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 that is recognized at fair value and therefore are not included in any premium or discount of the financial instrument in accordance with ASC 825-10-25-3. That is, the interest method is used only for applicable discounts and premiums since up-front costs and fees are recognized in earnings as they are incurred or received (see Section 5.5 for discussion of the initial recognition of up-front costs).
Chapter 7 — Special Accounting Models for Certain Types of Debt
Chapter 7 — Special Accounting Models for Certain Types of Debt
7.1 Background
This chapter discusses the specialized accounting models that apply
to the following types of debt:
-
Sales of future revenues (see Section 7.2).
-
Participating mortgages (see Section 7.3).
-
Indexed debt (see Section 7.4).
-
Joint-and-several liability arrangements (see Section 7.5).
-
Convertible debt (see Section 7.6).
-
Debt exchangeable into the stock of another entity (see Section 7.7).
7.2 Sales of Future Revenues
7.2.1 Background
A seller of future revenue should evaluate whether the proceeds received should
be accounted for as debt or deferred income under ASC 470-10. Sales of future
revenue that are accounted for as debt are subject to the interest method, as
further discussed below.
7.2.2 Scope
ASC 470-10
25-1 An entity receives cash
from an investor and agrees to pay to the investor for a
defined period a specified percentage or amount of the
revenue or of a measure of income (for example, gross
margin, operating income, or pretax income) of a
particular product line, business segment, trademark,
patent, or contractual right. It is assumed that
immediate income recognition is not appropriate due to
the facts and circumstances. The payment to the investor
and the future revenue or income on which the payment is
based may be denominated in a foreign currency.
In a sale of future revenue (such as a profit-sharing agreement, a securitization
of a participation in a future revenue stream, a celebrity bond, or other
contingent payment obligation that varies on the basis of future revenue or
income), an entity receives an up-front lump sum payment from an investor and,
in return, agrees to pass on a specified percentage or amount of its future
revenue or income to that investor for a specified period. The share of revenue
or income owed to the investor may be graduated (e.g., 50 percent of the first
$1 million of revenue and then 25 percent of the amount in excess of $1 million)
or may be different from year to year. Further, the entity might guarantee a
minimum amount to be paid to the investor or there may be a maximum total amount
payable. The underlying cash flows that the entity will pass on might originate
from its contractual arrangements with third parties (e.g., fees and royalties
that it will receive from the licensing of patents, copyrights, trademarks, or
technology and franchise agreements) or its operations (e.g., a specified
interest in revenue, gross margin, or income of the entity or one of its
subsidiaries, business segments, or product lines).
Example 7-1
Sale of Royalty Income
Company C makes an up-front payment of $60 million to
Company D in exchange for the right to collect five
years of future royalties from specified songs covered
by intellectual property rights owned by D.
Example 7-2
Sale of Patent Infringement Litigation Claims
Company L enters into a patent
litigation funding agreement with Company Y. Company Y
is engaged in the business of investing in commercial
legal claims it believes to be meritorious. Under the
agreement, Y agrees to pay up to $20 million of the
litigation costs that will be incurred by L to pursue
claims against defendants that may be infringing on L’s
patents. In exchange, L assigns to Y the rights to an
amount received in connection with a settlement in a
judgment equal to 100 percent of Y’s invested amount
plus a fixed percentage of consideration received in
excess of 100 percent of Y’s invested amount. Company L
would account for this arrangement as a sale of future
revenue only if the arrangement was not considered a
freestanding derivative or a hybrid instrument with an
embedded derivative that must be bifurcated. Generally,
arrangements such as these that are indexed to
litigation represent derivative instruments that are not
eligible for the scope exception in ASC
815-10-15-59(d).
Example 7-3
Sale of Net Income
Company E enters into an agreement with Company P under
which P makes an up-front cash payment of $10 million in
exchange for a right to 40 percent of E’s net profits
from the operation of a hotel for 72 calendar months.
Company E is responsible for the management of the
financial affairs of the hotel, including the payment of
all expenses of construction, opening, operating,
furnishing, supplying, marketing, maintaining, and
repairing the hotel. Company P does not have any
operational responsibilities or rights related to the
hotel. Further, the arrangement does not create a
partnership or joint venture between the parties.
Company E has the right to terminate the agreement at
any time, provided that it pays P a termination fee in
an amount equal to the net present value of the expected
net profits from the date of the termination until the
end of the term of the agreement.
Typically, an entity is not required to account for a contract
for the sale of future revenues as a derivative instrument because ASC
815-10-15-59(d) contains a scope exception for non-exchange-traded contracts for
which the settlement is based on a specified volume of sales or service revenues
of one of the parties to the contract (see Section 8.4.10). Therefore, any derivative
(or embedded derivative) would generally be subject to this scope exception.
Sales of future revenues that are addressed by ASC 470-10
represent transactions that are not within the scope of the guidance in ASC
860-10 on transfers of financial assets. ASC 860-10 only applies to transfers of
recognized financial assets (see Section 2.2 of Deloitte’s Roadmap
Transfers and Servicing
of Financial Assets). ASC 860-10-20 defines a financial
asset as follows:
Cash, evidence of an ownership interest in an entity, or
a contract that conveys to one entity a right to do either of the
following:
-
Receive cash or another financial instrument from a second entity
-
Exchange other financial instruments on potentially favorable terms with the second entity.
At the 1997 AICPA Conference on Current SEC Developments, then
SEC Professional Accounting Fellow Armando Pimentel noted that the SEC staff
“has applied this definition very strictly” (i.e., narrowly). Accordingly, a
seller of a right that entitles the holder to a share of receivables that have
not yet been recognized for accounting purposes (e.g., receivables that will be
recognized in the future related to existing or anticipated orders for the
entity’s goods or services) would apply the guidance on sales of future revenue
in ASC 470-10 instead of the guidance on transfers of financial assets in ASC
860-20. (See Deloitte’s Roadmap Revenue Recognition for further
discussion of the point in time at which a receivable should be recorded under a
contract with a customer in accordance with ASC 606.)
A contract to service a financial asset (i.e., a servicing
right) entitles the holder to a stream of future revenue associated with a
financial asset, but that contract is not a financial asset because it depends
on the delivery of future services. The accounting for a transfer of servicing
rights is addressed in ASC 860-50-40 (see Chapter 6 of Deloitte’s Roadmap Transfers and Servicing of
Financial Assets).
7.2.3 Classification
7.2.3.1 Background
ASC 470-10
25-2 While the
classification of the proceeds from the investor as
debt or deferred income depends on the specific
facts and circumstances of the transaction, the
presence of any one of the following factors
independently creates a rebuttable presumption that
classification of the proceeds as debt is
appropriate:
-
The transaction does not purport to be a sale (that is, the form of the transaction is debt).
-
The entity has significant continuing involvement in the generation of the cash flows due the investor (for example, active involvement in the generation of the operating revenues of a product line, subsidiary, or business segment).
-
The transaction is cancelable by either the entity or the investor through payment of a lump sum or other transfer of assets by the entity.
-
The investor’s rate of return is implicitly or explicitly limited by the terms of the transaction.
-
Variations in the entity’s revenue or income underlying the transaction have only a trifling impact on the investor’s rate of return.
-
The investor has any recourse to the entity relating to the payments due the investor.
ASC 470-10 requires a seller of future revenue to evaluate
whether the offsetting entry to the proceeds received should be classified
as debt or deferred income. It is generally inappropriate to record the
proceeds immediately as income, because the seller maintains some continuing
involvement and the earnings process is not completed when the cash is
received. Further, the proceeds cannot be recorded to equity unless the
contract legally represents an ownership interest that is not required to be
classified as a liability under GAAP (e.g., under ASC 480; see Deloitte’s
Roadmap Distinguishing
Liabilities From Equity).
ASC 470-10-25-2 requires an
entity to consider six factors in determining the appropriate classification
of the proceeds:
|
Factors That Create Rebuttable Presumption of
Debt
|
Factors That Could Help Overcome the Debt
Presumption
|
|---|---|
|
“[T]he form of the transaction is debt” (see
Section 7.2.3.2)
|
The transaction purports to be a sale
|
|
“The entity has significant continuing involvement in
the generation of the cash flows due the investor”
(see Section 7.2.3.3)
|
The entity is not significantly involved in the
generation of the cash flows owed to the
investors
|
|
“The transaction is cancelable by either the entity
or the investor through payment of a lump sum or
other transfer of assets by the entity” (see
Section 7.2.3.4)
|
The agreement is not cancelable
|
|
“The investor’s rate of return is implicitly or
explicitly limited by the terms of the transaction”
(see Section 7.2.3.5)
|
There is no cap on payments to the investor
|
|
“Variations in the entity’s revenue or income
underlying the transaction have only a trifling
impact on the investor’s rate of return” (see
Section 7.2.3.6)
|
Variations in the level of revenue or income can
produce at least moderate variations in the
investor’s return
|
|
“The investor has any recourse to the entity relating
to the payments due the investor” (see
Section 7.2.3.7)
|
The agreement includes no guarantees, recourse, or
collateral provisions
|
If any of the six factors in ASC 470-10-25-2 are present, there is a
rebuttable presumption that the proceeds should be classified as debt.
Accounting for the proceeds from the sale of future revenue as debt
highlights that the proceeds received will be repaid in cash, not in goods
or services. Such accounting is appropriate when the transaction is in the
form of debt or any of the factors in ASC 470-10-25-2 are present.
The presumption that the proceeds should be classified as
debt can be overcome, and the proceeds may be accounted for as deferred
income, if the transaction purports to be a sale and none of factors in ASC
470-10-25-2 are present. Such accounting suggests that the entity has
accelerated the collection of cash from the sales of goods or services in a
manner similar to a nonrefundable advance payment received from a customer.
However, in practice, accounting for the proceeds as deferred revenue is
rare.
Example 7-4
Sale of Future Revenue Accounted for as
Debt
On March 31, 20X0, Entity A enters into an agreement
with Entity B under which A agrees to sell $250
million of future receivables associated with its
anticipated sales of a specified product in exchange
for a $175 million up-front cash payment. Entity A
continues to be solely responsible for research and
development, regulatory compliance, intellectual
property protection, manufacturing, marketing,
distribution, sales, product liability, and
reimbursement associated with the product. Under the
agreement, A is required to make quarterly payments
for five years. Quarterly repayment amounts are
subject to both a fixed cap of $25 million each
quarter and a variable cap equal to 10 percent of
quarterly revenues. Any amounts that remain
outstanding after five years are to be paid in
subsequent quarters subject to the 10 percent of
quarterly revenues cap. Entity A has an option to
prepay its obligation at an amount equal to $250
million less amounts already paid at the time of
prepayment. Entity B has a security interest in A’s
rights related to the product and will have a
secured interest in the future receivables once they
come into existence. Entity A concludes that the
transaction should be accounted for as debt under
ASC 470-10 because the factors in ASC
470-10-25-2(b)–(f) are present. Entity A treats the
proceeds of $175 million as the principal amount of
the debt. The additional $75 million that will be
repaid is recognized as interest over the life of
the debt.
7.2.3.2 Legal Form of Debt
A sale of future revenue may have the legal form of a nonrecourse borrowing.
If the transaction’s legal form is that of debt (e.g., a securitization of
future revenue), the issuer should classify the transaction as debt.
Accounting for the transaction as deferred revenue would be inappropriate
since the form of a transaction that is legally debt is respected under U.S.
GAAP.
Even if the legal form of a transaction is not that of debt, it may have
debt-like characteristics that suggest that it should be accounted for as
debt. Such characteristics may include the following:
-
The proceeds must be used for a specific purpose (e.g., the purchase of equipment).
-
There are covenants restricting the entity’s level of indebtedness until the initial amount received is repaid.
-
The contract has a predefined prepayment schedule (e.g., periodic repayments and a final repayment).
-
There is a contractual interest charge.
-
The entity pledges its assets as collateral to ensure the repayment of the proceeds received.
-
Any portion of the proceeds received that remain unpaid becomes immediately due and payable on a specified date even if revenue or income is insufficient.
7.2.3.3 Seller’s Involvement in the Generation of the Cash Flows
If the entity has significant continuing involvement in the generation of the
cash flows, it is presumed that the transaction represents debt. Such
involvement might take the following forms:
-
Manufacturing.
-
Marketing.
-
Distribution.
-
Repairs and maintenance.
-
Intellectual property protection.
-
Customer service.
-
Billing and handling of customer accounts.
-
Decisions concerning delivery of service and operations.
The evaluation of whether the entity has significant
involvement in the generation of the cash flows depends in part on whether
the underlying cash flows originate from the entity’s contractual
arrangements or its operations. In a licensing or other contractual
arrangement, continuing involvement of the seller will vary on the basis of
the terms of the arrangement. For example, the licensing of a patent will
generally require little ongoing activity by the seller except for
protection from patent infringement claims, whereas the seller’s obligations
under a franchise arrangement are generally substantial, such as providing
inventory, advertising, and training. The cash flows generated from the
operations of a subsidiary, business segment, or product line are typically
within the entity’s control, and its involvement is continuous.
At the 1997 AICPA Conference on Current SEC Developments,
then SEC Professional Accounting Fellow Armando Pimentel suggested that this
criterion is often “very difficult to overcome . . . because the seller of
the item generally continues to be involved in the marketing, promotion, or
direct generation of the asset’s cash flows. For example, if the seller
continues to market and promote the asset, in order to preserve or improve
the future cash flows to the investor, then the transfer would meet this
rebuttable presumption.”
7.2.3.4 Cancellation Provisions
If either the seller or the investor has the right to cancel the transaction
in exchange for a payment by the seller, the transaction is presumed to be
debt. An agreement that is cancelable by the entity permits the entity to
retain the benefits of revenue or income that exceeds expectations. An
agreement that is cancelable by the investor limits the investor’s exposure
to the risk that revenue or income will not meet expectations. Examples of
cancellation provisions include call or prepayment features held by the
seller and put features held by the buyer.
7.2.3.5 Limited Investor Rate of Return
If the investor’s rate of return is either explicitly or implicitly limited,
the transaction is presumed to be debt. A cap on the rate of return limits
the investor’s potential upside associated with changes in revenue or
income. Examples of contractual limits include fixed repayment amounts or
stated ceilings on total payments or rates of return.
7.2.3.6 Limited Investor Exposure to Variability
If the transaction terms are designed so that variations in the underlying
revenue or income have, as described in ASC 470-10-25-2(e), “only a trifling
impact on the investor’s rate of return,” the transaction is presumed to be
debt. In such a case, the investor is not significantly exposed to the risks
and rewards of changes in revenue or income in the transaction. For
instance, if the entity is required to repay the proceeds received
irrespective of the amounts of revenue generated, this criterion is met.
7.2.3.7 Investor Recourse Rights
If the investor has recourse to the seller (e.g., collateral), the
transaction is presumed to be debt because recourse rights limit the
investor’s exposure to reductions in the amount of revenue or income.
Examples of recourse provisions include:
-
Guaranteed minimum annual cash flows.
-
Guaranteed minimum rates of return.
-
Carryover provisions (if annual cash flows are insufficient, the buyer is entitled to recover any shortfall in the following year).
-
Extensions of the term (the expected term of cash flows to generate the buyer’s return may be five years while the agreement is for eight years with a cap; the additional three years act as a guarantee).
-
Acceleration provisions (if certain negative events occur, payments to the buyer are accelerated).
At the 1997 AICPA Conference on Current SEC Developments, Mr. Pimentel
suggested that this criterion is often “very difficult to overcome,
especially in cases where the transfer of the item is structured as an asset
securitization. Typically, asset securitizations require the transferor to
retain some type of recourse, either by transferring cash or other assets to
the investor, or by subordinating future receipts from a retained
interest.”
7.2.4 Debt Model
7.2.4.1 Initial Accounting
If the proceeds received in a sale of future revenue are
accounted for as debt, the entity makes the following entry upon initial recognition:
Cash (or other consideration received)
Debt
If the transaction includes the exchange of separate freestanding financial
instruments or other rights or privileges (e.g., the buyer obtains a right
to reduced pricing in future purchases of a product), the entity may need to
allocate a portion of the proceeds received to such other units of account
(see Section 3.4) before determining
the initial carrying amount of the debt. Further, the entity should evaluate
whether the amount recognized as debt contains any embedded feature (e.g., a
contingent prepayment option) that must be bifurcated as a derivative
instrument (see Chapter 8).
7.2.4.2 Subsequent Accounting
ASC 470-10
35-3 Amounts recorded as
debt shall be amortized under the interest method
(see Subtopic 835-30) . . . .
After initial recognition, an entity uses the interest method (see Section 6.2) to account for the amount
recorded as debt. Because sales of future revenues typically do not involve
fixed contractual cash flows, the entity must make estimates of the timing
and amount of the cash flows payable. While the effective interest rate is
computed at inception by solving for the constant effective yield that
equates the proceeds received to the future estimated payments (see
Section 6.2.3.3), it would be
inappropriate to apply a negative effective interest rate (see below).
In each period, the net carrying amount is the present value of the estimated
future cash payments, discounted by using the effective interest rate (see
Section 6.2.3.5). However, in the
absence of a TDR, it would be inappropriate to reduce the debt’s net
carrying amount below the initial carrying amount (i.e., the proceeds), less
payments previously made by the borrower to the investor, since ASC
450-30-25-1 precludes the recognition of contingent gains (see Section 6.2.5.5), and a debt obligation
cannot be derecognized unless either of the extinguishment conditions in ASC
405-20-40-1 is met (see Section 9.2). Actual cash
repayments are recorded as either interest expense or a reduction of the
outstanding debt balance, including accrued interest, in accordance with the
interest method.
Interest cost is accrued in each period by applying the
effective interest rate against the debt’s net carrying amount (see
Section
6.2.3.4).
Interest expense
Debt (or accrued interest)
Example 7-5
Application of Interest Method to a Sale of Future
Revenue
Entity R enters into a sale-of-future-revenue
arrangement within the scope of ASC 470-10 and
determines that the arrangement must be accounted
for as debt by applying the interest method in ASC
835-30. Entity R receives initial cash proceeds of
$10 million. It prepares a preliminary amortization
schedule on the basis of the initial proceeds and
the estimated future cash payments shown in the
second column of the table below. The final column
shows the maximum remaining undiscounted cash flows
that the entity could be required to be pay under
the contractual terms (such payments are limited to
a maximum amount of $5 million per year). (The
effective interest rate of this series of cash flows
is approximately 14.9 percent.)
If the timing or amount of the actual or estimated cash
flows changes, the effective interest rate or the net carrying amount (or
both) may need to be updated (see the next section).
7.2.4.3 Changes in Actual or Estimated Cash Flows
7.2.4.3.1 Background
If the timing or amount of the actual or estimated cash flows changes,
the original amortization schedule for the debt should be updated to
reflect the revised cash flows, subject to the limitation on reducing
the net carrying amount discussed in Section 7.2.4.2. An entity generally should apply one of
the methods identified in the table below to account for changes in the
amount or timing of cash flows.
|
Updated Effective Interest Rate?
|
Updated Net Carrying Amount?
|
Immediate Earnings Effect?
| |
|---|---|---|---|
|
Prospective (see Section
7.2.4.3.2)
|
Yes
|
No
|
No
|
|
Retrospective (see Section
7.2.4.3.3)
|
Yes
|
Yes
|
Yes
|
|
Cumulative catch-up (see Section
7.2.4.3.4)
|
No
|
Yes
|
Yes
|
The application of any of these methods is an entity-wide accounting
policy election. Once an accounting policy has been adopted, ASC
250-10-45-11 requires the entity to use it consistently.
7.2.4.3.2 Prospective Interest Method
Under the prospective interest method, the entity recalculates the
effective interest rate on the basis of the current carrying amount and
the revised estimate of remaining future payments as of the date on
which the estimate changes. This method of recognizing interest is
similar to that in (1) ASC 470-50-40-14 related to debt modifications
and exchanges that do not qualify for extinguishment accounting (see
Section 10.4.3) and (2) ASC 470-60-35-5 related
to TDRs in which the net carrying amount is less than the future cash
flows (see Section 11.4.4.2).
Unlike the retrospective and catch-up methods, the prospective method
does not require an entity to immediately adjust the current carrying
amount of the debt or the recognition of a gain or loss in earnings as a
result of the change in estimated cash flows. Instead, the change in the
estimate of remaining future cash flows is recognized prospectively as a
yield adjustment.
A benefit of the prospective interest method is that it is relatively simple to apply. As noted in paragraph 99 of FASB Concepts Statement 7,
a drawback of this method is that it can “[obscure] the impact of
changes in estimated cash flows.” Further, the “interest rate that is
derived . . . is unrelated to the rate at initial recognition or to
current market rates for similar assets and liabilities.”
Connecting the Dots
An entity may determine that because of a
significant unexpected change in circumstances, the remaining
undiscounted cash flows payable on a sale of future revenue that
is accounted for as debt is less than the current net carrying
amount of the debt. For example, assume that on January 1, 20X1,
an entity receives cash proceeds of $25 million in return for
repayment of a specified percentage of sales on a newly
commercialized product. As of December 31, 20X2, the entity had
adjusted the carrying amount of the debt obligation to $27
million, which included the recognition of interest expense of
$5 million less cash payments made of $3 million. Further,
assume that on March 31, 20X2, because of litigation related to
the product that generates the repayments on the debt, the
entity determines that it now expects the total future
undiscounted cash flows payable to be only be $5 million.
On the basis of informal discussions with staff
in the SEC’s Office of the Chief Accountant (OCA), we understand
that in such a situation, an entity that applies the prospective
method could either (1) cease recognizing any interest on the
debt (in which case it would apply the future cash payments to
the net carrying amount of the debt until there is a change in
future cash flow expectations or the debt is legally
extinguished) or (2) amortize the net carrying amount (i.e., $27
million) to the initial carrying amount less the payments made
(i.e., $22 million) on the basis of the interest method. Under
the latter alternative, in the absence of a change in cash flow
expectations, the entity would recognize interest income of $5
million over time (which reflects a reversal of the $5 million
in interest expense previously recognized). The entity could
not, however, reduce the net carrying amount below the initial
amount borrowed less payments previously made since the
conditions for liability extinguishment in ASC 405-20 would not
be met on the basis of the revised expectations of future cash
flows.
7.2.4.3.3 Retrospective Interest Method
Under the retrospective interest method, an entity periodically
recalculates the effective interest rate on the basis of the rate that
would have existed at the debt’s inception and takes into account the
original carrying amount, actual payments to date, and the revised
estimate of remaining future payments. (However, the effective interest
rate should not be reduced to the extent that the net carrying amount in
any period would decline below the initial carrying amount less payments
made to date; see Section 7.2.4.2.) Under this method, the debt’s carrying
amount is adjusted in each period to an amount equal to the present
value of the estimated remaining future payments, discounted by using
the revised effective interest rate. The adjustment to the carrying
amount is recognized in earnings as an adjustment to interest expense in
the period in which it occurs.
This method is similar to the prepayment interest method discussed in ASC 310-20-35-26. Unlike the catch-up and prospective methods, the retrospective method requires an entity to adjust both the current carrying amount and the effective interest rate when the amount or timing of actual or estimated cash flows change. As noted in paragraph 100 of FASB Concepts Statement 7, a drawback of this method is that it
“requires that entities retain a detailed record of all past cash
flows.”
7.2.4.3.4 Cumulative Catch-Up Method
Under the cumulative catch-up method, the effective interest rate is not
revised when actual or estimated cash flows change from those estimated
as of the date on which the debt was issued. Instead, the debt’s
carrying amount is adjusted to an amount equal to the present value of
the estimated remaining future payments, discounted by using the
original effective interest rate as of the date on which the estimate
changes. (However, the net carrying amount cannot be reduced to an
amount less than the initial carrying amount less payments made to date;
see Section 7.2.4.2.) The adjustment to the carrying amount is recognized in earnings as an adjustment to interest expense in the period in which the change in estimate occurred. Paragraph 98 of FASB Concepts Statement 7 suggests that this method is “consistent with the
present value relationships portrayed by the interest method.”
