investor than those for
convertible debt. The terms of the warrants are
influenced by the desire for a successful debt
financing. Detachable warrants often trade
separately from the debt instrument. Thus, the two
elements of the security exist independently and may
be treated as separate securities.
05-3 From the point of
view of the issuer, the sale of a debt security with
warrants results in a lower cash interest cost than
would otherwise be possible or permits financing not
otherwise practicable. The issuer usually cannot
force the holders of the warrants to exercise them
and purchase the stock. The issuer may, however, be
required to issue shares of stock at some future
date at a price lower than the market price existing
at that time, as is true in the case of the
conversion option of convertible debt. Under
different conditions the warrants may expire without
exercise. The outcome of the warrant feature thus
cannot be determined at time of issuance. In either
case the debt must generally be paid at maturity or
earlier redemption date whether or not the warrants
are exercised.
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 . . .
.
As indicated in ASC 470-20-05-2 and 05-3, as long as both of the following
apply, a transaction that includes the issuance of both a debt instrument
and a warrant on the issuer’s equity shares should be treated as if it
contains two separate freestanding financial instruments:
-
The “warrants . . . trade separately from the debt instrument.”
-
The “warrants may expire without exercise,” whereas “the debt must . . . be paid at maturity or [an] earlier redemption date whether or not the warrants are exercised.”
Satisfying these two conditions is equivalent to meeting condition (b) in the
ASC master glossary definition of a freestanding financial instrument (see
Section 3.3.2.1).
Conversely, in accordance with ASC 470-20-25-3, if a warrant on an issuer’s
equity shares is not detachable from a debt instrument and the warrant
cannot be exercised unless the debt is surrendered, the debt and warrant are
treated as a single combined freestanding financial instrument since they
“are substantially equivalent to a convertible debt instrument.”
3.3.3 Other Elements That Warrant Separate Accounting Recognition
3.3.3.1 Background
ASC 835-30
25-4 . . . If cash and some
other rights or privileges are exchanged for a note,
the value of the rights or privileges shall be given
accounting recognition . . . .
ASC 470-20
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).
In addition to any freestanding financial instruments (see Section 3.3.2), a debt issuer should
consider whether a debt transaction contains any other elements that warrant
accounting recognition separately from the debt. For example:
-
Contractual terms that are within the scope of the guidance on registration payment arrangements in ASC 825-20 must be treated as a separate unit of account (see Section 3.3.3.2).
-
When an entity elects to account for debt by applying the fair value option in ASC 815-15 or ASC 825-10, the unit of account for the debt excludes any inseparable third-party guarantee (see Section 3.3.3.3).
-
If debt is issued in exchange for cash and other rights or privileges that do not form part of the debt, those other rights or privileges should be recognized separately (see Section 3.3.3.4).
-
Sometimes a debt transaction involves the exchange of nonfinancial items (see Section 4.3.5).
-
A debt issuer should evaluate features embedded in hybrid debt instruments to determine whether such features must be separated as derivatives under ASC 815 (see Chapter 8). (Note that the transaction proceeds are first allocated among the hybrid debt instrument and any other freestanding financial instruments before the embedded derivative is bifurcated from the hybrid debt instrument.)
-
A debt issuer should evaluate convertible debt to determine whether it includes a separable equity component under the guidance in ASC 470-20-25-13 on substantial premiums (see Section 7.6).
To identify transaction elements that warrant separate
accounting recognition, the debt issuer must sometimes perform a more
careful evaluation of the transaction and apply professional judgment (e.g.,
if the effective interest rate that would be computed on the basis of the
initially ascribed debt proceeds is unreasonable; see Section 3.3.3.4). If
separate accounting recognition is required, a portion of the debt proceeds
may need to be allocated to the other transaction elements. Alternatively,
the value of other transaction elements might represent an addition to the
debt proceeds if they benefit the debtor (e.g., a valuable right that
qualifies as an asset).
3.3.3.2 Registration Payment Arrangements
ASC Master Glossary
Registration Payment Arrangement
An arrangement with both of the following
characteristics:
- It specifies that the issuer will endeavor to
do either of the following:
-
File a registration statement for the resale of specified financial instruments and/or for the resale of equity shares that are issuable upon exercise or conversion of specified financial instruments and for that registration statement to be declared effective by the U.S. Securities and Exchange Commission (SEC) (or other applicable securities regulator if the registration statement will be filed in a foreign jurisdiction) within a specified grace period
-
Maintain the effectiveness of the registration statement for a specified period of time (or in perpetuity).
-
- It requires the issuer to transfer consideration to the counterparty if the registration statement for the resale of the financial instrument or instruments subject to the arrangement is not declared effective or if effectiveness of the registration statement is not maintained. That consideration may be payable in a lump sum or it may be payable periodically, and the form of the consideration may vary. For example, the consideration may be in the form of cash, equity instruments, or adjustments to the terms of the financial instrument or instruments that are subject to the registration payment arrangement (such as an increased interest rate on a debt instrument).
ASC 825-20
15-1 The guidance in this
Subtopic applies to all entities that issue a
registration payment arrangement.
15-2 The guidance in this
Subtopic applies to the following transactions and
activities:
- A registration payment arrangement regardless of whether it is issued as a separate agreement or included as a provision of a financial instrument or other agreement. An arrangement that requires the issuer to obtain and/or maintain a listing on a stock exchange, instead of, or in addition to, obtaining and/or maintaining an effective registration statement, is within the scope of this Subtopic if the remaining characteristics of the definition of the term registration payment arrangement are met.
15-4 The guidance in this
Subtopic does not apply to any of the following:
-
Arrangements that require registration or listing of convertible debt instruments or convertible preferred stock if the form of consideration that would be transferred to the counterparty is an adjustment to the conversion ratio. See Subtopic 470-20 on debt with conversion and other options or Subtopic 505-10 on equity for related guidance.
-
Arrangements in which the amount of consideration transferred is determined by reference to either of the following:
-
An observable market other than the market for the issuer’s stock
-
An observable index.
For example, if the consideration to be transferred if the issuer is unable to obtain an effective registration statement is determined by reference to the price of a commodity. See Subtopic 815-15 for related guidance. -
-
Arrangements in which the financial instrument or instruments subject to the arrangement are settled when the consideration is transferred (for example, a warrant that is contingently puttable if an effective registration statement for the resale of the equity shares that are issuable upon exercise of the warrant is not declared effective by the SEC within a specified grace period).
15-5 The guidance in this
Subtopic shall not be applied by analogy to the
accounting for contracts that are not registration
payment arrangements meeting the criteria in paragraphs
825-20-15-2 through 15-3. For example, a building
contract that includes a provision requiring the
contractor to obtain a certificate of occupancy by a
certain date or pay a penalty every month until the
certificate of occupancy is obtained is not addressed by
this Subtopic.
25-1 An
entity shall recognize a registration payment
arrangement as a separate unit of account from the
financial instrument(s) subject to that
arrangement.
25-2 The
financial instrument(s) subject to the registration
payment arrangement shall be recognized in
accordance with other applicable generally accepted
accounting principles (GAAP) (for example, Subtopics
815-10; 815-40; and 835-30) without regard to the
contingent obligation to transfer consideration
pursuant to the registration payment
arrangement.
25-3 The contingent
obligation to make future payments or otherwise transfer
consideration under a registration payment arrangement
shall be recognized separately in accordance with
Subtopic 450-20.
30-1 An
entity shall measure a registration payment
arrangement as a separate unit of account from the
financial instrument(s) subject to that
arrangement.
30-2 The
financial instrument(s) subject to the registration
payment arrangement shall be measured in accordance
with other applicable generally accepted accounting
principles (GAAP) (for example, Subtopics 815-10;
815-40; and 835-30) without regard to the contingent
obligation to transfer consideration pursuant to the
registration payment arrangement.
30-3 The contingent
obligation to make future payments or otherwise
transfer consideration under a registration payment
arrangement shall be measured separately in
accordance with Subtopic 450-20.
30-4 If the transfer of
consideration under a registration payment arrangement
is probable and can be reasonably estimated at
inception, the contingent liability under the
registration payment arrangement shall be included in
the allocation of proceeds from the related financing
transaction using the measurement guidance in Subtopic
450-20. The remaining proceeds shall be allocated to the
financial instrument(s) issued in conjunction with the
registration payment arrangement based on the provisions
of other applicable GAAP. A financial instrument issued
concurrently with a registration payment arrangement
might be initially measured at a discount to its
principal amount under this allocation methodology. For
example, if the financial instruments issued
concurrently with the registration payment arrangement
are a debt instrument and an equity-classified warrant,
the remaining proceeds after recognizing and measuring a
liability for the registration payment arrangement under
that Subtopic would be allocated on a relative fair
value basis between the debt and the warrant pursuant to
paragraph 470-20-25-3.
30-5 If all of the
following criteria are met, the issuer’s share price
at the reporting date shall be used to measure the
contingent liability under Subtopic 450-20:
- An entity would be required to deliver shares under a registration payment arrangement.
- The transfer of that consideration is probable.
- The number of shares to be delivered can be reasonably estimated.
35-1 If the transfer of
consideration under a registration payment
arrangement becomes probable and can be reasonably
estimated after the inception of the arrangement or
if the measurement of a previously recognized
contingent liability increases or decreases in a
subsequent period, the initial recognition of the
contingent liability or the change in the
measurement of the previously recognized contingent
liability (in accordance with Subtopic 450-20) shall
be recognized in earnings.
ASC 825-20 contains special unit-of-account guidance on registration payment
arrangements. An issuer of a debt instrument may agree to pay specified
amounts if a registration statement for the resale of the instrument or
other instruments subject to the arrangement (e.g., shares that might be
delivered upon conversion of the debt) is not declared effective or if
effectiveness of the registration statement is not maintained. For example,
a convertible debt instrument may require the issuer to:
-
Use its “best efforts” to file a registration statement for the resale of shares and have the registration statement declared effective by the end of a specified grace period (e.g., within 90 to 180 days).
-
Maintain the effectiveness of a registration statement for a period.
If the issuer fails to meet these conditions, the contract may require it to
make cash payments to the counterparty unless or until a registration
statement is declared effective. For example, the contract may require that
after the 180-day grace period, the entity must pay the investor 2 percent
of the contract purchase price for each month in which there is no
registration statement in effect.
A registration payment arrangement is treated as a unit of
account that is separate from the related debt instrument even if such
payment arrangement is included in the terms of the debt instrument.
However, a payment arrangement that does not meet the definition of a
registration payment arrangement is not within the scope of the ASC 825-20
guidance on registration payment arrangements; ASC 825-20-15-5 specifically
states that the guidance in ASC 825-20 “shall not be applied by analogy to
the accounting for contracts that are not registration payment arrangements”
under ASC 825-20. For example, some debt instruments issued in accordance
with an exemption from registration under the Securities Act of 1933 require
the issuing entity to pay additional interest at a specified time after the
issuance date if (1) the debt instrument is not freely tradable by its
holders or (2) the issuer has not filed in a timely manner any report or
document that must be submitted to the SEC under Section 13 or Section 15(d)
of the Securities Exchange Act of 1934. Because these payment provisions do
not pertain to the filing or maintenance of either an effective registration
statement or an exchange listing, they do not meet the definition of a
registration payment arrangement. Instead, they must be evaluated under the
embedded derivative requirements in ASC 815-15 (see Section 8.4.11).
A registration payment arrangement that is within the scope
of ASC 825-20 is treated as a contingent liability (see Deloitte’s Roadmap
Contingencies, Loss
Recoveries, and Guarantees). This means that proceeds
from the related financing transaction are allocated to the registration
payment arrangement upon initial recognition only if there is a probable
obligation to make payments under the arrangement that can be reasonably
estimated (see ASC 825-20-30-4). If the obligation becomes probable and can
be reasonably estimated after inception, a contingent liability is then
recognized, with an offset to earnings. Any subsequent change in the amount
of the contingent liability is also recognized in earnings (see ASC
825-20-35-1). If the entity is required to deliver shares under the
arrangement, the number of shares can be reasonably estimated, and the
transfer is probable, the entity measures the contingent liability by using
the issuer’s stock price as of the reporting date (see ASC 825-20-30-5).
An arrangement would not be accounted for as a separate unit of account under
ASC 825-20 if it contains any of the following provisions:
-
The form of consideration transferred is a contingently adjustable conversion ratio in a convertible instrument.
-
The payment is adjusted by reference either to an observable market other than the issuer’s stock (e.g., a commodity price) or to an observable index.
-
The payment is made when the contract subject to the arrangement is settled (e.g., a payment that is made upon the exercise of an option on own stock that is subject to the arrangement).
Accordingly, an entity would consider such provisions in its
analysis of whether an equity conversion option or other embedded feature
must be bifurcated from the debt as a derivative instrument under ASC 815-15
(see Chapter 8).
3.3.3.3 Debt Issued With Third-Party Guarantee
ASC 825-10
25-13 For the
issuer of a liability issued with an inseparable
third-party credit enhancement (for example, debt
that is issued with a contractual third-party
guarantee), the unit of accounting for the liability
measured or disclosed at fair value does not include
the third-party credit enhancement. This paragraph
does not apply to the holder of the issuer’s
credit-enhanced liability or to any of the following
financial instruments or transactions:
-
A credit enhancement granted to the issuer of the liability (for example, deposit insurance provided by a government or government agency)
-
A credit enhancement provided between reporting entities within a consolidated or combined group (for example, between a parent and its subsidiary or between entities under common control).
An issuer of a debt security might purchase a financial guarantee from a
third party that guarantees that it will pay its debt obligation. The issuer
incorporates the guarantee into the terms of the debt such that it transfers
with the security in transactions among investors. By packaging the debt
with a third-party guarantee, the issuer is able to reduce the debt’s stated
interest rate or receive higher debt proceeds.
If third-party guaranteed debt is accounted for at fair
value (e.g., under the fair value option in ASC 815-15 or ASC 825-10; see
Sections
4.4 and 8.5.6), the debt’s fair value is determined as if it was not
guaranteed (see ASC 820-10-35-18A and ASC 825-10-25-13). Upon debt issuance,
therefore, the debt proceeds would be allocated between the debt and the
third-party guarantee (see the example below). This treatment differs if the
guaranteed debt is not accounted for or disclosed at fair value. When debt
is accounted for at amortized cost, it is acceptable not to allocate any
amount of the debt proceeds to the guarantee (i.e., a guarantee asset is not
recognized). Nevertheless, the payment to the guarantor represents a debt
issuance cost that should be deducted from the debt proceeds under ASC
835-30-45-1A (see the example below and Section 5.3).
Example 3-6
Debt Issued With Third-Party Guarantee
In
connection with a debt issuance, Entity A agrees to
pay $2.5 million to Entity C in exchange for C’s
guarantee to pay the holder of A’s debt any
outstanding principal or interest payments that
become due if A were to default on such payments.
The guarantee is incorporated into the debt terms,
and it transfers with the debt. Entity A receives
$100 million of debt proceeds. Without the
guarantee, the fair value of the debt is estimated
to be $97.5 million. Entity A elects to apply the
fair value option to the debt. It treats the payment
to the guarantor for the guarantee as an up-front
cost or fee, which is expensed under ASC
825-10-25-3, and the amount allocated to the
guarantee from the debt proceeds as a reimbursement
of its payment to the guarantor. At inception, A
makes the following accounting entries:
Note that in this example, the amount paid to
purchase the guarantee equals the difference between
the principal amount and initial fair value of the
issued debt without the guarantee; if this was not
the case, the issuer would recognize an inception
gain or loss for the difference.
If A
did not elect to apply the fair value option to the
debt, it would recognize the following accounting
entries at inception:
3.3.3.4 Other Transaction Elements
ASC 835-30
25-4 When a
note is received or issued solely for cash and no
other right or privilege is exchanged, it is
presumed to have a present value at issuance
measured by the cash proceeds exchanged. If cash and
some other rights or privileges are exchanged for a
note, the value of the rights or privileges shall be
given accounting recognition as described in
paragraph 835-30-25-6.
25-6 A note
issued solely for cash equal to its face amount is
presumed to earn the stated rate of interest.
However, in some cases the parties may also exchange
unstated (or stated) rights or privileges, which are
given accounting recognition by establishing a note
discount or premium account. In such instances, the
effective interest rate differs from the stated
rate. For example, an entity may lend a supplier
cash that is to be repaid five years hence with no
stated interest. Such a non-interest-bearing loan
may be partial consideration under a purchase
contract for supplier products at lower than the
prevailing market prices. In this circumstance, the
difference between the present value of the
receivable and the cash loaned to the supplier is
appropriately regarded as an addition to the cost of
products purchased during the contract term. The
note discount shall be amortized as interest income
over the five-year life of the note, as required by
Section 835-30-35.
ASC 470-20
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).
If a debt transaction involves other stated or unstated
rights or privileges, an issuer must recognize those rights or privileges
separately from the debt by allocating or attributing an amount to them upon
initial recognition of the debt. For example, ASC 835-30-25-6 specifies that
if an issuer extends a three-year loan that pays no interest to a supplier
in exchange for cash equal to the face amount of the loan and a right to
purchase products from the supplier at a below-market price, a portion of
the amount lent equal to the difference between the cash paid and the
present value of the receivable must be attributed to the right and added to
the cost of the products purchased during the contract term (i.e., the right
is accounted for as an asset that is separate from the loan). Although that
example applies to the creditor’s accounting, the requirement in ASC
835-30-25-6 to separately recognize other stated or unstated rights or
privileges separately from a debt instrument also applies to the debtor (see
Section 4.3.4).
To appropriately identify all accounting elements that
warrant separate accounting recognition, an issuer may sometimes need to
more carefully examine the nature, purpose, and economic substance of a
transaction and apply professional judgment. If the effective interest rate
that would be computed on the basis of the debt proceeds is unreasonable
(e.g., it does not reflect the general level of interest rates, the issuer’s
creditworthiness, or an embedded equity conversion feature), the debt’s
initial fair value is materially different from the amount of debt proceeds
received, or the accounting otherwise appears misleading, the transaction
presumptively includes other elements that should be identified and
recognized separately from the debt, and appropriate disclosures should be
provided. Entities are strongly encouraged to consult with their independent
accountants in these circumstances.
At the 2014 AICPA Conference on Current SEC and PCAOB
Developments, then SEC Professional Accounting Fellow Hillary Salo noted
that entities need to closely evaluate a transaction in which the fair value
of the financial liabilities issued exceeds the net proceeds received to
determine whether (1) the fair value measurements are appropriate, (2) the
transaction is with a related party, or (3) any other identifiable
transaction elements exist (see Section 3.4.3.1). She indicated that
if no other transaction element can be identified, the difference should be
recognized as an expense. Although her remarks focused on liabilities that
are accounted for at fair value on a recurring basis, they are also relevant
in other situations in which the amount of proceeds initially attributed to
a debt issuance (1) would result in an unreasonable effective interest rate
or (2) is clearly different from the debt’s fair value at issuance.
Debt transactions with related parties might include a
distribution or contribution component (see Section 9.3.7 for a discussion of the
accounting for debt extinguishments with related parties). In practice, a
pro rata distribution to current equity owners is recognized as an equity
transaction (i.e., as a deemed dividend with a debit to retained earnings or
other applicable equity account; see Section 9.5.5 of Deloitte’s Roadmap
Distinguishing
Liabilities From Equity), whereas a non-pro-rata
distribution is recognized as a charge to earnings in the period in which
the distribution is declared. Accordingly, if a debt transaction involves a
payment to a related party that is not attributable to the debt, the
recognition of an expense might be required upon issuance unless the payment
represents a pro rata distribution to all holders of common stock or
equivalent current ownership interests, in which case it may be treated as
an equity distribution. Examples of rights or privileges for which separate
accounting recognition might be required as an expense in a transaction with
a related party include:
- A selling shareholder’s agreement to abandon certain acquisition plans, forgo other transactions, settle litigation, settle employment contracts, or voluntarily restrict its ability to purchase shares of the issuer in exchange for consideration from the issuer.
- A shareholder or former shareholder’s agreement not to purchase additional shares of the issuer in exchange for a payment (i.e., a “standstill agreement”).
Example 3-7
Debt Issued With Loan Commitment and
Warrants
Entity B enters into a credit facility arrangement
with a lender for the issuance of a term loan
facility in the aggregate principal amount of up to
$150 million. The contractual terms specify the
issuance of a term loan advance of $5 million at the
closing of the agreement. Additional term loan
advances are available to B under the arrangement as follows:
-
Six months after closing, B may request an additional term loan advance from the lender of $45 million if certain financial and operational conditions are met.
-
One year after closing, B may request an additional term loan advance from the lender of $50 million if certain financial and operational conditions are met.
-
Two years after closing, B may request an additional term loan advance from the lender of up to $50 million if certain financial and operational conditions are met.
The drawn components of the debt
arrangement can be separately transferred by the
lender. (Note that the conclusion in this example
would not change if the drawn and undrawn components
of the debt arrangement represented a single
freestanding financial instrument because the
additional term loans potentially issuable by B do
not have to be recognized as derivatives under ASC
815.)
At the arrangement’s inception, the
lender pays $5 million in cash to B, and B gives the
lender net-cash settleable warrants on its own stock
that have an initial fair value of $7 million. The
warrants represent freestanding financial
instruments, meet the definition of a derivative in
ASC 815, and do not qualify for any scope exception
from derivative accounting. Accordingly, they are
required to be accounted for at fair value, with
changes in fair value recognized in earnings. The
initial term loan advance is on market terms for a
similar borrower for debt with similar terms (i.e.,
its fair value is $5 million) and does not meet the
definition of a derivative in ASC 815. Further, the
fair value of the commitments B has received from
the lender to obtain additional term loan advances
in the future is $7 million. (This component does
not meet the definition of a derivative in ASC 815,
but if it did, it would qualify for the scope
exception for loan commitments.) The transaction is
on arm’s-length terms; economically, B has received
cash and loan commitments with an aggregate fair
value of $12 million and has issued debt and
warrants with an aggregate fair value of $12
million.
If the rights and privileges
associated with the loan commitments given by the
lender were not separately recognized, the
accounting would be misleading. That is, B would
need to either (1) reduce the initial carrying
amount of the advance to zero and recognize an
up-front loss of $2 million even though B has not
incurred any economic loss and has an obligation to
repay the advance or (2) recognize the advance as an
asset of $2 million even though it represents an
obligation, since that is the net fair value of the
advance and commitments. By analogy to Ms. Salo’s
remarks at the 2014 AICPA Conference on Current SEC
and PCAOB Developments (see Section
3.4.3.1), it would be appropriate in
this example for B to recognize the loan commitments
as a component of the proceeds it has received for
the advance (i.e., as an asset) separately from the
advance. Entity B would make the following
accounting entries:
3.4 Allocation of Proceeds to Units of Account
3.4.1 Background
This section discusses an issuer’s allocation of proceeds among freestanding
financial instruments when those instruments are issued in a single transaction,
including allocation methods (see the next section) and certain application
issues (see Section
3.4.3).
3.4.2 Allocation Methods
3.4.2.1 Background
Generally, an issuer uses one of the following two approaches to allocate
proceeds received upon a debt issuance among freestanding financial
instruments and any other elements that are part of the same transaction:
-
A with-and-without method (also known as a residual method; see Section 3.4.2.2).
-
A relative fair value method (see Section 3.4.2.3).
The appropriate allocation method depends on the accounting
that applies to each freestanding financial instrument issued as part of the
transaction (see Section
3.3.2). The issuer should also consider whether it is
necessary to allocate an amount to any other rights or privileges included
in the transaction (see Section 3.3.3). That is, in the application of these
allocation methods, it is assumed that the proceeds received represent the
aggregate fair value of the instruments issued.
Proceeds are allocated among the freestanding financial
instruments that form part of the same transaction before any amounts are
allocated to component parts of those freestanding financial instruments
(such as an embedded derivative instrument that is bifurcated under ASC
815-15).
After applying the appropriate method for allocating
proceeds among freestanding financial instruments, an entity would evaluate
whether any of those instruments contain embedded derivatives that require
separation under ASC 815-15 (see Chapter 8). If so, it would use the
with-and-without method (see the next section) to separate them from the
host contract (see Section
8.5.3.1).
When a debt issuance involves both the issuance and the receipt of noncash
financial instruments (e.g., an entity issues debt in exchange for cash and
a put option that permits it to sell its own equity shares), the fair value
of the items received represents a component of the proceeds that are
allocated among the financial instruments issued.
3.4.2.2 With-and-Without Method
If one or more, but not all, of the freestanding financial instruments issued
as part of a single transaction must be recognized as assets or liabilities
measured at fair value on a recurring basis (e.g., one of the instruments is
accounted for as a derivative instrument under ASC 815 or at fair value
under the fair value option in ASC 825-10; see Section 4.4), the issuer should use the with-and-without
method to allocate the proceeds among the freestanding financial
instruments. This approach is analogous to the allocation method for
bifurcated embedded derivatives in ASC 815-15-30-2 and 30-3 (see
Section 8.5.3.1).