7.2.5 Deferred Income Model
ASC 470-10
35-3 Amounts . . .
recorded as deferred income shall be amortized under the
units-of-revenue method.
ASC Master Glossary
Units-of-Revenue Method
A method of amortizing deferred revenue that arises under
certain sales of future revenues. Under this method,
amortization for a period is calculated by computing a
ratio of the proceeds received from the investor to the
total payments expected to be made to the investor over
the term of the agreement, and then applying that ratio
to the period’s cash payment.
If the proceeds received in a sale of future revenue are
presented as deferred income, the entity makes the following entry on initial recognition:
Cash (or other consideration received)
Deferred income
Subsequently, the entity amortizes the amount of deferred income over time. At
inception, the entity determines a unit-of-revenue method ratio equal to the
fraction of the proceeds received to the total expected cash payments to be made
over the term of the agreement. In each period, the amount of amortization is
calculated by applying the unit-of-revenue method ratio to that period’s cash
payment. Periodically, the ratio is updated to reflect changes in estimated cash
flows. Under the deferred income method, no interest expense is accrued.
7.3 Participating Mortgages
7.3.1 Background
ASC 470-30 addresses a debtor’s accounting for a participating mortgage, which is
a mortgage loan that entitles the investor to share in either (or both) an
increase in the market value of, or the income from, a mortgaged real estate
project. Under ASC 470-30, the accounting depends on whether the participation
involves market value appreciation (see Section 7.3.3) or
the project’s results of operations (see Section
7.3.4).
7.3.2 Scope
ASC 470-30
05-1 This
Subtopic establishes the borrower’s accounting for a
participating mortgage loan if the lender is entitled to
participate in any of the following:
-
Appreciation in the fair value of the mortgaged real estate project
-
The results of operations of the mortgaged real estate project.
05-2 The
desire for instruments in which the return to the
lenders was tied more closely to the performance of the
property led to the introduction of participating
mortgage loans.
05-3
Participating mortgage loans and nonparticipating
mortgage loans share all of the following
characteristics:
-
Debtor-creditor relationships between those who provide initial cash outlays and hold the mortgages, and those who are obligated to make subsequent payments to the mortgage holders
-
Real estate collateral
-
Periodic fixed-rate or floating-rate interest payments
-
Fixed maturity dates for stated principal amounts.
05-4 However,
unlike a nonparticipating mortgage loan arrangement, in
a participating mortgage loan, the lender participates
in appreciation in the fair value of the mortgaged real
estate project or the results of operations of the
mortgaged real estate project, or in both.
05-5 The
terms and economics of participating mortgage loan
agreements vary by agreement. The terms and economics of
one agreement may create a circumstance in which any
participation payment is remote. In another agreement,
the terms and economics may transfer many of the risks
and rewards of property ownership.
05-8 The
participation terms of a participating mortgage loan
agreement usually are negotiated concurrently with the
other terms of the underlying mortgage loan. A borrower
agrees to participation rights generally because of
market conditions, or in exchange for concessions
granted by the lender on some other term(s) of the loan,
such as a lower interest rate or a higher loan-to-value
ratio.
05-9 The
lender’s participation reduces the borrower’s potential
realization of operating results or gain on the sale of
the real estate. However, the participation also may
reduce any of the following:
-
The contract interest the borrower is required to pay
-
The risk that the borrower will be unable to pay interest at the stated or floating rate in the loan agreement and, consequently, the risk that the borrower will default on the loan and need to sell the property
-
The amount of capital the borrower has at risk, because the loan-to-value ratio normally is higher.
Further, the obligation to pay the lender a share of the
property appreciation does not increase the current
exposure of the borrower to loss in its investment,
because the participation payments are made only if the
fair value of the property appreciates.
15-1 The
guidance in this Subtopic applies to the following
entities:
- All borrowers in participating mortgage loan arrangements.
15-2 The
guidance in this Subtopic does not apply to the
following entities:
- Creditors in participating mortgage loan arrangements.
15-3 The
guidance in this Subtopic does not apply to the
following transactions and activities:
-
Participating leases
-
Debt convertible at the option of the lender into equity ownership of the property
-
Participating loans resulting from troubled debt restructurings.
In exchange for allowing the creditor to participate in the real
estate project that is financed by a loan, the debtor might receive a reduced
interest rate, more favorable debt covenants, higher loan-to-value ratios, or
other benefits. That is, the lender generally grants certain concessions to the
borrower in return for the right to participate in the appreciation in the fair
value of the mortgaged real estate project, the operations of the project, or
both. The borrower has received something of value (e.g., a lower interest rate)
in exchange for the participation feature and must therefore recognize the
exchange.
ASC 470-30 does not apply to (1) participating mortgages for
which the borrower has elected the fair value option in ASC 815-15 (see
Section 8.5.6)
or ASC 825-10 (see Section
4.4), (2) participating leases, (3) debt that is convertible into
an ownership interest in the mortgaged property, or (4) participating loans
resulting from TDRs under ASC 470-60 (see Chapter 11). If a participation feature in
a debt obligation is contingent on the sale of the property (e.g., a requirement
to pay 20 percent of any sales proceeds) and the borrower has no obligation to
sell the property, ASC 470-30 does not apply because the lender is not entitled
to participate unless the borrower elects to sell the property. Further, ASC
470-30 applies only to debt with a participation feature that does not represent
a separate unit of account (see Section 3.3). If the participation feature
is a separate unit of account that is not subject to other applicable GAAP
(e.g., derivative accounting), the issuer should consider the indexed-debt
guidance that applies to separable contingent payments (see Section 7.4).
Typically, participation features in participating mortgage loans are not
bifurcated as derivative instruments under ASC 815-15. There are scope
exceptions in ASC 815-10-15-59 to the derivative accounting requirements for
non-exchange-traded contracts whose underlying on which the settlement is based
is either (1) the price or value of a nonfinancial asset of one of the parties
of the contract provided that the asset is not readily convertible to cash (if
the nonfinancial asset is unique and the nonfinancial asset is owned by the
party that would not benefit from an increase in the fair value of the
nonfinancial asset; see Section 8.4.9.5) or (2) specified
volumes of sales or service revenues of one of the parties to the contract (see
Section 8.4.10.5). ASC 815-15-55-8 and 55-9 contain the
following illustration of a participation feature that is exempt from the scope
of ASC 815:
ASC 815-15
55-8 Under an example
participating mortgage, the investor receives a
below-market interest rate and is entitled to
participate in the appreciation in the fair value of the
project that is financed by the mortgage upon sale of
the project, at a deemed sale date, or at the maturity
or refinancing of the loan. The mortgagor must continue
to own the project over the term of the mortgage.
55-9 This instrument has a
provision that entitles the investor to participate in
the appreciation of the referenced real estate (the
project). However, a separate contract with the same
terms would be excluded by the exception in paragraph
815-10-15-59(b) because settlement is based on the value
of a nonfinancial asset of one of the parties that is
not readily convertible to cash. (This Subtopic does not
modify the guidance in Subtopic 470-30.)
It may be appropriate for an entity to apply the participating mortgage guidance
by analogy to other financial instruments that pay amounts on the basis of the
issuer’s own operations unless the feature must be bifurcated as a derivative
instrument under ASC 815-15 or other accounting requirements apply.
7.3.3 Participation in Market Value Appreciation
7.3.3.1 Background
ASC 470-30
05-6 A lender may be
entitled to participate in appreciation in the fair
value of a project at any one of the following
times:
-
Upon the sale of the project
-
At a deemed sale date
-
At the maturity or refinancing of the loan.
In exchange for more favorable debt terms, a debtor might permit the creditor
to participate in the appreciation in the value of the mortgaged property
(e.g., 25 percent of any increase in the value of the property in excess of
the initially appraised value). That participation feature might be payable
on earliest of the loan’s maturity date, the sale of the property, or the
refinancing of the loan.
7.3.3.2 Initial Accounting
ASC 470-30
25-1 If a lender is
entitled to participate in the appreciation of the
market value of a mortgaged real estate project, the
borrower shall recognize a participation liability
with a corresponding debit to a debt discount
account.
30-1 If the lender is
entitled to participate in appreciation in the fair
value of the mortgaged real estate project, the
borrower shall determine the fair value (see
Subtopic 820-10) of the participation feature at the
inception of the loan (see paragraph 470-30-25-1 for
guidance on how to recognize the participation
feature).
ASC 470-30 requires that when the lender participates in the appreciation of
the mortgaged real estate project’s market value, the debtor must recognize
a participation liability equal to the fair value of the participation
feature at the inception of the loan. The offsetting entry is recognized as
a discount on the debt, which is amortized as an adjustment to interest cost
over the life of the loan.
For example, the debtor might make the following entry on
initial recognition:
Cash (or other consideration received)
Mortgage loan discount
Mortgage loan
Participation feature (at fair value)
7.3.3.3 Subsequent Accounting
ASC 470-30
35-1 The debt discount
shall be amortized by the interest method, using the
effective interest rate.
35-2 Interest expense on
participating mortgage loans consists of the
following three components:
-
Amounts designated in the mortgage agreement as interest
-
Amounts related to the lender’s participation in results of operations
-
Amortization of debt discount related to the lender’s participation in the fair value appreciation of the mortgaged real estate project.
35-4A If a lender is
entitled to participate in the appreciation of the
market value of a mortgaged real estate project,
both of the following are required at the end of
each reporting period:
-
The balance of the participation liability shall be adjusted to equal the current fair value of the participation feature.
-
The corresponding debit or credit shall be recorded in the related debt-discount account.
35-5 The revised debt
discount shall be amortized prospectively, using the
effective interest rate.
45-1 The amortization of
the debt discount relating to the participation
liability shall be included in interest expense.
After the inception of the loan, the entity adjusts for any
changes in the fair value of the participation feature so that its
measurement equals its current fair value as of the reporting date, with a
corresponding offset to the debt discount. For example, if the fair value of
the participation feature increases, the debtor would make the following
entry:
Mortgage loan discount
Participation feature (increase in fair value)
If the fair value of the participation feature decreases,
the debtor would make the following entry:
Participation feature (decrease in fair value)
Mortgage loan discount
The adjusted debt discount is amortized prospectively to
interest expense by adjusting the debt’s effective interest rate over its
remaining life (see Section 6.2.3.3); that is, by using a prospective interest
method. This means that although changes in the fair value of a market value
participation feature in a participating mortgage are reflected immediately
on the debtor’s balance sheet, they are not recognized immediately in net
income. Instead, they are recognized over time through a prospective yield
adjustment that affects the recognition of interest expense over the debt’s
remaining life.
Generally, both increases and decreases in the fair value of
the participation feature are recognized. However, ASC 470-30-35-3 precludes
subsequent reversals of appreciation if interest amounts have been
capitalized under ASC 835-20 (see Section 14.2.4).
Periodic interest expense for mortgage loans that entitle
the lender to participate in the market value appreciation of the mortgaged
real estate project includes amounts designated in the mortgage agreement as
interest and the periodic amortization of the debt discount created by the
participation liability. These amounts should be recognized by using the
interest method (see Section 6.2). If the investor also participates in the
results of the mortgaged real estate project’s operations, such amounts are
recognized as interest expense as they become due (see Section 7.3.4.3).
7.3.3.4 Example
ASC 470-30
Example 1: Accounting by Participating Mortgage
Loan Borrower
55-1 This Example
illustrates the guidance in this Subtopic.
55-2 Assume that on
January 1, 19X1, Borrower Co. purchased a property
for $10 million. On that date, Borrower paid $1
million cash and entered into a participating
mortgage loan agreement with Lender Co. in the
amount of $9 million.
55-3 The loan agreement
has the following terms:
-
15 year term
-
Interest-only periodic payments, principal to be repaid at end of term
-
5% stated interest rate
-
20% participation in appreciation in the value of the property above $10 million, payable at maturity (or earlier if the asset is sold or the loan is refinanced).
55-4 Assumptions related
to the fair value of the participation feature are
as follows.
55-5 Based on the
preceding assumptions, Borrower Co. should make the
following journal entries for this participating
mortgage loan.
a. On January 1, 19X1, the following journal
entries should be recorded:
b. By the end of 19X1, entries to record
interest expense and amortization of discount
throughout the year would have taken the following
form:
c. At the end of 19X2, entries to record
interest expense and amortization of discount
throughout the year would have taken the following
form:
7.3.4 Participation in Results of Operations
7.3.4.1 Background
ASC 470-30
05-7 In agreements in which
lenders participate in results of operations, the
definition of the results of operations may vary
among agreements. Examples of these definitions
include, but are not limited to, the following:
-
Revenue
-
Income
-
Cash flows before or after debt service.
In exchange for more favorable debt terms, a debtor might allow a creditor to
participate in the results of operations of a real estate project. For
example, the debtor and creditor might agree to share in the revenue, net
income, or net cash flows of a mortgaged office or apartment building.
7.3.4.2 Initial Accounting
ASC 470-30 prescribes an accounting model for mortgage loans for which the
lender participates in the results of operations of the mortgaged real
estate project that is different from the accounting model for market value
participation features. Under ASC 470-30, the borrower recognizes no
liability for the fair value of the participation feature at inception.
Instead, a participation liability is recognized as amounts become
contractually due.
Therefore, the debtor might make the following entry on initial recognition:
Cash (or other consideration received)
Mortgage loan
7.3.4.3 Subsequent Accounting
ASC 470-30
35-2 Interest expense on
participating mortgage loans consists of the
following three components:
-
Amounts designated in the mortgage agreement as interest
-
Amounts related to the lender’s participation in results of operations
-
Amortization of debt discount related to the lender’s participation in the fair value appreciation of the mortgaged real estate project.
35-4 Amounts due to a
lender pursuant to the lender’s participation in the
real estate project’s results of operations (as
defined in the participating mortgage loan
agreement) shall be charged to interest expense in
the borrower’s corresponding financial reporting
period, with a corresponding credit to the
participation liability.
Interest expense on mortgage loans that participate in the results of
operations consist of the amounts designated in the loan agreement as
interest as well as amounts that become due to the creditor related to the
participation feature in the results of operations. The participation
feature in the results of operations is not separately recognized by the
borrower before related amounts become due. When amounts become due, the
debtor recognizes a corresponding charge to the income statement (interest
expense). For example, the debtor might make the following entry when it
becomes legally obligated to pay such amounts:
Interest expense
Mortgage loan (or accrued mortgage
participation liability)
A creditor that participates in both market value
appreciation and results of operations of the mortgaged real estate project
applies the guidance on participation features in market value appreciation
when accounting for the participation in such appreciation (see Section 7.3.3).
7.3.5 Other Considerations
7.3.5.1 Variable-Rate Participating Mortgages
ASC 470-30
35-3 Amounts designated in
the mortgage agreement as interest shall be charged
to income in the period in which the interest is
incurred. If the loan’s stated interest rate varies
based on changes in an independent factor, such as
an index or rate (for example, the prime rate, the
London Interbank Offered Rate [LIBOR], or the U.S.
Treasury bill weekly average rate), the calculation
of the interest shall be based on the factor (the
index or the rate) as it changes over the life of
the loan. Interest recognized pursuant to this
guidance is subject to the requirements of Subtopic
835-20. Once capitalized, amounts shall not be
adjusted for the effects of reversals of
appreciation.
The amount that is reported as interest expense for a
participating mortgage loan includes the stated interest rate, amounts due
to the lender for its participation in the real estate project’s results of
operations (see Section
7.3.4.3), and the amortization of any debt discount
associated with a participation liability in the real estate project’s fair
value appreciation (see Section 7.3.3). For stated interest rates that vary on the
basis of changes in a reference interest rate index (such as a prime rate or
benchmark interest rate), ASC 470-30 requires the debtor to accrue the
amounts designated as interest in accordance with the interest rate in
effect in each period as such rate changes over the debt’s life (see also
Section
6.2.5.2).
7.3.5.2 Extinguishments
ASC 470-30
40-1 If the participating
mortgage loan is extinguished before its due date,
the difference between the recorded amount of the
debt (including the unamortized debt discount and
the participation liability) and the amount
exchanged to extinguish the debt is a debt
extinguishment gain or loss.
45-2 If the participating
mortgage loan is extinguished before its due date,
the debt extinguishment gain or loss shall be
reported as required by paragraph 470-50-40-2.
The borrower should apply the general derecognition guidance
for liabilities in ASC 405-20 (see Chapter 9) and ASC 470-50 (see
Chapter
10). The calculation of the debt extinguishment gain or loss is
based on a comparison of the reacquisition price with the net carrying
amount of the debt. The net carrying amount includes any related
participation liability and any unamortized debt discount. Because ASC
470-30 requires entities to measure participation liabilities related to the
market value appreciation of the mortgaged real estate project at their fair
value on a recurring basis, the debtor should update its estimate of the
fair value of a participation liability as of the extinguishment date.
7.3.5.3 Disclosure
ASC 470-30
50-1 The borrower’s
financial statements shall disclose both of the
following:
-
The aggregate amount of participating mortgage obligations at the balance sheet date, with separate disclosure of the aggregate participation liabilities and related debt discounts
-
Terms of the participations by the lender in either the appreciation in the fair value of the mortgaged real estate project or the results of operations of the mortgaged real estate project, or both.
ASC 470-30 requires entities to provide additional disclosures beyond those
that otherwise apply to debt instruments.
7.4 Indexed Debt
7.4.1 Background
ASC 470-10 includes guidance on the issuer’s accounting for
certain debt instruments that require the issuer to make both guaranteed and
contingent payments that are linked to a specific price or index. However, since
the indexation feature in most of the debt instruments must be bifurcated under
ASC 815-15 as an embedded derivative, the indexed-debt guidance in ASC 470-10
applies only to certain contingent payment obligations that do not need to be
separated as embedded derivatives under ASC 815-15 (see Chapter 8) and are not
subject to other GAAP.
7.4.2 Scope
ASC 470-10
25-3 Debt instruments may be
issued with both guaranteed and contingent payments. The
contingent payments may be linked to the price of a
specific commodity (for example, oil) or a specific
index (for example, the S&P 500). In some instances,
the investor’s right to receive the contingent payment
(an indexing feature) is separable from the debt
instrument. If the indexing feature does not warrant
separate accounting under Topic 815 or the instrument
does not meet the definition of a derivative under Topic
815, the entire instrument shall be accounted for in
accordance with paragraphs 470-10-25-4 and
470-10-35-4.
The guidance on indexed debt instruments in ASC 470-10 applies
to debt instruments that are issued with both guaranteed (fixed) and contingent
(indexed) payments. The contingent payment obligation might be embedded in the
debt (see the next section) or legally separable from it (see Section 7.4.4). However,
the indexed-debt guidance does not apply if (1) the contingent payment
obligation is subject to derivative accounting under ASC 815 (see Chapter 8), (2) the
issuer has elected the fair value option under ASC 815-15 (see Section 8.5.6) or ASC
825-10 (see Section
4.4), or (3) the indexed debt is within the scope of guidance on
sales of future revenue in ASC 470-10 (see Section 7.2) or participating mortgages in
ASC 470-30 (see Section
7.3).
In many cases, indexation features must be accounted for as derivatives under ASC
815-15 because (1) changes in a commodity price or index (e.g., the price of
gold) or in an equity price or index (e.g., S&P 500) are not considered
clearly and closely related to a debt host contract (see Sections
8.4.9.3 and 8.4.7.3.2) and (2) contingent
features that are explicitly cash settled meet the net settlement characteristic
in the definition of a derivative (see Section 8.3.4.4). If
the indexation feature is accounted for as a derivative, the indexed-debt
guidance in ASC 470-10 does not apply; if the feature is not subject to
derivative accounting, the issuer should evaluate whether to apply the
indexed-debt guidance.
Examples of debt instruments that could be within the scope of the indexed-debt
guidance include debt securities whose principal or interest payments vary on
the basis of:
-
An inflation index, such as CPI, that is considered clearly and closely related to the debt host (see Section 8.4.3.3).
-
A nonfinancial asset if the indexation feature does not have to be separated as a derivative under ASC 815-15 (e.g., the nonfinancial asset is unique, not readily convertible to cash, and owned by a party to the contract; see Section 8.4.9.5).
7.4.3 Embedded Indexation Feature
Upon initial recognition of a debt instrument within the scope of the
indexed-debt guidance in ASC 470-10, no proceeds are allocated to an indexation
feature that is embedded in the debt. However, subsequent changes in the
intrinsic value of the feature must be recognized (see Section
7.4.5).
7.4.4 Separate Indexation Features
ASC 470-10
25-4 If the investor’s right
to receive the contingent payment is separable, the
proceeds shall be allocated between the debt instrument
and the investor’s stated right to receive the
contingent payment. The premium or discount on the debt
resulting from the allocation shall be accounted for in
accordance with Subtopic 835-30.
If a contingent payment obligation within the scope of the indexed-debt guidance
in ASC 470-10 is legally separable from the related debt instrument (i.e., it is
a freestanding financial instrument; see Section
3.3), the proceeds received for the debt should be allocated
between the debt and the investor’s right to receive contingent payments upon
initial recognition. The discount (or reduced premium) on the debt instrument
from such allocation should be accounted for in accordance with the interest
method (see Section 6.2).
ASC 470-10 does not specify the method for allocating the proceeds between the
debt liability and the separable contingent payment obligation. As a result,
various allocation approaches for separating the contingent payment feature may
be acceptable, including the following:
-
Relative fair value — The proceeds are allocated between the debt and the contingent payment obligation on the basis of the relative fair values of each component.
-
Fair value of debt component — The proceeds are allocated between the debt and the contingent payment obligation by first recognizing the carrying amount of the debt on the basis of the fair value of a similar debt instrument without the contingent payment obligation. The contingent payment obligation is then recognized as the difference between the proceeds received upon issuance and the carrying amount of the debt (i.e., a residual amount).
-
Fair value of contingent payment obligation — The proceeds are allocated between the debt and the contingent payment obligation by first recognizing the carrying amount of the contingent payment obligation on the basis of the fair value of such component. The debt is then recognized as the difference between the proceeds received upon issuance and the carrying amount of the contingent payment obligation (i.e., a residual amount).
Even though the separable contingent payment obligation is
subsequently remeasured on the basis of its intrinsic value (see the next
section), entities would generally not allocate the proceeds on the basis of the
intrinsic value of the contingent payment obligation as of the issuance date of
the debt because to do so would generally result in the allocation of no amount
to the contingent payment obligation (i.e., the obligation has no intrinsic
value at inception).
7.4.5 Intrinsic Value Method
ASC 470-10
35-4 As the applicable index
value increases such that an issuer would be required to
pay an investor a contingent payment at maturity, the
issuer shall recognize a liability for the amount that
the contingent payment exceeds the amount, if any,
originally attributed to the contingent payment feature.
The liability for the contingent payment feature shall
be based on the applicable index value at the balance
sheet date and shall not anticipate any future changes
in the index value. When no proceeds are allocated
originally to the contingent payment, the additional
liability resulting from the fluctuating index value
shall be accounted for as an adjustment of the carrying
amount of the debt obligation.
ASC 470-10 requires the issuer to apply an intrinsic value approach to the
measurement of contingent payment obligations in indexed debt instruments. The
intrinsic value is determined on the basis of the applicable index value as of
the balance sheet date and does not take into account future changes in the
index value (e.g., on the basis of projections or forward market prices). In
other words, the liability measurement is based on the settlement amount that
would be payable on the basis of the conditions as of the reporting date.
Changes in the index value of an indexed debt instrument are accounted for as
adjustments to the carrying amount of the (1) debt obligation (if embedded) or
(2) contingent payment liability (if separable). Such changes should be
recognized in the income statement as they occur (e.g., as interest
expense).
At the 1997 AICPA Conference on Current SEC Developments, then
SEC Professional Accounting Fellow Russell Mallett stated, in part:
While accounting practice typically recognizes changes
in a debt obligation in the income statement, the [EITF] . . . did not
reach a consensus on this point, although a majority of the Task Force
believed expense treatment was appropriate.
Further, Mr. Mallett provided an example of an indexed debt instrument with a
floor on the settlement amount equal to the original principal amount and
suggested that such an index feature essentially is an embedded written option.
He further noted that “generally, the staff believes that the obligations
resulting from written options should be recognized in the balance sheet and
changes in those obligations should be recognized immediately in the income
statement. Therefore, consistent with the [indexed-debt] guidance in [ASC
470-10], the staff concluded that the indexed debt obligation should be adjusted
based on the changes in the [index value] at each balance sheet date and that
any changes in the obligation should be recognized in the income statement.”
The cumulative amount of additional expense recognized for the contingent payment
obligation should not be less than zero. That is, while previously recognized
additional expense may potentially be reversed in a subsequent financial
reporting period if the index value declines, the cumulative total expense
recognized should not be less than zero. An expectation that the issuer will not
be required to repay the initial amount of the obligation is akin to a
contingent gain that should be recognized only if or when the payment obligation
is legally extinguished under ASC 405-20 (see Section
9.2).
7.5 Joint-and-Several Liability Arrangements
7.5.1 Background
ASC 405-40
05-1 This Subtopic addresses
the recognition, measurement, and disclosure of
obligations resulting from joint and several liability
arrangements.
In a joint-and-several liability arrangement, two or more entities are
co-obligors with respect to the same obligation. Because each co-obligor is a
primary obligor, the creditor can demand repayment of the full amount of the
obligation from any of the co-obligors. A co-obligor cannot refuse to pay the
full amount even if it did not borrow that amount. Depending on what the
co-obligors have agreed to among themselves and under any applicable laws,
however, a co-obligor that has paid amounts to the creditor on behalf of other
co-obligors might be able to seek repayment of such amounts from its
co-obligors.
Example 7-6
Joint-and-Several Debt Instrument
Two entities each borrow $200 under a joint-and-several
liability debt arrangement. The creditor can demand
repayment of up to $400 from either of the two
co-obligors when the debt becomes due even though each
of them only received $200 of debt proceeds.
7.5.2 Scope
ASC 405-40
15-1 The guidance in this
Subtopic applies to obligations resulting from joint and
several liability arrangements for which the total
amount under the arrangement is fixed at the reporting
date, except for obligations otherwise accounted for
under the following Topics:
-
Asset Retirement and Environmental Obligations, see Topic 410
-
Contingencies, see Topic 450
-
Guarantees, see Topic 460
-
Compensation — Retirement Benefits, see Topic 715
-
Income Taxes, see Topic 740.
For the total amount of an obligation under an
arrangement to be considered fixed at the reporting date
there can be no measurement uncertainty at the reporting
date relating to the total amount of the obligation
within the scope of this Subtopic. However, the total
amount of the obligation may change subsequently because
of factors that are unrelated to measurement
uncertainty. For example, the amount may be fixed at the
reporting date but change in future periods because an
additional amount was borrowed under a line of credit
for which an entity is jointly and severally liable or
because the interest rate on a joint and several
liability arrangement changed.
15-2 Although the total
amount of the obligation of the entity and its
co-obligors must be fixed at the reporting date to be
within the scope of this Subtopic, the amount that the
entity expects to pay on behalf of its co-obligors may
be uncertain at the reporting date.
25-1 An entity shall
recognize obligations resulting from joint and several
liability arrangements when the arrangement is included
in the scope of this Subtopic. In some circumstances,
the arrangement is included in the scope of this
Subtopic at the inception of the arrangement (for
example, a debt arrangement); in other circumstances,
the arrangement is included in the scope of this
Subtopic after the inception of the arrangement (for
example, when the total amount of the obligation becomes
fixed, consistent with paragraph 405-40-15-1).
ASC 405-40 applies to all entities that have obligations
resulting from joint-and-several liability arrangements regardless of the
relationship among the parties involved in the agreement. Examples of
obligations that may be subject to joint-and-several liability include debt
obligations, line-of-credit arrangements, settled litigation, and judicial
rulings. However, ASC 405-40 does not apply to obligations within the scope of
other Codification topics (including ASC 410, ASC 450, ASC 460, ASC 715, and ASC
740). For example, if an entity is a guarantor or co-guarantor of a debt
arrangement and the creditor can seek repayment from the entity only if the
creditor has been unable to collect amounts due from the debtor, the entity
would apply the guidance on guarantees in ASC 460, not ASC 405-40. A significant
difference between a joint-and-several liability arrangement and a guarantee
obligation is that an entity is a primary obligor under the former and a
secondary obligor under the latter.
The scope of ASC 405-40 is limited to arrangements for which the
total amount is fixed as of the reporting date. For the total amount to be
considered fixed, it cannot be subject to measurement uncertainty (such as
uncertainty associated with ongoing litigation). Liabilities that are subject to
measurement uncertainty are accounted for under ASC 450 or other GAAP. If the
measurement uncertainty is resolved after the inception of the arrangement
(e.g., settled litigation), ASC 405-40 applies when the total amount becomes
fixed. The total amount would be considered fixed as of the reporting date even
if (1) the portion the entity expects to pay among its co-obligors is subject to
measurement uncertainty or (2) the total amount varies over time because of
factors unrelated to measurement uncertainty (e.g., an additional amount was
borrowed or the interest rate changed).
7.5.3 Measurement
ASC 405-40
30-1 Obligations resulting
from joint and several liability arrangements included
in the scope of this Subtopic initially shall be
measured as the sum of the following:
-
The amount the reporting entity agreed to pay on the basis of its arrangement among its co-obligors.
-
Any additional amount the reporting entity expects to pay on behalf of its co-obligors. If some amount within a range of the additional amount the reporting entity expects to pay is a better estimate than any other amount within the range, that amount shall be the additional amount included in the measurement of the obligation. If no amount within the range is a better estimate than any other amount, then the minimum amount in the range shall be the additional amount included in the measurement of the obligation.
35-1 Obligations resulting
from joint and several liability arrangements included
in the scope of this Subtopic subsequently shall be
measured using the guidance in Section 405-40-30.
Upon initial recognition and on each subsequent measurement date, obligations
within the scope of ASC 405-40 are measured as the sum of (1) the amount the
entity has agreed to pay under the arrangement among the co-obligors (i.e., the
amount the entity has agreed to be ultimately liable for; not the full amount)
and (2) any additional amount the entity expects to pay on behalf of its
co-obligors (e.g., because a co-obligor is expected to be unable to pay some or
all of the amount it has agreed to be liable for among its co-obligors).
In determining how much it has agreed to pay under the arrangement among the
co-obligors, the entity should consider any written agreements among the
co-obligors as well as other facts and circumstances. In the absence of a
written agreement between the parties, factors that could result in a conclusion
that there is an implicit agreement include information about how the parties
have acted in the past, which party received the proceeds, and which party has
made principal repayments or interest settlements.
In determining any additional amount it expects to pay on behalf
of its co-obligors, the entity applies a measurement approach similar to that
for loss contingencies in ASC 450-20 (see Deloitte’s Roadmap Contingencies, Loss Recoveries,
and Guarantees). That is, if a best estimate of the
additional amount is available, the entity should record that amount. If there
is a range of potential estimates and some amount within the range is a better
estimate than any other amount within the range, the best estimate should be
recorded. If no amount within the range is a better estimate than any other
amount, the minimum amount within the range should be recorded.
Example 7-7
Initial Recognition of Joint-and-Several Debt
Instrument
Company A and Company B co-issue and are jointly and
severally liable for $400 of debt. The total amount of
the obligation for the debt is fixed as of the reporting
date. The joint-and-several obligation is within the
scope of ASC 405-40. The arrangement between A and B
states that A agrees to pay the full $400 obligation,
and B does not expect to pay additional amounts on
behalf of A.
Accordingly, A would record a liability of $400, and B
would not record any liability because it has not agreed
to pay any amount and does not expect to pay additional
amounts on behalf of A.
Example 7-8
Initial Recognition of Joint-and-Several Debt
Instrument — Allocation Among Obligors
Assume the same facts as in the example
above, except that the arrangement between Company A and
Company B states that each party will pay $200. In this
scenario, A and B would record a liability of $200
because each has agreed to pay that amount and neither
expects to pay additional amounts on behalf of the other
party.
Example 7-9
Initial Recognition of Joint-and-Several Debt
Instrument — Total Amount Recognized by Parties
Exceeds Total Amount of Obligation
Assume the same facts as in the previous
example, except that Company A expects to pay between
$100 and $200 on behalf of Company B. In this scenario,
A would record $300 and B would record $200 of
liabilities for the debt. Each would record the amount
it agreed to pay on the basis of the arrangement with
its co-obligor (i.e., $200). In addition, A would record
$100 of liabilities, which represents the minimum amount
in the range of $100 to $200 that A expects to pay on
behalf of B (its co-obligor) because no other amount in
the range is a better estimate of what A expects it
would pay (see ASC 405-40-30-1(b)).
7.5.4 Offsetting Entry
ASC 405-40
25-2 The corresponding entry or
entries shall depend on facts and circumstances of the
obligation. Examples of corresponding entries include
the following:
-
Cash for proceeds from a debt arrangement
-
An expense for a legal settlement
-
A receivable (that is assessed for impairment) for a contractual right
-
An equity transaction with an entity under common control.
30-2 The corresponding entry or
entries shall depend on the facts and circumstances of
the obligation.
ASC 405-40 does not prescribe the specific offsetting entry or entries an entity
should make when recognizing or remeasuring the liability in a joint-and-several
liability arrangement. Accordingly, an entity must use judgment and consider the
facts and circumstances.
To the extent that an entity has received cash for amounts it
has borrowed under a joint-and-several liability arrangement, the appropriate
offsetting entry would be to cash. If the entity expects to pay amounts on
behalf of co-obligors, the offsetting entry for such amounts depends on whether
the entity has a contractual right to recover those amounts from its co-obligors
(e.g., under a side agreement). If it has such a right, it should record a
receivable and evaluate it for impairment under ASC 310 or ASC 326 (see
Deloitte’s Roadmap Current
Expected Credit Losses), as applicable. If the entity has
no such right, the appropriate offsetting entry might be an expense. Any
expected recoveries (e.g., if the entity sues its co-obligors) would be
evaluated as a contingency under ASC 450-20 and ASC 450-30 (see Deloitte’s
Roadmap Contingencies, Loss
Recoveries, and Guarantees).
If the co-obligors are related parties, an entity should consider the reasons
for, and substance of, the arrangement among the co-obligors in determining the
corresponding entry or entries for any amounts that it has agreed or expects to
pay on behalf of its co-obligors. For an amount owed from a shareholder or
related party (such as a sister company) to be classified as an asset (a
receivable), the terms of the transaction generally should be comparable to the
terms that would be expected to be available from external sources (e.g.,
interest rates, payment terms and maturities, evidence of the ability and intent
of repayment, and nature and sufficiency of collateral). If an entity has agreed
or expects to pay an amount on behalf of a co-obligor that is a related party
and receivable classification is not appropriate, the appropriate corresponding
entry might be to equity. For example, if a subsidiary expects to pay an amount
on behalf of its parent, the substance of the subsidiary’s payment might be that
of an equity distribution from the subsidiary to the parent.
7.5.5 Disclosure
ASC 405-40
50-1 An entity shall
disclose the following information about each
obligation, or each group of similar obligations,
resulting from joint and several liability arrangements
included in the scope of this Subtopic:
- The nature of the arrangement, including:
-
How the liability arose
-
The relationship with other co-obligors
-
The terms and conditions of the arrangement.
-
-
The total outstanding amount under the arrangement, which shall not be reduced by the effect of any amounts that may be recoverable from other entities
-
The carrying amount, if any, of an entity’s liability and the carrying amount of a receivable recognized, if any
-
The nature of any recourse provisions that would enable recovery from other entities of the amounts paid, including any limitations on the amounts that might be recovered
-
In the period the liability is initially recognized and measured or in a period the measurement changes significantly:
-
The corresponding entry
-
Where the entry was recorded in the financial statements.
-
50-2 The disclosures
required by this Section do not affect the related-party
disclosure requirements in Topic 850. The disclosure
requirements in this Section are incremental to those
requirements.
An entity must disclose information about the nature and amount of each
obligation (or each group of similar obligations) within the scope of ASC
405-40, including how the liability arose, the relationship with other
co-obligors, and any other relevant terms and conditions of the explicit or
implicit agreement between them.
7.6 Convertible Debt
7.6.1 Background
ASC 470-20
Convertible Debt
Instruments
05-4 A convertible debt
instrument is a complex hybrid instrument bearing an
option, the alternative choices of which cannot exist
independently of one another. The holder ordinarily does
not sell one right and retain the other. Furthermore,
the two choices are mutually exclusive; they cannot both
be consummated. Thus, the instrument will either be
converted or be redeemed. The holder cannot exercise the
option to convert unless he forgoes the right to
redemption, and vice versa.
05-5 A convertible debt
instrument may offer advantages to both the issuer and
the purchaser. From the point of view of the issuer,
convertible debt has a lower interest rate than does
nonconvertible debt. Furthermore, the issuer of
convertible debt instruments, in planning its long-range
financing, may view convertible debt as essentially a
means of raising equity capital. Thus, if the fair value
of the underlying common stock increases sufficiently in
the future, the issuer can force conversion of the
convertible debt into common stock by calling the issue
for redemption. Under these market conditions, the
issuer can effectively terminate the conversion option
and eliminate the debt. If the fair value of the stock
does not increase sufficiently to result in conversion
of the debt, the issuer will have received the benefit
of the cash proceeds to the scheduled maturity dates at
a relatively low cash interest cost.
05-6 On the other hand, the
purchaser obtains an option to receive either the face
or redemption amount of the instrument or the number of
common shares into which the instrument is convertible.
If the fair value of the underlying common stock
increases above the conversion price, the purchaser
(either through conversion or through holding the
convertible debt containing the conversion option)
benefits through appreciation. The purchaser may at that
time require the issuance of the common stock at a price
lower than the fair value. However, should the fair
value of the underlying common stock not increase in the
future, the purchaser has the protection of a debt
security. Thus, in the absence of default by the issuer,
the purchaser would receive the principal and interest
if the conversion option is not exercised.
05-7 Entities may issue
convertible debt instruments that may be convertible
into common stock at the lower of a conversion rate
fixed at time of issuance and a
fixed discount to the market price of the common stock
at the date of conversion.
05-7A Entities also may
issue convertible debt instruments that, by their stated
terms, may be settled in cash (or other assets) upon
conversion, including partial cash settlement.
05-8 Certain convertible
debt instruments may have a contingently adjustable
conversion ratio; that is, a conversion price that is
variable based on future events such as any of the
following:
- A liquidation or a change in control of an entity
- A subsequent round of financing at a price lower than the convertible security’s original conversion price
- An initial public offering at a share price lower than an agreed-upon amount.
05-8A Certain convertible
debt instruments may become convertible only upon the
occurrence of a future event that is outside the control
of the issuer or holder.
Instruments
15-2A The guidance on
convertible debt instruments in this Subtopic shall be
considered after considering the guidance in the Fair
Value Option Subsections of Subtopic 825-10 on financial
instruments.
15-2B The guidance on
convertible debt instruments in this Subtopic shall be
considered after considering the guidance in Subtopic
815-15 on bifurcation of embedded derivatives for an
embedded conversion option or other embedded feature
(for example, an embedded prepayment option) as
applicable (see paragraph 815-15-55-76A). The relevant
guidance in this Subtopic does not affect an issuer’s
determination under Subtopic 815-15 of whether an
embedded conversion option or other embedded feature
shall be separately accounted for as a derivative
instrument.
15-2C The guidance in this
Subtopic does not apply to a convertible debt instrument
award issued to a grantee that is subject to the
guidance in Topic 718 on stock compensation unless the
instrument is modified as described in and no longer
subject to the guidance in that Topic. The guidance in
this Subtopic does not apply to stock-settled debt that
is subject to the guidance in Subtopic 480-10 on
distinguishing liabilities from equity or other
Subtopics (see paragraph 470-20-25-14), unless the
stock-settled debt also contains a substantive
conversion feature (as discussed in paragraphs
470-20-40-7 through 40-10) for which all relevant
guidance in this Subtopic shall be considered in
addition to the relevant guidance in other
Subtopics.
15-2D For purposes of
determining whether an instrument is within the scope of
this Subtopic, a convertible preferred stock shall be
considered a convertible debt instrument if it has both
of the following characteristics:
- It is a mandatorily redeemable financial instrument.
- It is classified as a liability under Subtopic 480-10.
For related implementation guidance, see paragraph
470-20-55-1A.
Debt Instruments With Detachable Warrants
25-3 . . . [I]f stock purchase
warrants are not detachable from the debt instrument and
the debt instrument must be surrendered to exercise the
warrant, the two instruments taken together are
substantially equivalent to a convertible debt
instrument and the accounting specified in paragraph
470-20-25-12 shall apply.
Convertible Debt Instruments
25-14 If a debt instrument
has a conversion option that continuously resets as the
underlying stock price increases or decreases so as to
provide a fixed value of common stock to the holder at
any conversion date, the instrument shall be considered
stock-settled debt that is subject to the guidance in
Subtopic 480-10 or other Subtopics (such as Subtopic
718-10, 815-15, or 825-10). Example 4 (see paragraph
470-20-55-18) illustrates application of the guidance in
this paragraph.
ASC 470-20 applies to an issuer’s accounting for convertible
debt unless (1) the issuer has elected the fair value option1 or (2) the embedded conversion option must be bifurcated under ASC 815-15.
If an issuer elects to account for convertible debt at fair value on a recurring
basis under the fair value option in ASC 815-15 (see Section 8.5.6) or ASC 825-10 (see Section 4.4), no embedded derivative features would be
bifurcated and any issuance costs would be expensed at inception (see Section 5.5). The convertible debt instrument
would be subsequently remeasured to its fair value on each reporting date, with
such changes in fair value reflected in earnings except for the portion of the
changes attributable to the change in instrument-specific credit risk, which
would be reported in OCI (see Section
6.3).
If the fair value option has not been elected, an issuer of convertible debt
applies the following steps in ASC 815-15-55-76A to account for the debt instrument:
- “Step 1. Identify embedded features, including the embedded conversion option that must be evaluated under Subtopic 815-15.”
- “Step 2. Apply the guidance in Subtopic 815-15 to determine whether any of the embedded features identified in Step 1 must be separately accounted for as derivative instruments.”
- “Step 3. Apply the guidance in Subtopic 470-20 to account for the convertible debt instrument (including the embedded conversion option and any other embedded features, which are not separately accounted for as a derivative instrument in Step 2) as a liability.”
- “Step 4. If one or more embedded features are required to be separately accounted for as a derivative instrument based on the analysis performed in Step 2, that embedded derivative shall be separated from the host contract in accordance with the guidance in this Subtopic.”
If the embedded conversion option must be bifurcated as a derivative liability
under ASC 815-15, the recognition and measurement guidance in ASC 470-20 does
not apply. However, if the embedded conversion option does not have to be
bifurcated under ASC 815-15 but there are other embedded features that must be
bifurcated (e.g., redemption options or interest features), the guidance in ASC
470-20 applies. See Chapter 8 for
discussion of the evaluation of embedded derivative features in convertible debt
instruments.
In the remaining discussion below, it is assumed that the issuer has not elected
the fair value option and that the embedded conversion option is not bifurcated
under ASC 815-15.
7.6.2 Convertible Debt Not Issued at a Substantial Premium
ASC 470-20
25-12 A debt with an embedded
conversion feature shall be accounted for in its
entirety as a liability and no portion of the proceeds
from the issuance of the convertible debt instrument
shall be accounted for as attributable to the conversion
feature unless the conversion feature is required to be
accounted for separately as an embedded derivative under
Subtopic 815-15 or the conversion feature results in a
premium that is subject to the guidance in paragraph
470-20-25-13.
25-15 If the issuance
transaction for a convertible debt instrument within the
scope of this Subtopic includes other unstated (or
stated) rights or privileges in addition to the
convertible debt instrument, a portion of the initial
proceeds shall be attributed to those rights and
privileges based on the guidance in other applicable
U.S. generally accepted accounting principles
(GAAP).
Upon the initial recognition of convertible debt, the issuer presents the entire
amount attributable to the debt as a liability. The initial carrying amount of
the convertible debt liability is reduced by any direct and incremental issuance
costs paid to third parties that are associated with the convertible debt
issuance (see Section 5.3). No amount
attributable to the debt is initially recognized within equity unless the
instrument is issued at a substantial premium (see Section 7.6.3). In determining the amount attributable to the
convertible debt instrument, the issuer should allocate the proceeds to other
unstated (or stated) rights and privileges on the basis of the guidance in other
U.S. GAAP (see Section 3.4). For example,
if convertible debt is issued with detachable warrants, the issuer should
allocate the proceeds received to the two instruments in accordance with ASC
470-20-25-2.
Example 7-10
Issuance of
Convertible Debt Instrument Without Any Other
Instruments
Entity A issues a five-year convertible
debt instrument at par for net cash proceeds of $8
million, which is its principal amount. The instrument
has a stated interest rate of 1.5 percent per annum and
an embedded conversion option that gives the holder the
right to convert the debt on its maturity date into a
fixed number of A’s shares of common stock subject to
standard antidilution adjustments. The interest rate on
the convertible debt is lower than that on similar
nonconvertible debt issued by A, since investors are
willing to accept a lower rate because of the value of
the embedded conversion option. Entity A estimates that
if the embedded conversion option had been issued
separately as a freestanding financial instrument, its
fair value at inception would have been $1 million.
Further, A has determined that it does not have to
bifurcate the conversion option as a derivative under
ASC 815-15. Therefore, A makes the following journal
entry at issuance:
Convertible debt is subsequently accounted for at amortized cost
in accordance with the interest method described in ASC 835-30 (see Section 6.2). Reported
interest expense on convertible debt to which ASC 470-20-25-12 applies is
generally lower than that on similar nonconvertible debt, since the issuer is
“paying” for the low interest rate by providing an equity conversion feature
that is not recognized for accounting purposes.
In GAAP, there are several exceptions to the prohibition in ASC
470-20-25-12 against separately recognizing a conversion feature embedded in a
convertible debt instrument:
-
If the conversion feature meets the bifurcation criteria in ASC 815-15 (see Section 8.4.7), it is accounted for separately from the debt host contract as a derivative at fair value, with changes in fair value recognized in earnings.
-
If the conversion feature was bifurcated as a derivative but no longer meets the bifurcation criteria, ASC 815-15-35-4 requires the issuer to reclassify the previously bifurcated conversion option into equity (see Section 8.5.4.3).
-
If the convertible debt is modified or exchanged and the modification or exchange is not accounted for as an extinguishment, the amount of any increase in the fair value of the conversion feature associated with the modification or exchange reduces the carrying amount of the debt, with a corresponding increase in equity (see Section 10.4.3).
-
If the convertible debt is issued at a substantial premium to its face amount, it is presumed that the premium should be accounted for in equity (see the next section) unless the conversion feature requires bifurcation as a derivative under ASC 815-15-25-1 (see Section 8.4.7).
7.6.3 Convertible Debt Issued at a Substantial Premium
ASC 470-20
25-13 If a convertible debt
instrument is issued at a substantial premium, there is
a presumption that such premium represents paid-in
capital.
25-15 If the issuance
transaction for a convertible debt instrument within the
scope of this Subtopic includes other unstated (or
stated) rights or privileges in addition to the
convertible debt instrument, a portion of the initial
proceeds shall be attributed to those rights and
privileges based on the guidance in other applicable
U.S. generally accepted accounting principles
(GAAP).
Sometimes, convertible debt is sold or initially recognized at a substantial
premium over the principal amount to be repaid at maturity. In this
circumstance, there is a presumption that the premium should be recognized in
equity as paid-in capital if it is substantial.