Under the with-and-without method, a portion of the proceeds equal to the
fair value of the instrument (or instruments) measured at fair value on a
recurring basis is first allocated to that instrument (or instruments) on
the basis of its fair value as of the initial measurement date. The
remaining proceeds are then allocated to the other instrument(s) issued in
the same transaction either on a residual basis, if there is only one
remaining instrument, or by using a relative fair value approach if there
are multiple remaining instruments. The with-and-without allocation approach
avoids the recognition of a “day 1” gain or loss in earnings that is not
associated with a change in the fair value of the instrument(s) subsequently
measured at its fair value. Under this approach, if there is only one
freestanding financial instrument to which the residual proceeds are
allocated, the issuer is not required to estimate that instrument’s fair
value.
Example 3-8
Debt Issued With Liability-Classified
Warrants
Entity C issues debt to Entity B, together with a
detachable and separately transferable warrant, for
total proceeds of $10,000, which is also the par
amount of the debt. The warrant gives the holder the
right to purchase shares issued by C, which are
redeemable for cash at the holder’s option. Entity C
determines that the debt and the warrant represent
separate freestanding financial instruments.
Rather than electing to account for
the debt by using the fair value option in ASC
825-10 (see Section 4.4), C
will account for it at amortized cost by using the
interest method in ASC 835-30 (see Section
6.2). In evaluating whether the warrant
is within the scope of ASC 480, C determines that
the warrant is a freestanding financial instrument
that embodies an obligation to repurchase the
issuer’s equity shares and that the issuer may be
required to settle the obligation by transferring
assets. In a manner consistent with the guidance in
ASC 480, C will account for the warrant as a
liability that is measured both initially and
subsequently at fair value, with changes in fair
value recognized in earnings (see Chapter
5 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity). Entity C estimates that
the initial fair value of the warrant is $2,000.
In determining the initial carrying amounts, C
allocates the proceeds received between the debt and
the warrant. Because the warrant, but not the debt,
will be measured at fair value, with changes in fair
value recognized in earnings, C should first measure
the fair value of the warrant ($2,000) and allocate
that amount to the warrant liability. The amount of
proceeds allocated to the debt is the difference
between the total proceeds received ($10,000) and
the fair value of the warrant ($2,000). The
resulting discount from the par amount of the debt
($2,000) is accreted to par by using the
effective-interest method in ASC 835-30 (see
Section
6.2).
3.4.2.3 Relative Fair Value Method
The relative fair value method is appropriate if either of the following
applies: (1) none of the freestanding financial instruments issued as part
of a single transaction are measured at fair value, with changes in fair
value recognized in earnings on a recurring basis, or (2) after the entity
uses the with-and-without method to measure freestanding financial
instruments at fair value, more than one freestanding financial instrument
remains. To apply the relative fair value method, the entity allocates the
proceeds (or remaining proceeds after using the with-and-without method) on
the basis of the fair values of each freestanding financial instrument at
the time of the instrument’s issuance. ASC 470-20-25-2 requires an entity to
use the relative fair value approach to allocate proceeds in certain
transactions involving debt and detachable warrants (see Section 3.4.3.2). The approach is also
appropriate for other transactions that involve freestanding financial
instruments not measured at fair value on a recurring basis.
Under the relative fair value method, the issuer makes separate estimates of
the fair value of each freestanding financial instrument and then allocates
the proceeds in proportion to those fair value amounts (e.g., if the
estimated fair value of one of the instruments is 20 percent of the sum of
the estimated fair values of each of the instruments issued in the
transaction, 20 percent of the proceeds would be allocated to that
instrument). Because the issuer needs to independently measure each
freestanding financial instrument issued as part of the transaction, more
fair value estimates must be made under the relative fair value method than
under the with-and-without method.
In some transactions involving the issuance of more than two freestanding
financial instruments, both the with-and-without method and the relative
fair value method will apply. For example, if one freestanding financial
instrument is measured at fair value on a recurring basis and others are
not, the freestanding financial instrument that is subsequently measured at
fair value on a recurring basis should be initially measured at its fair
value, and the remaining amount of proceeds should be allocated among the
freestanding financial instruments not subsequently measured at fair value
on the basis of their relative fair values.
When a debt transaction involves both the issuance of financial instruments
and the receipt of noncash financial assets (e.g., tranche debt financings
that include the issuance of debt and the receipt of loan commitments), the
fair value of the noncash financial assets received may be treated as part
of the total proceeds received. Under this approach, the sum of the amount
of cash proceeds and the fair value of the noncash financial assets received
is allocated on a relative fair value basis to the financial instruments
issued.
After using the appropriate method(s) to allocate the proceeds to the
freestanding financial instruments, the entity should separate any component
parts from an individual freestanding financial instrument in accordance
with applicable GAAP (e.g., embedded derivatives).
3.4.3 Application Issues
3.4.3.1 Fair Value Exceeds Debt Proceeds
Sometimes the estimated fair value as of the issuance date of the liabilities
that are subsequently accounted for at fair value (e.g., debt that is
accounted for under the fair value option in ASC 825-10 and detachable
warrants that are accounted for as derivatives under ASC 815) exceeds the
amount of net debt proceeds received.
Example 3-9
Fair Value of
Instruments Exceeds Proceeds Received
Entity Y issues debt and detachable
warrants for $100 million of cash proceeds. It
elects to account for the debt at fair value under
the fair value option in ASC 825-10, and it accounts
for the warrants as derivatives at fair value under
ASC 815. The total estimated fair value of the debt
and the warrants is $120 million as of the issuance
date.
At the 2014 AICPA Conference on Current SEC and PCAOB
Developments, then SEC Professional Accounting Fellow Hillary Salo stated,
in part:
[T]he staff understands that there are substantive
reasons reporting entities may enter into these types of
arrangements, including circumstances in which alignment with a
particular investor is viewed as beneficial to the reporting entity
or because a reporting entity is in financial distress and requires
financing. For example, assume a reporting entity that wants to
align itself with a specific investor issues $10 million of
convertible debt at par and is required to bifurcate an in the money
conversion option with a fair value of $12 million. In this case,
the fair value of the financial liability required to be measured at
fair value (that is, the embedded derivative) exceeds the net
proceeds received under the transaction.
Ms. Salo advised entities to apply judgment and perform the following steps
in determining the appropriate accounting for “these types of unique fact
patterns”:
-
“[V]erify that the fair values of the financial liabilities required to be measured at fair value are appropriate under Topic 820.”Connecting the DotsAn entity must apply the fair value measurement requirements in ASC 820 when calculating estimated values. For a detailed discussion of the requirements in ASC 820, see Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the Fair Value Option).
-
“[E]valuate whether the transaction was conducted on an arm’s length basis, including an assessment as to whether the parties involved are related parties under Topic 850.”Connecting the DotsAs noted in ASC 820-10-35-3, a “fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date under current market conditions.” Under ASC 820-10-20, market participants are parties that are independent of each other (i.e., not related parties). Circumstances in which the transaction price may not represent fair value include transactions between related parties and those taking place under duress or in which the entity was forced to accept the transaction price because of financial difficulties.In practice, pro rata distributions to equity owners are recognized as equity transactions (i.e., as a deemed dividend with a debit to retained earnings or other applicable equity account), whereas non-pro-rata distributions are recognized as a charge to earnings in the period in which the distribution is declared. Accordingly, if a wholly owned subsidiary issues debt to its parent, any excess of the fair value of the instruments issued over the proceeds received might represent a deemed dividend from the subsidiary to the parent. If a related-party transaction represents a non-pro-rata distribution, however, expense recognition may be appropriate.In her speech, Ms. Salo emphasized that transactions that are not at arm’s length or are entered into with a related party “require significant judgment; therefore, [the SEC staff] would encourage consultation with OCA in those circumstances.”
-
“[E]valuate all elements of the transaction to determine if there are any other rights or privileges received that meet the definition of an asset under other applicable guidance.”Connecting the DotsIf a transaction is conducted on an arm’s-length basis and the total fair value of the liabilities measured at fair value exceeds the proceeds received, an entity should carefully evaluate whether the difference is attributable to some other transaction element that qualifies for accounting recognition (e.g., separate freestanding financial instruments, other rights or privileges, or transaction costs; see Section 3.3.3). If so, those elements should be recognized separately (e.g., as an asset or expense in accordance with other applicable GAAP). Under ASC 505-30, there is a presumption that a purchase of shares at a price significantly in excess of the open market price includes other elements for which separate accounting is required.
If an entity, after performing these steps, determines that no other
transaction elements can be identified, the excess of the fair value over
the proceeds is recognized as an expense (an up-front loss). Ms. Salo
indicated that the SEC staff expects “clear and robust disclosure of the
nature of the transaction, including reasons why the entity entered into the
transaction and the benefits received.”
Connecting the Dots
The above guidance may also be relevant when the aggregate fair value
of the debt and other instruments issued exceeds the proceeds and
some of the instruments issued are not subsequently accounted for at
fair value.
3.4.3.2 Debt With Detachable Warrants
ASC 470-20
25-2 Proceeds from the
sale of a debt instrument with stock purchase
warrants (detachable call options) shall be
allocated to the two elements based on the relative
fair values of the debt instrument without the
warrants and of the warrants themselves at time of
issuance. The portion of the proceeds so allocated
to the warrants shall be accounted for as paid-in
capital. The remainder of the proceeds shall be
allocated to the debt instrument portion of the
transaction. This usually results in a discount (or,
occasionally, a reduced premium), which shall be
accounted for under Topic 835.
25-3 The same accounting
treatment applies to issues of debt instruments
(issued with detachable warrants) that may be
surrendered in settlement of the exercise price of
the warrant. However, if 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.
30-1 The allocation of
proceeds under paragraph 470-20-25-2 shall be based
on the relative fair values of the two instruments
at time of issuance.
30-2 When detachable warrants
(detachable call options) are issued in conjunction
with a debt instrument as consideration in purchase
transactions, the amounts attributable to each class
of instrument issued shall be determined separately,
based on values at time of issuance. The debt
discount or premium shall be determined by comparing
the value attributed to the debt instrument with the
face amount thereof.
When an entity issues debt together with detachable stock
purchase warrants that represent separate freestanding financial instruments
(see Section
3.3.2), the proceeds received must be allocated between the
debt and the warrants. Although ASC 470-20-25-2 may appear to suggest that
the relative fair value method should always be applied to debt issued
together with detachable warrants, the scope of this guidance is limited to
situations in which (1) the warrants are classified as equity and the debt
is not subsequently measured at fair value on a recurring basis and (2)
there are no other transaction elements that must be accounted for
separately (e.g., other stated or unstated rights or privileges). While ASC
470-20-25-2 suggests that the amounts allocated to detachable warrants
should be accounted for as paid-in capital, that guidance conflicts with
other GAAP under which entities must classify certain contracts on the
entity’s own equity as assets or liabilities (e.g., ASC 480 and ASC 815).
Neither ASC 480 nor ASC 815 exempts detachable warrants on the issuer’s
equity shares that are classified as assets or liabilities from the initial
recognition guidance within those topics.
An entity should account for the portion of the proceeds
allocated to the warrants as paid-in capital only if the warrants qualify
for classification as equity instruments. If warrants must be classified as
a liability under ASC 480, ASC 815-40, or other GAAP, the entity should
account for the amount attributable to them under that guidance.
Accordingly, an entity should not rely solely on the guidance in ASC
470-20-25-2 and 25-3 when classifying detachable warrants as liabilities or
equity or when allocating proceeds between debt and detachable warrants. For
a discussion of how to determine the appropriate classification and
measurement of a detachable warrant, see Deloitte’s Roadmaps Contracts on an Entity’s Own
Equity and Distinguishing Liabilities From
Equity.
The following table provides
an overview of the appropriate allocation of proceeds between debt and
detachable warrants at initial recognition:
|
Warrant Accounted for at Fair Value, With Fair Value
Changes Recognized in Earnings
|
Warrant Classified as Equity
| |
|---|---|---|
|
Debt accounted for at amortized cost
|
With-and-without method (i.e.,
warrant is measured initially at fair value and debt
is measured as the residual; see Section
3.4.2.2). If it is determined that the
transaction price for the debt and warrants does not
represent fair value, special considerations are
necessary.
|
Relative fair value method (see
Section 3.4.2.3). If it is determined
that the transaction price for the debt and warrants
does not represent fair value, special
considerations are necessary.
|
|
Debt accounted for at fair value, with changes in
fair value recognized in earnings
|
Debt is measured initially at fair
value. If the initial fair values of the debt and
warrants, in the aggregate, exceed the proceeds
received, special considerations are necessary (see
Section 3.4.3.1).
|
With-and-without method (i.e., debt
is measured initially at fair value and warrant is
measured as the residual; see Section
3.4.2.2). If it is determined that the
transaction price for the debt and warrants does not
represent fair value, special considerations are
necessary.
|
3.5 Allocation of Issuance Costs to Units of Account
3.5.1 Background
This section discusses (1) how an issuer should allocate
issuance costs among freestanding financial instruments when those instruments
are issued in a single transaction (see the next section) and (2) certain
application issues (see Section 3.5.3). For a discussion of what qualifies as a debt
issuance cost, see Section
5.2.
3.5.2 Allocation Methods
On the basis of their specific facts and circumstances, entities
should consistently apply a systematic and rational method for allocating
issuance costs among freestanding financial instruments that form part of the
same transaction.
If the proceeds are allocated solely on the basis of the relative fair value
method, the related issuance costs should also be allocated on that
basis, which is consistent with the guidance in SAB Topic 2.A.6 (see
Section 3.5.3.3).
Connecting the Dots
An entity may issue debt and enter into a loan commitment with the same
counterparty at the same time. In such a case, the amount of proceeds
allocated to the loan commitment may be nominal. When the entity applies
the relative fair value method, it would therefore be appropriate to
allocate issuance costs on the basis of the relative amount of costs
that would have been incurred if the two freestanding financial
instruments had been entered into separately. For example, assume that
an entity incurs total issuance costs of $10 million for the issuance of
$200 million in debt and a commitment to enter into an additional $100
million of debt. The entity estimates that if it had issued the
instruments separately, it would have incurred issuance costs of $8
million and $6 million for the debt issuance and loan commitment,
respectively. Therefore, it would allocate $5.7 million of issuance
costs to the debt (i.e., $10 million × [$8 million ÷ $14 million]) and
$4.3 million of issuance costs to the loan commitment (i.e., $10 million
× [$6 million ÷ $14 million]).
If an entity allocates the proceeds by using the with-and-without method
(including allocation to a freestanding financial instrument that contains an
embedded derivative that must be bifurcated from its host contract), one of the
following two methods is generally appropriate in the allocation of the related
issuance costs:
-
The relative fair value method — The entity allocates issuance costs on the basis of the relative fair values of the freestanding financial instruments by analogy to ASC 470-20-25-2. SAB Topic 2.A.6 (see Section 3.5.3.3) states that this method should be applied in the allocation of costs between services received “[w]hen an investment banker provides services in connection with a business combination or asset acquisition and also provides underwriting services associated with the issuance of debt or equity securities.” However, if no proceeds are allocated to the debt under the with-and-without method, the entity expenses as incurred any issuance costs allocated to the debt under the relative fair value method because presenting a debt liability as an asset would be inappropriate.
-
An approach that is consistent with the allocation of proceeds — The entity allocates issuance costs in proportion to the allocation of proceeds between the freestanding financial instruments (see Section 3.4.2).
The method used should be applied consistently to similar
transactions. Any issuance costs allocated to a freestanding or an embedded
financial instrument that is subsequently measured at fair value through
earnings must be expensed as of the issuance date (see, for example, ASC
825-10-25-3). For additional discussion of the allocation of issuance costs, see
Section 3.3.4.4 of Deloitte’s Roadmap
Distinguishing Liabilities From
Equity.
3.5.3 Application Issues
3.5.3.1 Credit Facilities With Both Revolving and Nonrevolving Components
An entity might incur costs and fees to obtain a credit
facility that includes both revolving- and nonrevolving-debt components. The
portion of the costs and fees that are allocated to the nonrevolving
component is deferred as an asset before the issuance of debt and reduces
the initial net carrying amount of any debt drawn in proportion to such
drawn amount (see Section
5.3). The portion allocated to the revolving component is
treated as a cost or fee to obtain a line-of-credit or revolving-debt
arrangement (see Section
5.4). If a portion of the costs and fees paid is attributable
to services received that are not directly related to the debt arrangement,
that portion is allocated to those services (see Section 3.5.3.3).
3.5.3.2 Transactions That Involve the Receipt of Noncash Financial Assets
When a debt issuance transaction involves the receipt of noncash financial
assets by the issuing entity (e.g., tranche debt financings that include the
issuance of debt and the receipt of loan commitments at inception), the
related issuance costs may be allocated in one of two ways:
-
Only to the financial liability (and any equity instruments) issued. No costs are allocated to the noncash financial assets received since they form part of the proceeds received, which are allocated to the financial instruments issued.
-
Both to the noncash financial assets received and to the financial liabilities (and any equity instruments) issued, without regard to whether the fair values are positive or negative (i.e., by using absolute values). Costs and fees are allocated to noncash financial assets on the basis that transaction costs would have been incurred in a stand-alone transaction for those assets.
Example 3-10
Tranche Debt Financing With Warrants
Entity S enters into a tranche debt financing
arrangement with an investment firm. On the initial
closing date, S issues to the investment firm a note
payable with a principal amount of $30 million and
warrants on its own stock. In exchange, S receives
cash proceeds of $30 million and a loan commitment
under which it may draw up to $200 million of
additional notes if certain business milestones are
met. In addition, S incurs $3.2 million of
third-party costs directly attributable to the
financing arrangement.
Entity S determines that the note payable, the
warrants, and the loan commitment represent separate
units of account. It engages a valuation specialist
that provides the following fair value estimates:
- Note payable — $16,532,595.
- Loan commitment — $38,385,821.
- Warrants — $51,853,226.
Entity S does not elect to account for the notes by
using the fair value option in ASC 825-10 and has a
policy of allocating issuance costs on a relative
fair value basis under ASC 470-20-25-2 (see
Section
3.4.2.3). Entity S can elect to use
either of the following approaches to allocate the
issuance costs:
Approach 1 — Allocate Third-Party Issuance
Costs Only to the Debt and Warrants
Under this approach, the proceeds received after
deduction of third-party costs are allocated to the
debt and warrants on the basis of their relative
fair values. No third-party costs are allocated to
the loan commitment asset, since that asset forms
part of the proceeds received.
Approach 2 — Allocate Third-Party Issuance
Costs to the Debt, Warrants, and Loan Commitment
Asset
Under this approach, third-party costs are allocated
to the debt, warrants, and loan commitment asset on
the basis of their relative fair values without
regard to whether the fair values are positive or
negative (i.e., by using absolute values). The
allocation of some of the third-party costs to the
loan commitment asset is also consistent with the
treatment of transaction costs associated with
financial assets that are not classified as held for
trading (i.e., if only a loan commitment had been
obtained, there could have been third-party costs
that would be capitalizable).
Note that since it would be inappropriate to allocate
negative third-party costs to the loan commitment
asset, an entity determines the relative fair values
on the basis of the absolute amounts of the items.
In this example, because the fair value of the
proceeds received equals that of the financial
instruments issued, the use of the relative fair
value allocation method does not affect the
allocation of proceeds to the financial instruments
issued.
3.5.3.3 Interim Bridge Financing and Other Services
SEC Staff Accounting Bulletins
SAB Topic 2.A.6, Debt Issue Costs in Conjunction With
a Business Combination [Reproduced in ASC
340-10-S99-2]
Facts:
Company A is to acquire the net assets of Company B
in a transaction to be accounted for as a business
combination. In connection with the transaction,
Company A has retained an investment banker to
provide advisory services in structuring the
acquisition and to provide the necessary financing.
It is expected that the acquisition will be financed
on an interim basis using “bridge financing”
provided by the investment banker. Permanent
financing will be arranged at a later date through a
debt offering, which will be underwritten by the
investment banker. Fees will be paid to the
investment banker for the advisory services, the
bridge financing, and the underwriting of the
permanent financing. These services may be billed
separately or as a single amount.
Question 1: Should total fees
paid to the investment banker for
acquisition-related services and the issuance of
debt securities be allocated between the services
received?
Interpretive Response: Yes.
Fees paid to an investment banker in connection with
a business combination or asset acquisition, when
the investment banker is also providing interim
financing or underwriting services, must be
allocated between acquisition related services and
debt issue costs.
When an investment banker provides services in
connection with a business combination or asset
acquisition and also provides underwriting services
associated with the issuance of debt or equity
securities, the total fees incurred by an entity
should be allocated between the services received on
a relative fair value basis. The objective of the
allocation is to ascribe the total fees incurred to
the actual services provided by the investment
banker.
FASB ASC Topic 805, Business Combinations, provides
guidance for the portion of the costs that represent
acquisition-related services. The portion of the
costs pertaining to the issuance of debt or equity
securities should be accounted for in accordance
with other applicable GAAP.
Question 2: May the debt
issue costs of the interim “bridge financing” be
amortized over the anticipated combined life of the
bridge and permanent financings?
Interpretive Response: No.
Debt issue costs should be amortized by the interest
method over the life of the debt to which they
relate. Debt issue costs related to the bridge
financing should be recognized as interest cost
during the estimated interim period preceding the
placement of the permanent financing with any
unamortized amounts charged to expense if the bridge
loan is repaid prior to the expiration of the
estimated period. Where the bridged financing
consists of increasing rate debt, the guidance
issued in FASB ASC Topic 470, Debt, should be
followed.1
____________________
1 As noted in FASB ASC
paragraph 470-10-35-2, the term-extending provisions
of the debt instrument should be analyzed to
determine whether they constitute an embedded
derivative requiring separate accounting in
accordance with FASB ASC Topic 815, Derivatives and
Hedging.
SAB Topic 2.A.6 (reproduced in ASC 340-10-S99-2) addresses an entity’s
accounting for fees paid to an investment bank to obtain interim bridge
financing and other services in connection with an acquisition that will be
accounted for as a business combination. The fees paid represent
consideration for multiple items received, including (1) interim bridge
financing to help the entity pay for the acquisition, (2) underwriting
services related to a future debt offering to finance the acquisition on a
more permanent basis, and (3) acquisition-related advisory services. Under
this guidance, an entity must allocate the fees paid between the different
components (i.e., the bridge financing, the underwriting services, and the
acquisition-related services) on a relative fair value basis.
Although the debtor may anticipate that the interim bridge financing will be
replaced by permanent debt financing, the costs allocated to the interim
bridge financing are amortized over the estimated life of the interim
financing. Any remaining unamortized costs attributed to the interim bridge
financing are charged to earnings once the bridge financing is repaid. Those
costs cannot be treated as an issuance cost of the subsequent debt
offering.
Connecting the Dots
In the SAB Topic 2.A.6 fact pattern, the short-term debt with an
investment bank will be replaced by long-term debt with other third
parties (i.e., the counterparties of the short- and long-term debt
instruments differ). However, an entity can use other types of
financing arrangements to complete a business combination, including
financing obtained on a short-term basis that contractually extends
to long-term financing if the acquisition is consummated. For
example, assume that an entity obtains a loan from a third party
with a short-term maturity date that, according to its contractual
terms, will be replaced with long-term financing from the same
counterparty if a business combination is consummated on or before
the stated maturity date of the short-term financing. The interest
rate on the short-term and long-term components of the financing are
the same. The entity issues the short-term financing at a 10 percent
discount to its stated principal amount. No additional costs or fees
are paid by the entity if the short-term financing is replaced by
the long-term financing. The discount paid for the short-term
financing represents a fee paid for the overall financing
arrangement. In this example, the bridge financing guidance in SAB
Topic 2.A.6 does not apply. Rather, the entity has, in substance,
obtained long-term financing that is puttable by the holder if a
proposed acquisition does not occur by a stated date. Regardless of
whether the short-term and long-term components of the overall
arrangement legally comprise one loan or two, the entity should
account for the financing arrangement as contingently puttable
long-term debt. Therefore, the discount incurred at inception is
related to the overall arrangement and not just the short-term
component.
3.5.3.4 Unit Structures
A unit structure issued with debt represents a combination
of (1) a debt instrument and (2) a variable-share forward (VSF) contract to
issue common shares or an option to issue common shares to the counterparty.
An entity must evaluate the terms of these types of issuances to determine
whether the debt instrument and equity-linked instrument constitute a single
combined unit of account or two separate units of account. While the
specific facts and circumstances of each individual unit structure must be
considered, these structures will generally consist of separate units of
account for the debt instrument and the equity-linked instrument because the
two instruments are legally detachable and separately exercisable. The
example below illustrates the accounting for the issuance and redemption of
such structures.
Example 3-11
Issuance and Redemption of Unit Structure
Issuance
Entity A issues 10-year, $100 par units for $100 per
unit. Each unit consists of the following two
securities that were issued together but can be
separately transferred by the holders:
-
A senior note payable that has a 10-year maturity and a principal amount of $100 per unit. The note pays interest at a fixed rate of 8 percent annually (i.e., $8 annually) and is subject to a mandatory remarketing at the end of eight years.
-
A VSF contract that pays the holder contract adjustment payments and obligates the holder to purchase a variable number of A’s common shares for $100 per unit in eight years, as follows:1
- If the 30-day volume-weighted average share price is equal to or greater than $105, the holder receives 0.95 shares for $100.
- If the 30-day volume-weighted average share price is equal to or less than $90, the holder receives one share for $100.