ASC 470-20-25-13 applies only to convertible debt instruments that are not
specifically addressed in other GAAP; therefore, it does not apply to:
-
Convertible debt instruments with a conversion feature that must be bifurcated as a derivative under ASC 815-15 (see Section 8.4.7).
-
Debt instruments that contain a conversion feature that economically represents a share-settled redemption feature (see Section 8.4.7.2.5).
The guidance on allocating a substantial premium to paid-in capital may apply in
circumstances in which, for example:
-
An acquirer assumes an acquiree’s outstanding convertible debt in a business combination.
-
Convertible debt is issued upon the exercise of a physically settled liability-classified warrant.
While ASC 470-20 does not define substantial, in practice, a premium of 10
percent or more is considered substantial. In certain circumstances, however, a
premium of less than 10 percent may also be considered substantial (e.g., for a
zero-coupon convertible debt instrument that is initially recognized at a
premium because of the value of the conversion feature and for which negative
interest expense would be reported if the premium was not allocated to
equity).
Although ASC 470-20 does not specifically address such cases, an entity may be
able to overcome the presumption that it should record a substantial premium in
APIC if the premium is not attributable to the value of the equity conversion
feature. For example, the presumption may be overcome if:
-
The convertible debt was issued or assumed at a premium because it pays a higher coupon rate than similar nonconvertible debt.
-
The convertible debt includes an embedded feature other than the conversion feature that significantly increased the proceeds received for the debt.
When convertible debt is initially recognized under ASC 470-20-25-13, the
principal amount of the debt is recognized as a liability, and the premium is
recognized in APIC. The issuer should also determine whether the instrument
contains any other embedded features that must be bifurcated as derivatives
under ASC 815-15 (e.g., a put, call, redemption, or indexation feature; see
Chapter 8). While the issuer should
reduce the initial carrying amount of the convertible debt by any direct or
incremental issuance costs paid to third parties that are associated with the
debt’s issuance, the guidance in U.S. GAAP does not explicitly address whether
or, if so, how to allocate such costs between an instrument’s debt and equity
components (see Section 3.5).
Because a separated equity component (a premium) is contained
within the convertible debt to which the guidance on substantial premiums in ASC
470-20-25-13 applies, the issuer cannot elect the fair value option in ASC
815-15 (see Section
8.5.6) or ASC 825-10 (see Section 4.4). Therefore, except for any
bifurcated embedded derivatives, the liability-classified portion of the
convertible debt instrument is subsequently measured at amortized cost, which
the issuer determines by using the interest method described in ASC 835-30 (see
Section 6.2).
The issuer does not subsequently remeasure the amount initially recognized for
the premium in equity.
Example 7-11
Assumption of Convertible Debt in a Business
Combination
Entity A acquires Entity B and assumes
B’s outstanding convertible debt. The convertible debt’s
fair value ($1.2 million) is significantly higher than
its principal amount ($1 million). Entity A determines
that it does not have to bifurcate the conversion option
as a derivative under ASC 815-15. In accordance with ASC
805-20-30-1, the acquirer in a business combination
measures liabilities assumed at their acquisition-date
fair values. Because the difference between the
convertible debt’s fair value and face amount is
substantial, A allocates a portion of the initial
carrying amount equal to the excess of the fair value
over the face amount (i.e., $200,000) to equity (APIC)
under ASC 470-20-25-13.
Example 7-12
Liability-Classified Physically Settled
Warrant
On January 15, 20X0, Company A issues to
Company B a freestanding warrant for its fair value. The
warrant gives B the right to exercise the warrant for
$100 in cash during the next five years and to receive
A’s $100 par value convertible debt. The debt is
convertible into 10 shares of A’s common stock, whose
fair value is $10 per share on January 15, 20X0. Company
B exercises the warrant on February 15, 20X3, when the
fair value of A’s stock is $20 per share and the fair
value and carrying amount of the warrant is $110.
Although the warrant requires physical settlement upon
its exercise, A has determined that the warrant must be
classified as a liability. Company A would record such
exercise and the resulting issuance of the convertible
debt as follows:
As a result of this accounting, A records the convertible
debt at a substantial premium. Under ASC 470-20-25-13,
there is a presumption that the premium represents
APIC.
7.6.4 Own-Share Lending Arrangements in Connection With Convertible Debt Issuance
7.6.4.1 Overview
ASC 470-20
05-12A An entity for which
the cost to an investment banking firm (investment
bank) or third-party investors (investors) of
borrowing its shares is prohibitive (for example,
due to a lack of liquidity or extensive open short
positions in the shares) may enter into
share-lending arrangements that are executed
separately but in connection with a convertible debt
offering. Although the convertible debt instrument
is ultimately sold to investors, the share-lending
arrangement is an agreement between the entity
(share lender) and an investment bank (share
borrower) and is intended to facilitate the ability
of the investors to hedge the conversion option in
the entity’s convertible debt.
05-12B The terms of a
share-lending arrangement require the entity to
issue shares (loaned shares) to the investment bank
in exchange for a nominal loan processing fee.
Although the loaned shares are legally outstanding,
the nominal loan processing fee is typically equal
to the par value of the common stock, which is
significantly less than the fair value of the loaned
shares or the share-lending arrangement. Generally,
upon maturity or conversion of the convertible debt,
the investment bank is required to return the loaned
shares to the entity for no additional
consideration.
05-12C Other terms of a
share-lending arrangement typically require the
investment bank to reimburse the entity for any
dividends paid on the loaned shares. Typically, the
arrangement precludes the investment bank from
voting on any matters submitted to a vote of the
entity’s shareholders to the extent the investment
bank is the owner of the shares.
ASC 470-20 provides guidance on an issuer’s accounting for
equity-classified share-lending arrangements on its own shares that are
executed in contemplation of a convertible debt issuance. In practice, an
issuer may enter into such an arrangement to help ensure the successful
completion of the convertible debt offering by facilitating investors’
ability to economically hedge their exposure to the share price risk
associated with the issuer’s stock that is inherent in the convertible
instrument.
Example 7-13
Own-Share
Lending in Conjunction With Convertible Debt
Issuance
Issuer A is issuing convertible debt. However, before
agreeing to buy the debt, certain prospective
investors would like to ensure that they can
economically hedge their exposure to the share price
risk related to A’s stock that is associated with
the embedded conversion option. Accordingly, the
prospective investors enter into derivative
contracts on the underlying shares (e.g., options,
forwards, or total return swaps) with Bank B that
offset the exposure related to the “long” position
in A’s stock that would result from the convertible
debt investment. To economically hedge its own
exposure from writing such derivatives, B borrows
the underlying shares and sells them short in the
market.
Because B cannot secure a sufficient number of
underlying shares in the market (i.e., they are not
readily available to market participants) or the
price is too high, it borrows the underlying shares
by entering into a share-lending arrangement
directly with A. The terms of the arrangement
require B to pay a nominal processing fee to A
(e.g., the par value of the shares) that is
significantly less than the agreement’s fair
value.
Issuer A is motivated to enter into the agreement
because the pricing and successful completion of the
convertible debt offering depend on the investors’
ability to enter into derivative contracts to hedge
their equity price exposure, which in turn depends
on B’s ability to borrow the shares.
During the period in which the shares are on “loan,”
they are legally outstanding and the holder is
legally entitled to any dividends paid on them,
although it must reimburse A for such payments. Upon
the conversion or maturity of the convertible debt,
B must physically return the loaned shares to A for
no consideration. If B defaults in returning the
loaned shares, A is contractually entitled to a cash
payment equal to the shares’ fair value.
7.6.4.2 Scope
The guidance on the issuer’s accounting for own-share lending arrangements in
ASC 470-20 applies to arrangements that have the following terms and characteristics:
-
The issuer is lending its equity shares to the counterparty (i.e., it has issued its equity shares on loan).
-
The issuer receives a nominal fee that is significantly less than the fair value of the shares and of the arrangement.
-
The counterparty will return the loaned shares to the issuer on the arrangement’s maturity date for no additional consideration. If the counterparty is unable to return the loaned shares, it may be required to reimburse the issuer in cash.
-
The arrangement qualifies as equity under GAAP.
-
The arrangement was executed in contemplation of a convertible debt issuance or other financing.
In evaluating whether the contract qualifies as equity under
GAAP, the issuer should consider the requirements in ASC 480 and ASC
815-40.
Connecting the Dots
For a discussion of the evaluation of whether an
own-share lending arrangement qualifies as equity under ASC 815-40,
see Deloitte’s Roadmap Contracts on an Entity’s Own
Equity, in particular Sections 2.9,
4.3.5.12, and 5.2.3.6.
7.6.4.3 Initial Accounting
ASC 470-20
25-20A At the date of
issuance, a share-lending arrangement entered into
on an entity’s own shares in contemplation of a
convertible debt offering or other financing shall
be measured at fair value (in accordance with Topic
820) and recognized as an issuance cost, with an
offset to additional paid-in capital in the
financial statements of the entity.
30-26A At the date of
issuance, a share-lending arrangement entered into
on an entity’s own shares in contemplation of a
convertible debt offering or other financing shall
be measured at fair value in accordance with Topic
820.
Own-share lending arrangements within the scope of this
guidance are initially recorded at fair value and recognized as a debt
issuance cost with an offset to APIC in the issuer’s financial statement
(i.e., Dr: Debt; Cr: Equity — APIC).
The terms of a share-lending arrangement entered into in contemplation of a
convertible debt issuance typically require an entity to issue its common
shares to a counterparty (e.g., the bank) in exchange for a nominal
processing fee. The processing fee is significantly less than the fair value
of the shares and is typically less than a market fee that would be charged
in a share-lending arrangement that was not entered into in contemplation of
a convertible debt issuance. To promote the issuance of the debt, the issuer
may sometimes accept less than the market rate on the share-lending
arrangement. The fair value of the share-lending arrangement will be
determined on the basis of the difference between the contractual processing
fee and a market-based fee that would typically be charged for lending such
shares, adjusted as necessary to reflect the nonperformance risk of the
share borrower.
Example 7-14
Initial Accounting for Own-Share Lending
Arrangement
Issuer A issues convertible debt at
par for cash proceeds of $250 million. The stated
interest rate on the debt is 2.5 percent per annum.
The debt is due five years from the issuance date
and is convertible into A’s equity shares at the
holder’s option. Issuer A determines that the
convertible debt should be accounted for under ASC
470-20-25-12. Accordingly, the equity conversion
option is not separately recognized as an equity
component under ASC 470-20.
In contemplation of the convertible debt issuance, A
executes a share-lending arrangement with Bank B to
help ensure the successful completion of the debt
offering, and A receives $100,000 for the
arrangement (which is also the par amount of the
shares issued). However, the fair value of the
arrangement is $15 million. Issuer A evaluates the
share-lending arrangement under ASC 470-20 and ASC
815-40 and determines that it qualifies as
equity.
On the date that both the debt issuance and the
share-lending arrangement occur, A makes the
following journal entry:
7.6.4.4 Subsequent Accounting
ASC 470-20
35-11A If it becomes probable
that the counterparty to a share-lending arrangement
will default, the issuer of the share-lending
arrangement shall recognize an expense equal to the
then fair value of the unreturned shares, net of the
fair value of probable recoveries, with an offset to
additional paid-in capital. The issuer of the
share-lending arrangement shall remeasure the fair
value of the unreturned shares each reporting period
through earnings until the arrangement consideration
payable by the counterparty becomes fixed.
Subsequent changes in the amount of the probable
recoveries should also be recognized in
earnings.
Unless an issuer elects to account for debt arising from an
own-share lending arrangement at fair value under the fair value option in
ASC 825-10, it uses the effective interest method to amortize any debt
discount (or reduced premium) that is created by recognizing the
arrangement. The amount recognized in equity is not remeasured as long as
(1) the share-lending arrangement qualifies as equity under ASC 815-40 and
(2) it is not probable that the counterparty to the share-lending
arrangement will default in returning the loaned shares (or an equivalent
amount of consideration).
If it becomes probable that the counterparty to the
share-lending arrangement will default in returning the loaned shares (or an
equivalent amount of consideration), the issuer must recognize an expense
equal to the fair value of the unreturned shares adjusted for the fair value
of any probable recoveries. The offsetting entry for the expense is to APIC
(i.e., Dr: Loss; Cr: Equity — APIC).
Even though the share-lending arrangement is classified in
equity, it is appropriate to record an expense because the issuer incurs a
loss from the counterparty’s failure to satisfy its obligation to return the
loaned shares. Under the contractual terms of the instrument, the issuer
should have received the shares back (or an equivalent amount of
consideration), but instead it received no value or something of lesser
value because of the counterparty’s default.
The amount of the loss (i.e., the fair value of the unreturned shares
adjusted for probable recoveries) is remeasured each period (e.g., for
changes in the fair value of the unreturned shares) until the consideration
payable becomes fixed. The issuer recognizes changes in the amount of the
loss in earnings with an offset to APIC.
7.6.5 Temporary Equity
ASC 480-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: Classification and Measurement of
Redeemable Securities
2. ASR 268 requires preferred securities that are
redeemable for cash or other assets to be classified
outside of permanent equity if they are redeemable (1)
at a fixed or determinable price on a fixed or
determinable date, (2) at the option of the holder, or
(3) upon the occurrence of an event that is not solely
within the control of the issuer. As noted in ASR 268,
the Commission reasoned that “[t]here is a significant
difference between a security with mandatory redemption
requirements or whose redemption is outside the control
of the issuer and conventional equity capital. The
Commission believes that it is necessary to highlight
the future cash obligations attached to this type of
security so as to distinguish it from permanent
capital.”
3(e). Convertible debt instruments that contain a
separately classified equity component. Other
applicable GAAP may require a convertible debt
instrument to be separated into a liability component
and an equity component.FN8 In these
situations, the equity-classified component of the
convertible debt instrument should be considered
redeemable if at the balance sheet date the issuer can
be required to settle the convertible debt instrument
for cash or other assets (that is, the instrument is
currently redeemable or convertible for cash or other
assets). For these instruments, an assessment of whether
the convertible debt instrument will become redeemable
or convertible for cash or other assets at a future date
should not be made. For example, a convertible debt
instrument that is not redeemable at the balance sheet
date but could become redeemable by the holder of the
instrument in the future based on the passage of time or
upon the occurrence of a contingent event is not
considered currently redeemable at the balance sheet
date.
12. Initial measurement. The SEC staff believes
the initial carrying amount of a redeemable equity
instrument that is subject to ASR 268 should be its
issuance date fair value, except as follows: . . .
d. For convertible debt instruments that
contain a separately classified equity component,
an amount should initially be presented in
temporary equity only if the instrument is
currently redeemable or convertible at the
issuance date for cash or other assets (see
paragraph 3(e)). The portion of the
equity-classified component that is presented in
temporary equity (if any) is measured as the
excess of (1) the amount of cash or other assets
that would be required to be paid to the holder
upon a redemption or conversion at the issuance
date over (2) the carrying amount of the
liability-classified component of the convertible
debt instrument at the issuance date.
16. [Subsequent measurement.] The
following additional guidance is relevant to the
application of the SEC staff’s views in paragraphs 14
and 15: . . .
d. For convertible debt instruments that
contain a separately classified equity component,
an amount should be presented in temporary equity
only if the instrument is currently redeemable or
convertible at the balance sheet date for cash or
other assets (see paragraph 3(e)). The portion of
the equity-classified component that is presented
in temporary equity (if any) is measured as the
excess of (1) the amount of cash or other assets
that would be required to be paid to the holder
upon a redemption or conversion at the balance
sheet date over (2) the carrying amount of the
liability-classified component of the convertible
debt instrument at the balance sheet
date.FN15
23. Convertible debt instruments that contain a
separately classified equity component. For
convertible debt instruments subject to ASR 268 (see
paragraph 3(e)), there should be no incremental earnings
per share accounting from the application of this SEC
staff announcement. Subtopic 260-10 addresses the
earnings per share accounting.
_____________________
FN8 See Subtopics 470-20 and
470-50; and Paragraph 815-15-35-4.
FN15 ASR 268 does not impact
the application of other applicable GAAP to the
accounting for the liability component or the accounting
upon derecognition of the liability and/or equity
component.
In financial statements filed with the SEC under Regulation S-X, issuers of
equity-classified instruments that are redeemable for cash or other assets in
circumstances that are not under the issuers’ sole control must (1) present such
instruments on the face of the balance sheet in a caption that is separate from
both liabilities and stockholders’ equity (i.e., as “temporary equity”) and (2)
apply specific measurement, disclosure, and EPS guidance to them. In addition,
an issuer that is subject to the SEC’s requirements should consider whether it
must classify as temporary equity all or a portion of the equity component of a
convertible debt instrument that contains such a component, including each of
the following:
-
Convertible debt instruments that contain a separately recognized equity component as a result of a previous modification or exchange involving the instrument that (1) was not accounted for as an extinguishment and (2) increased the fair value of the conversion option (see Section 10.4.3).
-
Convertible debt instruments that contain a separately recognized equity component as a result of the reclassification of a previously bifurcated embedded conversion feature (see Section 8.5.4.3).
Terms and features that could trigger classification as temporary equity are not
limited to those that are explicitly described as redemption or put features but
also include, for example, certain call, conversion, and liquidation features
that could force the issuer to redeem an instrument for cash or assets in
circumstances that are not solely within its control.
For convertible debt instruments that contain a separately
recognized equity component, ASC 480-10-S99-3A(3)(e) limits the scope of the
application of the guidance on temporary equity to scenarios in which the
convertible instrument is currently redeemable or convertible by the investor
for cash or other assets. Unlike its application to other redeemable equity
instruments, the guidance on classifying a convertible debt instrument with a
separately recognized equity component as temporary equity must be applied only
at the ends of reporting periods in which the instrument is currently redeemable
for cash or other assets. Thus, the guidance does not apply in reporting periods
in which the instrument will become redeemable or convertible only on a future
date. As a result of this guidance, an entity that has an outstanding
convertible debt instrument with a separately recognized equity component must
assess, in each financial reporting period, whether the equity component (or a
portion thereof) must be classified in temporary equity. As indicated in ASC
480-10-S99-3A(12)(d) and ASC 480-10-S99-3A(16)(d), the amount that must be
classified in temporary equity is limited to the excess (if any) of “(1) the
amount of cash or other assets that would be required to be paid to the holder
upon a redemption or conversion . . . over (2) the carrying amount of the
liability-classified component of the convertible debt instrument” both at
initial measurement and on subsequent balance sheet dates.
For a comprehensive discussion of the SEC’s temporary equity
guidance, see Chapter
9 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity.
Example 7-15
Convertible Debt
With Separated Equity Component
Entity A issued a convertible debt
instrument for net proceeds of $100. Upon the
instrument’s issuance, A was required to separate the
conversion feature as a derivative under ASC 815-15.
After issuance, however, the conversion feature no
longer met the bifurcation criteria in ASC 815-15-25-1.
Accordingly, A reclassified the carrying amount of the
conversion feature as equity under ASC 815-15-35-4.
As of the reporting date, the current carrying amount of
the debt is $90 and the carrying amount of the
equity-classified conversion feature is $10. The
instrument also includes a cash-settled put option that
permits the investor to put the instrument back to A at
any time for $97. Entity A is not required to bifurcate
the put option and account for it as a derivative under
ASC 815-15. In this case, A would present $3 of the
equity component in permanent equity and $7 in temporary
equity because $7 of the equity component is currently
redeemable (i.e., the excess of the current redemption
amount over the carrying amount of the debt’s liability
component).
If, instead, the put option was contingent and the
contingency was not met as of the reporting date, no
amount would be presented in temporary equity
(irrespective of whether it was probable that the
contingency would be met in the future) because the
SEC’s guidance on redeemable securities in ASC
480-10-S99-3A only applies to convertible debt
instruments with a separately classified equity
component if the instrument is currently redeemable or
convertible as of the reporting date.
Footnotes
1
The fair value option cannot be applied to a convertible
debt instrument issued at a substantial premium. Such an instrument must
be accounted for in accordance with the guidance in Section 7.6.3.
7.7 Debt Exchangeable Into the Stock of Another Entity
ASC 470-20 — SEC Materials — SEC Staff Guidance
Comments Made by SEC Observer at Emerging Issues Task
Force (EITF) Meetings
SEC Observer Comment: Debt Exchangeable for the Stock of
Another Entity
S99-1 The following is the text of
the SEC Observer Comment: Debt Exchangeable for the Stock of
Another Entity.
An issue has been discussed involving an
enterprise that holds investments in common stock of other
enterprises and issues debt securities that permit the
holder to acquire a fixed number of shares of such common
stock. These types of transactions are commonly affected
through the sale of either debt with detachable warrants
that can be exchanged for the stock investment or debt
without detachable warrants (the debt itself must be
exchanged for the stock investment — also referred to as
“exchangeable” debt). Those debt issues differ from
traditional warrants or convertible instruments because the
traditional instruments involve exchanges for the equity
securities of the issuer. There have been questions as to
whether the exchangeable debt should be treated similar to
traditional convertibles as specified in Subtopic 470-20 or
whether the transaction requires separate accounting for the
exchangeability feature. The SEC staff believes that
Subtopic 470-20 does not apply to the accounting for debt
that is exchangeable for the stock of another entity and
therefore separation of the debt element and exchangeability
feature is required.
A debt instrument may contain a feature that requires or permits its exchange into
the shares of a third party rather than the issuer’s equity shares (“exchangeable
debt”). For example, the terms of a debt instrument may include an option for the
holder to require the issuer to deliver a fixed number of shares of common stock of
a third party in lieu of repaying the debt’s principal amount at maturity. From the
issuer’s perspective, exchangeable debt is substantially different from convertible
debt because the embedded exchange feature is not settled in the issuer’s equity
shares but in third-party stock.
Accordingly, the issuer of exchangeable debt should not analyze such
debt as convertible debt under ASC 470-20. Instead the issuer should evaluate
whether the exchange feature must be separated as a derivative under ASC 815-15 (see
Section 8.4.7) and,
if not, whether the SEC staff observer comments in ASC 470-20-S99-1 apply. Under ASC
470-20-S99-1, the exchange feature would be accounted for separately from the debt
even if it is not required to be separated as a derivative under ASC 815 (e.g., the
feature might not need to be separated as a derivative if it does not meet the net
settlement characteristic in the definition of a derivative; see Section 8.4.7).
ASC 470-20-S99-1 does not address the measurement of an exchange feature that does
not have to be accounted for as a derivative. An entity might analogize to the
guidance on embedded features that are accounted for as derivatives and account for
the exchange feature at fair value, with changes in fair value recognized in net
income. Alternatively, an entity might look to the indexed-debt guidance in ASC
470-10 and account for the exchange feature on the basis of an intrinsic value
approach under which changes in intrinsic value are recognized in net income. Under
that approach, the exchange feature is measured on the basis of the excess, if any,
of the current value of the third-party stock over the debt’s net carrying amount,
without regard to the time value inherent in the option to exchange the debt for
third-party stock (see Section 7.4.5).
In consolidated financial statements, a contract exchangeable into
the equity shares of a consolidated subsidiary is analyzed in a manner similar to a
contract convertible into the parent’s equity shares provided that the subsidiary is
a substantive entity (see Section
2.6.1 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity).
This is the case irrespective of whether the debt instrument is issued by the parent
or subsidiary. Accordingly, if a parent issues a debt instrument that is
exchangeable into the equity shares of a consolidated subsidiary and the subsidiary
is a substantive entity, the exchange feature would be analyzed as a conversion
feature under ASC 470-20 unless it has to be accounted for as a derivative
instrument under ASC 815 (e.g., if it can be net settled and does not qualify for
the scope exception in ASC 815-10-15-74(a) for certain contracts on the entity’s own
equity). Equity shares issued by an equity-method investee, however, are not
considered part of the entity’s own equity.
In the subsidiary’s separate financial statements, the equity of its
parent is not considered part of the subsidiary’s equity. Therefore, a debt
instrument that is issued by a subsidiary and exchangeable into the parent’s equity
shares would not be analyzed in a manner similar to a contract that is convertible
into the subsidiary’s equity shares in the subsidiary’s separate financial
statements (see Section
2.6.2 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity).
In the parent’s consolidated financial statements, however, the same debt instrument
would be analyzed as a debt instrument that is convertible into the issuer’s equity
shares.
Chapter 8 — Embedded Derivatives
Chapter 8 — Embedded Derivatives
8.1 Background
ASC 815-15
05-1
Contracts that do not in their entirety meet the definition
of a derivative instrument (see paragraphs 815-10-15-83
through 15-139), such as bonds, insurance policies, and
leases, may contain embedded derivatives. The effect of
embedding a derivative instrument in another type of
contract (the host contract) is that some or all of the cash
flows or other exchanges that otherwise would be required by
the host contract, whether unconditional or contingent on
the occurrence of a specified event, will be modified based
on one or more underlyings.
15-2
The guidance in this Subtopic applies only to contracts that
do not meet the definition of a derivative instrument in
their entirety.
Although outstanding debt instruments typically do not meet the definition of a
derivative in their entirety (e.g., they usually lack a derivative’s initial net
investment characteristic; see Section 8.3.4.3), the
contractual terms of debt arrangements may include one or more embedded features
that could affect the cash flows, values, or other exchanges required by the terms
in a manner similar to a derivative. An entity is required to evaluate such features
to determine whether they must be accounted for separately from their host debt
contract as derivative instruments under ASC 815 (see Section 8.4).
In developing the derivative accounting requirements that are now located in ASC 815
(such as the requirement to measure derivatives at fair value on a recurring basis),
the FASB concluded that an entity should not be able to circumvent those
requirements by incorporating derivatives in the contractual terms of nonderivative
contracts (e.g., outstanding debt). Accordingly, it decided that derivatives that
are embedded in the terms of nonderivative contracts should be accounted for as
derivatives separately from the contracts in which they are embedded when certain
criteria are met. An entity is thus unable to avoid the recognition and measurement
requirements of ASC 815 merely by embedding a derivative instrument in a
nonderivative financial instrument or other contract.
Not all embedded features need to be bifurcated from their host
contracts. For example, entities should not bifurcate features that:
- Would not have met the definition of a derivative in ASC 815 on a freestanding basis (see Section 8.3.4) or that qualify for a derivative accounting scope exception (see Section 8.3.5).
- Are embedded in contracts that are accounted for in their entirety at fair value, with changes in fair value recognized in earnings on a recurring basis (see Section 8.3.3).
- Have economic characteristics and risks that are clearly and closely related to those of their host contract.
Accordingly, a debtor must carefully evaluate the terms of outstanding debt
arrangements to determine whether they contain any features that must be accounted
for as derivatives separately from their debt host contracts under ASC 815-15.
Examples of such terms include:
-
Interest payments that are leveraged or inversely related to market interest rates or are subject to a collar, cap, or floor (see Section 8.4.1).
-
The holder’s right to require the issuer to repay the outstanding amount before the stated maturity date (i.e., a put or redemption option; see Section 8.4.4).
-
The issuer’s right to prepay the stated amount (i.e., a call option; see Section 8.4.4).
-
Terms that accelerate the repayment of principal or interest upon the occurrence or nonoccurrence of an event (e.g., an event of default, a change of control, or an IPO; see Section 8.4.4).
-
Term extension features (see Section 8.4.5).
-
A right or obligation to convert the instrument into the debtor’s equity instruments (e.g., common or preferred stock), including a right or obligation that is contingent on the occurrence of a specified event (e.g., debt that is mandatorily convertible into the issuer’s equity shares upon an IPO; see Section 8.4.7).
-
Foreign currency features (see Section 8.4.8).
-
Payments that are triggered upon the occurrence or nonoccurrence of an event that is unrelated to an interest rate index or the issuer’s credit risk (e.g., late filings; see Section 8.4.11).
This chapter provides an overview of the derivative separation requirements that
apply to embedded features in debt instruments.
8.2 Identification of Embedded Features
8.2.1 General
ASC Master Glossary
Embedded
Derivative
Implicit or explicit terms that affect
some or all of the cash flows or the value of other
exchanges required by a contract in a manner similar to
a derivative instrument.
Hybrid
Instrument
A contract that embodies both an
embedded derivative and a host contract.
A contract that does not in its entirety meet the definition of a derivative
(e.g., outstanding debt) may contain one or more embedded features that would
have met the definition of a derivative (see Section 8.3.4)
if they had been transacted on a stand-alone basis. ASC 815 describes a contract
that contains an embedded derivative as a “hybrid instrument.” For example, debt
with an equity conversion feature is a hybrid instrument. The contract in which
such a feature is embedded is the host contract.
Features that are legally detachable and separately exercisable from a financial
instrument represent freestanding financial instruments; therefore, they are not
evaluated as embedded derivatives even if they are contractually part of the
same contract (e.g., a freestanding warrant or loan commitment that is issued as
part of the contractual terms of a debt instrument). Such features are treated
as separate units of account since they meet the definition of a freestanding
financial instrument (see Section
3.3).
8.2.2 Payoff-Profile Approach to Identifying Embedded Derivatives
8.2.2.1 Background
To identify embedded derivatives, an entity should not rely
solely on how terms are described in the contractual provisions of a debt
instrument; rather, the entity should consider the economic payoff profile
of the contractual terms. Under the payoff-profile approach, the embedded
features in a hybrid instrument are identified on the basis of the monetary
or economic value that each feature conveys upon settlement (e.g., a feature
that settles at a fixed monetary amount is evaluated separately from a
feature that settles at an amount indexed to a specified underlying, such as
the debtor’s stock price). Embedded features with different payoff profiles
are evaluated separately. The payoff-profile approach to identifying
embedded features is consistent with the definition of an embedded
derivative in ASC 815-15-20, which focuses on how an implicit or explicit
term affects the cash flows or values of other exchanges required by a
contract.
If an embedded feature’s economic payoff profile differs
from how the provision is described in the instrument’s contractual terms,
an entity must evaluate the feature on the basis of its payoff profile, not
its contractual form (see Section 3.2). For example, a term that is described as a
conversion feature would be evaluated as a redemption feature if, upon
exercise, it represents a right for the investor to receive a variable
number of equity shares worth a fixed monetary amount (see also Section 8.4.7.2.5).
Further, the contractual conversion terms of a debt instrument might need to
be separated into multiple features on the basis of the nature of the
payoff. For instance, depending on the circumstances at conversion or the
types of events that could trigger a conversion, such terms might specify
the delivery of either (1) a variable number of the issuer’s equity shares
with an aggregate fair value at settlement equal to a fixed monetary amount
(a share-settled redemption feature) or (2) a fixed number of the issuer’s
equity shares (an equity conversion feature). It is therefore appropriate to
separate the stated conversion terms into a redemption feature and an equity
conversion feature even though they are described in the same contractual
conversion provision. Note, however, that a payment feature that can only be
triggered upon the settlement of another payment feature should generally be
analyzed as part of the settlement amount of that other payment feature even
if it has a dissimilar payoff. For example, an interest make-whole payment
(e.g., a requirement to pay the present value of the remaining scheduled
interest payments if a debt instrument is settled early before its maturity
date) should be evaluated as part of an equity conversion feature if it is
payable only upon the exercise of that equity conversion feature. In this
scenario, the interest make-whole payment represents an adjustment to the
settlement amount of the equity conversion feature.
8.2.2.2 Features With Different Forms of Settlement
Different terms within a debt instrument that have the same
economic payoff profile may need to be evaluated on a combined basis even if
they involve different forms of settlement. For example, a convertible debt
instrument might contain provisions related to the redemption and conversion
of the instrument in separate sections of the debt indenture. If triggered,
the redemption provisions require settlement at an amount of cash equal to
the greater of a fixed monetary amount and the fair value of a fixed number
of the debtor’s equity shares. The conversion provisions require settlement
in a fixed number of the debtor’s equity shares. In this example, the
requirement to potentially redeem the debt for cash at an amount equal to
the fair value of a fixed number of equity shares would be analyzed as a
part of the equity conversion feature (not as part of the redemption
feature). The requirement to potentially redeem the debt for cash at a fixed
monetary amount would be evaluated as a redemption feature. See also
Example 8-2.
8.2.2.3 Equity Conversion Features
Under the payoff-profile approach, an equity conversion
feature (see Section
8.4.7.2.2) generally is evaluated as a single embedded
feature even if it contains multiple exercise contingencies. The equity
conversion feature would not be split into embedded features for each of the
exercise contingencies if the payoff is similar for each of the exercise
contingencies. For example, a conversion feature that would result in the
delivery of a fixed number of the issuer’s equity shares upon exercise might
be exercisable in multiple circumstances, such as if the instrument trades
at a price below 98 percent of par, the common stock trades at a price in
excess of 120 percent of par, the issuer elects to call the debt, or
specified corporate transactions take place. Such a conversion feature would
be analyzed as one embedded conversion feature, not as multiple conversion
features. A debt instrument may also contain (1) a provision that allows the
holder to convert the instrument into a fixed number of equity shares (i.e.,
a conversion feature that requires settlement in shares) and (2) a provision
that allows the holder to receive cash in an amount equal to 115 percent of
the value of the fixed number of shares underlying the conversion feature (a
cash-settled feature). In this circumstance, both provisions would be
evaluated as a single embedded derivative. This is because the cash-settled
feature, if exercised, results in the settlement of the monetary value
underlying the conversion feature.
In a manner consistent with the approach described above, an equity
conversion feature that may be exercised at any time at the holder’s option
would be combined with an equity conversion feature that is automatically
exercised upon the occurrence or nonoccurrence of a specified event when the
payoff profiles of such conversion features are the same. See also Example 8-2.
8.2.2.4 Redemption Features
In the analysis of redemption features under the payoff-profile approach,
call options and put options are considered separate embedded derivatives
even if the redemption prices are the same. This is because the payoff
profile of a call option differs from the payoff profile of a put option
even when the redemption prices of the options are the same. If a debtor has
a right to redeem an outstanding debt instrument at its principal amount
(i.e., the right to call the instrument from the holder), it would be
economically motivated to exercise this option only if the fair value of the
debt exceeded its principal amount. However, if a creditor has the right to
force redemption of an outstanding debt instrument at its principal amount,
it would be economically motivated to exercise this option only if the fair
value of the debt was less than its principal amount. Given that the payoff
profiles of call options and put options differ and the holders of such
options are also different parties, a call option is never combined with a
put option and treated as a single embedded derivative under the
payoff-profile approach.
Connecting the Dots
A call option should be evaluated as a put option if the holder of
the instrument controls the issuer’s board of directors or voting
rights unless there are consent or other approval rights held by
independent directors not appointed by the holder of the instrument.
Noncontingent redemption features should be combined with contingent
redemption features when the payoff profiles are the same. For example, if a
debt instrument contains (1) a noncontingent put option that allows the
holder to force redemption at the instrument’s principal amount upon the
mere passage of time and (2) a contingent put option that allows the holder
to force redemption at the instrument’s principal amount upon the occurrence
of a downgrade in the issuer’s credit rating, the two put options would
represent a single combined embedded derivative since they share the same
payoff profile and are held by the same party to the instrument. However, as
discussed above, a noncontingent call option would not be combined with a
contingent put option even if the redemption prices of the two options were
the same.
See Example 8-2 for an illustration of
the identification of the units of account for embedded redemption
features.
8.2.2.5 Features With Interdependent Payoffs
Other features that have an interdependent payoff are
evaluated on a combined basis as a single embedded feature. For example, a
debt instrument may contain multiple additional interest provisions that
specify a fixed increase to the interest rate (e.g., 0.25 percent or 0.50
percent) upon the occurrence of any of a number of specified events (e.g.,
an event of default involving the debtor, the debtor’s late submission of
its SEC filings, or the holder’s inability to freely trade the instrument;
see Section
8.4.11). If there is a contractual ceiling on the total
amount of additional interest that the debtor could be required to pay under
all of the additional interest provisions, each such additional interest
provision would be interdependent, because no incremental amount would be
payable once the ceiling is reached even if an event that otherwise would
trigger an additional interest payment were to occur. Accordingly, those
additional interest provisions would be evaluated on a combined basis as one
embedded interest feature. If any of the underlying events that would
trigger additional interest payments is not clearly and closely related to
the debt host, the combined additional interest feature would not be clearly
and closely related to the debt host even if additional interest provisions
individually would have been clearly and closely related to the debt host.
However, if additional interest provisions are independent (i.e., they are
additive), it may be appropriate to evaluate each one separately. That is,
the determination of whether an embedded derivative must be bifurcated might
differ for each individual additional interest feature depending on what
triggers it.
Connecting the Dots
Callable debt may contain a provision that requires
the debtor to pay a premium to the holder if it were to call the
debt before its maturity (see Example 8-13 for an
illustration). Such a provision might be called “an interest
make-whole provision,” a “change-in-control interest make-whole,” a
“maintenance premium payment,” a “maintenance call,” or a “lump-sum
call payment.” Regardless of its label, the feature would require
the debtor, upon exercise of the feature’s call option, to make a
lump-sum payment to the investor as compensation for future interest
payments that will not be paid because of the shortening of the
outstanding life of the instrument (e.g., the present value of the
debt’s remaining interest cash flows, discounted at a small spread
over the then-current U.S. Treasury rate). When an interest
make-whole provision is triggered by the exercise of a call option,
the make-whole provision is considered an integral component of the
call option; it is not a distinct embedded feature that must be
separately evaluated under ASC 815-15. See Section 8.4.4
for further discussion of the evaluation of embedded call
options.
Similarly, convertible debt may include a provision
that requires the conversion rate to be adjusted upon a fundamental
change transaction (such as a change of control) on the basis of a
make-whole table (see Section 4.3.7.9 of Deloitte’s
Roadmap Contracts on an Entity’s Own Equity for
an example). The purpose and design of the table is to make the
holder whole for lost time value in the conversion option upon the
early settlement of the debt. Such a make-whole provision is
evaluated as part of the conversion option, not as a separate
embedded feature.
8.2.3 Illustrations of the Identification of Embedded Features
Example 8-1
Loan With Interest
That Varies on the Basis of the Issuer’s Stock
Market Capitalization
Company A entered into a loan agreement
that contains variable interest payments. The interest
rate on the loan is defined as a market-based variable
component (e.g., LIBOR) plus an applicable margin. The
applicable margin varies on the basis of the issuer’s
stock market capitalization, as follows:
Because the applicable margin is
additive to the variable base rate, the issuer may
identify it as an embedded feature that is separate from
the variable base rate. Under this view, there are two
embedded features: (1) the variable base rate and (2)
the applicable margin. The variable base rate is
evaluated under ASC 815-15-25-26 because it is based
solely on interest rates (see Section 8.4.1).
The applicable margin is indexed to the issuer’s stock
market capitalization, which is an underlying other than
an interest rate or interest rate index (see Section
8.4.1), the debtor’s creditworthiness
(see Section 8.4.2), or inflation (see
Section 8.4.3). Accordingly, this
feature should not be evaluated under ASC 815-15-25-26.
It would be considered not clearly and closely related
to the debt host (see Section
8.4.7).
An entity is not permitted to identify embedded features that
are not clearly present in the hybrid instrument. For example, an entity is not
permitted to disaggregate a fixed-rate debt instrument into (1) a floating-rate
debt instrument and (2) an embedded interest rate swap that exchanges floating
interest payments for fixed interest payments.
Example 8-2
Convertible Promissory Note With Various Embedded
Features
During the fiscal year ended December 31, 20X3, Entity X
issued $20 million of convertible promissory notes with
the following terms:
-
Interest — The notes carry a fixed rate of interest of 1 percent per annum.
-
Maturity date — The notes mature on the earlier of (1) June 30, 20X8, or (2) the date on which, upon the occurrence (and during the continuance) of an event of default, such amounts are declared due and payable by an investor or become automatically due and payable (see below).
-
Mandatory prepayment — In the event of a change of control of X, the outstanding principal amount of the notes and all accrued and unpaid interest on them are due and payable immediately before the closing of such change of control.
-
Automatic conversion — If X sells shares of its capital stock for aggregate gross proceeds of at least $40 million (a “qualified financing”) before the maturity date, the outstanding principal amount of the notes and all accrued and unpaid interest on them automatically convert into shares issued in such qualified financing at a price equal to the lesser of (1) the price per share paid by investors in the qualified financing and (2) the quotient of $25 million and the amount of X’s fully diluted equity capital.
-
Voluntary conversion — Upon the election of a majority of the investors, the outstanding principal amount of the notes and all accrued and unpaid interest on them may be converted into shares of X’s capital stock issued in any equity financing for capital raising purposes at a price equal to the lesser of (1) the price per share paid by investors in such financing and (2) the quotient of $25 million and the amount of X’s fully diluted equity capital. If no qualified financing occurs on or before the maturity date, a majority of the investors can elect to convert the outstanding principal amount of the notes and all accrued and unpaid interest on them into shares of X’s preferred stock at a price per share equal to the quotient of $25 million and the amount of X’s fully diluted equity capital.
-
Conversion upon a change of control — If a change of control occurs before a qualified financing, the investors may elect to convert the outstanding principal amount of the notes and all accrued and unpaid interest on the notes immediately before such change of control into shares of X’s common stock at a price per share equal to the quotient of $25 million and the amount of X’s fully diluted equity capital.
-
Revenue-based payment feature — Entity X is required to make payments of up to $1 million each quarter based on 10 percent of all revenue over $10 million.
-
Rights of investors upon default — Upon the occurrence of an event of default (other than an event of default involving voluntary or involuntary bankruptcy or insolvency proceedings) and at any time thereafter during the continuance of such an event of default, a majority of the investors may elect to declare all outstanding obligations under the notes to be immediately due and payable. Upon the occurrence of any event of default involving voluntary or involuntary bankruptcy or insolvency proceedings, immediately and without notice, all outstanding obligations under the notes automatically become immediately due and payable. Investors also have the right to receive additional interest on the notes at a rate equal to 1 percent per annum of the principal amount of the notes outstanding for each day during the first 180 days after the occurrence of an event of default and 2 percent per annum of the principal amount of the notes outstanding from the 181st day following the occurrence of an event of default. All events of default represent credit-risk-related covenants (see Section 8.4.2.3).
Entity X is evaluating whether any embedded features must
be separated from the notes and accounted for as
derivatives under ASC 815-15. It has determined that the
notes should be analyzed as a debt host contract under
ASC 815-15 (see Section 8.3.2).
Under the payoff-profile approach, the notes contain the
following embedded features that should be evaluated
under ASC 815-15:
-
Contingent redemption features — The features below involve the contingent settlement of the notes for consideration of the same fixed monetary amount. Because each feature is settleable for the same monetary amount and no feature is a call option, X analyzes them as one combined embedded put feature under the guidance on redemption features (see Section 8.4.4):
-
If a qualified financing occurs before the maturity date, the outstanding principal amount of the notes and all accrued and unpaid interest on them automatically convert into shares of the capital stock issued in the qualified financing at a price no higher than the price paid per share by its investors in the qualified financing. Although this feature is settled in shares, the number of shares delivered under the feature varies on the basis of the fair value of those shares (i.e., price per share paid by the investors) so that the total fair value of those shares will equal the outstanding principal amount and accrued and unpaid interest on the notes regardless of changes in the fair value of the shares. Accordingly, this feature is effectively an early redemption of the notes that uses shares as “currency.” Entity X therefore analyzes it as a redemption feature under the monetary payoff profile approach (see Section 8.4.7.2.5).
-
Upon the election of a majority of the investors, the outstanding principal amount of the notes and all accrued and unpaid interest on them may be converted into shares of X’s capital stock issued in any equity financing for capital raising purposes at a price no higher than the price per share paid by investors in such financing. Although this feature is settled in shares, the number of shares that may ultimately be delivered will vary on the basis of the fair value of those shares (i.e., price per share paid by the investors), such that the total fair value of those shares will equal the outstanding principal amount and accrued and unpaid interest on the notes regardless of changes in the fair value of the shares. Accordingly, this feature is effectively an early redemption of the notes that uses shares as “currency.” Entity X therefore analyzes it as a redemption feature under the monetary payoff profile approach (see also Section 8.4.7.2.5).
-
In the event of a change of control, the outstanding principal amount of each note that has not otherwise been converted into equity securities, plus all accrued and unpaid interest, is due and payable immediately before the closing of the change of control.
-
Upon the occurrence of an event of default and at any time thereafter during the continuance of such event, a majority of the investors may declare all outstanding obligations payable by X under the notes to be immediately due and payable, and such amounts automatically become due upon the occurrence of a voluntary or involuntary bankruptcy or insolvency proceeding of X.
-
- Equity conversion
feature — The following features have an
equity-based return through conversion of the
notes into X’s equity shares at a conversion price
equal to the quotient of $25 million and the
amount of X’s fully diluted equity capital.
Because each feature has a payoff that is based on
an equity return, X analyzes them as one combined
embedded feature under the guidance on equity
features (see Section
8.4.7):
-
If a qualified financing occurs before the maturity date, the outstanding principal amount of the notes and all accrued and unpaid interest on the notes automatically convert into shares of the capital stock issued in the qualified financing at a price no higher than the quotient of $25 million and the amount of X’s fully diluted equity capital.
-
Upon the election of a majority of the investors, the outstanding principal amount of the notes and all accrued and unpaid interest on the notes may be converted into shares of X’s capital stock issued in any equity financing for capital raising purposes at a price no higher than the quotient of $25 million and the amount of X’s fully diluted equity capital.
-
If a qualified financing does not occur before the maturity date, the outstanding principal amount of the notes and all accrued and unpaid interest on them may be converted at the option of a majority of the investors into shares of X’s preferred stock at a price equal to the quotient of $25 million and the amount of X’s fully diluted equity capital.
-
If a change of control occurs before a qualified financing, the investors may elect to convert the outstanding principal amount of the notes and all accrued and unpaid interest on them immediately before such change of control into shares of X’s common stock at a price per share equal to the quotient of $25 million and the amount of X’s fully diluted equity capital.
-
-
Credit-sensitive payments — The right to receive additional interest on the notes at a rate equal to 1 percent per annum of the principal amount of the notes outstanding for each day during the first 180 days after the occurrence of an event of default and 2 percent per annum of the principal amount of the notes outstanding from the 181st day following the occurrence of an event of default represents an additional interest provision on the basis of a credit-related feature (see Section 8.4.2 for a discussion of the evaluation of such features).
-
Revenue-based payment feature — The requirement to make payments of up to $1 million each quarter based on 10 percent of all revenue over $10 million is an additional interest provision on the basis of a revenue feature (see Section 8.4.10 for a discussion of the evaluation of such features).
8.3 Bifurcation Criteria
8.3.1 Overall Framework
ASC 815-15
25-1 An embedded derivative
shall be separated from the host contract and accounted
for as a derivative instrument pursuant to Subtopic
815-10 if and only if all of the following criteria are
met:
-
The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract.
-
The hybrid instrument is not remeasured at fair value under otherwise applicable generally accepted accounting principles (GAAP) with changes in fair value reported in earnings as they occur.
-
A separate instrument with the same terms as the embedded derivative would, pursuant to Section 815-10-15, be a derivative instrument subject to the requirements of Subtopic 815-10 and this Subtopic. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.)
Once an entity has identified the embedded features that require evaluation, it
should determine whether those features must be accounted for separately as a
derivative. Under ASC 815-15-25-1, an entity is required to separately account
for a feature embedded within another contract (the host contract) when all of
the following three conditions are met:
-
The embedded feature and the host contract have economic characteristics and risks that are not clearly and closely related (see Section 8.3.2). For example, changes in the fair value of an equity interest — such as an equity conversion feature — are not clearly and closely related to changes in the interest rates on a debt host contract (see Section 8.4.7.3).