- If the 30-day volume-weighted average share price is between $90 and $105, the holder receives a variable number of shares equal to $100 divided by the stock price for $100.
The contract payment obligation
requires A to make a cash payment each year for 10
years equal to 3 percent times the stated amount of
$100 per unit (i.e., $3 annually). Such obligation
represents a financing of the net premium that A
would have otherwise had to pay to enter into the
VSF contract.
Assume that A has evaluated the unit structure and
determined that the senior note payable and VSF
contract are separate units of account. Furthermore,
assume that the VSF contract meets the conditions in
ASC 815-40 to be classified within equity and that A
has not elected to apply the fair value option to
the senior note payable.
Entity A should allocate the
proceeds received between the senior note payable
and the VSF contract (including the contract payment
obligation) in proportion to their relative fair
values at issuance. If the net fair value of the VSF
contract (including the contract payment obligation)
is zero, A would allocate the entire $100 proceeds
per unit to the liability associated with the senior
note payable.
In addition, A should determine the
fair value of the contract payment obligation at
issuance (e.g., by using a discounted cash flow
technique in accordance with ASC 820) and classify
that amount as a liability with an offsetting
reduction in stockholders’ equity. Assuming that the
fair value of the contract payment obligation is
$20, A would recognize the following journal entry
upon issuance of the units (per unit):
After issuance, A should (1) accrue interest on the
contract payment obligation (i.e., the difference
between the $20 initial carrying amount and the
undiscounted amount of the contract payments) by
using the interest method and (2) report that amount
as interest expense. Because the VSF contract is
classified in equity, A should not remeasure it
after issuance (see ASC 815-40-35-2).
Redemption
If A subsequently repurchases the units for cash
before their settlement dates, it should recognize
an extinguishment of debt for the two liabilities
(i.e., the senior note payable and the contract
payment obligation) and a settlement of the
equity-classified VSF contract (i.e., excluding the
contract payment obligation). The calculation of the
debt extinguishment gain or loss will depend on
whether the equity-classified VSF contract has a
positive or negative fair value to A.
If the equity-classified VSF contract has a positive
fair value to A, the reacquisition price paid by A
to extinguish the two liabilities equals the sum of
the cash paid and the fair value of the
equity-classified VSF contract at settlement. In
this circumstance, A effectively is using both cash
and the fair value of the VSF contract as
consideration to extinguish its two liabilities. If
the equity-classified VSF contract has a negative
fair value to A, the reacquisition price paid by A
to extinguish the two liabilities equals the cash
paid less the fair value of the equity-classified
VSF contract at settlement. In this circumstance,
part of the cash paid by A effectively is
consideration to settle the negative fair value of
the equity-classified VSF contract. The difference
between the reacquisition price calculated as
described above and the aggregate carrying amount of
the two liabilities should be recognized as a debt
extinguishment gain or loss in accordance with ASC
470-50-40-2.
If the equity-classified VSF contract has a positive
fair value to A, its fair value would be credited to
equity upon settlement (and, as described above,
result in an increase in the reacquisition price
paid to extinguish the two liabilities). If the
equity-classified VSF contract has a negative fair
value to A, its fair value would be debited to
equity upon settlement (and, as described above,
result in a decrease in the reacquisition price paid
to extinguish the two liabilities).
Assume that A repurchases the units before maturity
by making a cash payment of $105 per unit to each
unitholder. At the time of the repurchase, the
carrying amounts are as follows (per unit):
- Senior note payable: $100.
- Contract payment obligation: $14.
The fair value of the VSF contract (i.e., excluding
the contract payment obligation) on the date of
repurchase is $3 and is positive to A.
Entity A would recognize a $6 debt extinguishment
gain as a result of the settlement of the equity
unit structure. The debt extinguishment gain is
calculated as follows: aggregate carrying amount of
the debt of $114 ($100 and $14), less the
reacquisition price paid of $108 (i.e., the $105 in
cash consideration plus the $3 fair value of the
equity-classified derivative component of the VSF).
The fair value of the equity-classified VSF contract
(excluding the contract payment obligation) is
included in the reacquisition price paid because the
holder would have had to pay A $3 to settle the
contract if it had been settled separately. In other
words, A is using the settlement of the
equity-classified VSF contract as partial
consideration for the repurchase of the two
liabilities.
Entity A’s journal entries would be
as follows:
Footnotes
1
Economically, the VSF
contract’s payoffs are structured as if A had
purchased a put option and written a call option
on its own common shares.
Chapter 4 — Initial Recognition and Measurement of Debt
Chapter 4 — Initial Recognition and Measurement of Debt
4.1 Background
Debt is initially recognized on the settlement date (see Section 4.2). There is a
presumption that debt issued solely in exchange for cash should be initially
recognized at the amount of cash proceeds received (see Section 4.3.4). However, an entity should
evaluate debt that is issued in exchange for property, goods, or services to
determine whether to initially measure it at (1) its face amount or (2) the present
value of the cash flows, discounted by using an imputed interest rate (i.e., at fair
value under ASC 820) (see Section
4.3.5). Any difference between the debt’s initial carrying amount and
stated principal amount represents a discount or premium (see Section 4.3.6). In addition,
any debt for which the issuer elects the fair value option in ASC 815-15 or ASC
825-10 is initially measured at its fair value, with any up-front costs or fees
incurred recognized immediately in earnings (see Section 4.4).
4.2 Recognition Date
In practice, debt liabilities are initially recognized on the settlement date (i.e.,
the date on which the debtor receives the related proceeds such as cash or other
financial or nonfinancial assets) as opposed to the date on which the debt is priced
or the parties enter into a binding agreement to issue it.
If an entity enters into an agreement that requires or permits it to issue debt in
the future, it should consider whether it must recognize that agreement as a
derivative under ASC 815-10 until the debt is funded. Usually, such contracts are
not within the scope of the accounting requirements for derivatives because ASC 815
contains a scope exception for loan commitments (see Section 2.3.3), and the contract might not meet the net settlement
characteristic in the definition of a derivative (see Section
8.3.4.4). If an entity incurs costs and fees associated with a future
debt issuance or a commitment that requires or permits it to issue debt in the
future, it may need to capitalize such costs and fees as an asset (see Chapter 5).
4.3 Debt Subject to ASC 835-30
4.3.1 Background
ASC 835-30 provides guidance on the initial measurement of debt
for which the issuer has not elected the fair value option in ASC 815-15 (see
Section 8.5.6)
or ASC 825-10 (see Section
4.4). Certain types of payables are exempt from the scope of this
guidance (see the next section). While debt is initially measured at the present
value of the debt’s contractual cash flows (see Section 4.3.3), the initial measurement
guidance in ASC 835-30 on debt issued in exchange for cash (see Section 4.3.4) is
different from that on debt issued in exchange for property, goods, or services
(see Section
4.3.5). Section
4.3.6 describes the concepts of discount and premium.
4.3.2 Scope
ASC 835-30
15-3 With the exception of
guidance in paragraphs 835-30-45-1A through 45-3
addressing the presentation of discount and premium in
the financial statements, which is applicable in all
circumstances, and the guidance in paragraphs
835-30-55-2 through 55-3 regarding the application of
the interest method, the guidance in this Subtopic does
not apply to the following:
- Payables arising from transactions with suppliers in the normal course of business that are due in customary trade terms not exceeding approximately one year
- Amounts that do not require repayment in the future, but rather will be applied to the purchase price of the property, goods, or service involved . . .
- Amounts intended to provide security for one party to an agreement (for example, security deposits, retainages on contracts)
- The customary cash lending activities and demand or savings deposit activities of financial institutions whose primary business is lending money
- Transactions where interest rates are affected by the tax attributes or legal restrictions prescribed by a governmental agency (for example, industrial revenue bonds, tax exempt obligations, government guaranteed obligations, income tax settlements)
- Transactions between parent and subsidiary entities and between subsidiaries of a common parent
- The application of the present value measurement (valuation) technique to estimates of contractual or other obligations assumed in connection with sales of property, goods, or service, for example, a warranty for product performance
- Receivables, contract assets, and contract liabilities in contracts with customers, see paragraphs 606-10-32-15 through 32-20 for guidance on identifying a significant financing component in a contract with a customer.
The initial measurement guidance in ASC 835-30 applies to both receivables and
payables other than items (1) for which the entity has elected the fair value
option in ASC 815-15 (see Section 8.5.6) or ASC 825-10 (see
Section 4.4) or (2) that meet one or
more of the scope exceptions in ASC 835-30. ASC 835-30-15-3 includes the
following scope exceptions:
-
Payables resulting from the purchase of goods or services from suppliers in the normal course of business on customary terms not exceeding approximately one year (i.e., trade payables).
-
Payables to a parent, subsidiary, or entity under common control.
-
Debt that has an interest rate that is “affected by the tax attributes or legal restrictions prescribed by a governmental agency” such as “industrial revenue bonds, tax exempt obligations, government guaranteed obligations, [and] income tax settlements.”
- Certain obligations associated with sales of property, goods, or services:
-
Amounts that will be applied as a reduction to the price of property, goods, or services, such as deposits, advances, and progress payments (see Deloitte’s Roadmap Revenue Recognition for a discussion of the accounting for revenue contracts with a significant financing component).
-
Warranties for product performance and other obligations assumed in connection with sales of property, goods, or services.
-
Contract liabilities (i.e., under ASC 835-30-20, “[a]n entity’s obligation to transfer goods or services to a customer for which the entity has received consideration . . . from the customer”; see Deloitte’s Roadmap Revenue Recognition).
-
- Security deposits.
- Customary cash lending activities and demand or savings deposit activities of financial institutions.
4.3.3 Present Value Concepts
A key concept in ASC 835-30 is that the initial measurement of
debt represents the present value of the debt’s principal and interest cash
flows, discounted by using an appropriate interest rate. As discussed in
Section 2.3.1.1
of Deloitte’s Roadmap Fair
Value Measurements and Disclosures (Including the Fair Value
Option), when a note payable (i.e., debt) is initially
recognized on the basis of a present value technique under ASC 835-30, the
measurement is a fair value measurement subject to the guidance in ASC 820.
If debt is issued solely for cash and no other rights or
privileges are involved, there is a presumption that present value equals the
cash proceeds received (see Section 4.3.4). In this circumstance, the debtor identifies the
appropriate discount rate (i.e., the debt’s effective interest rate) by equating
the cash proceeds received to the debt’s contractual cash flows (see Section 6.2.3.3). If debt
is issued in exchange for property, goods, or services, however, the stated
interest rate may not be an appropriate discount rate (see Section 4.3.5.1).
Consequently, if interest is imputed at an appropriate rate (i.e., the debt’s
contractual cash flows are discounted by using an appropriate imputed discount
rate that differs from the stated interest rate), the debt is recognized at a
discount or premium (see Section 4.3.6). The discount or premium represents the
difference between the principal amount of the debt and the present value of the
contractual cash flows, calculated by using a discount rate that is appropriate
in the circumstances.
ASC 835-30
Example 1:
Illustration of Present Value Concepts
55-4 This Example illustrates
the guidance in paragraphs 835-30-05-2, 835-30-25-3
through 25-4, and 835-30-25-10 through 25-11 that the
coupon or stated rate of interest and the face amount of
a note or bond may not be the appropriate bases for
valuation. The presumption that market values provide
the evidence for valuation must be overcome before using
coupon or stated rates and face or maturity amounts as
the bases for accounting.
55-5 Upon issuance of a note or
bond, the issuer customarily records as a liability the
face or principal amount of the obligation. Ordinarily,
the recorded liability also represents the amount that
is to be repaid upon maturity of the obligation. The
value recorded in the liability account, however, may be
different from the proceeds received or the present
value of the obligation at issuance if the market rate
of interest differs from the coupon rate of interest.
For example, consider the issuance of a $1,000, 20-year
bond that bears interest at 10% annually. If we assume
that 10% is an appropriate market rate of interest for
such a bond, the proceeds at issuance will be $1,000.
The bond payable would be recorded at $1,000, which
represents the amount repayable at maturity and also the
present value at issuance, which is equal to the
proceeds. However, under similar circumstances, if the
prevailing market rate were more (less) than 10%, a
20-year 10% bond with a face amount of $1,000 would
usually have a value at issuance and provide cash
proceeds of less (more) than $1,000. The significant
point is that, upon issuance, a bond is valued at the
present value of the future coupon interest payments
plus the present value of the future principal payments
(face amount). These two sets of future cash payments
are discounted at the prevailing market rate of interest
(for an equivalent security) at the date of issuance of
the debt. As the 8% and 12% columns show, premium or
discount arises when the prevailing market rate of
interest differs from the coupon rate.
55-6 In the case of a $1,000
non-interest-bearing 20-year note, where the prevailing
market rate for comparable credit risks is 10%, the
following valuation should be made.
55-7 Comparison of the two
tables shows the significant impact of interest.
4.3.4 Debt Issued in Exchange For Cash
ASC 835-30
25-4 When a note is
received or issued solely for cash and no other right or
privilege is exchanged, it is presumed to have a present
value at issuance measured by the cash proceeds
exchanged. If cash and some other rights or privileges
are exchanged for a note, the value of the rights or
privileges shall be given accounting recognition as
described in paragraph 835-30-25-6.
25-6 A note issued solely
for cash equal to its face amount is presumed to earn
the stated rate of interest. However, in some cases the
parties may also exchange unstated (or stated) rights or
privileges, which are given accounting recognition by
establishing a note discount or premium account. In such
instances, the effective interest rate differs from the
stated rate. For example, an entity may lend a supplier
cash that is to be repaid five years hence with no
stated interest. Such a non-interest-bearing loan may be
partial consideration under a purchase contract for
supplier products at lower than the prevailing market
prices. In this circumstance, the difference between the
present value of the receivable and the cash loaned to
the supplier is appropriately regarded as an addition to
the cost of products purchased during the contract term.
The note discount shall be amortized as interest income
over the five-year life of the note, as required by
Section 835-30-35.
Nonauthoritative AICPA Guidance
Technical Q&As
Section 5220, “Interest Expense”
.07 Imputed Interest on Note Exchanged for Cash
Only
Inquiry — If an enterprise
receives cash in exchange for a non-interest bearing
long-term note payable with a stated amount equal to the
cash received, must interest be imputed on the note in
accordance with FASB ASC 835, Interest?
Reply — If there are rights or privileges other
than cash attendant to the exchange, the value of such
rights or privileges should be given accounting
recognition pursuant to FASB ASC 835-30-25-6. If the
note is issued solely for cash (that is, the cash
received is equivalent to the face amount of the note)
and no other right or privilege is exchanged, it is
presumed to have a present value at issuance measured by
the cash proceeds exchanged.
When an entity issues debt in a cash transaction that does not
include any other elements for which separate accounting recognition is required
(e.g., freestanding financial instruments or other stated or unstated rights or
privileges that warrant separate accounting recognition; see Section 3.3) and the
entity has not elected the fair value option in ASC 815-15 (see Section 8.5.6) or ASC
825-10 (see Section
4.4), a presumption exists that the debt should be initially
measured at the amount of cash proceeds received from the holder, adjusted for
debt issuance costs (see Chapter 5). Any difference between the stated principal amount
and the amount of the cash proceeds received, net of debt issuance costs, is
presented as a discount or premium (see Section 4.3.6).
If a debt issuance includes other freestanding financial
instruments or other elements that warrant separate accounting recognition (see
Section 3.3),
the cash proceeds should be allocated among the debt and those other units of
account as follows: first to any instrument that must be measured at fair value,
with changes recognized in earnings, and then to items not accounted for at fair
value. If the issuer is required to recognize as an asset any freestanding
financial instrument included in the transaction, the amount attributed to that
asset would be added to the amount of proceeds that is allocated among the
freestanding financial instruments that represent liabilities (and any equity
instruments issued). See Section 3.4 for additional discussion of the allocation of
proceeds and issuance costs.
Factors to consider in the determination of whether a transaction includes other
elements that should be recognized separately include (1) whether the effective
interest rate calculated on the basis of the proceeds allocated to the debt
would be unreasonable given the general level of interest rates, (2) the
issuer’s creditworthiness, and (3) the debt’s initial fair value. If the
transaction conveys rights or privileges unrelated to the debt, the issuer
should recognize such rights or privileges separately from the debt. If the
amount attributed to such rights or privileges represents an asset or expense,
such amount is added to the proceeds that are allocated to the debt and any
other freestanding financial liabilities or equity instruments issued. If the
transaction includes terms that meet the definition of a registration payment
arrangement, the issuer should also consider whether any amount should be
allocated to that arrangement. See Section 3.3.3 for additional discussion.
If the terms of a debt instrument include embedded features or other components
that must be recognized separately from the debt (e.g., any bifurcated embedded
derivative under ASC 815-15 or equity component under ASC 470-20), the amount
attributable to such features or components is allocated from the amount of
proceeds allocated to the debt after allocation to any other freestanding
financial instruments.
4.3.5 Debt Issued in Exchange for Property, Goods, or Services
4.3.5.1 General
ASC 835-30
05-2 Business transactions
often involve the exchange of cash or property,
goods, or service for a note or similar instrument.
When a note is exchanged for property, goods, or
service in a bargained transaction entered into at
arm’s length, there should be a general presumption
that the rate of interest stipulated by the parties
to the transaction represents fair and adequate
compensation to the supplier for the use of the
related funds. That presumption, however, must not
permit the form of the transaction to prevail over
its economic substance and thus would not apply if
interest is not stated, the stated interest rate is
unreasonable, or the stated face amount of the note
is materially different from the current cash sales
price for the same or similar items or from the fair
value of the note at the date of the transaction.
The use of an interest rate that varies from
prevailing interest rates warrants evaluation of
whether the face amount and the stated interest rate
of a note or obligation provide reliable evidence
for properly recording the exchange and subsequent
related interest.
25-7 A note exchanged for
property, goods, or service represents the following
two elements, which may or may not be stipulated in
the note:
-
The principal amount, equivalent to the bargained exchange price of the property, goods, or service as established between the supplier and the purchaser
-
An interest factor to compensate the supplier over the life of the note for the use of funds that would have been received in a cash transaction at the time of the exchange.
25-8 Notes exchanged for
property, goods, or services are valued and
accounted for at the present value of the
consideration exchanged between the contracting
parties at the date of the transaction in a manner
similar to that followed for a cash transaction.
When an entity issues debt in exchange for property, goods,
or services in a bargained transaction entered into at arm’s length (i.e.,
the debtor is the purchaser of property, goods, or services), and there are
no other separate elements in the transaction, there is a general
presumption that the debt’s stated rate of interest represents fair and
adequate compensation for the debtor’s use of the funds. In such cases, the
debt is initially measured at the present value of the contractual cash
flows, discounted by using the stated interest rate (i.e., typically the
stated principal amount) and adjusted for debt issuance costs (see Chapter 5), unless the issuer elects the
fair value option in ASC 815-15 (see Section 8.5.6) or ASC 825-10 (see
Section
4.4).
This presumption does not apply if (1) the debt has no
stated interest; (2) the stated interest rate is unreasonable (e.g., it does
not reflect the general level of interest rates or the issuer’s
creditworthiness); (3) the debt’s stated amount is materially different from
the current cash sales price for the same or similar items of property,
goods, or services; or (4) the debt’s stated amount is materially different
from the debt’s fair value on the date of the transaction. If the
presumption is inapplicable, the issuer must use other methods to determine
the debt’s initial measurement (see Section
4.3.5.2).
If the terms of a debt instrument include embedded features
or components that must be recognized separately from the debt (e.g., any
bifurcated embedded derivative under ASC 815-15), the amount attributed to
such features or components is allocated out of the initial measurement
amount.
4.3.5.2 Circumstances in Which the Presumption Does Not Apply
ASC 835-30
05-3 This Subtopic provides
guidance for the appropriate accounting when the
face amount of a note does not reasonably represent
the present value of the consideration given or
received in the exchange. This circumstance may
arise if the note is non-interest-bearing or has a
stated interest rate that is different from the rate
of interest appropriate for the debt at the date of
the transaction. Unless the note is recorded at its
present value in this circumstance, the sales price
and profit to a seller in the year of the
transaction and the purchase price and cost to the
buyer are misstated, and interest income and
interest expense in subsequent periods are also
misstated.
25-2 If determinable, the
established exchange price (which, presumably, is
the same as the price for a cash sale) of property,
goods, or service acquired or sold in consideration
for a note may be used to establish the present
value of the note. When notes are traded in an open
market, the market rate of interest and quoted
prices of the notes provide the evidence of the
present value. These methods are preferable means of
establishing the present value of the note.
25-10 In circumstances where
interest is not stated, the stated amount is
unreasonable, or the stated face amount of the note
is materially different from the current cash sales
price for the same or similar items or from the fair
value of the note at the date of the transaction,
the note, the sales price, and the cost of the
property, goods, or service exchanged for the note
shall be recorded at the fair value of the property,
goods, or service or at an amount that reasonably
approximates the fair value of the note, whichever
is the more clearly determinable. That amount may or
may not be the same as its face amount, and any
resulting discount or premium shall be accounted for
as an element of interest over the life of the
note.
If the stated rate of interest on debt issued in exchange for property, goods, or services does not represent fair and adequate compensation for the debtor’s use of funds, the issuer should determine whether price information is available for the property, goods, services, or debt. Such information would include current cash sales prices for the same or similar items of property, goods, or services or, if the debt is traded in an open market, the debt’s quoted price or market rate of interest. Paragraph 28 of FASB Concepts Statement 7 states, in part:
In the absence of a cash transaction, accountants turn to other
techniques for the initial measurement of an asset or liability, but
the measurement objective remains the same. The process begins by
determining whether others have bought or sold the same or similar
items in recent cash transactions.
If price information exists, the debt is initially measured
at whichever amount more clearly represents the fair value of the property,
goods, services, or debt. Any difference between the stated principal amount
and the initial measurement amount is presented as a discount or premium
(see Section
4.3.6). If there is no price information, the debt is
initially measured at the present value of its principal and interest
payments, discounted by using an imputed interest rate (see the next
section).
4.3.5.3 Imputed Interest Rate
ASC Master Glossary
Imputed Interest Rate
The interest rate that results from a process of
approximation (or imputation) required when the
present value of a note must be estimated because an
established exchange price is not determinable and
the note has no ready market.
ASC 835-30
10-1 The objective of the
guidance in this Subtopic is to approximate the rate
for a note that would have resulted if an
independent borrower and an independent lender had
negotiated a similar transaction under comparable
terms and conditions with the option to pay the cash
price upon purchase or to give a note for the amount
of the purchase that bears the prevailing rate of
interest to maturity.
25-3 If an established
exchange price is not determinable and if the note
has no ready market, the problem of determining
present value is more difficult. To estimate the
present value of a note under such circumstances, an
applicable interest rate is approximated that may
differ from the stated or coupon rate. This process
of approximation is called imputation, and the
resulting rate is called an imputed interest rate.
Nonrecognition of an apparently small difference
between the stated rate of interest and the
applicable current rate may have a material effect
on the financial statements if the face amount of
the note is large and its term is relatively
long.
25-11 In the absence of
established exchange prices for the related
property, goods, or service or evidence of the fair
value of the note (as described in paragraph
835-30-25-2), the present value of a note that
stipulates either no interest or a rate of interest
that is clearly unreasonable shall be determined by
discounting all future payments on the notes using
an imputed rate of interest. This determination
shall be made at the time the note is issued,
assumed, or acquired; any subsequent changes in
prevailing interest rates shall be ignored.
25-12 Paragraph 835-30-10-1
identifies the objective of the guidance in this
Subtopic for approximating an interest rate. The
variety of transactions encountered precludes any
specific interest rate from being applicable in all
circumstances. However, this paragraph provides the
following general guidelines:
-
The choice of a rate may be affected by the credit standing of the issuer, restrictive covenants, the collateral, payment and other terms pertaining to the debt, and, if appropriate, the tax consequences to the buyer and seller.
-
The prevailing rates for similar instruments of issuers with similar credit ratings will normally help determine the appropriate interest rate for determining the present value of a specific note at its date of issuance.
-
In any event, the rate used for valuation purposes shall be the rate at which the debtor can obtain financing of a similar nature from other sources at the date of the transaction.
25-13 The selection of a rate
may be affected by many considerations. For
instance, where applicable, the choice of a rate may
be influenced by the following:
-
An approximation of the prevailing market rates for the source of credit that would provide a market for sale or assignment of the note
-
The prime or higher rate for notes that are discounted with banks, giving due weight to the credit standing of the maker
-
Published market rates for similar-quality bonds
-
Current rates for debentures with substantially identical terms and risks that are traded in open markets
-
The current rate charged by investors for first or second mortgage loans on similar property.
In determining the initial measurement of debt, an entity uses an imputed
interest rate if all of the following conditions are met:
-
The debt was issued in exchange for property, goods, or services and does not represent a trade payable or other obligation that is exempt from ASC 835-30 (see Section 4.3.2).
-
Any of the following apply: (1) the debt has no stated interest; (2) the stated interest rate is unreasonable (e.g., it does not reflect the general level of interest rates or the issuer’s creditworthiness); (3) the debt’s stated amount is materially different from the current cash sales price for the same or similar items of property, goods, or services; or (4) the debt’s stated amount is materially different from the debt’s fair value on the date of the transaction.