-
The hybrid instrument (i.e., the combination of the embedded feature and its host contract) is not remeasured at fair value, with changes in fair value recorded immediately through earnings (e.g., under the fair value option in ASC 815-15 or ASC 825-10; see Section 8.3.3).
- The embedded feature — if issued separately — would be accounted for as a derivative instrument under ASC 815-10. In evaluating whether this condition is met, the entity considers both (1) the definition of a derivative in ASC 815-10 (see Section 8.3.4) and (2) the scope exceptions from derivative accounting in ASC 815-10 and ASC 815-15 (see Section 8.3.5).
There is no requirement to evaluate the bifurcation conditions in any particular
order. Because all three conditions must be met, the analysis ends if any one
condition is not satisfied. For example:
- If the hybrid instrument is accounted for at fair value, with changes in fair value recognized in earnings, the entity does not need to identify potential embedded derivatives and can omit an evaluation of whether any embedded features (1) are clearly and closely related to the host contract or (2) would have been accounted for as derivatives if they were freestanding contracts.
- If an embedded feature is clearly and closely related to its host contract, an evaluation of whether it meets the definition of a derivative is not required.
- If an embedded feature does not meet the definition of a derivative (e.g., it does not satisfy the net settlement characteristic in the definition of a derivative), it is unnecessary to evaluate whether it (1) is subject to any scope exception related to derivative accounting or (2) is clearly and closely related to its host contract since the feature would not be bifurcated as a derivative.
- If the feature is subject to a derivative scope exception, the entity can omit an evaluation of whether the feature is clearly and closely related to its host contract since bifurcation as a derivative is prohibited.
8.3.2 Condition 1 — Not Clearly and Closely Related
8.3.2.1 Background
ASC 815-15
25-1 An embedded
derivative shall be separated from the host contract
and accounted for as a derivative instrument
pursuant to Subtopic 815-10 if and only if all of
the following criteria are met:
- The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract. . . .
The first bifurcation condition in ASC 815-15-25-1 is that
the embedded feature and the host contract have economic characteristics and
risks that are not clearly and closely related to each other. In evaluating
whether this condition is met, the entity must determine the nature of the
host contract and identify the economic characteristics and risks of the
embedded feature. The manner in which an entity determines the nature of the
host contract depends on whether the hybrid contract is in the legal form of
debt (see the next section) or an outstanding share (see Section 8.3.2.3).
8.3.2.2 Hybrid Contracts in the Legal Form of Debt
If the hybrid instrument is in the legal form of debt (i.e.,
the holder has creditor rights), the host contract is considered to have the
economic characteristics and risks of a debt instrument. Although a hybrid
instrument may include embedded features that have the economic
characteristics and risks of an equity instrument (e.g., a dividend
participation right or a payment feature based on the entity’s stock price),
the host contract would nevertheless be considered a debt instrument if the
legal form of the hybrid instrument is debt.
For hybrid instruments with debt host contracts, the entity must identify the
terms of such debt host. The terms of a debt host contract are identified on
the basis of the stated or implied substantive terms of the hybrid
instrument (e.g., a fixed rate, a variable rate, or a zero coupon; see
Section 8.3.2.4). An entity is not permitted to
impute terms in the debt host contract that would result in the
identification of an embedded derivative that is not clearly present in the
hybrid instrument.
8.3.2.3 Hybrid Contracts in the Legal Form of an Outstanding Share
8.3.2.3.1 General
ASC 815-15
25-16 If the host contract
encompasses a residual interest in an entity, then
its economic characteristics and risks shall be
considered that of an equity instrument and an
embedded derivative would need to possess
principally equity characteristics (related to the
same entity) to be considered clearly and closely
related to the host contract.
25-17 Because the changes
in fair value of an equity interest and interest
rates on a debt instrument are not clearly and
closely related, the terms of convertible
preferred stock shall be analyzed to determine
whether the preferred stock (and thus the
potential host contract) is more akin to an equity
instrument or a debt instrument.
25-17A For a hybrid
financial instrument issued in the form of a
share, an entity shall determine the nature of the
host contract by considering all stated and
implied substantive terms and features of the
hybrid financial instrument, weighing each term
and feature on the basis of the relevant facts and
circumstances. That is, in determining the nature
of the host contract, an entity shall consider the
economic characteristics and risks of the entire
hybrid financial instrument including the embedded
derivative feature that is being evaluated for
potential bifurcation. In evaluating the stated
and implied substantive terms and features, the
existence or omission of any single term or
feature does not necessarily determine the
economic characteristics and risks of the host
contract. Although an individual term or feature
may weigh more heavily in the evaluation on the
basis of the facts and circumstances, an entity
should use judgment based on an evaluation of all
of the relevant terms and features. For example,
an entity shall not presume that the presence of a
fixed-price, noncontingent redemption option held
by the investor in a convertible preferred stock
contract, in and of itself, determines whether the
nature of the host contract is more akin to a debt
instrument or more akin to an equity instrument.
Rather, the nature of the host contract depends on
the economic characteristics and risks of the
entire hybrid financial instrument.
25-17B The guidance in
paragraph 815-15-25-17A relates to determining
whether a host contract within a hybrid financial
instrument issued in the form of a share is
considered to be more akin to a debt instrument or
more akin to an equity instrument for the purposes
of evaluating one or more embedded derivative
features for bifurcation under paragraph
815-15-25-1(a). It is not intended to address when
an embedded derivative feature should be
bifurcated from the host contract or the
accounting when such bifurcation is required. In
addition, the guidance in paragraph 815-15-25-17A
is not intended to prescribe the method to be used
in determining the nature of the host contract in
a hybrid financial instrument that is not issued
in the form of a share.
If the host contract is in the legal form of a share
(e.g., preferred stock), the evaluation of whether the contract should
be considered a debt host or an equity host is not based solely on its
legal form or whether it qualifies for presentation as equity (including
temporary equity) under GAAP. Instead, an entity is required to use a
“whole-instrument approach” under which it determines the nature of the
host contract by considering all of its stated or implied substantive
terms and features. Accordingly, an entity must further analyze the
economic characteristics and risks of the hybrid contract to determine
whether the contract should be considered a debt host or an equity host.
For example, an outstanding share that is classified as a liability
under ASC 480 or as temporary equity under ASC 480-10-S99-3A could
potentially qualify as a debt host contract depending on its terms and
conditions.
An entity must identify the nature of the host contract as of the hybrid
instrument’s initial recognition date (i.e., upon its issuance or
acquisition). The entity is required to reassess that determination upon
a modification or exchange of the hybrid instrument that is accounted
for as an extinguishment (see Section 10.4.2). The
determination of whether a reassessment is required for a modification
or exchange that is not accounted for as an extinguishment depends on
the relevant facts and circumstances.
Because this Roadmap addresses the issuer’s accounting for debt, the
accounting for outstanding shares is beyond its scope except for certain
types of liability-classified shares (see Section 2.3.2.3). Liability-classified outstanding
shares will generally contain debt host contracts. However, it is
possible for a such a share to contain an equity host contract.
Furthermore, some equity-classified hybrid instruments will contain debt
hosts (in which case the evaluation of embedded derivatives is the same
as that for a hybrid instrument that is in the legal form of debt). The
sections below therefore discuss the guidance on determining the nature
of the host contract for a hybrid instrument in the form of a share.
8.3.2.3.2 Framework for Determining Whether an Outstanding Share Is a Debt Host or an Equity Host
ASC 815-15
25-17C When applying the
guidance in paragraph 815-15-25-17A, an entity
shall determine the nature of the host contract by
considering all stated and implied substantive
terms and features of the hybrid financial
instrument, determining whether those terms and
features are debt-like versus equity-like, and
weighing those terms and features on the basis of
the relevant facts and circumstances. That is, an
entity shall consider not only whether the
relevant terms and features are debt-like versus
equity-like, but also the substance of those terms
and features (that is, the relative strength of
the debt-like or equity-like terms and features
given the facts and circumstances). In assessing
the substance of the relevant terms and features,
each of the following may form part of the overall
analysis and may inform an entity’s overall
consideration of the relative importance (and,
therefore, weight) of each term and feature among
other terms and features:
-
The characteristics of the relevant terms and features themselves (for example, contingent versus noncontingent, in-the-money versus out-of-the-money)
-
The circumstances under which the hybrid financial instrument was issued or acquired (for example, issuer-specific characteristics, such as whether the issuer is thinly capitalized or profitable and well-capitalized)
-
The potential outcomes of the hybrid financial instrument (for example, the instrument may be settled by the issuer issuing a fixed number of shares, the instrument may be settled by the issuer transferring a specified amount of cash, or the instrument may remain legal-form equity), as well as the likelihood of those potential outcomes. The assessment of the potential outcomes may be qualitative in nature.
25-17D The following are
examples (and not an exhaustive list) of common
terms and features included within a hybrid
financial instrument issued in the form of a share
and the types of information and indicators that
an entity (an issuer or an investor) may consider
when assessing the substance of those terms and
features in the context of determining the nature
of the host contract, as discussed in paragraph
815-15-25-17C:
-
Redemption rights. The ability for an issuer or investor to redeem a hybrid financial instrument issued in the form of a share at a fixed or determinable price generally is viewed as a debt-like characteristic. However, not all redemption rights are of equal importance. For example, a noncontingent redemption option may be given more weight in the analysis than a contingent redemption option. The relative importance (and, therefore, weight) of redemption rights among other terms and features in a hybrid financial instrument may be evaluated on the basis of information about the following (among other relevant) facts and circumstances:
-
Whether the redemption right is held by the issuer or investors
-
Whether the redemption is mandatory
-
Whether the redemption right is noncontingent or contingent
-
Whether (and the degree to which) the redemption right is in-the-money or out-of-the-money
-
Whether there are any laws that would restrict the issuer or investors from exercising the redemption right (for example, if redemption would make the issuer insolvent)
-
Issuer-specific considerations (for example, whether the hybrid financial instrument is effectively the residual interest in the issuer [due to the issuer being thinly capitalized or the common equity of the issuer having already incurred losses] or whether the instrument was issued by a well-capitalized, profitable entity)
-
If the hybrid financial instrument also contains a conversion right, the extent to which the redemption price (formula) is more or less favorable than the conversion price (formula), that is, a consideration of the economics of the redemption price (formula) and the conversion price (formula), not simply the form of the settlement upon redemption or conversion.
-
- Conversion rights. The ability for an investor
to convert, for example, a preferred share into a
fixed number of common shares generally is viewed
as an equity-like characteristic. However, not all
conversion rights are of equal importance. For
example, a conversion option that is noncontingent
or deeply in-the-money may be given more weight in
the analysis than a conversion option that is
contingent on a remote event or deeply
out-of-the-money. The relative importance (and,
therefore, weight) of conversion rights among
other terms and features in a hybrid financial
instrument may be evaluated on the basis of
information about the following (among other
relevant) facts and circumstances:
-
Whether the conversion right is held by the issuer or investors
-
Whether the conversion is mandatory
-
Whether the conversion right is noncontingent or contingent
-
Whether (and the degree to which) the conversion right is in-the-money or out-of-the-money
-
If the hybrid financial instrument also contains a redemption right held by the investors, whether conversion is more likely to occur before redemption (for example, because of an expected initial public offering or change-in-control event before the redemption right becoming exercisable).
-
- Voting rights. The ability for a class of
stock to exercise voting rights generally is
viewed as an equity-like characteristic. However,
not all voting rights are of equal importance. For
example, voting rights that allow a class of stock
to vote on all significant matters may be given
more weight in the analysis than voting rights
that are only protective in nature. The relative
importance (and, therefore, weight) of voting
rights among other terms and features in a hybrid
financial instrument may be evaluated on the basis
of information about the following (among other
relevant) facts and circumstances:
-
On which matters the voting rights allow the investor’s class of stock to vote (relative to common stock shareholders)
-
How much influence the investor’s class of stock can exercise as a result of the voting rights.
-
- Dividend rights. The nature of dividends can
be viewed as a debt-like or equity-like
characteristic. For example, mandatory fixed
dividends generally are viewed as a debt-like
characteristic, while discretionary dividends
based on earnings generally are viewed as an
equity-like characteristic. The relative
importance (and, therefore, weight) of dividend
terms among other terms and features in a hybrid
financial instrument may be evaluated on the basis
of information about the following (among other
relevant) facts and circumstances:
-
Whether the dividends are mandatory or discretionary
-
The basis on which dividends are determined and whether the dividends are stated or participating
-
Whether the dividends are cumulative or noncumulative.
-
- Protective covenants. Protective covenants
generally are viewed as a debt-like
characteristic. However, not all protective
covenants are of equal importance. Covenants that
provide substantive protective rights may be given
more weight than covenants that provide only
limited protective rights. The relative importance
(and, therefore, weight) of protective covenants
among other terms and features in a hybrid
financial instrument may be evaluated on the basis
of information about the following (among other
relevant) facts and circumstances:
-
Whether there are any collateral requirements akin to collateralized debt
-
If the hybrid financial instrument contains a redemption option held by the investor, whether the issuer’s performance upon redemption is guaranteed by the parent of the issuer
-
Whether the instrument provides the investor with certain rights akin to creditor rights (for example, the right to force bankruptcy or a preference in liquidation).
-
To determine the nature of the host contract under the whole-instrument
approach, an entity performs the following steps:
-
Identify all of the hybrid financial instrument’s stated and implied substantive terms and features (see Section 8.3.2.3.3).
-
Determine whether each of the identified terms and features is more debt-like or equity-like (see Section 8.3.2.3.4).
-
Consider the relative weight of the identified terms and features “on the basis of the relevant facts and circumstances” (see Section 8.3.2.3.5).
-
Reach a conclusion about the nature of the host contract (see Section 8.3.2.3.6).
8.3.2.3.3 Step 1 — Identify the Hybrid Instrument’s Substantive Terms and Features
The first step in applying the whole-instrument approach is to identify
all of the substantive terms and features of the hybrid financial
instrument, whether stated or implied. ASC 815-15-25-17D lists common
terms and features in hybrid instruments that are in the form of
shares.
8.3.2.3.4 Step 2 — Determine Whether the Identified Terms and Features Are More Debt-Like or Equity-Like
The next step in applying the whole-instrument approach
is to determine whether the identified substantive terms and features of
the hybrid instrument are more debt- or equity-like. To make this
determination, an entity should analyze the terms’ or features’ economic
characteristics and risks.
ASC 815-15-25-16 explains that a host contract is considered equity-like
if it “encompasses a residual interest in an entity.” By contrast, a
term or feature that is not consistent with a residual interest in the
issuing entity would most likely be considered debt-like. ASC
815-15-25-17D provides examples of common terms and features, discusses
whether such terms and features are generally debt- or equity-like, and
lists factors that an entity might consider in determining the relative
weight to assign to such terms and features.
The following chart
illustrates which characteristics are generally more debt-like or
equity-like:
8.3.2.3.5 Step 3 — Weigh the Identified Terms and Features
The third step is to weigh each of the hybrid financial instrument’s
substantive terms and features — qualitatively, quantitatively, or both
— “on the basis of the relevant facts and circumstances,” as described
in ASC 815-15-25-17C. The entity determines the “relative strength” or
weight of each of the hybrid financial instrument’s substantive terms
and features by considering the following:
-
The characteristics of the relevant terms and features themselves — For example, for a redemption option, the entity should consider whether the option is (1) mandatory or optional and (2) contingent or noncontingent. A mandatory redemption right would be given more weight than an optional redemption right, and a noncontingent redemption right would be given more weight than a contingent redemption right. ASC 815-15-25-17D provides a list of characteristics that a reporting entity should consider in its analysis. Although not an all-inclusive list, these characteristics are discussed further in the table below.
-
The circumstances under which the hybrid financial instrument was issued or acquired — This condition is generally meant to help an entity assess whether the hybrid financial instrument is, in substance, a residual interest in the issuing entity. For example, a hybrid financial instrument issued by a thinly capitalized entity (or one with an accumulated deficit) might be considered more equity-like than a hybrid financial instrument issued by a well-capitalized profitable entity. This is because in a thinly capitalized entity, the hybrid financial instrument may, in substance, represent a residual interest in that issuing entity even if other classes of equity are more subordinated.
-
The potential outcomes of the hybrid financial instrument as well as the likelihood of those potential outcomes — This condition is meant to help an entity assess the hybrid financial instrument’s likely economic return. For example, a hybrid financial instrument that is expected to be settled in a fixed number of common shares (thus providing a more equity-like return) might be viewed as more equity-like than a hybrid financial instrument that is expected to be settled in a specified amount of cash or a variable number of shares that is equal to a fixed dollar amount (thus providing a more debt-like return).
The table below provides examples of indicators that a reporting entity
should consider in determining whether to assign more or less weight to
the general view related to whether a term or feature is debt-like or
equity-like in the entity’s analysis of the nature of the host contract
for a hybrid instrument issued in the form of a share. This table does
not apply to hybrid instruments issued in the form of debt.
|
General View
|
Indicators That the General View Should Be Given
More Weight
|
Indicators That the General View Should Be Given
Less Weight
|
|---|---|---|
|
Redemption rights are debt-like
|
|
|
|
Conversion rights are an equity-like term or
feature
|
|
|
|
Voting rights are an equity-like term or
feature
|
|
|
|
Protective covenants are a debt-like term or
feature
|
|
|
|
Dividends are either a debt-like or an
equity-like feature
|
Dividend rights that are mandatory, stated, or
cumulative add weight to the view that a debt host
is more debt-like. Dividend rights that are
discretionary, participating, or noncumulative add
weight to the view that a debt host is more
equity-like.
| |
8.3.2.3.6 Step 4 — Reach a Conclusion About the Nature of the Host Contract
The final step is to reach a conclusion regarding the nature of the host
contract on the basis of the results of the analyses performed in the
previous steps. As explained in ASC 815-15-25-17A, “[i]n evaluating the
stated and implied substantive terms and features, the existence or
omission of any single term or feature does not necessarily determine
the economic characteristics and risks of the host contract. Although an
individual term or feature may weigh more heavily in the evaluation on
the basis of the facts and circumstances, an entity should use judgment
based on an evaluation of all of the relevant terms and features.” To
further emphasize this point, ASC 815-15-25-17A states by way of example
that “an entity shall not presume that the presence of a fixed-price,
noncontingent redemption option held by the investor in a convertible
preferred stock contract, in and of itself, determines whether the
nature of the host contract is more akin to a debt instrument or more
akin to an equity instrument.” If the nature of the host contract is
still not clear, the entity should consider the expected outcome of the
hybrid financial instrument in reaching a conclusion. Given the
complexity of determining the nature of a host contract of a hybrid
instrument with both conversion and redemption features, entities are
encouraged to consult with their accounting advisers.
8.3.2.4 Host Contract Terms
ASC 815-15
25-24 The characteristics
of a debt host contract generally shall be based on
the stated or implied substantive terms of the
hybrid instrument. Those terms may include a
fixed-rate, variable-rate, zero-coupon, discount or
premium, or some combination thereof.
25-25 In the absence of
stated or implied terms, an entity may make its own
determination of whether to account for the debt
host as a fixed-rate, variable-rate, or zero-coupon
bond. That determination requires the application of
judgment, which is appropriate because the
circumstances surrounding each hybrid instrument
containing an embedded derivative may be different.
That is, in the absence of stated or implied terms,
it is appropriate to consider the features of the
hybrid instrument, the issuer, and the market in
which the instrument is issued, as well as other
factors, to determine the characteristics of the
debt host contract. However, an entity shall not
express the characteristics of the debt host
contract in a manner that would result in
identifying an embedded derivative that is not
already clearly present in a hybrid instrument. For
example, it would be inappropriate to do either of
the following:
-
Identify a variable-rate debt host contract and an interest rate swap component that has a comparable variable-rate leg in an embedded compound derivative, in lieu of identifying a fixed-rate debt host contract
-
Identify a fixed-rate debt host contract and a fixed-to-variable interest rate swap component in an embedded compound derivative in lieu of identifying a variable-rate debt host contract.
A contract in the legal form of debt is always considered a debt host
contract (see Section 8.3.2.2). If the contract is in the legal form of an
outstanding share, the entity must determine whether it has the
characteristics and risks of a debt host contract or an equity host contract
(see Section 8.3.2.3).
The terms of a debt host contract are identified on the basis of the terms of
the hybrid debt instrument. For example, a fixed-rate hybrid debt contract
would have a fixed-rate debt host contract, and a variable-rate hybrid debt
contract would have a variable-rate debt host contract. An entity is not
permitted to impute terms in the host contract that are not clearly present
in the hybrid instrument, such as artificial terms that “introduce leverage,
asymmetry, or some other risk exposure not already present in the hybrid
instrument.” For example, a debtor cannot impute a pay-fixed,
receive-variable interest rate swap and identify the debt host contract as
variable-rate debt if the hybrid debt instrument makes fixed interest
payments.
8.3.2.5 Determining Whether an Embedded Feature Is Clearly and Closely Related to Its Host Contract
ASC 815 contains extensive application guidance on the evaluation of whether
particular types of embedded features should be considered clearly and
closely related to their host contracts (see Section 8.4). An embedded feature needs to possess
principally debt-like characteristics to be considered clearly and closely
related to a debt host contract. Contractual terms could potentially qualify
as a debt-like feature if they are based on market interest rates, the
issuer’s credit risk, or inflation. However, an entity cannot assume that a
feature that is based on one of those underlyings is clearly and closely
related to a debt host contract without further analysis under the detailed
provisions in ASC 815-15 (e.g., the negative-yield test and the
double-double test for underlyings based on interest rates; see Section 8.4.1).
The table below provides examples of embedded features that would or would
not be considered clearly and closely related to a debt host contract. Note,
however, that the assessment could differ depending on the facts and
circumstances and other specific requirements of ASC 815.
|
Clearly and Closely Related
|
Not Clearly and Closely Related
|
|---|---|
|
|
Because the scope of this Roadmap is limited to debt instruments, it does not
address the evaluation of embedded features in equity host contracts.
8.3.3 Condition 2 — Hybrid-Instrument Accounting
ASC 815-15
25-1 An embedded
derivative shall be separated from the host contract and
accounted for as a derivative instrument pursuant to
Subtopic 815-10 if and only if all of the following
criteria are met: . . .
b. The hybrid instrument is not remeasured at
fair value under otherwise applicable generally
accepted accounting principles (GAAP) with changes
in fair value reported in earnings as they occur.
. . .
The second bifurcation condition in ASC 815-15-25-1 is that the
hybrid instrument is not remeasured at fair value, with changes in fair value
recognized in earnings. If an issuer has applied the fair value option in ASC
815-15 or ASC 825-10 to a hybrid debt instrument (see Sections 4.4 and 8.5.6), an embedded feature would not be
bifurcated. This bifurcation condition would not be met for a financial
liability for which the fair value has been elected even though changes in fair
value attributable to instrument-specific credit risk are recognized in OCI
under ASC 825-10-45-5 (see Section 6.3.2).
ASC 825 prohibits an entity from electing the fair value option
for a financial instrument that would be classified, in whole or in part, as
equity. Because ASC 470-20 requires a convertible debt instrument issued at a
substantial premium to be presented, in part, in equity (see Section 7.6), the issuer
cannot elect the fair value option for it.
If a liability is measured at (1) intrinsic value under the
indexed-debt guidance in ASC 470-10 (see Section 7.4.5) or (2) settlement value in
accordance with ASC 480-10-35-3 (see Sections 4.3.1.2 and 5.3.1.1 of Deloitte’s
Roadmap Distinguishing
Liabilities From Equity), an entity should not consider
the liability to be accounted for at fair value when assessing whether an
embedded feature must be bifurcated. Although the intrinsic value or settlement
value might approximate fair value, it does not take into account all of an
instrument’s attributes that are included in a fair value estimate — for
example, the time value of an option. Thus, an instrument that is remeasured at
intrinsic value or settlement value may contain an embedded feature that must be
bifurcated.