-
There are no established exchange prices for the property, goods, or services.
-
The debt is not quoted in the open market.
The imputed rate represents an estimate of the interest rate at which the
issuer could obtain financing of a similar nature from other sources. In
other words, it is the rate that an independent borrower and lender would
negotiate on the issuance date in a cash transaction under comparable terms
and conditions.
Although ASC 835-30 does not explicitly describe how an entity uses an
imputed rate to determine the debt’s present value as a fair value
measurement, the FASB has affirmed that the fair value measurement guidance
in ASC 820 related to the application of present value techniques applies to
such measurements.
In estimating the imputed rate, the issuer would consider
information about observed rates of interest for comparable debt as of the
transaction date. Whether debt for which observable data are available can
be compared depends on the debt’s characteristics such as the amount and
timing of the contractual cash flows, the issuer’s creditworthiness (e.g.,
published credit rating), the seniority or subordination of the debt,
collateral and other credit enhancements, restrictive covenants, tax
treatment for the issuer and the holder, and any embedded features (e.g.,
put or call options).
If there is no debt instrument with substantially the same characteristics as
the debt, the issuer might determine the imputed rate by using a build-up
method that takes into account observable data related to the risk-free
yield curve and credit spreads for similar debt, adjusted as appropriate for
differences in the debt’s characteristics. In a manner similar to the
objective of a fair value measurement, the issuer should maximize the use of
observable inputs (e.g., quoted prices or rates in active markets for
similar debt and inputs that are derived principally or corroborated by
observable market data) and minimize the use of unobservable inputs.
Entities that determine the present value of debt by using
an imputed rate may need to apply the guidance in ASC 820 related to
discount rate adjustment techniques (ASC 820-10-55-10 through 55-12), the
build-up method (ASC 820-10-55-33 and 55-34), the effect of an entity’s
credit standing (ASC 820-10-55-57 and 55-57A), and the application of
present value techniques to debt obligations (ASC 820-10-55-85 through
55-89). For additional discussion of the application of fair value
measurement techniques, see Deloitte’s Roadmap Fair Value Measurements and Disclosures
(Including the Fair Value Option).
Once the imputed rate has been determined, the issuer
discounts the debt’s contractual cash flows by using that rate and
recognizes the debt at its present value. Any difference between the debt’s
present value and stated amount is presented as a discount or premium (see
the next section).
4.3.6 Discounts and Premiums
ASC Master Glossary
Discount
The difference between the net proceeds, after expense,
received upon issuance of debt and the amount repayable
at its maturity. See Premium.
Premium
The excess of the net proceeds, after expense, received
upon issuance of debt over the amount repayable at its
maturity. See Discount.
ASC 835-30
25-5 . . . The difference
between the face amount and the proceeds upon issuance
is shown as either discount or premium. For example, if
a bond is issued at a discount or premium, such discount
or premium is recognized in accounting for the original
issue. The coupon or stated interest rate is not
regarded as the effective yield or market rate.
Moreover, if a long-term non-interest-bearing note or
bond is issued, its net proceeds are less than face
amount and an effective interest rate is based on its
fair value upon issuance.
25-9 The difference between
the face amount and the present value upon issuance is
shown as either discount or premium.
45-1A The discount or
premium resulting from the determination of present
value in cash or noncash transactions is not an asset or
liability separable from the note that gives rise to it.
Therefore, the discount or premium shall be reported in
the balance sheet as a direct deduction from or addition
to the face amount of the note. Similarly, debt issuance
costs related to a note shall be reported in the balance
sheet as a direct deduction from the face amount of that
note. The discount, premium, or debt issuance costs
shall not be classified as a deferred charge or deferred
credit.
When the stated principal or face amount of a debt instrument differs from its
initial carrying amount, a discount or premium arises. Under the interest
method, a discount or premium is amortized over the debt’s life, typically to
interest expense (see Sections 6.2 and
14.2.4).
Example 4-1
Issuance of Debt at a Discount
Entity D issues long-term debt with a principal amount of
$100 million at a 2 percent discount to par for cash
proceeds of $98 million. It makes the following
entries:
Premiums and discounts are valuation accounts that do not exist
separately from the related debt (i.e., they are not separate units of account).
Therefore, an entity is not permitted to present premiums and discounts as
assets or liabilities that are separate from the debt. Instead, debt discounts
are treated as deductions from, and debt premiums are treated as additions to,
the carrying amount of the debt to which they are related.
Economically, reasons for the existence of a discount or premium may include the following:
-
The debt’s stated interest rate differs from the market rate of interest for the instrument upon issuance. For example, if debt with a coupon rate of 6 percent is issued when the market rate of interest for similar debt is 5 percent, issuance of the debt at a premium to par would be expected since investors would be willing to invest an amount in excess of the principal amount to compensate for the above-market coupon rate. Conversely, if the market rate of interest exceeds the stated coupon rate upon issuance, issuance of the debt at a discount to par would be expected.
-
The debt is a zero-coupon instrument that pays no interest during its life. Zero-coupon instruments are generally issued at a discount to par; the discount represents compensation for the time value of money over the debt’s life.
-
The debt was issued with other freestanding financial instruments. For instance, ASC 470-20 requires the proceeds received for debt issued with detachable warrants (see Section 3.4.3.2) to be allocated between the debt and the warrants, resulting in a discount on the debt even if the transaction proceeds were equal to the principal amount of the debt.
-
The debt contains an embedded component that must be separated, such as an embedded derivative under ASC 815-15 (e.g., a bifurcated put, call, or conversion feature; see Chapter 8). For example, if debt was issued at par and contains an embedded redemption feature that must be bifurcated as a derivative liability under ASC 815-15, a debt discount would arise for accounting purposes.
-
The debt contains an embedded feature that is not accounted for separately from the debt. For instance, if the stated interest rate equals the market rate of interest for nonconvertible debt, but the debt contains a conversion feature that is not required to be accounted for separately from the debt, an investor should be willing to purchase the debt at a premium to par. (Note, however, that a substantial premium to par may need to be recognized in equity under ASC 470-20-25-13; see Section 7.6.)
-
The debtor paid a fee to the creditor as part of the debt issuance.
-
The debt is designated as a hedged item in a fair value hedging relationship under ASC 815-25, and the carrying amount has been adjusted for changes in fair value as a result of the application of fair value hedge accounting (see Section 14.2.1.2).
If the stated interest rate on a debt instrument is fixed at different levels
during the life of the debt or includes an interest-free period, a discount or
premium to the principal amount could arise after the initial recognition of the
debt even if the debt was issued at par. For example, if a debt instrument has
an increasing interest rate (or an initial interest-free period), the
application of the interest method (see Chapter 6) by using a constant effective interest rate would be
expected to result in the creation of a premium during the term of the debt.
4.4 Debt Subject to the Fair Value Option
4.4.1 Background
ASC 825-10
05-5 The Fair Value Option
Subsections of this Subtopic address both of the
following:
-
Circumstances in which entities may choose, at specified election dates, to measure eligible items at fair value (the fair value option)
-
Presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities.
Under ASC 825-10, entities can elect the fair value option to
account for certain financial assets and financial liabilities at fair value.
For a comprehensive discussion of this guidance, see Chapter 12 of Deloitte’s Roadmap Fair Value Measurements and
Disclosures (Including the Fair Value Option). The
sections below summarize the fair value option requirements that apply to items
within the scope of this Roadmap.
4.4.2 Scope
ASC 825-10
15-4 All entities may elect
the fair value option for any of the following eligible
items:
-
A recognized financial asset and financial liability, except any listed in the following paragraph
-
A firm commitment that would otherwise not be recognized at inception and that involves only financial instruments (for example, a forward purchase contract for a loan that is not readily convertible to cash — that commitment involves only financial instruments — a loan and cash — and would not otherwise be recognized because it is not a derivative instrument)
-
A written loan commitment . . . .
15-5 No entity may elect the
fair value option for any of the following financial
assets and financial liabilities: . . .
e. Deposit liabilities, withdrawable on demand,
of banks, savings and loan associations, credit
unions, and other similar depository
institutions.
f. Financial instruments that are, in whole or
in part, classified by the issuer as a component
of shareholders’ equity (including temporary
equity).
An entity may elect the fair value option for any eligible item
within the scope of ASC 825-10. Unless a specific scope exception applies, debt
represents an eligible item for which the issuer may elect the fair value
option. Under ASC 825-10-15-4(b), the fair value option is available to a holder
of an unrecognized loan commitment provided that the commitment (1) meets the
definition of a firm commitment (e.g., the terms include a disincentive for
nonperformance that is sufficiently large to make performance probable) and (2)
involves only financial instruments (see Section 2.3.4). A loan commitment does not
meet the definition of a firm commitment if it includes subjective provisions
that permit either party to rescind it (e.g., it permits the potential lender to
rescind its commitment in the event of a material adverse change in the holder’s
financial condition or performance).
The ability to elect the fair value option does not depend on whether (1) its
application serves to mitigate volatility in reported earnings that would
otherwise arise as a result of measuring items on different bases or (2) the
entity manages and monitors performance of an item on a fair value basis. The
ability to elect the fair value option for a debt instrument is also not
predicated on the reliability of the fair value measurement; however, the inputs
used for such measurement must reflect market participant assumptions (including
adjustments that market participants demand for the risk associated with
unobservable inputs or the valuation technique used to determine fair value). In
addition, entities are required to disclose the categorization of fair value
measurements within the fair value hierarchy, including whether significant
inputs to those measurements are observable or unobservable.
The fair value option is not available for financial instruments
that are, in whole or in part, classified by the issuer as a component of
shareholders’ equity (including temporary equity). Thus, the fair value option
cannot be elected for convertible debt issued at a substantial premium to par
for which an equity component has been recognized under ASC 470-20-25-13. An
entity also cannot elect the fair value option for deposit liabilities,
withdrawable on demand, of banks, savings and loan associations, credit unions,
and other similar depository institutions. Instead, such liabilities are
accounted for under ASC 942-405.
4.4.3 Election Dates
ASC 825-10
25-1 This Subtopic permits all
entities to choose, at specified election dates, to
measure eligible items at fair value (the fair value
option).
25-2 The decision about whether
to elect the fair value option:
-
Shall be applied instrument by instrument, except as discussed in paragraph 825-10-25-7
-
Shall be irrevocable (unless a new election date occurs, as discussed in paragraph 825-10-25-4)
-
Shall be applied only to an entire instrument and not to only specified risks, specific cash flows, or portions of that instrument.
An entity may decide whether to elect
the fair value option for each eligible item on its
election date. Alternatively, an entity may elect the
fair value option according to a preexisting policy for
specified types of eligible items.
25-4 An entity may choose to
elect the fair value option for an eligible item only on
the date that one of the following occurs:
a. The entity first recognizes the eligible
item.
b. The entity enters into an eligible firm
commitment. . . .
e. An event that requires an eligible item to
be measured at fair value at the time of the event
but does not require fair value measurement at
each reporting date after that . . . .
25-5 Some of the events that
require remeasurement of eligible items at fair value,
initial recognition of eligible items, or both, and
thereby create an election date for the fair value
option as discussed in paragraph 825-10-25-4(e) are:
-
Business combinations, as defined in Subtopic 805-10
-
Consolidation or deconsolidation of a subsidiary or VIE
-
Significant modifications of debt, as defined in Subtopic 470-50.
An issuer is permitted to elect the fair value option for a debt instrument on
the date on which (1) the debt is first recognized, or (2) an event occurs that
causes the debt to be remeasured at fair value under GAAP at the time of the
event but does not result in a requirement to apply subsequent fair value
measurement (e.g., a business combination). Once an entity elects the fair value
option, it may not revoke fair value accounting unless a new election date
occurs.
The determination of whether a debt modification or exchange
qualifies as a remeasurement event for the borrower depends on whether the debt
is treated as a new debt instrument under ASC 470-50 (see Section 10.4.2). If
modification accounting is applied, the debt is considered to reflect the
continuation of the original contract and a new election date is not available.
If extinguishment accounting applies, the new debt instrument is eligible to be
elected under the fair value option at its initial recognition. If a debt
modification or exchange represents a TDR (see Chapter 11), the debt instrument is not
considered a new instrument and, therefore, a new election date for the fair
value option is not available. For additional discussion of election dates, see
Section 12.3.2
of Deloitte’s Roadmap Fair
Value Measurements and Disclosures (Including the Fair Value
Option).
While ASC 825 provides little guidance on the documentation an entity must
maintain to support its election of the fair value option, it indicates that the
decision to elect the fair value option should be made as of the election date
for each eligible item. Entities also have the flexibility to establish an
automatic election policy for certain eligible items of an identical or similar
nature. In deciding to permit entities to elect the fair value option, the FASB
noted that maintaining evidence of compliance with the election requirements of
ASC 825 is a matter of internal control. In all scenarios, an entity must
support its fair value option election under ASC 825 with appropriate concurrent
documentation that eliminates any question regarding whether the entity elected
to apply fair value measurement to a particular instrument.
4.4.4 Level of Aggregation
ASC 825-10
25-7 The fair value option
may be elected for a single eligible item without
electing it for other identical items with the following
four exceptions:
-
If multiple advances are made to one borrower pursuant to a single contract (such as a line of credit or a construction loan) and the individual advances lose their identity and become part of a larger loan balance, the fair value option shall be applied only to the larger balance and not to each advance individually. . . .
25-10 The fair value option
need not be applied to all instruments issued or
acquired in a single transaction (except as required by
paragraph 825-10-25-7(a) through (b)). For example,
investors in shares of stock and registered bonds might
apply the fair value option to only some of the shares
or bonds issued or acquired in a single transaction. For
this purpose, an individual bond is considered to be the
minimum denomination of that debt security.
25-11 A financial instrument
that is legally a single contract may not be separated
into parts for purposes of applying the fair value
option. In contrast, a loan syndication arrangement may
result in multiple loans to the same borrower by
different lenders. Each of those loans is a separate
instrument, and the fair value option may be elected for
some of those loans but not others.
Generally, an entity can elect the fair value option on an
instrument-by-instrument basis. Thus, an entity can elect it for a debt
instrument without doing so for other separate but identical debt instruments if
they represent separate units of account (see Section
3.3). Further, ASC 825-10-25-10 specifies that an entity might
elect the fair value option for only some of the bonds issued in a single
transaction and that, “[f]or this purpose, an individual bond is considered to
be the minimum denomination of that debt security.”
If a group of lenders jointly fund a loan to a single borrower and each lender
loans a specific amount to the borrower and has the right to demand repayment
from the borrower, the loan from each lender is considered separate and distinct
from the loans from other lenders even if each of the loans forms part of the
same overall loan syndication agreement (see Section
10.3.2.4). Thus, ASC 825-10-25-11 permits election of the fair
value option for each loan in a loan syndication arrangement in which the loans
are made to the same borrower by different lenders.
However, under ASC 825-10-25-11, a “financial instrument that is legally a single
contract may not be separated into parts for purposes of applying the fair value
option.” For example, a debt host contract that remains after the separation of
an embedded financial derivative under ASC 815-15 (e.g., convertible debt with a
bifurcated conversion feature) is not eligible for the fair value option.
Nevertheless, the entire hybrid financial instrument is eligible for the fair
value option provided that no specific exception applies to the instrument.
Example 4-2
Unit of Account for Fair Value Option Election
Purposes — Debt
Entity E enters into, and documents in the same contract,
a debt instrument with a $1 million principal amount and
a warrant on 100,000 shares of common stock with a
single investor. Since the warrant is legally detachable
and separately exercisable, the debt instrument and
warrant individually represent freestanding financial
instruments (i.e., the debt instrument is considered an
individual contract under ASC 825-10-25-11).
Accordingly, E could apply the fair value option to its
liability related to the $1 million debt instrument
provided that it is not subject to any of the fair value
option exceptions in ASC 825-10-15-5. The warrant would
be separately evaluated as a liability or equity
instrument under other applicable U.S. GAAP (e.g., ASC
480, ASC 815, and ASC 815-40).
However, E could not apply the fair value option to only
$500,000 of the $1 million principal amount of debt
because the entire principal amount represents a single
unit of account and ASC 825-10-25-11 prohibits the
election of the fair value option for only a portion of
the amount of an individual bond. If, however, E had
entered into the contract with 10 different investors,
it could individually make the fair value option
election for the $1 million principal amount of the debt
component of each of the 10 different contracts (e.g.,
it could elect the fair value option for the $1 million
debt component related to five investors and not elect
the fair value option for the $1 million debt component
for the other five investors).
An entity that can make multiple debt draws under a single credit facility (e.g.,
a line of credit or tranche debt financing) cannot apply the fair value option
to each draw individually if, as described in ASC 825-10-25-7(a), such draws
“lose their identity and become part of a larger loan balance.”
Example 4-3
Unit of Account for Fair Value Option Election
Purposes — Line of Credit
Entity F has a $5 million line-of-credit agreement with
Bank A. On March 1, 20X7, F draws $500,000 on its line
of credit and chooses not to elect the fair value
option. On April 1, 20X7, F draws another $1 million.
Because the $1 million is added to the $500,000 and
becomes part of the larger balance, the fair value
option may not be elected for the $1 million. When F
chose not to elect the fair value option for the
$500,000, it also chose not to elect the fair value
option for any subsequent draws on that line of credit.
Under ASC 825-10-25-4, that election is irrevocable
unless a new election date occurs.
An entity cannot separately elect the fair value option for the accrued interest
on a debt instrument, nor can it elect the fair value option and exclude the
accrued interest component. (Accrued interest simply represents one or more
future interest cash flows of the debt.) Rather, in accordance with ASC
825-10-25-2(c), the entity must either (1) elect the fair value option for an
interest-bearing financial asset or financial liability that includes any
accrued interest or (2) not elect the fair value option for any component of an
interest-bearing financial asset or financial liability.
Section 3.3.3.3 discusses the unit of
account for a liability issued with an inseparable third-party credit
enhancement.
4.4.5 Initial Measurement
ASC 820-10
30-1 The fair value
measurement framework, which applies at both initial and
subsequent measurement if fair value is required or
permitted by other Topics, is discussed primarily in
Section 820-10-35. This Section sets out additional
guidance specific to applying the framework at initial
measurement.
30-2 When an asset is
acquired or a liability is assumed in an exchange
transaction for that asset or liability, the transaction
price is the price paid to acquire the asset or received
to assume the liability (an entry price). In contrast,
the fair value of the asset or liability is the price
that would be received to sell the asset or paid to
transfer the liability (an exit price). Entities do not
necessarily sell assets at the prices paid to acquire
them. Similarly, entities do not necessarily transfer
liabilities at the prices received to assume them.
30-3 In many cases, the
transaction price will equal the fair value (for
example, that might be the case when on the transaction
date the transaction to buy an asset takes place in the
market in which the asset would be sold). . . .
30-3A When determining
whether fair value at initial recognition equals the
transaction price, a reporting entity shall take into
account factors specific to the transaction and to the
asset or liability. For example, the transaction price
might not represent the fair value of an asset or a
liability at initial recognition if any of the following
conditions exist:
-
The transaction is between related parties, although the price in a related party transaction may be used as an input into a fair value measurement if the reporting entity has evidence that the transaction was entered into at market terms.
-
The transaction takes place under duress or the seller is forced to accept the price in the transaction. For example, that might be the case if the seller is experiencing financial difficulty.
-
The unit of account represented by the transaction price is different from the unit of account for the asset or liability measured at fair value. For example, that might be the case if the asset or liability measured at fair value is only one of the elements in the transaction (for example, in a business combination), the transaction includes unstated rights and privileges that are measured separately, in accordance with another Topic, or the transaction price includes transaction costs.
-
The market in which the transaction takes place is different from the principal market (or most advantageous market). For example, those markets might be different if the reporting entity is a dealer that enters into transactions with customers in the retail market, but the principal (or most advantageous) market for the exit transaction is with other dealers in the dealer market.
30-6 If another Topic
requires or permits a reporting entity to measure an
asset or a liability initially at fair value and the
transaction price differs from fair value, the reporting
entity shall recognize the resulting gain or loss in
earnings unless that Topic specifies otherwise.
35-3 A fair value
measurement assumes that the asset or liability is
exchanged in an orderly transaction between market
participants to sell the asset or transfer the liability
at the measurement date under current market
conditions.
When an entity elects to measure debt (or another eligible item)
under the fair value option, it initially measures it at fair value in
accordance with ASC 820. That guidance stipulates that the fair value represents
an exit price under the assumption that an asset is sold or a liability or
equity instrument is transferred (assumed) in an orderly transaction between
unrelated market participants under current market conditions. In many cases,
the transaction price for an asset, liability, or equity instrument equals its
fair value upon initial recognition. However, in certain situations, it is not
appropriate to assume that the transaction price (which is an entry price) is
the initial fair value (which is an exit price) of an asset, liability, or
equity instrument.
Accordingly, if an issuer elects to measure debt at fair value, it needs to
assess whether the debt proceeds represent the fair value at inception and
consider whether one or more of the factors in ASC 820-10-30-3A are present.
Section 3.3 addresses situations in
which the unit of account for the transaction price of debt differs from the
unit of account for fair value accounting purposes.
In many cases, it is inappropriate to record an inception gain
or loss as of the date of initial recognition. At the 2006 AICPA Conference on
Current SEC and PCAOB Developments, then SEC Professional Accounting Fellow
Joseph McGrath stated the following:
[W]e have heard that some believe that it is “open
season” on inception gains. I would caution those constituents that
there continue to be many instances in which day one gains are not
appropriate. [ASC 820] does not allow the practice of “marking to model”
when the transaction occurs in the entity’s principal market. Rather,
transaction prices would generally be used in such a circumstance, and
the model would be calibrated to match transaction price.
Mr. McGrath’s remarks indicate that if none of the factors in ASC 820-10-30-3A
are present, the transaction price is most likely the best estimate of fair
value. However, if any of the criteria in ASC 820-10-30-3A are met, there may be
a difference between the transaction price and fair value. For example, ASC
820-10-30-3A(c) indicates that the transaction price might not represent fair
value at initial recognition if “the transaction price includes transaction
costs.” That might be the case in a transaction that includes a structuring
fee.
For a discussion of the evaluation of situations in which the fair value exceeds
the debt proceeds received, see Section
3.4.3.1.
Chapter 5 — Accounting for Debt Issuance Costs and Fees
Chapter 5 — Accounting for Debt Issuance Costs and Fees
5.1 Background
Entities generally incur costs and fees related to the issuance of debt. Further, an
entity might incur fees and costs to secure a commitment to obtain debt financing in
the future. This chapter discusses the accounting for such costs and fees.
5.2 Qualifying Debt Issuance Costs
ASC 470-20
45-1A Transaction costs incurred
with third parties other than the investor(s) and that
directly relate to the issuance of convertible debt
instruments within the scope of this Subtopic shall be
reported in accordance with the guidance in Section
835-30-45.
SEC Staff Accounting Bulletins
SAB Topic 5.A, Expenses of Offering [Reproduced in ASC
340-10-S99-1]
Facts: Prior to the effective date of
an offering of equity securities, Company Y incurs certain
expenses related to the offering.
Question: Should such costs be
deferred?
Interpretive Response: Specific
incremental costs directly attributable to a proposed or
actual offering of securities may properly be deferred and
charged against the gross proceeds of the offering. However,
management salaries or other general and administrative
expenses may not be allocated as costs of the offering and
deferred costs of an aborted offering may not be deferred
and charged against proceeds of a subsequent offering. A
short postponement (up to 90 days) does not represent an
aborted offering.
Nonauthoritative AICPA Guidance
Technical Q&As Section 4110, “Issuance of Capital
Stock”
.01 Expenses Incurred in Public Sale of Capital
Stock
Inquiry — A closely held corporation is issuing stock
for the first time to the public.
How would costs, such as legal and accounting fees, incurred
as a result of this issue, be handled in the accounting
records?
Reply — Direct costs of obtaining capital by issuing
stock should be deducted from the related proceeds, and the
net amount recorded as contributed stockholders’ equity.
Assuming no legal prohibitions, issue costs should be
deducted from capital stock or capital in excess of par or
stated value.
Such costs should be limited to the direct cost of issuing
the security. Thus, there should be no allocation of
officers’ salaries, and care should be taken that legal and
accounting fees do not include any fees that would have been
incurred in the absence of such issuance.
Debt issuance costs are specific incremental costs and fees that are
(1) paid to third parties and (2) directly attributable to the issuance of a debt
instrument. They exclude costs and fees paid to the creditor, which represent a
reduction of the debt proceeds (see Section 5.3.3.2). Costs and
fees that would have been incurred irrespective of whether there is a proposed or
actual offering do not qualify as debt issuance costs. Thus, debt issuance costs
represent costs and fees incurred with third parties that result directly from and
are essential to the financing transaction and would not have been incurred by the
issuer had the financing transaction not occurred.
SAB Topic 5.A (reproduced in ASC 340-10-S99-1) addresses the accounting for expenses
related to an offering of equity securities and is applicable by analogy to debt
issuance costs. Under this guidance, allocated management salaries and other general
and administrative expenses do not represent issuance costs. Further, if a proposed
offering is aborted (including the postponement of an offering for more than 90
days), the associated costs do not represent issuance costs of a subsequent
offering.