8.3.4 Condition 3 — Derivative Instrument
8.3.4.1 Background
ASC 815-15
25-1 An embedded
derivative shall be separated from the host contract
and accounted for as a derivative instrument
pursuant to Subtopic 815-10 if and only if all of
the following criteria are met: . . .
c. A separate instrument with the same terms
as the embedded derivative would, pursuant to
Section 815-10-15, be a derivative instrument
subject to the requirements of Subtopic 815-10 and
this Subtopic. (The initial net investment for the
hybrid instrument shall not be considered to be
the initial net investment for the embedded
derivative.)
ASC 815-10
15-83 A derivative
instrument is a financial instrument or other
contract with all of the following
characteristics:
- Underlying, notional amount, payment
provision. The contract has both of the following
terms, which determine the amount of the
settlement or settlements, and, in some cases,
whether or not a settlement is required:
-
One or more underlyings
-
One or more notional amounts or payment provisions or both.
-
- Initial net investment. The contract requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
- Net settlement. The contract can be settled
net by any of the following means:
-
Its terms implicitly or explicitly require or permit net settlement.
-
It can readily be settled net by a means outside the contract.
-
It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.
-
The third bifurcation condition in ASC 815-15-25-1 is that the embedded
feature would have been accounted for as a derivative instrument under ASC
815 if it were a separate freestanding instrument. This condition is
satisfied if the feature both (1) would have met the definition of a
derivative instrument in ASC 815-10 if it had been a freestanding contract
and (2) does not meet any of the scope exceptions in ASC 815-10 and ASC
815-15. An entity is not permitted to bifurcate as a derivative an embedded
feature that (1) does not meet the definition of a derivative instrument on
a freestanding basis or (2) qualifies for a derivative scope exception.
To evaluate whether an embedded feature would have met the definition of a
derivative instrument on a freestanding basis, an entity considers whether
the feature possesses all three characteristics of a derivative instrument
described in ASC 815-10-15-83:
-
Underlying and either a notional amount or payment provision (see Section 8.3.4.2).
-
Initial net investment (see Section 8.3.4.3).
-
Net settlement (see Section 8.3.4.4).
Under ASC 815, a feature that does not possess all of these characteristics
is not considered a derivative (i.e., it should not be separated as a
derivative). Further, a feature that meets the definition of a derivative
instrument should not be bifurcated if it meets one or more scope exception
in either ASC 815-10-15 or ASC 815-15-15 (see Section
8.3.5).
8.3.4.2 Underlying, Notional Amount, and Payment Provision Terms
ASC 815-10
15-83 A
derivative instrument is a financial instrument or
other contract with all of the following
characteristics:
- Underlying, notional amount,
payment provision. The contract has both of the
following terms, which determine the amount of the
settlement or settlements, and, in some cases,
whether or not a settlement is required:
-
One or more underlyings
-
One or more notional amounts or payment provisions or both. . . .
-
The first characteristic of a derivative in ASC 815-10-15-83
is that it has both “[o]ne or more underlyings” (see the next section) and
either “[o]ne or more notional amounts or payment provisions or both” (see
Section
8.3.4.2.2).
8.3.4.2.1 Underlying
ASC Master Glossary
Underlying
A specified interest rate, security price,
commodity price, foreign exchange rate, index of
prices or rates, or other variable (including the
occurrence or nonoccurrence of a specified event
such as a scheduled payment under a contract). An
underlying may be a price or rate of an asset or
liability but is not the asset or liability
itself. An underlying is a variable that, along
with either a notional amount or a payment
provision, determines the settlement of a
derivative instrument.
ASC 815-10
15-88 An underlying is a
variable that, along with either a notional amount
or a payment provision, determines the settlement
of a derivative instrument. An underlying usually
is one or a combination of the following:
-
A security price or security price index
-
A commodity price or commodity price index
-
An interest rate or interest rate index
-
A credit rating or credit index
-
An exchange rate or exchange rate index
-
An insurance index or catastrophe loss index
-
A climatic or geological condition (such as temperature, earthquake severity, or rainfall), another physical variable, or a related index
-
The occurrence or nonoccurrence of a specified event (such as a scheduled payment under a contract).
15-89 However, an
underlying may be any variable whose changes are
observable or otherwise objectively verifiable. An
underlying may be a price or rate of an asset or
liability but is not the asset or liability
itself.
15-90 Reference to either
a notional amount or a payment provision is needed
in relation to an underlying to compute the
contract’s periodic settlements and resulting
changes in fair value.
15-91 Example 3 (see
paragraph 815-10-55-77) illustrates the
determination of an underlying if a commodity
contract includes a fixed element and a variable
element.
All derivatives have one or more underlyings. An underlying is a variable
(e.g., a price, rate, index, or the occurrence or nonoccurrence of a
specified event) that could cause the payments or other settlements
required by a contract to change.
Examples of the underlyings of features embedded in a debt host contract
include the following:
-
Interest rates or interest rate indexes — The interest payments on some debt instruments fluctuate on the basis of changes in market interest rates, such as LIBOR or SOFR. Such fluctuations might be subject to a maximum rate (a cap), a minimum rate (a floor), or a range (collar). In addition, the debtor might have a right to elect which variable interest rate index will apply (a choose-your-rate option). Many debt instruments contain put or call options that could change the rate of return realized by the creditor if they are triggered. See Section 8.4.1 for further discussion.
-
Credit ratings or other measures of credit risk — Some debt instruments have interest payments that vary on the basis of a measure of the debtor’s credit risk, such as an external credit rating. Alternatively, a debt instrument might require additional interest to be paid upon an event of default involving the debtor. See Section 8.4.2 for further discussion.
-
Inflation rates — Inflation-indexed debt securities pay interest that varies on the basis of changes in an inflation index, such as a CPI. See Section 8.4.3 for further discussion.
-
The occurrence or nonoccurrence of specified events — Debt instruments often contain features that accelerate repayment or permit prepayment of amounts due or require specified payments to be made upon the occurrence or nonoccurrence of specified events. For example, debt instruments often contain put or call options that are contingent on the occurrence or nonoccurrence of a change of control, an IPO, a qualified debt or equity financing, the debtor’s stock price, or the debt’s traded price. Further, many debt instruments require additional interest to be paid upon the occurrence or nonoccurrence of specified events, such as the inability to freely trade the instrument or the achievement of business milestones. See Sections 8.4.4 (puts, calls, and other redemption features) and 8.4.11 (other contingent payments) for further discussion.
-
Stock prices or stock price indexes — When debt is convertible into a fixed number of the debtor’s equity shares (e.g., common or preferred stock), the share price is an underlying of the conversion feature. When the monetary value of the payoff fluctuates on the basis of changes in a stock price, the stock price is considered an underlying even if the contractual terms do not explicitly refer to the stock price. For example, the terms of a conversion feature that requires gross physical settlement in a fixed number of shares upon conversion might not refer to the stock price. Nevertheless, the stock price is an underlying because the monetary value of the conversion feature fluctuates on the basis of changes in the price of the shares that would be delivered upon conversion. See Section 8.4.7 for further discussion.
-
Currency exchange rates or currency exchange rate indexes — A debt instrument might contain terms that permit payments to be made in more than one currency at a fixed or specified exchange rate. Other debt instruments have principal and interest payments that are denominated in different currencies. See Section 8.4.8 for further discussion.
-
Commodity prices or commodity price indexes — Sometimes, the payments on a debt instrument fluctuate on the basis of changes in the price of a commodity, such as gold, crude oil, or natural gas. See Section 8.4.9 for further discussion.
-
Sales volume, revenue, or other performance metrics — Some debt instruments require payments that vary on the basis of changes in measures of sales volume, revenue, or earnings. See Section 8.4.10 for further discussion.
In the determination of the contractual cash flows or other exchanges
required by a derivative and its value, the underlying is applied to a
notional amount (e.g., an interest rate might be applied to the debt’s
outstanding amount) or there is a payment provision (e.g., a fixed
payment might be triggered if a specified event occurs).
8.3.4.2.2 Notional Amount or Payment Provision
ASC Master Glossary
Notional Amount
A number of currency units, shares, bushels,
pounds, or other units specified in a derivative
instrument. Sometimes other names are used. For
example, the notional amount is called a face
amount in some contracts.
Payment Provision
A payment provision specifies a fixed or
determinable settlement to be made if the
underlying behaves in a specified manner.
ASC 815-10
15-92 A notional amount is
a number of currency units, shares, bushels,
pounds, or other units specified in the contract.
Other names are used, for example, the notional
amount is called a face amount in some contracts.
The settlement of a derivative instrument with a
notional amount is determined by interaction of
that notional amount with the underlying. The
interaction may be simple multiplication, or it
may involve a formula with leverage factors or
other constants. As defined in the glossary, the
effective notional amount is the stated notional
amount adjusted for any leverage factor. If a
requirements contract contains explicit provisions
that support the calculation of a determinable
amount reflecting the buyer’s needs, then that
contract has a notional amount. See paragraphs
815-10-55-5 through 55-7 for related
implementation guidance. For implementation
guidance on identifying a commodity contract’s
notional amount, see paragraph 815-10-55-5.
15-93 As defined in the
glossary, a payment provision specifies a fixed or
determinable settlement to be made if the
underlying behaves in a specified manner. For
example, a derivative instrument might require a
specified payment if a referenced interest rate
increases by 300 basis points.
To meet the definition of a derivative, a contract must contain a
notional amount or a payment provision. A notional amount is a quantity
that interacts with an underlying in the determination of the cash flows
or fair value of the contract. Examples of notional amounts include
monetary quantities (e.g., the principal amount of debt) or a number of
equity shares (e.g., the number of equity shares that would be received
upon conversion of a convertible debt instrument).
A payment provision is a fixed or determinable payment that is triggered
by specified changes in the underlying. Examples include the payment of
a fixed amount upon the occurrence or nonoccurrence of an event (e.g.,
change of control or an event of default).
8.3.4.3 Initial Net Investment
ASC 815-10
15-83 A derivative instrument
is a financial instrument or other contract with all
of the following characteristics: . . .
b. Initial net investment. The contract
requires no initial net investment or an initial
net investment that is smaller than would be
required for other types of contracts that would
be expected to have a similar response to changes
in market factors. . . .
15-96 If the initial net
investment in the contract (after adjustment for the
time value of money) is less, by more than a nominal
amount, than the initial net investment that would
be commensurate with the amount that would be
exchanged either to acquire the asset related to the
underlying or to incur the obligation related to the
underlying, the characteristic in paragraph
815-10-15-83(b) is met. The amount of that asset
acquired or liability incurred should be comparable
to the effective notional amount of the contract.
This does not imply that a slightly off-market
contract cannot be a derivative instrument in its
entirety. That determination is a matter of facts
and circumstances and shall be evaluated on a
case-by-case basis. Example 16, Case C (see
paragraph 815-10-55-166) illustrates the guidance in
this paragraph.
The second characteristic of a derivative in ASC 815-10-15-83 is that it has
“no initial net investment or an initial net investment that is smaller than
would be required for other types of contracts that would be expected to
have a similar response to changes in market factors.” To evaluate this
characteristic, an entity compares the contract’s initial net investment
with the amount needed to acquire (or incur) the effective notional amount
of the asset (or liability) related to the contract’s underlying. The
characteristic is present if the initial net investment is smaller, by more
than a nominal amount, than that for other types of contracts with a similar
response to changes in market factors. For example, there is often no
initial investment required for freestanding swaps and forward contracts.
For freestanding option contracts, the initial investment usually must be
smaller than the amount needed to invest in the option’s reference asset. If
the contract’s initial investment approximates the initial investment needed
to acquire (or incur) the related asset (or liability), the net investment
characteristic is not met.
The initial investment in a hybrid instrument is not considered the initial
net investment for an embedded feature in that instrument (as noted in ASC
815-15-25-1). Instead, the initial net investment in the embedded feature is
the amount an entity would have been required to invest in a freestanding
contract with terms that are similar to those of the embedded feature,
excluding the host contract of the hybrid instrument. That is, the initial
investment needed to acquire or incur the host contract (e.g., the fair
value of a debt host contract) does not form part of the initial investment
of any embedded feature in the same hybrid instrument. Therefore, the
initial net investment characteristic typically is met for embedded features
in debt host contracts.
Example 8-3
Initial Net Investment in Conversion Option
Embedded in a Debt Instrument
The initial net investment in a conversion option
embedded in a debt instrument is the option’s fair
value; it is not the fair value of the convertible
debt or the fair value of the shares that would be
delivered upon exercise of the conversion feature.
When evaluating whether the initial net investment
characteristic is met, an entity compares the fair
value of the conversion option on the date of the
debt’s issuance with the fair value of the
underlying shares that are deliverable to the
holders upon exercise of the conversion option. If
the fair value of the conversion option is less, by
more than a nominal amount, than the fair value of
the instrument into which the option is convertible
on the date of issuance, the initial net investment
characteristic is met.
8.3.4.4 Net Settlement
8.3.4.4.1 Background
ASC 815-10
15-83 A derivative
instrument is a financial instrument or other
contract with all of the following
characteristics: . . .
c. Net settlement. The contract can be
settled net by any of the following means:
1. Its terms implicitly
or explicitly require or permit net
settlement.
2. It can readily be
settled net by a means outside the contract.
3. It provides for
delivery of an asset that puts the recipient in a
position not substantially different from net
settlement.
15-99 A
contract fits the description in paragraph
815-10-15-83(c) if its settlement provisions meet
criteria for any of the following:
-
Net settlement under contract terms
-
Net settlement through a market mechanism
-
Net settlement by delivery of derivative instrument or asset readily convertible to cash.
The third characteristic of a derivative in ASC
815-10-15-83 is net settlement. ASC 815-10 specifies that a contract
meets the net settlement characteristic in the definition of a
derivative if it permits net settlement in any of the following ways:
(1) under the contractual terms (see Section 8.3.4.4.2), (2) through a
market mechanism (see Section 8.3.4.4.3), or (3) by delivery of a derivative
instrument or an asset that is readily convertible to cash (see
Section
8.3.4.4.4).
The table below lists examples of features that may or may not meet the
net settlement characteristic if they are embedded in a debt host
contract.
|
Net Settlement Characteristic Met
|
Net Settlement Characteristic Not Met
|
|---|---|
|
|
8.3.4.4.2 Net Settlement Under Contract Terms
ASC 815-10
Net Settlement Under Contract Terms
15-100 In this form of net
settlement, neither party is required to deliver
an asset that is associated with the underlying
and that has a principal amount, stated amount,
face value, number of shares, or other
denomination that is equal to the notional amount
(or the notional amount plus a premium or minus a
discount). (For example, most interest rate swaps
do not require that either party deliver
interest-bearing assets with a principal amount
equal to the notional amount of the contract.) Net
settlement may be made in cash or by delivery of
any other asset (such as the right to receive
future payments — see the discussion beginning in
paragraph 815-10-15-104), whether or not that
asset is readily convertible to cash.
In a contractual net settlement, neither party is required to deliver an
asset that is associated with the underlying and whose principal amount,
stated amount, face value, number of shares, or other denomination is
equal to the notional amount. One form of contractual net settlement is
a one-way transfer of cash or assets, such as a net amount of cash or a
net number of shares (“cashless exercise”) that is equivalent to the
gain or loss on the contract. An embedded feature in a debt host
contract that is contractually settled net would meet this condition
(e.g., a conversion feature that permits net share or net cash
settlement of the conversion spread while the principal amount of the
debt is settled in cash). If the contractual terms require or permit
either party to elect net settlement, the net settlement characteristic
is met even if the item that may be delivered upon settlement is not
readily convertible to cash (e.g., a net share settlement involving
private company shares; see Section 8.4.7).
In accordance with ASC 815-10-15-107, the exercise of an embedded put or
call option in a debt host contract is considered a contractual net
settlement of that embedded option “because neither party is required to
deliver an asset that is associated with the underlying” (see
Section 8.4.4.4).
8.3.4.4.3 Net Settlement Through a Market Mechanism
ASC 815-10
Net Settlement Through a Market
Mechanism . . .
15-110 In this form of net
settlement, one of the parties is required to
deliver an asset of the type described in
paragraph 815-10-15-100, but there is an
established market mechanism that facilitates net
settlement outside the contract. (For example, an
exchange that offers a ready opportunity to sell
the contract or to enter into an offsetting
contract.) Market mechanisms may have different
forms. Many derivative instruments are actively
traded and can be closed or settled before the
contract’s expiration or maturity by net
settlement in active markets.
The net settlement characteristic is met if an established market
mechanism exists that facilitates net settlement outside of the
contract, such as the ability to sell the derivative on an exchange.
This condition is typically not applicable to embedded features since
they cannot be settled separately from their host contracts. If a
feature is legally detachable and separately exercisable from a
contract, it is considered a separate freestanding financial instrument,
not an embedded feature (see Section
3.3.2).
8.3.4.4.4 Net Settlement by Delivery of a Derivative Instrument or an Asset Readily Convertible to Cash
ASC Master Glossary
Readily Convertible to Cash
Assets that are readily convertible to cash have
both of the following:
-
Interchangeable (fungible) units
-
Quoted prices available in an active market that can rapidly absorb the quantity held by the entity without significantly affecting the price.
(Based on paragraph 83(a) of FASB Concepts
Statement No. 5, Recognition and Measurement in
Financial Statements of Business
Enterprises.)
ASC 815-10
Net Settlement by Delivery of Derivative
Instrument or Asset Readily Convertible to
Cash
15-119 In this form of net
settlement, one of the parties is required to
deliver an asset of the type described in
paragraph 815-10-15-100, but that asset is readily
convertible to cash or is itself a derivative
instrument.
15-121 Examples of assets
that are readily convertible to cash include a
security or commodity traded in an active market
and a unit of foreign currency that is readily
convertible into the functional currency of the
reporting entity.
15-122 An asset (whether
financial or nonfinancial) shall be considered to
be readily convertible to cash only if the net
amount of cash that would be received from a sale
of the asset in an active market is either equal
to or not significantly less than the amount an
entity would typically have received under a net
settlement provision. The net amount that would be
received upon sale need not be equal to the amount
typically received under a net settlement
provision. Parties generally should be indifferent
as to whether they exchange cash or the assets
associated with the underlying, although the term
indifferent is not intended to imply an
approximate equivalence between net settlement and
proceeds from sale in an active market.
15-123 The form of a
financial instrument is important; individual
instruments cannot be combined for evaluation
purposes to circumvent compliance with the
criteria beginning in paragraph 815-10-15-119.
Example 8 (see paragraph 815-10-55-111)
illustrates this guidance.
Effect of Conversion Costs
15-125 If an entity
determines that the estimated costs that would be
incurred to immediately convert the asset to cash
are not significant, then receipt of that asset
puts the entity in a position not substantially
different from net settlement. Therefore, an
entity shall evaluate, in part, the significance
of the estimated costs of converting the asset to
cash in determining whether those assets are
readily convertible to cash.
15-126 For purposes of
assessing significance of such costs, an entity
shall consider those estimated conversion costs to
be significant only if they are 10 percent or more
of the gross sales proceeds (based on the spot
price at the inception of the contract) that would
be received from the sale of those assets in the
closest or most economical active market.
The net settlement characteristic is met if the contract is settled in a
manner in which the recipient’s position is not substantially different
from that in a contractual net settlement. Thus, if a contract is
settled as a result of a two-way (gross) exchange of items that are
readily convertible to cash or are derivatives, the net settlement
characteristic is met. ASC 815-10-20 specifies that an item is “readily
convertible to cash” if it has both “[i]nterchangeable (fungible) units”
and “[q]uoted prices available in an active market that can rapidly
absorb the quantity held by the entity without significantly affecting
the price.” For example, an equity conversion feature embedded in a debt
host would be considered readily convertible to cash if the shares that
would be delivered upon conversion can be rapidly absorbed in the market
without significantly affecting the stock price (see Section
8.4.7.5). If the conversion costs (e.g., sales
commissions on the quoted price) would exceed 10 percent of the spot
price at the inception of the contract, however, the feature would not
be considered readily convertible to cash (see ASC 815-10-15-126). The
evaluation of whether an embedded feature is readily convertible to cash
is performed on the basis of the smallest increment in which it can be
settled under its contractual terms (see Section
8.4.7.5).
8.3.4.4.5 Ongoing Evaluation
ASC 815-10
15-127 The assessment of
the significance of . . . conversion costs shall
be performed only at inception of the
contract.
15-139 The evaluation of
whether items to be delivered under a contract are
readily convertible to cash shall be performed at
inception and on an ongoing basis throughout a
contract’s life (except that, as stated in
paragraph 815-10-15-127, the assessment of the
significance of those conversion costs shall be
performed only at inception of the contract).
Example 4, Cases B, C, and D (see paragraphs
815-10-55-87 through 55-89) illustrate this
guidance.
Example 4: Net Settlement at Inception and
Throughout a Contract’s Life
55-84 As required by
paragraphs 815-10-15-110 through 15-118 and
815-10-15-119 through 15-120, respectively, the
evaluation of whether a market mechanism exists
and whether items to be delivered under a contract
are readily convertible to cash must be performed
at inception and on an ongoing basis throughout a
contract’s life. For example, if a market
develops, if an entity effects an initial public
offering, or if daily trading volume changes for a
sustained period of time, then those events need
to be considered in reevaluating whether the
contract meets the definition of a derivative
instrument. Similarly, if events occur after the
inception or acquisition of a contract that would
cause a contract that previously met the
definition of a derivative instrument to cease
meeting the criteria (for example, an entity
becomes delisted from a national stock exchange),
then that contract cannot continue to be accounted
for under this Subtopic. The guidance in
paragraphs 815-10-15-125 through 15-127 about
assessing the significance of transaction costs is
not relevant when determining whether such a
contract no longer meets the definition of a
derivative instrument.
An entity is required to evaluate whether a market
mechanism exists (see Section 8.3.4.4.3) and whether the items to be delivered
are readily convertible to cash (see Section 8.3.4.4.4) both at
inception and on an ongoing basis throughout a contract’s life. For
example, an embedded conversion feature might become readily convertible
to cash after the issuance of a debt contract if the shares to be
delivered upon exercise of the conversion feature are not initially
readily convertible to cash but the entity subsequently undertakes an
IPO or the market trading volume increases such that those shares become
capable of being rapidly absorbed in the market without significantly
affecting the stock price (see Section 8.4.7.5.6). Conversely, an
embedded conversion feature might cease to be readily convertible to
cash if the shares are no longer listed on a stock exchange. However, an
entity should not reassess whether the costs needed to immediately
convert the asset to cash would exceed 10 percent of the spot price (see
Section 8.3.4.4.4).
8.3.5 Scope Exceptions
ASC 815-10
15-13 Notwithstanding the
conditions in paragraphs 815-10-15-83 through 15-139,
the following contracts are not subject to the
requirements of this Subtopic if specified criteria are
met:
-
Regular-way security trades
-
Normal purchases and normal sales
-
Certain insurance contracts and market risk benefits
-
Certain financial guarantee contracts
-
Certain contracts that are not traded on an exchange
-
Derivative instruments that impede sales accounting
-
Investments in life insurance
-
Certain investment contracts
-
Certain loan commitments
-
Certain interest-only strips and principal-only strips
-
Certain contracts involving an entity’s own equity
-
Leases
-
Residual value guarantees
-
Registration payment arrangements
-
Certain fixed-odds wagering contracts.
ASC 815-15
15-3 The guidance in this
Subtopic does not apply to any of the following items,
as discussed further in this Section:
-
Normal purchases and normal sales contracts
-
Unsettled foreign currency transactions
-
Plain-vanilla servicing rights
-
Features involving certain aspects of credit risk
-
Features involving certain currencies.
An embedded derivative that meets a derivative accounting scope exception in ASC
815-10-15-13 or ASC 815-15-15-3 should not be bifurcated from its host contract.