AICPA Technical Q&As Section 4110.01 addresses the accounting for expenses
incurred in a public sale of capital stock and is applicable by analogy to debt
issuance costs. Under this guidance, issuance costs are limited to the direct costs
of issuing the security. Legal and accounting fees that would have been incurred
irrespective of whether the instrument was issued do not represent issuance costs of
that instrument.
The table below lists examples of costs and fees that may or may not qualify as debt
issuance costs.
|
Qualifying Costs if Directly Attributable to
Debt Issuance1
|
Nonqualifying Costs
|
|---|---|
|
|
Connecting the Dots
At the 2023 AICPA & CIMA Conference on Current SEC and PCAOB
Developments, Mr. Carlton Tartar spoke about a fact pattern addressed by the
SEC staff in which a registrant proposed treating costs related to the
initial preparation and auditing of its financial statements as deferred
offering costs because the financial statements were prepared for the sole
purpose of pursuing an IPO. The staff ultimately objected to the
registrant’s proposed accounting because although the registrant needed to
obtain audited financial statements to pursue an IPO, audited financial
statements may be obtained for various other reasons. As a result, the staff
did not view these costs as being directly attributable to the planned
offering.
In accordance with these views, costs incurred with accountants to obtain
audited financial statements would not be viewed as incremental costs that
are directly attributable to the issuance of a debt instrument, unlike other
costs incurred with accountants, which may be considered directly
attributable to such an issuance.
Footnotes
1
Note that such costs may qualify as
debt issuance costs only if they are incurred before
the debt is issued. If costs incurred after an
issuance of debt were not obligations as of the
issue date, they cannot qualify as debt issuance
costs.
5.3 Costs and Fees Associated With Nonrevolving Debt
5.3.1 Background
Before nonrevolving debt is issued, qualifying costs and fees associated with the
contemplated issuance are deferred as an asset (see Section
5.3.2), including any loan commitment fees paid to the creditor
(see Section 5.3.3). Upon the debt’s issuance, the costs to
issue it are presented as a deduction from the debt’s net carrying amount in a
manner similar to a debt discount (see Section
4.3.6). Fees paid to the creditor are treated as a reduction of
the debt proceeds received, not as a debt issuance cost (see Section
5.3.3.2). Debt issuance costs associated with nonrevolving debt
are amortized to interest expense over the life of the related debt in a manner
similar to a debt discount (see Chapter
6).
The guidance in this section does not apply to debt for which
the issuer has elected the fair value option in ASC 815-15 (see Section 8.5.6) or ASC
825-10 (see Section
4.4). If a transaction involves multiple units of account, the
issuer should allocate the related issuance costs among those units of account
(see Section
3.5).
5.3.2 Accounting for Costs and Fees Incurred Before Debt Issuance
5.3.2.1 General
Entities often incur fees and costs in connection with a
debt issuance before the recognition of the debt liability (e.g., document
preparation costs, legal fees, and commitment fees). ASC 835-30 does not
address the balance sheet presentation of such fees and costs. In developing
ASU 2015-03, the FASB considered but ultimately decided against providing
guidance on the accounting for costs incurred before the receipt of debt
proceeds. Paragraph BC4 of ASU 2015-03 states, in part:
The Board acknowledges that costs may be incurred
before an associated debt liability is recorded in the financial
statements (for example, the costs are incurred before the proceeds
are received on a debt liability or costs incurred in association
with undrawn line of credit). However, the Board did not consider
providing explicit guidance in circumstances in which the proceeds
have not yet been received because it observed that in practice
entities defer issuance costs and apply them against the proceeds
when they are received. For example, the accounting treatment for
issuance costs associated with equity instruments is that the costs
generally are deferred and charged against the gross proceeds of the
offering (paragraph 340-10-S99-1).
Entities should present specific incremental costs and fees that are directly
attributable to a contemplated issuance of debt as a deferred charge (i.e.,
an asset) before the issuance of the debt. This treatment applies to
eligible costs and fees paid to the creditor and third parties even though
amounts paid to the creditor ultimately represent a reduction of proceeds as
opposed to debt issuance costs. It would be inappropriate to record a
contra-liability when there is no associated liability. On the date on which
the issued debt is recognized as a liability, the carrying amount of the
deferred charge is reclassified as a reduction of the initial carrying
amount of the debt unless those costs and fees are attributable to a
line-of-credit or revolving-debt arrangement (see Section 5.4). Costs and fees paid to third parties are
treated as debt issuance costs (see Section
5.3.3.1), whereas costs and fees paid to the creditor are
treated as a direct deduction from the proceeds (see Section
5.3.3.2).
If an entity incurs fees and costs in connection with a
contemplated debt issuance and it becomes probable that the debt will not be
issued, the entity should immediately expense any related costs and fees,
including any previously deferred costs, in a manner consistent with the
guidance on loss contingences in ASC 450-20-25-2 (see Deloitte’s Roadmap
Contingencies, Loss
Recoveries, and Guarantees). Similarly, any
previously deferred costs and fees should be expensed if a contemplated debt
offering is aborted (including an anticipated debt offering that is
postponed for more than 90 days; see Section 5.2).
5.3.2.2 Nonrevolving Loan Commitment Fees
An entity may incur costs and fees to obtain a nonrevolving loan commitment.
Such expenses are sometimes paid in a form other than cash. For instance,
start-up and emerging companies that have limited cash resources often issue
contracts on their own equity in exchange for commitments to obtain debt
financing (e.g., warrants that vest on the basis of debt draws).
As discussed in Section 2.3.3, a commitment to obtain
debt financing usually is exempt from derivative accounting requirements in
accordance with the scope exception in ASC 815-10-15-69. It is generally
appropriate for an entity to defer fees and costs it has paid for a
commitment to obtain nonrevolving debt as an asset until the related debt is
drawn. The potential debtor’s deferral of loan commitment costs and fees as
an asset is analogous to the creditor’s treatment of fees received for a
loan commitment under ASC 310-20-25-11, which generally requires commitment
fees to be deferred.
Example 5-1
Warrant Issued in Exchange for Delayed-Draw Term
Loan Commitment
Company A executes a delayed-draw
term loan agreement with Bank B, which permits, but
does not require, A to draw up to $125 million of
term loans in five separate tranches of $25 million
each on specified future dates. Company A determines
that its commitment to obtain term loans from B
should not be accounted for as a derivative under
ASC 815. Instead, the loan commitment represents an
asset. In exchange for the commitment, A agrees to
issue a warrant that allows B to purchase shares of
A’s common stock. The warrant is issuable and only
exercisable by B if A elects to obtain term loan
funding from B. The number of shares that A will
deliver to B upon exercise of the warrant is indexed
to the principal amount of term loans issued under
the agreement. Company A has determined that the
warrant issued to B is a single freestanding
financial instrument (see Chapter 3).
Under ASC 815-40, the warrant is
outstanding for accounting purposes even though it
is contingent on debt draws and is not legally
issued until such debt draws occur (see Section
2.8 of Deloitte’s Roadmap Contracts on an Entity’s Own
Equity). Company A determines that
the warrant is not within the scope of ASC 480 since
it does not embody an obligation of A (see Section
2.2.1.3 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity); that is, A is under no
obligation to draw debt and the warrant does not
become issued or exercisable unless A issues debt
under the agreement. However, because the amount of
debt draws is not an input into the pricing of a
fixed-for-fixed option on A’s own equity, the
warrant does not qualify as equity under ASC
815-40-15 (see Section 4.3.3 of
Deloitte’s Roadmap Contracts on an Entity’s
Own Equity) but must be recognized
by A as a liability initially and subsequently at
its fair value (see Section 6.2 of
Deloitte’s Roadmap Contracts on an Entity’s
Own Equity). Company A determines
that the initial fair value of the warrants is $1.5
million. Accordingly, A makes the following
accounting entry to recognize its loan commitment
asset (it is assumed in this entry that the initial
fair value of the warrant equals the initial value
of the loan commitment asset):
Note that in this example, the warrant is considered a
freestanding financial instrument, which is
generally the case for these types of arrangements.
If, however, the warrant was considered embedded in
the loan commitment, the warrant would be bifurcated
from the loan commitment host contract and
recognized as a derivative liability unless it did
not meet the definition of a derivative. An entity
would not be able to apply the loan commitment scope
exception to the warrant because this scope
exception could only be applied to the host
contract.
If all or a portion of the total commitment amount is funded, a proportionate
amount of the commitment asset reduces the initial net carrying amount of
the funded debt. This accounting treatment is different from that for
revolving loan commitment fees, which are deferred and amortized as an asset
over the term of the revolving debt (see Section 5.4).
Example 5-2
Funding of Delayed-Draw Term Loan
Commitment
After obtaining the delayed-draw
term loan commitment described in Example
5-1, Company A requests and obtains $25
million of term loan funding from Bank B. Company A
continues to have a right to obtain funding of $100
million from B in accordance with the terms of the
commitment. Accordingly, A reclassifies as debt
discount a portion of the amount originally deferred
as a loan commitment asset. The amount reclassified
corresponds to the proportion of the amount of term
loan funding obtained compared with the total amount
of funding that was originally available under the
loan commitment, or $1,500,000 × ($25,000,000 ÷
$125,000,000). Company A recognizes the debt
discount as follows:
Since the warrant represents a unit of account that
is separate from the loan commitment, it continues
to be accounted for under ASC 815-40. If the warrant
represents a single unit of account, it will
continue to be accounted for in its entirety as a
liability at fair value, with changes in fair value
recognized in earnings. Such accounting is not
affected by the reclassification of a portion of the
loan commitment asset as debt discount.
Note that this example does not specifically address
A’s evaluation of whether any portion of the loan
commitment asset becomes impaired because A does not
expect to fund term loans under the debt
agreement.
If a term loan commitment is canceled or terminates, the
related commitment costs and fees are immediately expensed. Expense
recognition is also required if it becomes probable that (1) the debtor will
not meet all of the conditions that it must satisfy to draw down on a
commitment or (2) the creditor will not be financially capable of honoring
the commitment.
5.3.2.3 Shelf Registration Costs and Fees
Nonauthoritative AICPA Guidance
Technical Q&As Section 4110, “Issuance of
Capital Stock”
.10 Costs Incurred in Shelf
Registration
Inquiry — A public company incurs legal and
other fees in connection with an SEC filing for a
stock issue it plans to offer under a shelf
registration. How should the company account for
these costs?
Reply — The costs should be capitalized as a
prepaid expense. When securities are taken off the
shelf and sold, a portion of the costs attributable
to the securities sold should be charged against
paid in capital. Any subsequent costs incurred to
keep the filing “alive” should be charged to expense
as incurred. If the filing is withdrawn, the related
capitalized costs should be charged to expense.
A shelf registration permits a company to issue securities
in one or more separate future offerings, with the size and price determined
at the time of sale. AICPA Technical Q&As Section 4110.10 addresses the
accounting for “legal and other fees in connection with an SEC filing for a
stock issue [a public company] plans to offer under a shelf registration.”
It is appropriate to apply this guidance by analogy to the costs and fees
incurred by an entity to set up a shelf registration of debt securities.
Under the AICPA’s guidance, the initial shelf registration costs are
capitalized as a prepaid expense (i.e., deferred as an asset). When the
entity issues securities under the shelf, an appropriate portion of the
deferred costs is reclassified as a debt issuance cost of the issued debt.
For example, deferred costs might be allocated to current and future debt
offerings on the basis of estimates of the amount of debt the entity might
issue under the shelf over its expected life. Any subsequent costs to
maintain the shelf registration (i.e., to keep it “alive”) are charged to
expense as incurred. If the filing is withdrawn or expires, any remaining
capitalized costs should be immediately expensed. If an entity incurs costs
and fees in connection with a shelf registration but it becomes probable
that the entity will not use it, the entity should immediately expense any
related costs and fees, including any previously deferred costs, in a manner
consistent with the guidance on loss contingences in ASC 450-20-25-2 (see
Deloitte’s Roadmap Contingencies, Loss Recoveries, and
Guarantees).
5.3.2.4 Secondary Offering Costs
Contracts governing the sale of debt securities that are
sold in a private placement offering (a “primary offering”) often require
the issuer to register the securities with the SEC within a specified
period. It is common for these contracts to specify a penalty, such as a
higher interest rate for debt securities, for failure to complete the
registration. Registration of the securities is usually accomplished through
a secondary offering, which does not yield any proceeds.
The appropriate accounting for the specific incremental costs directly
attributable to the secondary offering (e.g., underwriting fees, attorneys’
fees, and accountants’ fees) depends on the circumstances. Informal
discussions with the SEC staff have indicated that the acceptable method of
accounting for the secondary offering costs depends on whether the terms of
the primary offering contractually require the issuer to effect a secondary
offering.
5.3.2.4.1 Contractual Obligation Is Present in Primary Offering
If, as of the date of the primary offering, the issuer is contractually
obligated to enter into a secondary offering (e.g., a registration
rights agreement), the obligation constitutes a liability for future
third-party registration costs that should be recognized as of the date
of the primary offering as an additional cost of the offering. The
issuer should estimate and defer as a debt issuance cost the specific
incremental costs of the secondary offering upon completion of the
primary offering (assuming that completion of the registration is deemed
to be probable within a reasonable period), as applicable.
This guidance is supported by the fact that the costs of the secondary
offering meet the definition of a liability upon completion of the
primary offering. Furthermore, recognition of the secondary offering
costs as an expense as of the date of the primary offering, or as
incurred, appears inconsistent with analogous guidance in ASC 825-20. In
accordance with ASC 825-20-30-4, “[i]f the transfer of consideration
under a registration payment arrangement is probable and can be
reasonably estimated at inception, the contingent liability under the
registration payment arrangement shall be included in the allocation of
proceeds from the related financing transaction” and not recorded as an
expense.
5.3.2.4.2 Contractual Obligation Is Not Present in Primary Offering
If there is no contractual obligation to enter into a secondary offering
as of the date of the primary offering, the two offerings are
disassociated and the costs of the secondary offering should be expensed
as incurred. This approach is supported analogously in SAB Topic 5.A,
which states, in part:
Specific incremental costs directly attributable to a proposed or
actual offering of [equity] securities may properly be deferred
and charged against the gross proceeds of the offering. However,
management salaries or other general and administrative expenses
may not be allocated as costs of the offering and deferred
costs of an aborted offering may not be deferred and
charged against proceeds of a subsequent offering. A
short postponement (up to 90 days) does not represent an aborted
offering. [Emphasis added]
In essence, SAB Topic 5.A requires consideration of whether transaction
costs have been incurred as part of a single, combined offering or as
the result of a separate, subsequent offering. If there is no
contractual obligation to have a secondary offering, entities should
treat the secondary offering as a separate subsequent offering. Because
the separate secondary offering does not result in additional proceeds
(i.e., no additional capital raising), the costs associated with the
secondary offering should be expensed as incurred. That is, the
secondary offering is the economic equivalent of an aborted
offering.
5.3.3 Accounting for Costs and Fees Upon Debt Issuance
5.3.3.1 Debt Issuance Costs
ASC 835-30
45-1A [D]ebt issuance
costs related to a note shall be reported in the
balance sheet as a direct deduction from the face
amount of that note. [D]ebt issuance costs shall not
be classified as a deferred charge . . . .
Debt issuance costs must be presented as a direct deduction
from the carrying amount of a debt liability once the debt is issued.
Therefore, such costs are treated in the same manner as a debt discount (see
Section
4.3.6).
Example 5-3
Initial Recognition of Debt Issuance Costs
Entity D issues long-term debt at par for cash
proceeds of $100 million. It incurs $1 million of
debt issuance costs. Therefore, D makes the
following entry:
Entities are not permitted to present debt issuance costs as
deferred charges (i.e., assets) unless the debt has not yet been issued (see
Section
5.3.2) or the costs are related to line-of-credit or
revolving-debt arrangements (see Section 5.4).
After the issuance of the debt, debt issuance costs are
amortized as additional interest expense over the life of the debt in a
manner similar to a debt discount (see Section
6.2) unless the issuer has elected the fair value option in
ASC 815-15 or ASC 825-10 for the debt, in which case any up-front costs and
fees are expensed as incurred (see Section 5.5).
5.3.3.2 Fees and Other Amounts Paid to the Creditor
Issuance costs are limited to incremental and direct costs
incurred with parties other than the investor (creditor). Although amounts
paid to both the creditor and third parties in connection with a debt
issuance reduce the debt’s initial net carrying amount, the distinction
between amounts paid to the creditor and amounts paid to third parties is
relevant in certain situations. For example, an entity treats amounts paid
to the creditor differently from amounts paid to a third party when it
evaluates whether a put or call option embedded in a debt host contract
should be bifurcated as a derivative (see Section 8.4.4). That evaluation
includes an assessment of whether a significant discount or premium exists.
Whereas creditor fees affect the size of any discount or premium,
third-party costs do not. Further, entities treat creditor fees and
third-party costs differently when evaluating and accounting for debt
modifications and extinguishments under ASC 470-50 (see Section 10.3.3.2.4).
Therefore, a debtor may need to distinguish and separately track the amount
of debt discounts and debt issuance costs.
Amounts paid to the creditor upon issuance represent a
reduction in the proceeds received. Accordingly, such amounts are treated as
an increase to a debt discount or a reduction in a debt premium and not as
an issuance cost. Examples of such amounts include origination fees,
commitment fees, reimbursement of the creditor’s expenses, and other amounts
paid to the creditor in connection with the issuance of the debt. Depending
on the relationship between the debtor and creditor, amounts paid to the
creditor could represent a dividend or other equity distribution (see
Section
3.3.3.4). An entity should use judgment and consider the
particular facts and circumstances when determining what these amounts
represent.
In some situations, an amount paid to a creditor may represent compensation
for services associated with the issuance of the debt to parties other than
the creditor. Such amounts may be appropriately characterized as debt
issuance costs. For example, some portion of the total fees paid to a lead
financial institution in a syndicated loan with multiple lenders (see
Section 10.3.2.4) may represent arrangement fees
associated with the placement of debt to other participating lenders (such
amounts represent debt issuance costs). Issuers of debt will need to use
judgment on the basis of the particular facts and circumstances to determine
whether a portion of fees paid to a lead bank should be treated as debt
issuance costs and, if so, how that amount is determined. In making this
determination, entities should be mindful that a lead bank may pass on fees
it receives to participating banks in a syndication. Such fees would not
represent debt issuance costs since the lead bank is merely functioning as
an agent to pass on fees to other lenders in the arrangement.
As another example, in some debt offerings the proceeds received are reduced
by an amount described as an “initial purchasers’ discount,” which is
payable to a bank that has helped arrange the offering. If the related
amount serves to compensate the bank for underwriting fees and the bank
immediately transfers the debt to third-party investors that pay the stated
principal amount without deduction for the initial purchasers’ discount, the
related amount represents a debt issuance cost. However, if the bank
continues to hold some or all of the debt or the ultimate investors receive
some or all of the discount through a reduction in the price they pay for
the debt, some or all of the amount represents a debt discount.
5.3.4 Accounting After Debt Issuance
ASC 835-30
45-3 Amortization of
discount or premium shall be reported as interest
expense in the case of liabilities or as interest income
in the case of assets. Amortization of debt issuance
costs also shall be reported as interest expense.
Unless a debt instrument is subsequently measured at fair value on a recurring
basis (see Section 5.5), any debt issuance costs reduce the instrument’s
initial net carrying amount in a manner similar to a debt discount (see
Section 4.3.6). Under ASC 835-30-45-3, both debt discount and
debt issuance costs must be amortized and reported as interest expense. Further,
ASC 470-50-40-18(a), which addresses the accounting for modifications and
exchanges of debt instruments (see Chapter 10), implies that debt issuance costs should be
amortized by using the interest method. It states, in part:
Costs incurred with third parties . . . shall be associated with the new
debt instrument and amortized over the term of the new debt instrument
using the interest method in a manner similar to debt issue costs.
Accordingly, entities should reflect eligible debt issuance
costs as an adjustment to the initial proceeds received in the calculation of
the debt’s original effective interest rate (see Section 6.2.3).
5.4 Costs and Fees Associated With Revolving Debt
ASC 835-30 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Presentation and Subsequent
Measurement of Debt Issuance Costs Associated With
Line-of-Credit Arrangements
S45-1 On April
7, 2015, the FASB issued Accounting Standards Update
2015-03, Interest — Imputation of Interest (Subtopic
835-30): Simplifying the Presentation of Debt Issuance
Costs, which requires entities to present debt
issuance costs related to a recognized debt liability as a
direct deduction from the carrying amount of that debt
liability. The guidance in Update 2015-03 (see paragraph
835-30-45-1A) does not address presentation or subsequent
measurement of debt issuance costs related to line-of-credit arrangements.
Given the absence of authoritative guidance within
Update 2015-03 for debt issuance costs related to
line-of-credit arrangements, the SEC staff would not
object to an entity deferring and presenting debt
issuance costs as an asset and subsequently
amortizing the deferred debt issuance costs ratably
over the term of the line-of-credit arrangement,
regardless of whether there are any outstanding
borrowings on the line-of-credit arrangement.
ASC 835-30-45-1A does not apply to costs incurred in connection with line-of-credit
or revolving-debt arrangements (whether drawn or undrawn). The terms of such
arrangements permit the amount of debt outstanding to fluctuate by giving the
borrower an option to borrow, repay, and reborrow amounts up to a specified maximum
amount (see Section 2.3.3). Economically,
issuance costs incurred are attributable to the overall credit facility rather than
any specific amount drawn.
At the June 18, 2015, EITF meeting, the SEC staff confirmed that ASC 835-30, as
amended by ASU 2015-03, “does not address the presentation and subsequent
measurement of debt issuance costs related to line-of-credit arrangements” and
announced that it would “not object to an entity deferring and presenting [such]
costs as an asset and subsequently amortizing the . . . costs ratably over the term
of the line-of-credit arrangement.” Accordingly, it would generally be appropriate
for an entity to present specific incremental costs and fees that are directly
attributable to a line of credit or other revolving-debt arrangement as a deferred
charge (i.e., an asset) notwithstanding the prohibition in ASC 835-30-45-1A against
classifying debt issuance costs as a deferred charge. The presentation of a deferred
charge is appropriate irrespective of whether such costs and fees are paid to the
creditor or third parties.
Generally, it is appropriate to use a straight-line method of amortizing such fees
and costs over the term of the arrangement because the SEC staff announcement refers
to amortizing such costs “ratably.” Further, straight-line amortization is supported
by analogy to the creditor’s accounting under ASC 310-20-55-8(c), which states:
The following amortization methods shall be applied to the associated types
of loan arrangements: . . .
c. Line of credit loans or arrangements with similar
characteristics: straight-line method.
Under the method outlined by the SEC staff on June 18, 2015, an entity presents
unamortized debt issuance costs associated with a line-of-credit or revolving-debt
arrangement as an asset even if the entity currently has a recognized debt liability
for amounts outstanding under the arrangement. Further, the entity amortizes such
costs over the life of the arrangement irrespective of whether it repays previously
drawn amounts.
Connecting the Dots
In some situations, it may be acceptable to amortize debt issuance costs of
revolving-debt agreements over the life of the outstanding debt as opposed
to over the commitment period. For example, assume that an entity enters
into an arrangement that allows it to issue revolving debt over a period of
three years. During this period, the entity may borrow, repay, and reborrow
up to $100 million of debt. At the end of the third year, the outstanding
amount of debt becomes a term loan that is repayable over five years. If the
following conditions are met, recognition of the debt costs over an
eight-year period would be acceptable:
- At the end of the third year, it is probable that the entity will have $100 million of debt outstanding that is repayable over a five-year period.
- There are no additional fees or costs incurred when the entity draws amounts on the arrangement, or the outstanding amount becomes a term loan repayable over a five-year period.
Once the outstanding debt becomes a term loan, the entity should use the
interest method to amortize the remaining unamortized debt issuance costs
over the debt’s five-year term.
This example does not address situations in which an entity incurs additional
fees and costs imposed by the lender over the life of the arrangement or in
which the amount of the term loan at the end of the revolving-debt period is
less than the maximum permitted outstanding debt.
The SEC staff announcement does not address whether other accounting policies might
be acceptable (e.g., reclassifying unamortized costs as a reduction of the related
liability once amounts are drawn). Entities are strongly encouraged to consult with
their accounting advisers before (1) electing an accounting policy that could result
in a write-off of remaining unamortized costs before the end of the arrangement’s
term or (2) presenting a negative liability balance for the arrangement (e.g., when
unamortized costs exceed the amount drawn or previously drawn amounts are
repaid).
The guidance in this section does not apply to debt for which the issuer has elected
the fair value option in ASC 815-15 or ASC 825-10 (see Section 5.5). If a transaction involves multiple units of account,
the issuer should allocate the related issuance costs among those units of account
(see Section 3.5).
For a discussion of the accounting for deferred costs and fees associated with a
line-of-credit or revolving-debt arrangement upon a modification or exchange of such
an arrangement, see Section 10.6.
5.5 Fair Value Option
ASC 825-10
25-3 Upfront costs and fees related
to items for which the fair value option is elected shall be
recognized in earnings as incurred and not deferred.
ASC 820-10
35-9B The price in the principal
(or most advantageous) market used to measure the fair value
of the asset or liability shall not be adjusted for
transaction costs. Transaction costs shall be accounted for
in accordance with other Topics. Transaction costs are not a
characteristic of an asset or a liability; rather, they are
specific to a transaction and will differ depending on how a
reporting entity enters into a transaction for the asset or
liability.
If an entity elects the fair value option in ASC 815-15 (see
Section 8.5.6) or
ASC 825-10 (see Section
4.4) for an item, it must recognize any up-front costs and fees in
earnings as incurred. This requirement is consistent with the guidance in ASC
820-10-35-9B, which indicates that transaction costs are not part of a fair value
measurement. As a result of the requirement to expense rather than defer up-front
costs and fees associated with accounting for debt at fair value by using the fair
value option, the reported amount of interest expense, if separately reported, will
differ from the amount that would be reported if the same liability is accounted for
by using the interest method.
Chapter 6 — Subsequent Accounting for Debt
Chapter 6 — Subsequent Accounting for Debt
6.1 Background
This chapter describes how an entity applies the interest method in
ASC 835-30 (see Section
6.2) and the fair value option in ASC 825-10 (see Section 6.3) to the
subsequent accounting for debt. The evaluation of whether features embedded in debt
must be separated and accounted for as derivatives under ASC 815-15 is addressed in
Chapter 8.
Chapter 7 discusses
specialized accounting models that apply to certain types of debt.
6.2 Interest Method
6.2.1 Background
ASC Master Glossary
Interest Method
The method used to arrive at a periodic interest cost
(including amortization) that will represent a level
effective rate on the sum of the face amount of the debt
and (plus or minus) the unamortized premium or discount
and expense at the beginning of each period.
ASC 835-30
25-5 The total amount of
interest during the entire period of a cash loan is
generally measured by the difference between the actual
amount of cash received by the borrower and the total
amount agreed to be repaid to the lender. . . .
Under the interest method, an entity uses present value techniques (see Section 4.3.3) to determine the net carrying
amount of the debt and the amount of periodic interest cost. The difference
between the net amount the debtor receives upon issuing debt and the aggregate
undiscounted amount it is required to pay as principal and interest over the
debt’s life represents the total interest cost on the debt. The total interest
cost over the debt’s life is allocated to individual reporting periods by using
the effective yield implicit in the debt’s contractual cash flows (see
Section 6.2.3.3). Through this allocation, any premium
or discount (see Section 4.3.6) and debt
issuance costs (see Section 5.3) are
amortized as interest cost over the debt’s life (see Section
6.2.4).
The debt’s net carrying amount at any point in time is the sum
of the present values of the debt’s remaining future principal and interest
payments, discounted at the debt’s effective interest rate. Other methods of
computing periodic interest cost may be used only if the results are not
materially different from those calculated under the interest method (see
Section
6.2.3.7). The issuer reports interest cost as interest expense unless
the cost qualifies for capitalization as borrowing costs under ASC 835-20 (see
Section
14.2.4). The scope of the interest method is addressed in the next
section.
6.2.2 Scope
ASC 835-30
45-1 The
guidance in this Section does not apply to the
amortization of premium and discount of assets and
liabilities that are reported at fair value and the debt
issuance costs of liabilities that are reported at fair
value.
55-1 The
guidance in the following paragraphs is not subject to
the scope limitation in paragraph 835-30-15-3(b).
55-2
Generally accepted accounting principles (GAAP) require
use of the interest method. . . .
Unless an issuer elects to account for a particular debt instrument under the
fair value option in ASC 815-15 (see Section 8.5.6) or ASC
825-10 (see Section 4.4), it must apply
the interest method to that debt, including the amortization of any debt
discount or premium and debt issuance costs. The interest method applies
irrespective of whether the debt has any stated interest (e.g., the interest
method applies to zero-coupon debt).
A debtor should evaluate whether features embedded in a debt contract (e.g.,
indexation, conversion, redemption, acceleration, extension, exchange, and
contingent payment features) must be separately accounted for as derivatives
under ASC 815-15 (see Chapter 8). When a
derivative has been bifurcated from a debt host contract, the interest method
applies to such contract but not to the embedded derivative (see Section 8.5). Further, an entity should evaluate
whether it can apply one of the special accounting models within GAAP for
certain types of debt, such as those for sales of future revenue, participating
mortgages, or indexed debt (see Chapter
7).
6.2.3 Interest Method Mechanics
6.2.3.1 Background
This section addresses the following topics:
-
The inputs necessary for application of the interest method (see Section 6.2.3.2).
-
The calculation of the effective interest rate under the interest method (see Section 6.2.3.3).
-
The calculation of periodic interest cost (see Section 6.2.3.4).
-
The calculation of the net carrying amount of debt under the interest method (see Section 6.2.3.5).
-
The accrual of interest cost between interest payment dates (see Section 6.2.3.6).
-
The use of alternative methods (see Section 6.2.3.7).
Further, Section 6.2.3.8 contains comprehensive examples
of the interest method’s application to the issuance of debt at a discount
and at a premium.
6.2.3.2 Inputs to the Interest Method
To apply the interest method, an entity must determine the debt’s initial net
carrying amount and the timing and amount of the debt’s contractual cash flows:
-
Initial net carrying amount — Chapter 4 discusses the initial measurement of debt, and Chapter 5 addresses the treatment of debt issuance costs. In the application of the interest method, the amount of proceeds and subsequent cash flows that are used to compute the effective interest rate are based on the amounts allocated to the debt host contract after separation of any embedded derivative (see Chapter 8) and any equity component (see Section 7.6).
-
Contractual cash flows — The timing and amount of the debt’s contractual cash flows are based on the debt’s contractual terms. The application of the interest method does not depend on whether such cash flows are designated as principal, interest, premium, discount, or fees.
Some debt instruments require the debtor to pay an exit fee or repayment
premium at maturity (e.g., 8 percent of the debt’s principal amount). If the
payment of such an amount is mandatory upon repayment of the debt, it should
be incorporated into the contractual cash flows that are used to apply the
interest method. However, an entity should evaluate exit fees and repayment
premiums that are contingent or variable to determine whether they must be
accounted for separately under ASC 815-15 (see Chapter 8) and, if not, whether special interest recognition
guidance applies (see Chapter 7).
Special considerations are necessary when the timing or amount of the cash
flows on debt is variable (see Sections 6.2.4 and
6.2.5).
The stated interest rate on debt may be fixed over the debt’s life; however,
some debt instruments have interest-free periods or different fixed rates
during the term of the debt. In these circumstances, proper application of
the interest method will result in a constant effective yield throughout the
entire term of the debt. Some debt instruments contain interest terms that
vary on the basis of a reference rate (e.g., a prime rate or benchmark rate)
and a margin. Section 6.2.5.2 discusses the application
of the interest method to variable-rate debt.
In the United States, interest on fixed-rate corporate bonds is often paid
semiannually in two equal installments. However, other payment frequencies
are also common (e.g., monthly, quarterly, or annually). For some debt
instruments (e.g., short-term commercial paper and zero-coupon bonds), no
periodic interest payments are made. Further, different day-count
conventions exist for determining the number of days between interest
payments. For example, under the contractual terms, it might be assumed that
a year has 360 days consisting of twelve 30-day months. Alternatively, it
might be assumed that a year has 365 days (or 366 days in a leap year). To
appropriately determine the timing and amount of a debt instrument’s
contractual cash flows, an entity should consider such terms and
conventions.
Typically, the application of the interest method is based on the contractual
cash flows produced until the debt’s contractual maturity date. However, a
shorter period may be appropriate for certain debt that is puttable by the
creditor before maturity (see Section 6.2.4.2).
6.2.3.3 Effective Interest Rate
The debt’s effective interest rate is the interest rate that
is implicit in the terms of the debt (i.e., the internal rate of return of
the debt’s initial carrying amount determined on the basis of the
contractual cash flows over the debt’s life). The effective interest rate
often differs from the debt’s stated interest rate because of premiums,
discounts, or debt issuance costs (see the previous section). The effective
interest rate would also differ from the stated rate on debt that has an
interest-free period or contains an interest rate that increases over the
debt’s life.
The effective interest rate
can be determined by using a software application (e.g., the internal rate
of return function in a spreadsheet program), a calculator, present value
tables, or iterative numerical techniques. Mathematically, the effective
interest rate is calculated by solving for the discount rate that equates
the debt’s initial net carrying amount to the contractual cash flows over
the debt’s life. Algebraically, this can be expressed as a discounted cash
flow equation in which P0 is the debt’s initial net
carrying amount, CFt is the debt’s principal and interest
cash outflows in each time period t until the final cash outflow in
time period T (i.e., t = 1, 2, 3, . . . , T), and
r is the effective interest rate that is used to discount those
cash flows:
Alternatively, if the
initial net carrying amount is treated as a negative cash outflow (i.e.,
P0 = –CF0), the equation can be
simplified as follows:
Example 6-1
Calculation of Effective Interest Rate
In December 20X0, Entity R receives
net proceeds of $940,000 for the issuance of a
one-year debt instrument with a stated principal
amount of $1 million that is repayable at maturity.
The debt instrument pays interest in arrears at a
stated annual rate of 10 percent of the principal
amount, payable quarterly in arrears. Accordingly, R
pays $25,000 at the end of each quarter, or ($1
million × 10%) ÷ 4. To determine the periodic
(quarterly) effective interest rate, R sets up the
following discounted cash flow equation:
As shown above, the quarterly
effective interest rate is 4.16 percent, or an
uncompounded annual effective rate of 16.64 percent.
The difference between the effective rate and the
cash interest paid equals the periodic amortization
of the discount on the debt.
6.2.3.4 Periodic Interest Cost
ASC 835-30
35-1 This Section provides
guidance for the measurement of interest income or
expense over the term of a note.
35-2 With respect to a
note for which the imputation of interest is
required, the difference between the present value
and the face amount shall be treated as discount or
premium and amortized as interest expense or income
over the life of the note in such a way as to result
in a constant rate of interest when applied to the
amount outstanding at the beginning of any given
period. This is the interest method.
35-3 The difference
between the periodic interest cost so calculated
using the interest method and the nominal interest
on the outstanding amount of the debt is the amount
of periodic amortization.
35-5 The amount chargeable
to interest expense under the guidance in this
Subtopic is eligible for inclusion in the amount of
interest cost capitalized in accordance with
Subtopic 835-20.
45-3 Amortization of
discount or premium shall be reported as interest
expense in the case of liabilities or as interest
income in the case of assets. Amortization of debt
issuance costs also shall be reported as interest
expense.
55-3 The interest method
produces periodic interest income at a constant
effective yield on a loan . . . .
Over the life of a debt instrument, the total amount of interest cost equals
the difference between the debt’s initial net carrying amount and the total
contractual payments owed. As a result of discounts, premiums, or debt
issuance costs, the amount that is reported as interest cost differs, both
cumulatively and in specific financial reporting periods, from the amount
contractually designated as interest cost.
To determine the periodic
amount of interest cost and the amortization of any discount, premium, or
debt issuance costs, an entity applies the effective interest rate to the
net carrying amount of the debt as of the beginning of the period. That is,
the amount of reported interest cost equals the product of (1) the net
carrying amount at the beginning of the period and (2) the periodic
effective interest rate.
In each financial reporting
period, any premium or discount (including debt issuance costs) is amortized
as an adjustment to interest cost. If the amount of interest actually paid
in cash differs from the amount of interest accrued, the difference is used
to adjust the amount of the remaining unamortized discount or premium.
The amortization of a debt discount increases reported interest cost relative
to the amount of interest paid, whereas the amortization of a debt premium
reduces reported interest cost.
Example 6-2
Amortization of Discount
Assume the same facts as in
Example 6-1
and that during the period between January 1, 20X1,
and March 31, 20X1, Entity R accrues $39,096
($940,000 × 0.0416) of interest cost even though it
pays only $25,000 of cash interest at the end of
that quarter. The difference of $14,096 reduces the
amount of the remaining unamortized discount (i.e.,
it increases the net carrying amount of the debt
instrument).
The full discount amortization schedule for R’s debt
instrument is shown below.
6.2.3.5 Net Carrying Amount
Under the interest method,
the debt’s net carrying amount at any point in time equals the sum of the
stated principal amount plus any remaining unamortized premium less any
remaining unamortized discount (including issuance costs). The debt’s net
carrying amount at the end of any financial reporting period can be
determined as follows:
Mathematically, the debt’s
net carrying amount at any point in time equals the present value of its
remaining future cash flows, discounted by using the debt’s effective
interest rate. Algebraically, this can be represented as follows (with
BV0 denoting the net carrying amount (“book value”) on
date t = 0):
Example 6-3
Calculation of Net Carrying Amount
Assume the same facts as in
Example 6-2. Immediately after the
interest payment on June 30, 20X1, Entity R
determines the debt’s net carrying amount by adding
the amount of the discount amortized (i.e., the
excess of interest expense accrued over interest
paid) to the net carrying amount at the beginning of
the period (i.e., $954,096 + $14,682 =
$968,778).
Alternatively, R can determine the net carrying
amount by calculating the present value of the
remaining cash flows, discounted by the effective
interest rate:
Although the carrying amount of a debt instrument for which the issuer has
not elected the fair value option in ASC 825-10 is not remeasured for
changes in its fair value, an adjustment to the net carrying amount is
required when a debt instrument is designated as a hedged item in a fair
value hedge (see Section 14.2.1.2). For a discussion of
foreign-denominated debt, see Section 14.2.3.
6.2.3.6 Accrual Between Payment Dates
If an entity issues financial statements between payment
dates, it must accrue interest payable and amortize any debt discount or
premium and debt issuance costs for the period since the last adjustment. In
practice, this allocation is sometimes performed on a straight-line basis.
However, if the effect of discounting would be material, the interest method
should be strictly applied to the adjustment.
Example 6-4
Accrual of Interest
Entity A issues a 15-year bond on March 31, 20X1, at
par for cash proceeds of $40 million. No debt
issuance costs were incurred. The stated coupon rate
is 5 percent per annum, payable semiannually in
arrears. Accordingly, A has an obligation to make
semiannual interest payments of $1 million
($40,000,000 × 5% × 0.5). Entity A makes the
following entry on March 31:
Because the bond was issued at par and no debt
issuance costs were incurred, the stated rate equals
the effective interest rate that is used to
recognize interest expense for financial reporting
purposes. During the period from March 31 to
September 30, A accrues interest of $1 million as
follows:
On September 30, A makes its first semiannual
interest payment of $1 million and the following
entry:
On December 31, A issues financial
statements. On a straight-line basis, A accrues
interest of $500,000 ($1,000,000 × 0.5) for the
period from October 1 to December 31:1
Under a time-proportionate
application of the interest method, A would have
accrued interest of $502,762 for the period from
September 30 to December 31, or $1,000,000 × (91 ÷
181 days). Such an approach is an appropriate
application of the interest method since interest
compounds only semiannually in this example. If,
however, interest compounded daily, the interest
rate was not constant throughout the life of the
instrument, or the debt was a zero coupon
instrument, A would be required to strictly apply
the interest method if it differed significantly
from the straight-line method or time-proportionate
method.
6.2.3.7 Use of Alternative Methods
6.2.3.7.1 General
ASC 835-30
35-4 Other methods of
amortization may be used if the results obtained
are not materially different from those that would
result from the interest method.
55-1 The guidance in the
following paragraphs is not subject to the scope
limitation in paragraph 835-30-15-3(b).
55-2 . . . There is no basis
for using an alternative to the interest method
except if the results of alternative methods do
not differ materially from those obtained by using
the interest method. Therefore, methods other than
the interest method, such as the rule of 78s, sum
of the years’ digits, and straight-line methods
shall not be used if their results materially
differ from the interest method.
55-3 The interest method
produces periodic interest income at a constant
effective yield on a loan; therefore, in a lending
arrangement in which interest collected in earlier
periods will be greater than that computed using
the interest method, the excess interest collected
shall be deferred and recognized as interest
income in later periods so as to produce a
constant yield. For example, the interest method
would be applied in this way to loans for which
interest is collected by the sum of the years’
digits method.
In determining the amount of interest to be recognized in each financial
reporting period, an entity may use an approach other than the interest
method (e.g., straight-line amortization) only if the results would not
be materially different from those calculated by using the interest
method. The interest method must be applied even if the contractual
terms of the debt instrument require the use of a different means of
allocating payments between amounts designated as principal repayments
and those designated as interest payments.
Generally, the total amount of interest reported over the entire life of
a debt instrument should not differ on the basis of the method used to
recognize interest in individual periods, but the amounts reported in
each individual period may be different. For example, straight-line
amortization of a debt discount results in greater amortization in
earlier periods and lower amortization in later periods than the
interest method. If an entity uses an approach other than the interest
method, it must assess whether the results are materially different in
each individual period. If the results are materially different in any
individual period, the interest method must be applied.
6.2.3.7.2 Straight-Line Amortization
Under the straight-line method, any debt discount or premium and debt
issuance costs for a nonamortizing loan are amortized in equal periodic
amounts over the life of the debt instrument. For example, if the debt
discount for a five-year $1,000 loan is $25, a fifth of that amount ($5)
is amortized to interest expense each year. This differs from the
interest method, which typically requires entities to amortize discounts
at an increasing amount over time and amortize premiums at a decreasing
amount over time. Under the interest method, the amount of discounts or
premiums amortized in each period differs because a constant effective
interest rate is applied to a changing net carrying amount that is
updated over time for the amortization of discounts or premiums. As
discussed in Section 6.2.3.7.1, use of the straight-line method for
amortizing debt discounts and debt premiums is acceptable only if the
results are not materially different from those calculated under the
interest method.
Example 6-5
Interest Method Compared With Straight-Line
Method
Under the straight-line method, the discount
amortization schedule is as follows for a
two-and-a-half year $100,000 debt instrument that
was issued for net proceeds of $95,000 and has a
stated coupon rate of 12 percent per annum,
payable semiannually in arrears:
Under the interest method, the discount
amortization schedule for the same debt instrument
is as follows:
6.2.3.7.3 Rule of 78s
Another alternative
method identified in ASC 835-30-55-2 for calculating principal and
interest portions of debt is the rule of 78s. Under this method, an
entity first calculates the sum of the digits (SD) for the number of
remaining payments scheduled to be made by the debtor over the debt’s
life. For example, for a six-month loan that will be repaid in six equal
monthly installments, the SD is 21 (1 + 2 + 3 + 4 + 5 + 6 = 21). The SD
can also be determined by using the following formula in which N
is the total number of payments:
The method is called the rule of 78s because the SD for
a loan that will be repaid in 12 monthly payments is 78, or [12 × (12 +
1)] ÷ 2 = 78.
Next, the entity determines the total amount of interest to be paid over
the life of the instrument by calculating the difference between the
original principal amount and the total amount to be repaid over the
life of the instrument. For example, if an entity borrows $12,000 and
the total amount to be repaid is $12,600, the total amount of interest
to be paid over the life of the loan is $600.
The amount of interest attributable to each period is
determined by multiplying the total amount of interest over the life of
the instrument by the fraction of the SD that is attributable to each
period. For example, the fraction of the SD that is attributable to the
first month of a six-month loan is 0.285 (6 ÷ 21 = 0.285).
As discussed in Section 6.2.3.7.1, use of the rule of 78s for amortizing
debt discounts and debt premiums is acceptable only if the results are
not materially different from those calculated under the interest
method.
Example 6-6
Interest Method Compared With Rule of 78s
Method
Under the rule of 78s, the computation of
interest for a six-month loan of $12,000 that will
be repaid in six equal monthly installments
totaling $12,600 is as follows:
Under the interest method, the entity would
compute the amount of interest on the basis of the
effective interest rate, which is approximately
1.41 percent per month. This results in the
following amortization schedule:
6.2.3.7.4 Sum-of-the-Years’-Digits Method
Another alternative method identified in ASC 835-30-55-2 is the
sum-of-the-years’-digits (SYD) method. The SYD method is similar to the
rule of 78s except that the digits used to allocate total interest cost
over the debt’s life do not represent the number of remaining payments
but rather the number of remaining years. The amount of interest
attributable to each year is calculated by multiplying the total amount
of interest over the instrument’s life by the fraction of the SYD that
is attributable to each year of the debt’s life. Although ASC 835-30
refers to the SYD method as a potential alternative to the interest
method for determining the amount of interest expense, it is more
commonly known as an accelerated method for the depreciation of the
deductible cost of a nonfinancial asset over its useful life for tax
purposes. As discussed in Section 6.2.3.7.1, use of the SYD method is acceptable
only if the results are not materially different from those calculated
under the interest method.
6.2.3.8 Comprehensive Examples
Example 6-7
Debt Issued at Discount
Entity D issues a 10-year $100 million bond on March
31, 20X1, at a 4 percent discount for proceeds of
$96 million. Further, D incurs debt issuance costs
of $1 million. The stated coupon rate is 10 percent
per annum, payable semiannually in arrears.
Accordingly, D has an obligation to make semiannual
interest payments of $5 million. It makes the
following entry on March 31, 20X1:
Because the bond was issued at a discount and debt
issuance costs were incurred, the stated interest
rate differs from the effective interest rate. By
solving for the rate that equates the initial net
proceeds to the future contractual interest and
principal cash flows (see Section 6.2.3.3), D determines that
the periodic (semiannual) effective interest rate
equals 5.42 percent. During the period from March 31
to September 30, A accrues interest of $5,144,694
($95,000,000 × 5.42% = $5,144,694) and makes the
following journal entry:
On September 30, 20X1, D makes its first semiannual
interest payment and recognizes the following
entry:
During the period from September 30,
20X1, to March 31, 20X2, D accrues interest of
$5,152,530 [($95,000,000 + $144,694) × 5.42% =
$5,152,530] and makes the following entry:
On March 31, 20X2, D makes its second semiannual
interest payment and recognizes the following
entry:
The full discount amortization schedule for D’s bond
is shown below.
Example 6-8
Debt Issued at a Premium
Entity P issues a five-year $10 million bond on March
31, 20X1, at a 4 percent premium for proceeds of
$10.4 million. Further, P incurs debt issuance costs
of $100,000. The stated coupon rate is 12 percent
per annum, payable semiannually in arrears.
Accordingly, P has an obligation to make semiannual
interest payments of $600,000. Entity P makes the
following entry on March 31, 20X1:
Because the bond was issued at net premium, the
stated interest rate differs from the effective
interest rate. By solving for the rate that equates
the initial net proceeds to the future contractual
interest and principal cash flows, P determines that
the periodic (semiannual) effective interest rate
equals 5.6 percent. During the period from March 31
to September 30, P accrues interest of $576,809
($10,300,000 × 5.6% = $576,809) as follows:
On September 30, 20X1, P makes its first semiannual
interest payment and recognizes the following
entry:
During the period from September 30, 20X1, to March
31, 20X2, P accrues interest of $575,510
[($10,300,000 – $23,191) × 5.6% = $575,510] as
follows:
On March 31, 20X2, P makes its second semiannual
interest payment and recognizes the following
entry:
The full premium amortization schedule for P’s bond
is shown below.
6.2.4 Amortization Period
6.2.4.1 General
ASC 835-30
35-2 With respect to a
note for which the imputation of interest is
required, the difference between the present value
and the face amount shall be treated as discount or
premium and amortized as interest expense or income
over the life of the note in such a way as to result
in a constant rate of interest when applied to the
amount outstanding at the beginning of any given
period. This is the interest method.
Although ASC 835-30-35-2 specifies that a discount or
premium should be amortized over the debt’s “life,” it does not explicitly
address whether life refers to the contractual term or some shorter period.
In practice, life has been interpreted to mean the debt’s full stated
contractual term unless the debt is puttable by the creditor at an amount in
excess of its accreted value before its stated maturity date (see the next
section). Special amortization guidance applies to extendable
increasing-rate debt (see Section 6.2.4.5).
6.2.4.2 Puttable Debt Involving a Discount
For debt issued at a discount that is puttable by the
creditor at an amount in excess of its accreted value (e.g., at an amount
equal to or in excess of its stated principal amount), the debtor should
amortize any debt discount and issuance costs from the date of issuance to
the earliest stated date on which the creditor has a noncontingent right to
exercise its put option. This means that in the calculation of the effective
interest rate, it should be assumed that the debtor exercises the put
option. From the debtor’s perspective, this is the highest possible yield
that it could be forced to pay if the circumstances do not change. This
guidance is supported by analogy to the requirement in ASC
480-10-S99-3A(15)(a) to accrete changes in the redemption value of
redeemable securities classified in temporary equity to the earliest
redemption date (see Section 9.5.2.3 of Deloitte’s Roadmap Distinguishing Liabilities
From Equity).
If debt becomes immediately due and payable because a mandatory redemption
feature is triggered, any remaining unamortized debt discount and debt
issuance costs should be recognized immediately as an expense. If a
contingent put right is triggered (or it becomes probable that it will be
triggered) so that the creditor obtains the right to exercise it (e.g., a
creditor’s right to accelerate the repayment of debt upon a debt covenant
violation), the debtor should assess whether it is necessary to accelerate
the amortization of any remaining unamortized debt discount and issuance
costs. If there is a reasonable likelihood that the creditor will not
exercise the put feature (e.g., because the creditor has waived the debt
covenant violation), continued amortization over the debt’s full contractual
term may be appropriate.
If the holder’s ability to exercise a put option is contingent on
circumstances beyond its control but the holder is expected to obtain the
unilateral ability to exercise it, it is acceptable to amortize discounts
and issuance costs over the period until the holder is expected to obtain
such unilateral ability. If the creditor does not have a unilateral right to
put the debt back to the company as of a specified date or on specified
dates (e.g., the exercise of the put is contingent on an uncertain future
event outside the creditor’s control) and it is not probable that the put
right will become exercisable by the creditor, any debt discount and debt
issuance costs should be amortized over the debt’s full contractual term. If
debt is puttable at an amount less than its accreted value (e.g., a put
option with a strike price that is less than the amount of net proceeds
received), amortization of the discount over the full contractual term would
also be appropriate since the debtor would not be paying the creditor for
any discount or issuance costs upon the exercise of the put.
Example 6-9
Puttable Debt Issued at a Discount
Entity D issues a 10-year $60 million debt instrument
on March 31, 20X1, at a 6 percent discount for net
cash proceeds of $56.4 million. The stated coupon
rate is 8 percent per annum, payable semiannually in
arrears. Accordingly, D has an obligation to make
semiannual interest payments of $2.4 million.
The holder has the unconditional
right to put the debt back to D at par at any time
after five years; therefore, the debt discount
should be amortized over five years to ensure that
its carrying amount is equal to the redemption
amount on the earliest redemption date. Entity D
computes the effective interest rate on the basis of
a five-year life and determines that the periodic
effective interest rate is 4.77 percent. The
discount amortization schedule for D’s debt is shown
below:
6.2.4.3 Puttable Debt Involving a Premium
For debt that is issued at a premium to par and puttable by the creditor at
an amount less than its accreted value (e.g., par), the debt premium should
be amortized over the contractual life of the debt. It would not be
appropriate to recognize the debt premium as a reduction of interest expense
from the date of issuance to the earliest stated redemption date. ASC
450-30-25-1 provides analogous guidance:
A contingency that might result in a gain usually should not be
reflected in the financial statements because to do so might be to
recognize revenue before its realization.
Example 6-10
Puttable Debt Issued at a Premium
Entity R issued debt at a premium with a 10-year
term. The holder has the unconditional right to put
the debt back to the company at par at any time
after five years. Entity R should amortize the debt
premium over the 10-year contractual life of the
debt.
6.2.4.4 Callable Debt
Any discount or premium for debt that is prepayable or callable by the debtor
(but is not puttable by the creditor) should be amortized over the
contractual term of the debt (i.e., the debtor should not assume that it
will exercise its call option).
Example 6-11
Callable Debt Issued at a Discount
Entity C issued two nonconvertible debt instruments.
Both instruments have a 10-year term and were issued
at a discount. The entity can call each debt
instrument at par at any time after five years. The
first debt instrument has an interest rate that
“steps up” during the contractual term of the debt
from 6 percent to 12 percent. The second debt
instrument has an interest rate that is variable for
five years and then becomes fixed for the remaining
term. Neither of the debt instruments is puttable by
the investor. For each instrument, C should amortize
the related debt discount and any issuance cost over
the full contractual term to the debt’s maturity.
Note that the application of the interest method to
the debt with the interest rate step-up must take
into account the contractual interest rate terms
throughout the contractual life of the
instrument.
6.2.4.5 Extendable Increasing-Rate Debt
ASC 470-10
35-1 A debt instrument may
have a maturity date that can be extended at the
option of the borrower at each maturity date until
final maturity. In such cases, the interest rate on
the note increases a specified amount each time the
note is renewed. For guidance on accounting for
interest, see Subtopic 835-30.
35-2 The borrower’s
periodic interest cost shall be determined using the
interest method based on the estimated outstanding
term of the debt. In estimating the term of the
debt, the borrower shall consider its plans,
ability, and intent to service the debt. Debt issue
costs shall be amortized over the same period used
in the interest cost determination. The
term-extending provisions of the debt instrument
should be analyzed to determine whether those
provisions constitute an embedded derivative that
warrants separate accounting as a derivative under
Subtopic 815-10.
45-8 If the debt is paid
at par before its estimated maturity, any excess
interest accrued shall be an adjustment of interest
expense.
An exception to the requirement to amortize discounts and premiums over the
contractual term applies to certain extendable increasing-rate debt
instruments. (This guidance does not apply to debt with a term extension
option that must be bifurcated as a derivative instrument under ASC 815-15;
see Section 8.4.5.) In accordance with ASC 470-10-35-2,
if a debt instrument has a contractual maturity date that can be extended at
the issuer’s option at an increasing interest rate, the debt discounts and
issuance costs must be amortized over the period in which the debt is
estimated to be outstanding even if that period extends beyond the debt’s
original contractual maturity date. That is, the effective interest rate is
calculated on the basis of the estimated term of the debt.
If extendable increasing-rate debt is repaid at par before its estimated
maturity, the issuer should not recognize a debt extinguishment gain for any
excess interest accrued. Instead, ASC 470-10-45-8 requires the debtor to
derecognize the excess interest accrued by adjusting the amount of reported
interest expense.
Example 6-12
Increasing-Rate Debt
Entity E issues a 90-day debt instrument at par for
proceeds of $100 million. The interest rate is 5
percent per annum. Entity E has an option to extend
the term for 90 days in each quarter at an
increasing interest rate. If the term is extended,
the interest rate increases by 0.5 percent in each
quarter during the first year and 0.25 percent in
each quarter after the first year. The estimated
outstanding term of the debt is two years. Entity E
determines that, if a two-year life is assumed, the
effective (quarterly) interest rate under ASC
470-10-35-2 is 1.6 percent. The interest recognition
schedule for this debt instrument is as follows:
Even though debt with a borrower extension option (at an increased interest
rate) is economically similar to a debt instrument with an interest rate
that steps up over time and that the borrower may call before maturity, the
guidance in ASC 470-10-35 does not apply to such callable debt. The guidance
in ASC 470-10-35 on extendable increasing-rate debt represents an exception
to the general interest recognition guidance in ASC 835-30. Discounts,
premiums, and issuance costs related to callable, increasing-rate debt are
amortized over the contractual term to maturity (see Section 6.2.4.4).
Example 6-13
Callable Increasing-Rate Debt
Entity C issues a note that is economically similar
to Entity E’s note in Example 6-12. However, C structures
the note as a callable five-year increasing-rate
note instead of a three-month instrument extendable
at an increasing interest rate. Entity C issues the
note at par for proceeds of $100 million. The
initial interest rate is 5 percent per annum,
payable quarterly. The interest rate increases by
0.5 percent in each quarter during the first year
and 0.25 percent in each quarter after the first
year. Under the call option, C has the right to
prepay the debt at any time at par. The estimated
outstanding term of the debt is two years. Entity C
determines that the effective (quarterly) interest
rate computed under ASC 835-30 is approximately 1.97
percent. The interest recognition schedule for this
note is as follows:
Connecting the Dots
ASC 470-10 does not specifically address whether an
issuer of extendable increasing-rate debt that uses the interest
method should periodically update the debt’s estimated life.
However, since ASC 470-10-45-8 acknowledges that there could be
excess accrued interest as of the date such debt is repaid, we
believe that there is no requirement for entities to reassess the
estimated life that was determined on the debt’s issuance date.
However, it would also be appropriate for an entity that uses the
interest method to elect, as an accounting policy, to continually
update the estimated life of extendable increasing-rate debt
provided that the entity makes any necessary adjustments to periodic
interest expense by applying a retrospective method (i.e., the
cumulative interest cost reported in any financial reporting
period-end is based on the updated effective yield).
6.2.5 Debt With Contingent or Variable Cash Flows or Other Unique Features
6.2.5.1 Background
Some debt instruments contain contractual features that
could affect the timing or amount of the contractual cash flows or the
settlement method (e.g., cash or equity shares). Such adjustments may be at
the option of the counterparty (e.g., a put or redemption feature) or
contingent on the occurrence or nonoccurrence of an event (e.g.,
noncompliance with a debt covenant). They may also be based on a price
(e.g., a commodity or equity price), appraised value (e.g., mortgaged real
estate), index (e.g., a stock market index), rate (e.g., consumer price
index [CPI]), or other measure (e.g., the issuer’s revenue, the cash flows
from a mortgaged real estate project, or the cash flows from a pool of
receivables). An entity should evaluate these types of features to determine
whether they must be separated from the instrument as derivatives under ASC
815-15 (see Chapter
8).
If ASC 815-15 does not require the separation of such a
feature and the issuer has not elected to account for the debt at fair value
under ASC 815-15 (see Section 8.5.6) or ASC 825-10 (see Section 4.4), the application of the
interest method may need to be altered. Special accounting models apply to
certain types of debt such as puttable debt (see Section 6.2.4.2), extendable
increasing-rate debt (see Section 6.2.4.5), sales of future revenue (see Section 7.2),
participating mortgages (see Section 7.3), indexed debt (see
Section
7.4), and convertible debt (see Section 7.6). The application of the
interest method to variable-rate debt is addressed in Section 6.2.5.2 and
to paid-in-kind (PIK) interest in Section 6.2.5.3. If no other
accounting literature is applicable, the debtor should consider the guidance
on loss contingencies in ASC 450-20 (see Section 6.2.5.4) and gain
contingencies in ASC 450-30 (see Section 6.2.5.5) to determine whether
any accounting is required before a payment occurs. However, a debtor should
accrue interest on the basis of the amounts that are contractually due even
if the debtor is unable, or expects to be unable, to pay some or all of
those amounts (see Section
6.2.5.6). Special considerations related to the application
of the interest method to nonrecourse beneficial interest obligations are
addressed in Section
6.2.5.7.
6.2.5.2 Variable-Rate Debt
If the stated interest rate of a debt instrument varies on the basis of
changes in a reference interest rate index (such as the prime rate or
benchmark interest rate), the debtor generally should accrue amounts
designated in the debt agreement as interest in accordance with the interest
rate in effect in each period as it changes over the debt’s life. ASC
470-30-35-3, which addresses participating mortgages (see Section
7.3.5), states, in part:
Amounts designated in the mortgage agreement as interest shall be
charged to income in the period in which the interest is incurred.
If the loan’s stated interest rate varies based on changes in an
independent factor, such as an index or rate (for example, the prime
rate, the London Interbank Offered Rate [LIBOR], or the U.S.
Treasury bill weekly average rate), the calculation of the interest
shall be based on the factor (the index or the rate) as it changes
over the life of the loan.
The definition of the interest method suggests that periodic interest cost is
determined on the basis of a level effective rate (see Section 6.2.1). Because the interest cash flows of
variable-rate debt vary in accordance with changes in a reference rate,
however, the application of a constant discount rate to the remaining
estimated cash flows could result in the recognition of significant gains
and losses that do not reflect changes in the debt’s outstanding amount.
Therefore, it is not appropriate to recognize interest payments that vary on
the basis of a reference interest rate by using an effective interest rate
that is frozen at inception (although a frozen effective yield may be used
to amortize a discount, a premium, or debt issuance costs, as discussed
below).
If variable-rate debt has an associated discount or premium or debt issuance
costs, an entity may amortize such amounts by using an amortization schedule
that is fixed at inception on the basis of the reference rate that was in
effect when the debt was first recognized. ASC 310-20 contains analogous
guidance on the application of the interest method to the recognition of net
fees and costs associated with the origination or acquisition of a loan
asset that has a stated interest rate that varies on the basis of changes in
an independent factor such as the prime rate. That guidance permits an
entity to either freeze the effective interest rate at inception or
continually update it as the factor changes over the loan’s life as long as
the method selected is applied consistently over the loan’s life. ASC
310-20-35-18(c) and ASC 310-20-35-19 state, in part:
If the loan’s stated interest rate varies based on future changes in
an independent factor, such as an index or rate (for example, the
prime rate, the London Interbank Offered Rate [LIBOR], or the U.S.
Treasury bill weekly average rate), the calculation of the constant
effective yield necessary to recognize fees and costs shall be based
either on the factor (the index or rate) that is in effect at the
inception of the loan or on the factor as it changes over the life
of the loan.
[The] lender may not change from one alternative to the other during
the life of the loan. The lender must select one of the two
alternatives and apply the method consistently throughout the life
of the loan.
6.2.5.3 PIK Interest
ASC Master Glossary
Payment-in-Kind
Bonds
Bonds in which the issuer has the
option at each interest payment date of making
interest payments in cash or in additional debt
securities. Those additional debt securities are
referred to as baby or bunny bonds. Baby bonds
generally have the same terms, including maturity
dates and interest rates, as the original bonds
(parent payment-in-kind bonds). Interest on baby
bonds may also be paid in cash or in additional
like-kind debt securities at the option of the
issuer.
Some debt instruments include a PIK interest feature that
requires or permits interest to be satisfied through the issuance of an
equivalent principal amount of additional debt instruments with the same
terms as the original debt instrument. The following are two types of such
PIK interest payment features:
-
On each interest payment date, the issuer satisfies the interest payment obligation by issuing to the holder(s) additional debt instruments that have the same terms as the original debt instrument (i.e., additional fungible securities).
-
On each interest payment date, the issuer increases the principal amount of the original debt instrument to reflect the interest accrued to the benefit of the holder. If the debt is convertible into equity shares, there is a proportionate increase in the number of such shares that will be issued upon exercise of the conversion feature. Economically, other than with respect to potential differences attributable to the compounding terms of an instrument, the PIK feature has the same effect as delivering additional debt instruments with the same terms as the original debt instrument.
Certain PIK interest rate features must be separated as
derivatives under ASC 815 (see Section 8.4.6). Otherwise, the
accounting for PIK features depends on whether they are discretionary or
nondiscretionary. A PIK feature in a nonconvertible debt instrument is
considered nondiscretionary if neither the issuer nor the holder can elect
other forms of payment for the interest (e.g., the interest must be paid in
kind and neither party can elect another form of payment before the debt is
repaid). Such a feature is considered discretionary if either the issuer or
the holder can elect a form of payment other than PIK instruments (e.g., the
issuer has the option to settle interest payment obligations by either
delivering cash or issuing PIK instruments).
The table below describes the accounting for PIK interest
features on nonconvertible debt instruments (for such features that are not
bifurcated as embedded derivatives).
|
Effective Interest Rate of the
Original Debt Instrument
|
Initial Measurement of PIK
Instruments Issued
| |
|---|---|---|
|
Nondiscretionary PIK interest
|
The contractual cash flows of the
PIK instruments that will be issued are incorporated
into the computation of the effective interest rate
of the original debt instrument. Unless some portion
of interest must be paid in cash (e.g., 5 percent in
cash and 5 percent in kind), an entity treats the
original debt instrument as a zero-coupon instrument
when applying the interest method.
|
When PIK interest is recognized, the
debtor measures the PIK instruments issued at the
present value of their contractual cash flows,
discounted by using the effective interest rate of
the original debt instrument.
|
|
Discretionary PIK interest
|
The effective interest rate of the
original debt instrument may be computed on the
basis of an assumption that the debtor will elect to
pay interest in the form of cash. Alternatively, the
debtor may assume that it will elect to pay interest
in the form of either PIK instruments or cash,
depending on which option is expected to be most
economical (e.g., by considering the fair value of
the PIK instruments in relation to the amount of
cash interest that would be paid). If interest is
expected to be paid in the form of PIK instruments,
the fair value of those PIK instruments is
incorporated into the computation of the effective
interest rate of the original debt instrument as an
assumed cash flow on each interest payment date.
|
When PIK interest is recognized, the
debtor initially measures any debt instrument issued
as PIK interest at its fair value as of its interest
cost recognition date. This initial measurement
approach is consistent with the accounting for stock
dividends in ASC 505-20-30-3.
If there is a difference between the cash flow
assumed in the application of the interest method as
of an interest payment date and the fair value of
the PIK instrument issued, the debtor makes a
corresponding adjustment to the amount of interest
cost recognized. An entity should consider the
frequency with which it recognizes accrued interest
and the compounding terms of the debt, among other
factors, to arrive at a reasonable and practical
approach to recognizing the initial fair value of
debt instruments issued as PIK interest. For
example, an entity may determine that the
contractual interest payment dates are the dates on
which the fair value of PIK instruments should be
measured.
|
The accounting approach for PIK interest on nonconvertible debt
instruments is also appropriate for convertible debt instruments; however,
entities need to consider additional factors when determining whether a
convertible instrument should be viewed as discretionary or nondiscretionary.
The terms of some convertible debt instruments include a PIK interest payment
feature that requires or permits the issuer to satisfy any interest payment
obligations by issuing the same convertible debt instrument. The following are
two types of such PIK interest payment features:
- On the interest payment date, the issuer satisfies the interest payment obligation by issuing additional convertible debt securities to the holder(s). That is, additional fungible securities are issued.
- On each interest payment date, the issuer increases the principal amount of the original debt security to reflect the interest accrued to the benefit of the holder, which results in a proportionate increase in the number of equity shares that will be issued upon exercise of the conversion feature. For example, some convertible debt securities contain a requirement for the issuer to pay accrued interest by increasing the security’s principal amount while maintaining the same conversion price (although the conversion rate per security increases). Upon conversion, the holders will receive additional common shares on the basis of the increased principal amount. Economically, other than with respect to potential differences attributable to the compounding terms of an instrument, such a PIK feature has the same effect as delivering additional instruments.
As further discussed below, the commitment date for the issuance of a convertible
debt instrument as interest affects the initial measurement of such PIK interest
payment (i.e., whether the PIK interest is initially recognized on the basis of
the commitment date for the original convertible debt instrument or the fair
value of the convertible debt instrument issued as PIK interest on the PIK
interest payment date).
|
PIK Feature
|
Description
|
Commitment Date for PIK Interest
|
|---|---|---|
|
Discretionary
|
A PIK feature is discretionary if
either of the following conditions exist:
|
The date that interest is accrued (i.e.,
the interest cost recognition date).
|
|
Nondiscretionary
|
A PIK feature is nondiscretionary if
both of the following conditions exist:
|
The commitment date for the original
convertible debt instrument.
|
There are two acceptable views on how to interpret the condition
that for PIK dividend payments to be nondiscretionary, the holder must always
receive the number of equity shares upon conversion as if all dividends have
been paid in kind if the original instrument (or part of it) is converted before
accumulated dividends are declared or accrued. An entity should select one view
and apply it consistently as an accounting policy election:
-
View A — Regardless of when during the security’s term the holder converts the instrument into equity shares, the holder must always receive upon conversion all of the interest that would have accrued during the entire life of the security (i.e., to the contractual maturity date).Under this view, the issuer must know at the inception of the original convertible debt instrument, regardless of the ultimate conversion date, the exact number of equity shares that will be issued to the holder upon full conversion (i.e., conversion of the original instrument at its principal amount adjusted for PIK interest or, if PIK interest is paid through the issuance of additional convertible debt instruments, conversion of both the original convertible debt instrument at its principal amount and any additional convertible debt instruments — potential contingent adjustments to the conversion rate for other reasons do not necessarily need to be considered). If the issuer cannot quantify the number of equity shares that will be issued or if the number of equity shares will differ depending on when the instrument is converted, the PIK feature is discretionary under this view. Accordingly, most PIK interest payments would be discretionary under View A since entities typically do not issue convertible debt instruments that allow the holder to effectively earn future interest that would not have accrued on an early conversion (i.e., instruments with make-whole equivalents to all future interest on an undiscounted basis).
-
View B — Regardless of when during the security’s term the holder converts the instrument into equity shares, the holder must always receive upon conversion all of the interest that has accrued during the entire period in which the security has been outstanding (i.e., to the conversion date).Under this view, the holder always receives upon conversion the number of equity shares as if all interest that has been earned to date is paid in equity shares (i.e., no interest amounts are paid in cash). If the conversion date falls between periodic contractual interest dates (i.e., accrual or payment dates) and the holder forfeits any interest that would have accrued from the last interest date, this forfeiture does not prevent the interest from being nondiscretionary since it is not payable in cash.
The view selected will not affect the conclusion that PIK interest is
discretionary in cases in which a convertible debt instrument allows either the
holder or issuer to choose to pay interest in cash or in kind. In these
circumstances, the PIK interest would be considered discretionary regardless of
whether the entity adopted View A or View B.
Example 6-14
Discretionary
PIK Interest Feature — Interest May Be Paid in
Cash or in Kind
Company R issued debt securities
with interest coupons that may be paid in cash or
additional debt securities at R’s option. The
original debt security pays interest at an 8 percent
per annum rate. Company R elects the form of
interest payments immediately before each payment
date. This PIK feature is considered discretionary
since R can choose the form of payment of the
interest coupons. Therefore, the initial measurement
amount of any PIK debt securities is their fair
value on the interest cost accrual date.
Example 6-15
Debt With
Discretionary and Nondiscretionary PIK Interest
Payments
On March 31, 20X0, Entity A issued
100,000 convertible debt securities, with a
principal amount of $1,000, for total proceeds of
$100 million. The securities’ original maturity date
is six years from the issuance date, and they earn
interest at an annual rate of 10 percent per annum
of the principal amount per security, compounded
annually. During the first three years, A is
required to pay interest in kind by delivering
additional debt securities. During years 4–6, A has
the option to pay interest either in cash or in
kind. If interest is paid in kind, the number of
additional debt securities is determined on the
basis of the initial purchase price (i.e., A will
deliver one-tenth of a debt security for each
outstanding debt security). The debt securities do
not contain any put, call, or redemption features.
Thus, at the end of year 3, after payment of
interest in kind, there will be a total of 133,100
debt securities outstanding (100,000 ×
1.103).
This example presents a unique fact
pattern in which the PIK interest payments could be
considered to contain both a discretionary and
nondiscretionary element. Debt securities issued
after March 31, 20X3, should be initially measured
as discretionary PIK instruments at their fair value
as of the interest accrual dates. However, debt
securities issued during the first three years may
be treated as nondiscretionary PIK instruments. That
is, A would treat the original instrument as paying
no interest during years 1–3 and, when applying the
interest method, would assume that the PIK
instruments that will be issued during those years
are instead paid in cash at the end of the original
instrument’s life.
6.2.5.4 Loss Contingencies
ASC 450-20
25-2 An estimated loss
from a loss contingency shall be accrued by a charge
to income if both of the following conditions are
met:
-
Information available before the financial statements are issued or are available to be issued (as discussed in Section 855-10-25) indicates that it is probable that . . . a liability had been incurred at the date of the financial statements. Date of the financial statements means the end of the most recent accounting period for which financial statements are being presented. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.
-
The amount of loss can be reasonably estimated.
The purpose of those conditions is to require accrual
of losses when they are reasonably estimable and
relate to the current or a prior period. . . . As
discussed in paragraph 450-20-50-5, disclosure is
preferable to accrual when a reasonable estimate of
loss cannot be made. Further, even losses that are
reasonably estimable shall not be accrued if it is
not probable that an asset has been impaired or a
liability has been incurred at the date of an
entity’s financial statements because those losses
relate to a future period rather than the current or
a prior period. Attribution of a loss to events or
activities of the current or prior periods is an
element of . . . liability incurrence.
Sometimes, debt instruments require the issuer to make one
or more payments upon the occurrence or nonoccurrence of specified events.
For example, a debt instrument might require the debtor to pay a fixed
amount on the basis of a condition linked to the issuer’s creditworthiness.
If no other accounting literature applies (e.g., the provision does not need
to be separated as a derivative under ASC 815-15 and is not subject to the
indexed-debt guidance in ASC 470-10), the issuer should evaluate whether it
must accrue a probable loss under the loss contingency guidance in ASC
450-20. Under that guidance, an expense must be accrued if it is probable
that a payment will be required and the amount of the payment can be
reasonably estimated (see Deloitte’s Roadmap Contingencies, Loss Recoveries, and
Guarantees). Note, however, that if the payment
varies on the basis of a price or an index (e.g., it varies on the basis of
a measure of inflation) and no other accounting literature applies, the
debtor should generally apply the guidance on indexed debt in ASC 470-10
(see Section
7.4) instead of the loss contingency guidance in ASC
450-20.
Example 6-16
Contingent Payment on Debt Instrument
Entity A has issued 10-year notes that include a
provision that requires A to maintain a leverage
ratio of 8:1 or lower as of each quarterly reporting
date. The leverage ratio is expressed as A’s total
consolidated indebtedness as of the date of
determination to its most recently reported
annualized EBITDA. If A fails to maintain the
specified leverage ratio, the notes become
immediately due and payable unless A makes a cash
payment of $20 million to the notes’ holders. Entity
A has determined that it is not required to separate
the contingent penalty provision as an embedded
derivative. In this circumstance, the contingent
payment represents a loss contingency that should be
evaluated under ASC 450-20-25-2. If it becomes
probable that A will be required to make the
payment, A should record an immediate charge to
earnings for the amount of the loss.
6.2.5.5 Gain Contingencies
ASC 450-30
25-1 A contingency that
might result in a gain usually should not be
reflected in the financial statements because to do
so might be to recognize revenue before its
realization.
Sometimes, debt instruments include contractual terms under
which some or all of the principal or interest payments will be forgiven
upon the occurrence or nonoccurrence of specified events. For example, some
debt securities include bail-in provisions under which a regulatory
authority has the power to write down or cancel the debt. In the absence of
the occurrence or nonoccurrence of the specified events, however, the full
stated amount of principal and interest is payable. If no other accounting
literature applies (e.g., the provision does not need to be separated as a
derivative under ASC 815-15), it is generally not appropriate for the issuer
to anticipate that some or all of its obligation might be canceled in the
future. Such an expectation is akin to a contingent gain that should be
recognized only if or when the gain is realized or realizable under the
guidance on gain contingencies in ASC 450-30 (see Chapter 3 of Deloitte’s Roadmap
Contingencies, Loss
Recoveries, and Guarantees). Further, under ASC
405-20, a debtor generally is not permitted to derecognize a debt obligation
before it has been extinguished (see Section 9.2).
Connecting the Dots
There is no guidance in U.S. GAAP that specifically addresses whether
an entity is permitted to account for a forgivable loan from a
government entity as an in-substance government grant. However, in
all situations in which a debtor expects to repay a forgivable loan,
it must account for that amount as debt.
6.2.5.6 Actual or Expected Payment Defaults
Under the interest method, a debtor accrues interest on the
basis of the amounts that are contractually due even if the debtor is
unable, or expects to be unable, to pay some or all of those amounts. In the
absence of a debt modification or exchange that qualifies as a debt
extinguishment (see Chapter 10) or TDR (see Chapter 11), it is not appropriate for
a debtor to adjust or write off debt discounts, premiums, or debt issuance
costs even if it has defaulted or is expected to default or violate
covenants of the underlying debt. Further, an entity is not permitted to
anticipate that the creditor will forgive some or all of the outstanding
amount of principal and interest in the future. The expectation of full or
partial forgiveness is akin to a contingent gain that should be given
accounting recognition only if or when the gain is realized or realizable
under the guidance on gain contingencies in ASC 450-30 (see the previous
section). Further, in accordance with ASC 405-20, a debtor generally is not
permitted to derecognize a debt obligation before it has been extinguished
(see Section
9.2).
However, an adjustment to the debt’s net carrying amount and the related
amounts of any debt discount, premium, or debt issuance costs may become
necessary if the debtor is subject to reorganization proceedings under the
U.S. Bankruptcy Code. ASC 852-10-45-6 states:
Debt discounts or premiums as well as debt issue costs shall be
viewed as valuations of the related debt. When the debt has become
an allowed claim and the allowed claim differs from the net carrying
amount of the debt, the recorded amount shall be adjusted to the
amount of the allowed claim (thereby adjusting existing discounts or
premiums, and deferred issue costs to the extent necessary to report
the debt at this allowed amount). The gain or loss resulting from
the entries to record the adjustment shall be classified as
reorganization items, as discussed in paragraph 852-10-45-9.
Premiums and discounts as well as debt issuance cost on debts that
are not subject to compromise, such as fully secured claims, shall
not be adjusted.
If the recorded amount is adjusted under ASC 852, discounts, premiums, and
issuance costs should continue to be amortized over the life of the debt
that was assumed when the obligation was originally recorded.
6.2.5.7 Nonrecourse Beneficial Interests
6.2.5.7.1 Background
For nonrecourse beneficial interest liabilities (i.e., obligations
indexed to a pool of financial assets) for which both fixed and
contingent payments are required, special methods of recognizing
interest expense may be acceptable if (1) the contingent payment
obligation is not subject to derivative accounting under ASC 815 (see
Chapter 8) and (2) the issuer has not elected the fair
value option for the instrument under ASC 815-15 (see Section
8.5.6) or ASC 825-10 (see Section 4.4). Such special methods include:
-
The expected-effective-yield method (see the next section).
-
The hypothetical liquidation at fair value (HLFV) method (see Section 6.2.5.7.3).
6.2.5.7.2 Expected-Effective-Yield Method
Under the expected-effective-yield method, the debtor recognizes interest
expense in each reporting period by using an effective interest rate
that is determined on the basis of expected cash flows over the life of
the debt.
Example 6-17
Liability Secured by Receivables
Entity A obtains a five-year loan from Bank B.
The loan has a fixed, stated interest rate of 12
percent and is collateralized by a pool of
revolving credit card receivables that A holds.
When A receives payments from the underlying
receivables, it is required under the terms of the
loan to use a specified portion of those cash
flows to pay the fixed interest and repay a
portion of the principal amount to B on the basis
of a waterfall schedule. If the projected cash
flows from the underlying receivables at any time
are insufficient to repay the principal amount and
to pay the fixed interest to B, A is required to
fund the deficit by using other assets. Further, B
is entitled to participate in any residual cash
flows generated by the pool once A has made its
required principal and fixed interest payments.
Because this participation is contingent on the
performance of the receivables, it represents a
contingent payment obligation of A. At inception
of the loan, there is an expectation that
contingent payments will be payable to B.
In this scenario, A may apply
either (1) a contingent interest expense
recognition model that is similar to the guidance
on indexed debt instruments (see Section
7.4) or on participating mortgages (see
Section 7.3), such as the HLFV method
(see Section
6.2.5.7.3), or (2) an effective-yield
interest expense recognition approach on the basis
of the effective interest rate expected to be paid
over the life of the loan by analogy to the method
that may be elected for anticipated prepayments on
a large number of similar loans under ASC
310-20-35-26 through 35-33.
If A elects to apply an effective-yield interest
expense recognition approach, it should reflect in
its determination of the effective interest rate
the amount and timing of all cash flows expected
to be paid on the loan, which would be affected by
the expected performance of the pool of
receivables. However, A cannot anticipate
nonpayment of the principal amount or the
fixed-interest cash flows because those payments
are contractual. Although those amounts must be
paid even if the cash flows from the pool of
receivables are insufficient, this conclusion
would not change if this were not the case.
If the expected timing or amount of the cash
flows change, A applies a retrospective interest
method (see ASC 310-20-35-26). That is, it
recalculates the effective interest rate by
determining the effective interest rate that would
have existed when the debt was first recognized on
the basis of the original net carrying amount,
actual payments to date, and the revised estimate
of remaining future payments. Entity A then
adjusts the debt’s current net carrying amount to
an amount equal to the present value of the
estimated remaining future payments, discounted by
using the revised effective interest rate, with an
offsetting adjustment to interest expense.
6.2.5.7.3 HLFV Method
An entity uses the HLFV method to measure interest expense for a
nonrecourse beneficial interest liability (i.e., an obligation indexed
to a pool of financial assets) as of each reporting date on the basis of
an assumption that the pool was liquidated, the assets held were sold at
fair value, and the proceeds on sale were distributed in accordance with
the waterfall provisions that govern the distribution of the cash flows
generated by the pool of assets.
Example 6-18
Nonrecourse
Beneficial Interest Liability
Entity E consolidates Trust T,
which is a collateralized loan obligation entity.
Trust T holds investments in variable-rate debt
instruments that pay interest at three-month LIBOR
and meet certain other criteria. In addition, T
has issued three classes of 10-year nonrecourse
beneficial interests in the assets it holds:
-
Class A notes — The principal amount of such notes is $500 million, they are the most senior interests issued by T, and they have a first-priority security interest in each asset T holds. The class A notes accrue interest at three-month LIBOR plus 50 basis points per annum, payable quarterly. No distributions of excess cash flows received on the assets held may be paid on the other notes issued by T until all principal and interest on the class A notes have been paid in full. If an event of default occurs (e.g., T fails to pay any required principal or interest payments on the class A notes when due), holders of a majority of the notes have the right to declare them immediately due and payable.
-
Class B notes — The principal amount of such notes is $50 million and they have a subordinated priority security interest in each asset held by T. Available cash flows received from the assets held by T are paid quarterly on the class B notes until a 15 percent annual internal rate of return is achieved. Trust T’s inability to make payments to holders of the class B notes does not constitute an event of default. At T’s inception, there was an expectation that the class B notes would achieve at least a 15 percent return.
-
Income notes — The principal amount of such notes is $25 million, they are the most subordinated beneficial interests issued by T, and they have no stated interest rate. The inability of T to make payments to holders of the income notes does not constitute an event of default. The income notes are held by E.
If certain coverage tests are
met, any excess cash flows received on the assets
held by T after required principal and interest
payments have been made on the class A notes and
class B notes are distributed quarterly to holders
of the class B notes and income notes on a 50:50
basis. Under the coverage tests, (1) the class A
notes’ overcollateralization ratio (i.e., the
ratio of the aggregate principal amount of debt
instruments held by T to the aggregate principal
amount of class A notes) must exceed 105 percent
and (2) the class A notes’ interest coverage ratio
(i.e., the ratio of the interest proceeds received
on the assets held by T [net of expenses and fees]
to the accrued and unpaid interest on the class A
notes) must exceed 115 percent on the applicable
quarterly payment date before distributions of
excess cash flows can be made to holders of class
B notes and income notes. If the coverage tests
are not met on a quarterly payment date, any
excess cash flows are used to pay down the
principal amount of the class A notes.
Entity E has determined that the
beneficial interests issued do not contain any
features that must be accounted for separately as
derivatives (see Chapter 8).
Further, E has not elected to apply the fair value
option in ASC 815-15 (see Section
8.5.6) or ASC 825-10 (see Section
4.4) to the beneficial interests.
There are two interest elements
related to the class B notes: (1) interest up to a
15 percent annual internal rate of return and (2)
excess interest determined on the basis of the
excess cash flows on the assets held by T.
Irrespective of T’s performance
(e.g., the level of credit losses), E should
recognize interest expense on the class B notes on
the basis of a 15 percent effective yield.
Although the class B notes may not receive
interest equal to a 15 percent annual return if
certain levels of credit or other losses occur,
the class B notes have a stated interest rate of
15 percent. In substance, the stipulated interest
rate on the class B notes is similar to the
stipulated interest rate on the class A notes
because both are nonrecourse debt obligations that
will receive the stated return only if the assets
held by T generate sufficient cash flows. Further,
it would be inappropriate for E to reduce the
carrying amount of the class B notes below the
unpaid principal amount plus accrued and unpaid
interest at a 15 percent annual internal rate of
return because the extinguishment criteria in ASC
405-20-40-1 (see Section 9.2) are
not met (i.e., T is not legally released from its
role as primary obligor under the class B notes
until the principal amount and accrued and unpaid
interest is repaid in full or T liquidates.
Because the excess interest that
will be paid on the class B notes is contingent on
the performance of T’s assets, it would be
appropriate for E to apply the contingent payment
obligation guidance related to indexed-debt
instruments in ASC 470-10 (see Section
7.4) or participating mortgages in ASC
470-30 (see Section 7.3). In
the calculation of the amount of excess interest
expense under this guidance, it would be
acceptable for E to apply the hypothetical
liquidation at book value method (as described in
ASC 323-10-55-54 through 55-57), except that the
fair value of the assets held by T should be used
in the hypothetical liquidation analysis (i.e.,
the HLFV method).
Under the HLFV method, as of
each financial reporting date, excess interest
expense on the class B notes is measured on the
basis of the assumption that T was liquidated, the
assets held were sold at fair value, and the
proceeds on sale were distributed in accordance
with the terms of the beneficial interests. This
method has the effect of recognizing excess
interest expense on the class B notes on the basis
of the “applicable index” (the fair value of T’s
assets) in accordance with the guidance on
indexed-debt instruments in ASC 470-10 (see
Section 7.4).
At the end of the first annual
reporting period, the aggregate fair value of the
assets held by T is $600 million and three-month
LIBOR is 2.0 percent. If these assets were to be
sold at fair value, $512 million would be
allocated to the class A notes (which includes the
repayment of principal of $500 million and the
payment of $12 million of interest). Further,
$57.5 million would be allocated to the class B
notes (which includes the repayment of principal
of $50 million and $7.5 million of interest at 15
percent). After these distributions, $30.5 million
would remain. Fifty percent of this residual cash
flow ($15.25 million) would be allocated to the
class B notes as additional interest. As a result,
at the end of the reporting period, E should
recognize total interest expense on the class B
notes of $22.75 million.
When applying the HLFV method in
subsequent financial reporting periods, E should
recognize excess interest expense amounts on the
basis of the excess of (1) the cumulative amounts
that would be paid to the class B notes (which
consist of (a) the 15 percent annual yield, (b)
the amount of excess interest above the 15 percent
yield that has been previously paid in cash, and
(c) the excess interest that results from the
current-period application of the HLFV method)
over (2) the total interest expense recognized in
prior periods. This could involve the reversal of
previously recognized excess interest, but in no
circumstance should the total interest expense
recognized, on a cumulative basis, be less than a
15 percent effective yield on the principal
amounts outstanding, plus the amount of any excess
interest above the 15 percent yield that has been
previously paid in cash. Therefore, the total
carrying amount related to the class B notes will
always equal the excess of (1) the initial
principal amount invested ($50 million), plus
interest accrued at a 15 percent annual effective
yield on the unpaid principal amount, plus excess
interest accrued over (2) principal and interest
amounts paid on the class B notes.
Also, the determination of
whether cash distributions are (would be)
reflected as repayments of principal or as a
return (and the associated impact such decision
has on the calculation of the 15 percent annual
yield) should be consistent with the contractual
terms of the beneficial interests. Reflecting
payments as a reduction of principal in accordance
with such terms is consistent with the legal
extinguishment concept in ASC 405-20-40-1 (see
Section 9.2) as long as under the
terms, interest no longer accrues at a 15 percent
annual yield for amounts that are considered
principal repayments.
Footnotes
1
Note that there are 91 days
between October 1, 20X1, and December 31, 20X1, as
compared with 181 total days in this interest
period.
6.3 Fair Value Option
6.3.1 Background
ASC 825-10
45-4 A business entity shall
report unrealized gains and losses on items for which
the fair value option has been elected in earnings (or
another performance indicator if the business entity
does not report earnings) at each subsequent reporting
date.
45-5 If an entity has
designated a financial liability under the fair value
option in accordance with this Subtopic or Subtopic
815-15 on embedded derivatives, the entity shall measure
the financial liability at fair value with qualifying
changes in fair value recognized in net income. The
entity shall present separately in other comprehensive
income the portion of the total change in the fair value
of the liability that results from a change in the
instrument-specific credit risk. The entity may consider
the portion of the total change in fair value that
excludes the amount resulting from a change in a base
market risk, such as a risk-free rate or a benchmark
interest rate, to be the result of a change in
instrument-specific credit risk. Alternatively, an
entity may use another method that it considers to
faithfully represent the portion of the total change in
fair value resulting from a change in
instrument-specific credit risk. The entity shall apply
the method consistently to each financial liability from
period to period.
As discussed in Section 4.4, entities can elect a fair
value option to account for certain financial assets and financial liabilities
at fair value. ASC 825-10-45-4 states that the changes in fair value of an item
for which the fair value option is elected should be recognized in net income
(or another performance indicator if an entity does not report net income).
However, this does not apply to the recognition of all of the change in the fair
value of a financial liability for which the fair value option has been elected.
The change must be presented in other comprehensive income (OCI) to the extent
that it is attributable to instrument-specific credit risk (see the next
section). The remaining portion of the change in fair value is recognized in net
income. Upon derecognition of the financial liability, any amounts accumulated
in OCI are recognized in net income (see Section 9.3.2). Special considerations are
necessary if an entity is required or elects to separately present interest
expense on debt for which it has elected the fair value option (see Section 6.3.3).
6.3.2 Presentation Guidance for Instrument-Specific Credit Risk
6.3.2.1 Measuring Instrument-Specific Credit Risk
The change in fair value attributable to a financial liability for which the
fair value option is elected must be presented in OCI to the extent that it
is attributable to instrument-specific credit risk. The change in fair value
attributable to instrument-specific credit risk represents the component of
the change in fair value of the financial instrument attributable to changes
in the specific credit risk of that instrument (e.g., changes in “credit
spread” associated with the instrument). As noted in ASC 825-10-45-5, one
acceptable method of isolating the change attributable to
instrument-specific credit risk is to calculate (1) the hypothetical change
in fair value of the instrument during the period that is attributable to
changes in the risk-free or benchmark rate and (2) the difference between
that amount and the total change in fair value. (This method of computing
the component of the total change in fair value that is attributable to
instrument-specific credit risk is illustrated in paragraphs B5.7.18 and
IE1–IE5 of IFRS 9.)
Alternatively, an entity may use another method that it considers to
faithfully represent the portion of the total change in fair value resulting
from a change in instrument-specific credit risk. However, the entity must
apply that method consistently to each financial instrument from period to
period.
Example 6-19
Calculation of Instrument-Specific Credit
Risk
On January 1, 20X8, Company A issues an
uncollateralized five-year bond with a par value and
fair value of $500 million and an interest rate of 8
percent and elects to record the bond at fair value
in accordance with ASC 825.
Assume the following:
-
Interest is paid annually; the bond has a bullet maturity.
-
Three-month LIBOR, a benchmark rate, was 5 percent on January 1, 20X8. As of March 31, 20X8, three-month LIBOR has increased to 5.5 percent.
-
The change in three-month LIBOR is the only relevant change in general market conditions.
-
The fair value of the bond as of March 31, 20X8, is $495 million, which indicates a market rate of interest on the bond of 8.3 percent.
-
Company A computes the change in fair value that is attributable to instrument-specific credit risk by calculating the portion of the total change in fair value of the instrument during the period that is not attributable to changes in general market conditions. As discussed above, entities are not required to use this method to calculate the change in fair value attributable to instrument-specific credit risk.
-
For simplicity, it is assumed that (1) there is a flat yield curve, (2) all changes in interest rates result from a parallel shift in the yield curve, and (3) the changes in three-month LIBOR are the only relevant changes in general market conditions. An entity should base its calculations on actual market conditions.
The market rate of interest upon the bond’s issuance
was 8 percent. The components of the market rate
include (1) the benchmark rate (three-month LIBOR)
of 5 percent, and (2) 3 percent, which represents
the bond’s credit risk or “credit spread.” At the
end of the period, three-month LIBOR increases to
5.5 percent and there are no other changes in
general market conditions that would affect the
valuation of the bond.
To determine the change in fair value of the bond
associated with instrument-specific credit risk, A
calculates the present value of the remaining
contractual cash flows by using an 8.5 percent rate
consisting of the benchmark interest rate at the end
of the period (5.5 percent) and the initial spread
from the benchmark rate upon issuance of the bond (3
percent). The resulting present value of the
remaining cash flows, discounted at 8.5 percent, is
$492 million.
The fair value of the bond as of March 31, 20X8, is
$495 million. Thus, the portion of the change in
fair value of the bond associated with
instrument-specific credit risk during the period is
$3 million. In other words, the fair value of the
bond decreased by $8 million because of a change in
general market conditions (the increase in LIBOR)
and increased by $3 million because of the narrowing
of the credit spread on the bond. Thus, in
accordance with ASC 825-10-45-5, in preparing its
financial statements and recognizing the bond at
fair value, A would reduce the carrying amount of
the bond by $5 million and would recognize a loss in
earnings of $8 million and a gain in OCI of $3
million. Note that A is also required to determine
instrument-specific credit risk for disclosure
purposes.
In the absence of other changes in general market
conditions, the change in fair value that is
attributable to instrument-specific credit risk in
the next period would be based on a comparison of
the fair value of the bond at the end of the period,
with the present value of future cash flows
discounted at three-month LIBOR at the end of the
period, added to an instrument-specific credit
spread of 2.8 percent (8.3% – 5.5%). The 8.3 percent
represents the implicit market yield on the bond at
the end of the previous period (i.e., the effective
yield of the bond, which is based on discounting the
remaining cash flows and a fair value of $495
million at the beginning of the period). To
determine the credit spread at the end of the
previous period, A subtracts the 5.5 percent (the
benchmark rate at the end of the previous
period).
6.3.2.2 Foreign-Currency-Denominated Liabilities
ASC 825-10
45-5A When changes in
instrument-specific credit risk are presented
separately from other changes in fair value of a
liability denominated in a currency other than an
entity’s functional currency, the component of the
change in fair value of the liability resulting from
changes in instrument-specific credit risk shall
first be measured in the liability’s currency of
denomination, and then the cumulative amount shall
be adjusted to reflect the current exchange rate in
accordance with paragraph 830-20-35-2. The
remeasurement of the component of the change in fair
value of the liability resulting from the cumulative
changes in instrument-specific credit risk shall be
presented in accumulated other comprehensive
income.
ASC 830-20
35-7A Paragraph 825-10-45-5A
requires that for a financial liability for which
the fair value option is elected, the change in the
liability’s fair value resulting from changes in
instrument-specific credit risk shall be presented
separately in other comprehensive income from other
changes in the liability’s fair value presented in
current earnings. The component of the change in
fair value of the liability resulting from changes
in instrument-specific credit risk shall first be
measured in the liability’s currency of
denomination, and then the cumulative amount shall
be adjusted to reflect the current exchange rate in
accordance with paragraph 830-20-35-2. The
remeasurement of the component of the change in fair
value of the liability resulting from the cumulative
changes in instrument-specific credit risk shall be
presented in accumulated other comprehensive
income.
ASC 825-10-45-5A and ASC 830-20-35-7A provide guidance on the measurement of
the instrument-specific credit risk component of a foreign-denominated
financial liability. In accordance with that guidance, entities are required
to apply the following two-step measurement approach:
-
Measure the instrument-specific credit risk component of the change in fair value of the liability in the liability’s currency of denomination.
-
Adjust the cumulative amount of changes in instrument-specific credit risk in the currency of denomination of the liability to the entity’s functional currency by using the exchange rate as of the measurement date (i.e., the balance sheet date).
6.3.2.3 Nonrecourse Financial Liabilities
The guidance in ASC 825-10-45-5 and 45-5A that requires separate presentation
in OCI of the portion of the change in fair value of a financial liability
that is attributable to instrument-specific credit risk does not apply to
liabilities that do not contain instrument-specific credit risk. A liability
that is nonrecourse to the issuer does not contain instrument-specific
credit risk. Therefore, changes in fair value associated with a nonrecourse
financial liability designated under the fair value option should be
recognized entirely in earnings. This view was discussed with the FASB
staff, which agreed with the conclusion reached.
It is important for an entity to differentiate between instrument-specific
credit risk and asset-specific performance risk when assessing a financial
liability whose amounts are payable only upon receipt of cash flows from
specified assets (e.g., securitization structures). This distinction is
important because in some circumstances, a financial liability may have
little or no instrument-specific credit risk and substantially all the
changes in the fair value of the liability may be attributable to
asset-specific performance risk. In such cases, when the borrower does not
have any obligation to make a payment if the assets to which the obligation
is contractually linked fail to perform, changes in the fair value of the
liability would be recognized in earnings. For example, an entity that
issues a note whose cash flows are contractually linked to an underlying
pool of financial assets (e.g., loans, corporate bonds) would have no
obligation to make payments unless amounts are received on the underlying
pool of assets. In such circumstances, all changes in fair value would be
recognized in earnings.
Depending on how the obligation is structured, there may
still be some instrument-specific credit risk when there is also
asset-specific performance risk. For example, if amounts received on the
underlying pool of assets are not immediately payable to the lender (i.e.,
there is a timing difference between the receipt of cash flows from the
assets and the payment on the obligation), the borrower will owe amounts to
the lender even when the assets have performed. Depending on whether the
borrower is able to use the cash received on the assets for purposes other
than to pay its obligation under the financial liability, there may be some
residual instrument-specific credit risk, but it is generally minimal.
6.3.3 Presentation of Interest Expense
An entity is not required to separately present, in its income statement,
interest expense for debt accounted for at fair value through earnings unless
(1) the entity must do so in accordance with regulatory guidance or (2) it is
industry practice to do so (for example, bank holding companies, brokers and
dealers in securities, and investment companies generally present interest
separately from other changes in fair value in their income statements).
However, the entity may elect, as an accounting policy, to present interest
expense separately from other changes in the fair value of financial instruments
measured at fair value through earnings. This election would apply to
interest-bearing financial liabilities that are measured at fair value through
earnings under the fair value option in ASC 825 or ASC 815, as well as those
interest-bearing liabilities that are measured at fair value under other
relevant GAAP. If an entity’s elected accounting policy related to separate
recognition of interest expense is considered significant, the entity should
disclose that policy in accordance with ASC 235-10-50-1.
If an entity elects, as an accounting policy, to separately present interest
expense on an interest-bearing financial liability accounted for at fair value
through earnings, the entity should, with one exception discussed below, include
amortization or accretion of any premium or discount on the instrument as part
of the separately reported interest expense. If the fair value initially
recognized for an interest-bearing financial liability (e.g., debt) differs from
the principal amount due at maturity, this difference is a premium or discount
that should be amortized or accreted. An entity should recognize the
amortization or accretion in interest expense if it is separately presented. The
premium or discount should be amortized by using the interest method that would
have applied to the interest-bearing financial liability if it had not been
recognized at fair value through earnings (see Section 6.2).
The guidance above does not apply to the following:
-
The portion of the difference between fair value and par at inception attributable to embedded features that are not indexed to interest rates or the issuer’s own credit (e.g., an in-the-money option that permits the holder to convert the debt instrument into a fixed number of the issuer’s equity shares). Entities should exclude such features from the discount or premium to be accreted or amortized.
-
Any transaction costs and fees, such as debt issuance costs, origination costs, and origination fees (i.e., up-front costs and fees) are not part of the initial measurement of a financial instrument th