Some of those scope exceptions might be more relevant to a debtor that evaluates
features embedded in debt host contracts, including those related to the following:
-
Certain insurance contracts (see ASC 815-10-15-52 through 15-57). A contract or feature is not subject to ASC 815 “if it entitles the holder to be compensated only if, as a result of an identifiable insurable event (other than a change in price), the holder incurs a liability or there is an adverse change in the value of a specific asset or liability for which the holder is at risk.” A disaster bond might qualify for this scope exception (see Section 8.4.12.4).
-
Certain financial guarantee contracts (see ASC 815-10-15-58). An embedded credit derivative in a credit-linked note could potentially qualify for this scope exception (see Section 8.4.2.5).
-
Certain contracts that are not traded on an exchange if the underlying on which the settlement is based on one of the following (ASC 815-10-15-59):
-
A climatic or geological or other physical variable (see Section 8.4.12.3).
-
The price or value of a nonfinancial asset of one of the parties to the contract if the asset is not readily convertible to cash. For example, this scope exception may be relevant for a participation feature in a participating mortgage (see Sections 7.3 and 8.4.9.5).
-
The fair value of a nonfinancial liability of one of the parties to the contract and the asset delivered is not readily convertible to cash.
-
Specified volumes of sales or service revenue of one of the parties to the contract. For example, an entity would evaluate interest payments indexed to sales revenue to determine whether they meet this scope exception (see Sections 7.2 and 8.4.10.5).
-
-
Loan commitments (see ASC 815-10-15-69 through 15-71 and Section 8.4.6.5). Note that an entity may evaluate a term extension option (see Section 8.4.5.5) or PIK feature embedded in a debt instrument to determine whether it meets this scope exception.
-
Contracts that are both indexed to the entity’s own stock and classified in stockholders’ equity (see ASC 815-10-15-74(a)). An entity would evaluate an embedded conversion feature to determine whether it meets this scope exception (see Section 8.4.7.6).
-
Contracts within the scope of ASC 718 (see ASC 815-10-15-74(b)). A convertible debt instrument issued in exchange for goods or services may meet this scope exception (see Section 8.4.7.7).
-
Registration payment arrangements (ASC 815-10-15-82; see Sections 3.3.3.2 and 8.4.12.2).
-
Monetary items that have principal or interest payments denominated in a foreign currency and for which foreign currency transaction gains and losses are recognized under ASC 830 (see Section 8.4.8.5). For example, this exception applies to certain dual currency bonds.
8.4 Application to Specific Embedded Features
8.4.1 Features Related to an Interest Rate
8.4.1.1 Background
This section discusses the analysis of whether an embedded feature that could
adjust the payments on a debt host contract that is based solely on an
interest rate or interest rate index should be separated as a derivative.
Examples of contractual provisions in debt contracts that should be
evaluated under the guidance discussed in this section include:
-
Interest payments that are leveraged on the basis of market interest rates (e.g., the contractual interest rate is a multiple of a benchmark interest rate).
-
Interest payments that move inversely with market interest rates (e.g., when market interest rates increase, the contractual interest rate decreases).
-
Interest payments that are based on a tenor of a benchmark interest rate that is different from the tenor of the interest payments (e.g., a constant maturity yield).
-
Choose-your-rate options (e.g., the debtor can elect to switch the basis of future variable-interest-rate payments to a different benchmark interest rate).
-
Caps, floors, or collars on interest payments indexed to a market interest rate.
-
Interest rate adjustments that are contingent on the level of interest rates.
-
Certain put and call options that are not otherwise required to be viewed as not clearly and closely related to the debt host contract (see Section 8.4.4.3).
This section does not address features that are contingent on, or indexed to,
underlyings other than an interest rate or interest rate index, including
features that are indexed to both interest rates and other underlyings (see
Section 8.4.1.3.2).
8.4.1.2 Bifurcation Analysis
The table below presents an overview of the bifurcation analysis of an
embedded feature that is based solely on an interest rate or interest rate
index and could adjust the cash flows of a debt host contract. However, an
entity should always consider the terms and conditions of a specific feature
in light of all the relevant accounting guidance before reaching a
conclusion.
|
Bifurcation Condition
|
Condition Met?
|
Analysis
|
|---|---|---|
|
Not clearly and closely related (see Section 8.3.2)
|
It depends
|
The issuer must evaluate whether an interest-related
feature is clearly and closely related to a debt
host in accordance with the negative-yield test and
the double-double test (ASC 815-15-25-26; see
Section 8.4.1.3).
|
|
Hybrid instrument not measured at fair value on a
recurring basis (see Section 8.3.3)
|
It depends
|
Debt is not measured at fair value on a recurring
basis unless the issuer elects the fair value option
in ASC 815-15 or ASC 825-10 (see Sections 4.4 and
8.5.6). However, the fair
value option cannot be elected for debt that
contains a separately recognized equity component at
inception.
|
|
Meets the definition of a derivative (see Section 8.3.4)
|
Yes
|
An interest-rate-related feature that adjusts the
payments of a debt host contract meets the
definition of a derivative (see Section
8.4.1.4).
|
|
Meets a scope exception (see Section 8.3.5)
|
No
|
No scope exception is available for features that are
based solely on an interest rate or an interest rate
index (see Section
8.3.5).
|
As shown in the table above, a debtor’s determination of whether it must
bifurcate as a derivative an embedded feature that is based solely on an
interest rate or interest rate index and could adjust the payments of a debt
host contract tends to focus on whether the feature is considered clearly
and closely related to the debt host contract unless the debtor has elected
to account for the debt under the fair value option in ASC 815-15 or ASC
825-10. Typically, such features meet the definition of a derivative and are
not exempt from derivative accounting.
8.4.1.3 Clearly-and-Closely-Related Analysis
8.4.1.3.1 General
ASC 815-15
25-26 For purposes of
applying the provisions of paragraph 815-15-25-1,
an embedded derivative in which the only
underlying is an interest rate or interest rate
index (such as an interest rate cap or an interest
rate collar) that alters net interest payments
that otherwise would be paid or received on an
interest-bearing host contract that is considered
a debt instrument is considered to be clearly and
closely related to the host contract unless either
of the following conditions exists:
-
The hybrid instrument can contractually be settled in such a way that the investor (the holder or the creditor) would not recover substantially all of its initial recorded investment (that is, the embedded derivative contains a provision that permits any possibility whatsoever that the investor’s [the holder’s or the creditor’s] undiscounted net cash inflows over the life of the instrument would not recover substantially all of its initial recorded investment in the hybrid instrument under its contractual terms).
-
The embedded derivative meets both of the following conditions:
-
There is a possible future interest rate scenario (even though it may be remote) under which the embedded derivative would at least double the investor’s initial rate of return on the host contract (that is, the embedded derivative contains a provision that could under any possibility whatsoever at least double the investor’s initial rate of return on the host contract).
-
For any of the possible interest rate scenarios under which the investor’s initial rate of return on the host contract would be doubled (as discussed in (b)(1)), the embedded derivative would at the same time result in a rate of return that is at least twice what otherwise would be the then-current market return (under the relevant future interest rate scenario) for a contract that has the same terms as the host contract and that involves a debtor with a credit quality similar to the issuer’s credit quality at inception.
-
25-27 Even though the
conditions in (a) and (b) in the preceding
paragraph focus on the investor’s rate of return
and the investor’s recovery of its investment, the
existence of either of those conditions would
result in the embedded derivative not being
considered clearly and closely related to the host
contract by both parties to the hybrid instrument.
Because the existence of those conditions is
assessed at the date that the hybrid instrument is
acquired (or incurred) by the reporting entity,
the acquirer of a hybrid instrument in the
secondary market could potentially reach a
different conclusion than could the issuer of the
hybrid instrument due to applying the conditions
in the preceding paragraph at different points in
time.
25-28 An embedded derivative
that alters net interest payments based on changes
in a stock price index (or another
non-interest-rate index) is not addressed in
paragraph 815-15-25-26.
ASC 815-15-25-26 addresses whether an embedded feature
whose only underlying is an interest rate or interest rate index should
be considered clearly and closely related to a debt host contract. There
are two conditions in ASC 815-15-25-26: one that focuses on the
investor’s recovery of its investment (the negative-yield test; see
Section
8.4.1.3.3) and one that focuses on the investor’s rate of
return (the double-double test; see Section 8.4.1.3.4). If either of
these conditions is met, neither party to the hybrid instrument would
consider the embedded derivative feature clearly and closely related to
the host contract. ASC 815-15-25-26 indicates that when an entity
assesses whether it meets these conditions, it should not consider the
likelihood that a condition will be satisfied — the condition is met if
there is any possibility whatsoever that it will be met.
8.4.1.3.2 Features That Are Indexed to Both Interest Rates and Other Underlyings
Because ASC 815-15-25-26 only applies to embedded
features “in which the only underlying is an interest rate or interest
rate index,” it does not apply to features that are indexed to, or
contingent on, something other than an interest rate or an interest rate
index, including features that are indexed to both an interest rate or
interest rate index and other underlyings. An embedded put, call, or
other redemption feature whose exercise is contingent on the occurrence
or nonoccurrence of a specified uncertain, future event (e.g., an IPO or
a change in control) would always have a second underlying (the
occurrence or nonoccurrence of the specified event). Therefore, the
redemption feature would only be subject to evaluation under ASC
815-15-25-26 if the event is solely related to an interest rate or an
interest rate index (e.g., an embedded call option that may only be
exercised when LIBOR is at or above 5 percent).
Although an embedded feature that has a payoff that is
indexed to both interest rates and another underlying (e.g., an event of
default, a stock price, commodity price, or the entity’s stock market
capitalization) is not subject to an evaluation under ASC 815-15-25-26,
such a feature would not be considered clearly and closely related to a
debt host contract unless either (1) the other underlying is based on
the issuer’s credit risk (see Section 8.4.2) or inflation (see
Section
8.4.3) or (2) the feature is a contingent redemption
feature that otherwise does not have to be separated under the guidance
on such features (see Section 8.4.4).
For guidance on the evaluation of features that are
indexed to underlyings other than an interest rate or interest rate
index, see, for example, Sections 8.4.2 (credit-sensitive
payments), 8.4.3 (inflation-indexed payments), 8.4.7
(equity-indexed payments), 8.4.8 (foreign currency
features), 8.4.9.3 (commodity-indexed payments), 8.4.10
(revenue-indexed payments), and 8.4.11 (other payments
contingent on underlyings other than interest rates, credit risk, or
inflation).
8.4.1.3.3 Negative-Yield Test
Under the negative-yield test (i.e., ASC
815-15-25-26(a)), an embedded interest rate feature is not clearly and
closely related to its debt host contract if it could contractually
cause the debt to be settled in such a way that the investor would not
recover substantially all of its initial recorded investment. In other
words, this test might be passed if it is contractually possible that
the creditor could be forced to accept a negative yield on its
investment.
The debtor performs the test as of the date on which it
initially recognizes the debt and does not subsequently reassess whether
the test is passed.
Example 8-4
Bond With
Leverage Feature
Company X invests in a $10
million 10-year bond that pays a fixed rate of 6
percent for the first two years and then pays a
variable rate calculated as 14 percent minus the
product of 2.5 times three-month LIBOR, without a
floor, for the remaining term of the bond. If
three-month LIBOR were to increase significantly,
the bond might result in a negative return, which
would effectively erode the bond’s principal. In
that case, X may not recover substantially all of
its initial investment. As a result, the
negative-yield test is passed. Company X and the
bond issuer should, therefore, separately account
for the embedded interest rate derivative unless
the entire hybrid financial instrument is
recognized at fair value, with changes in fair
value recognized in earnings.
In practice, the phrase “substantially all” in ASC
815-15-25-26(a) is interpreted to mean at least 90 percent of the
original investment. The test is performed on an undiscounted basis. If,
at inception, there is any contractual possibility whatsoever that the
undiscounted contractual net cash flows received by the creditor over
the life of the instrument will not be at least 90 percent of the
investment recorded by the investor at inception, the negative-yield
test is passed and the debtor would consider the feature not to be
clearly and closely related to the debt host. Otherwise, an embedded
feature that is based only on an interest rate or interest rate index
would be considered clearly and closely related to its host provided
that it does not pass the double-double test (ASC 815-15-25-26(b); see
Section
8.4.1.3.4).
ASC 815-15
25-29 The condition in
paragraph 815-15-25-26(a) applies only to those
situations in which the investor (creditor) could
be forced by the terms of a hybrid instrument to
accept settlement at an amount that causes the
investor not to recover substantially all of its
initial recorded investment. That condition does
not apply to a situation in which the terms of a
hybrid instrument permit, but do not require, the
investor to settle the hybrid instrument in a
manner that causes it not to recover substantially
all of its initial recorded investment, provided
that the issuer does not have the contractual
right to demand a settlement that causes the
investor not to recover substantially all of its
initial net investment.
If scenarios exist in which the investor contractually
would not recover substantially all of its initially recorded
investment, but the creditor could not be forced to accept such a
settlement or could prevent such a scenario from occurring, the
negative-yield test is not passed. The negative-yield test only applies
to scenarios in which the creditor could be forced to accept a
settlement under which it would not recover substantially all of its
initial recorded investment. If the creditor has a right, but not an
obligation, to settle the debt at an amount that is less than
substantially all of its initially recorded investment (e.g., an
embedded put option held by the creditor that has an exercise price at a
significant discount to the initial investment), the negative-yield test
is not passed.
Further, the negative-yield test does not reflect the
risk that the debtor might breach the contract (i.e., the test is not
met merely because of the risk that the debtor may default on its
obligation to repay the debt). The negative-yield test only applies to
scenarios in which the creditor contractually is at risk of not
recovering substantially all of its initial recorded investment.
ASC 815-15
Example
10: Interest-Rate-Related Underlyings — Recovering
Substantially All of an Initial Recorded
Investment
Case A: Note A
55-130 If an investor in a
10-year note has the contingent option at the end
of Year 2 to put it back to the issuer at its then
fair value (based on its original 10-year term),
the condition in paragraph 815-15-25-26(a) would
not be met even though the note’s fair value could
have declined so much that, by exercising the
option, the investor ends up not recovering
substantially all of its initial recorded
investment. See paragraph 815-15-25-29.
Case B: Note B
55-131 An investor purchased
from an A-rated issuer for $10 million a
structured note with a $10 million principal, a
9.5 percent interest coupon, and a term of 10
years at a time when the current market rate for
10-year A-rated debt is 7 percent. Assume that the
terms of the note require that, at the beginning
of the third year of its term, the principal on
the note be reduced to $7.1 million and the coupon
interest rate be reduced to zero for the remaining
term to maturity if interest rates for A-rated
debt have increased to at least 8 percent by that
date. That structured note would meet the
condition in paragraph 815-15-25-26(a) for both
the issuer and the investor because the investor
could be forced to accept settlement that causes
the investor not to recover substantially all of
its initial recorded investment. That is, if
increases in the interest rate for A-rated debt
trigger the modification of terms, the investor
would receive only $9 million, comprising $1.9
million in interest payments for the first 2 years
and $7.1 million in principal repayment, thus not
recovering substantially all of its $10 million
initial net investment.
Case C: Note C
55-132 The investor purchases
for $10,000,000 a structured note with a face
amount of $10,000,000, a coupon of 8.9 percent,
and a term of 10 years. The current market rate
for 10-year debt is 7 percent given the A credit
quality of the issuer. The terms of the structured
note require that if the interest rate for A-rated
debt has increased to at least 10 percent at the
end of 2 years, the coupon on the note be reduced
to zero, and the investor purchase from the issuer
for $10,000,000 an additional note with a face
amount of $10,000,000, a zero coupon, and a term
of 3.5 years.
55-133 The structured note
contains an embedded derivative that shall be
accounted for separately unless a fair value
election is made pursuant to paragraph
815-15-25-4.
55-134 The requirement that,
if interest rates increase and the embedded
derivative is triggered, the investor purchase the
second $10,000,000 note for an amount in excess of
its fair value (which is about $7,100,000 based on
a 10 percent interest rate) generates a result
that is economically equivalent to requiring the
investor to make a cash payment to the issuer for
the amount of the excess. As a result, the cash
flows on the original structured note and the
excess purchase price on the second note shall be
considered in concert. The cash inflows
($10,000,000 principal and $1,780,000 interest)
that will be received by the investor on the
original note shall be reduced by the amount
($2,900,000) by which the purchase price of the
second note is in excess of its fair value,
resulting in a net cash inflow ($8,880,000) that
is not substantially all of the investor’s initial
net investment on the original note.
55-135 As demonstrated by
this Case, if an embedded derivative requires an
asset to be purchased for an amount that exceeds
its fair value, the amount of the excess — and not
the cash flows related to the purchased asset —
shall be considered when analyzing whether the
hybrid instrument can contractually be settled in
such a way that the investor would not recover
substantially all of its initial recorded
investment under paragraph 815-15-25-26(a).
Whether that purchased asset is a financial asset
or a nonfinancial asset (such as gold) is not
relevant to the treatment of the excess purchase
price. It is noted that requiring the investor to
make a cash payment to the issuer is also
economically equivalent to reducing the principal
on the note.
55-136 The note described
could have been structured to include terms
requiring that the principal of the note be
substantially reduced and the coupon reduced to
zero if the interest rate for A-rated debt
increased to at least 10 percent at the end of 2
years. That alternative structure would clearly
have required that the embedded derivative be
accounted for separately, because that embedded
derivative’s existence would have resulted in the
possibility that the hybrid instrument could
contractually be settled in such a way that the
investor would not recover substantially all of
its initial recorded investment.
8.4.1.3.4 Double-Double Test
Under the double-double test (i.e., ASC
815-15-25-26(b)), an embedded interest rate feature is not clearly and
closely related to its debt host contract if there is a potential
scenario in which the investor could achieve a rate of return on the
host contract that at least doubles its initial rate of return and is
twice what would otherwise be the market return. The debtor evaluates
whether the double-double test is passed as of the date on which it
initially recognizes the instrument. It does not subsequently reassess
whether the test is passed.
This test is performed in two steps:
-
Step 1 — The debtor determines whether there is a possible future interest rate scenario, no matter how remote, in which the embedded feature would at least double the investor’s initial rate of return on the host contract. In making this assessment, an entity must differentiate between the return on the host contract and the return on the hybrid instrument. The initial rate of return on the host contract excludes the effects of the embedded feature. If no such scenario exists, the embedded feature would be considered clearly and closely related to its host provided that it does not pass the negative-yield test (ASC 815-15-25-26(a); see Section 8.4.1.3.3). If any such scenario exists, the debtor must proceed to step 2 below.
-
Step 2 — The debtor determines whether, for any of the scenarios identified in the first step for which the investor’s initial rate of return on the host contract would be doubled, the embedded derivative would at the same time result in a rate of return that is at least twice what otherwise would be the then-current market return (under the relevant future interest rate scenario) for a contract that has the same terms as the host contract and that involves a debtor with a credit quality similar to the issuer’s credit quality at inception. If such a high return is possible, the embedded feature would not be considered clearly and closely related to its host contract. If such a high return is not possible for a feature that is based solely on an interest rate or interest rate index and the embedded feature also does not pass the negative-yield test (ASC 815-15-25-26(a); see Section 8.4.1.3.3), the embedded feature is considered clearly and closely related to the host contract.
Example 8-5
Debt With
Interest Step-Up Feature
Company A invests in 30-year
variable-rate debt issued by Company B. The debt
is indexed to the three-month LIBOR rate plus 4
percent. As of the date of issuance, the
three-month LIBOR rate was 2 percent. The debt’s
terms also specify that if the three-month LIBOR
rate increases to 5 percent, the debt issuer is
required to pay 23 percent for the remaining term
of the bonds.
If B were to issue 30-year
variable-rate debt without any embedded
derivatives (i.e., the interest rate reset
feature), it would pay a coupon of three-month
LIBOR plus 6 percent. Consequently, the initial
rate of return on the host contract is 8 percent
(three-month LIBOR of 2 percent plus 6 percent).
Company A must determine whether the embedded
derivative could at least double its initial rate
of return on the host contract, which was 8
percent as of the issuance date, in any of the
possible interest rate environments. When
three-month LIBOR increases to 5 percent, the 23
percent interest rate feature more than doubles
the initial rate of return of 8 percent on the
host contract; therefore, the first condition is
satisfied.
To apply the second part of ASC
815-15-25-26(b), A must determine whether, for any
of the possible interest rate scenarios under
which its initial rate of return on the host
contract would be doubled (i.e., when three-month
LIBOR is at 5 percent), the embedded derivative
would at the same time result in a rate of return
that is at least twice what otherwise would be the
then-current market return on a contract with the
same terms as the host contract. When three-month
LIBOR increases to 5 percent, the rate of return
on a contract with the same terms as the host
contract (and involving a debtor with a credit
quality similar to B’s credit quality at debt
inception) would be 11 percent (three-month LIBOR
of 5 percent plus 6 percent). The second condition
is, therefore, also satisfied, because when
three-month LIBOR increases to 5 percent, the 23
percent return generated by the embedded
derivative feature in the debt is more than twice
the 11 percent return (three-month LIBOR of 5
percent plus 6 percent) on the contract with the
same terms as the host contract.
Both A and B would be required
to account for the embedded derivative separately
unless the entire hybrid financial instrument is
recognized at fair value, with changes in fair
value recognized in earnings. Note that ASC
815-15-25-26 indicates that when an entity
assesses whether it meets one of the conditions,
it should not consider the probability that the
condition will be satisfied; the condition should
be considered satisfied if there is any
possibility whatsoever that the condition will be
met. Therefore, the probability that the
three-month LIBOR rate will increase to 5 percent
is not relevant to the analysis of whether the
condition is met. However, an entity should
consider such probability when valuing any
bifurcated embedded derivative.
ASC 815-15
25-37 The conditions in
paragraph 815-15-25-26(b) do not apply to an
embedded call option in a hybrid instrument
containing a debt host contract if the right to
accelerate the settlement of the debt can be
exercised only by the debtor (the issuer or the
borrower). This guidance does not affect the
application of the condition in paragraph
815-15-25-26(a) or the application of paragraphs
815-15-25-41 through 25-43. In addition, this
guidance does not apply to other embedded
derivative features that may be present in the
same hybrid instrument.
25-38 The conditions in
paragraph 815-15-25-26(b) apply only to situations
that meet the two conditions specified in
paragraph 815-15-25-26(b)(1) through (b)(2) and
for which the investor has the unilateral ability
to obtain the right to receive the high rate of
return specified in those paragraphs. If the
embedded derivative is an option rather than a
forward contract, it is important to analyze
whether the investor is the holder of that option.
For an embedded call option, the issuer or
borrower (and not the investor) is the holder, and
thus only the issuer (borrower) can exercise the
option. Consequently, the investor does not have
the unilateral ability to obtain the right to
receive the high rate of return, which is
contingent on the issuer’s exercise of the
embedded call option.
If scenarios exist in which the investor could double
its initial return but the debtor could prevent any such scenarios from
occurring, the double-double test does not apply. For example, the
double-double test does not apply if the debtor has a right, but not an
obligation, to settle the debt at an amount that would pass the
double-double test (e.g., an embedded call option held by the debtor
that has an exercise price that potentially could double the investor’s
initial return). The double-double test is passed only if scenarios
exist in which the debtor contractually could not prevent a settlement
that would pass the double-double test. ASC 815-15-55-25 (below)
contains six examples that illustrate this concept.
ASC 815-15
55-25 Application of the
guidance in paragraphs 815-15-25-37 through 25-39
to specific debt instruments is provided in the
following table.
|
Instrument
|
Paragraph 815-15-25-26(b)
Applicable to the Embedded Call Option?
|
Comments
|
|---|---|---|
|
1. An unsecured commercial
loan that includes a prepayment option that
permits the loan to be prepaid by the borrower at
a fixed amount at any time at a specified premium
over the initial principal amount of the loan.
|
No.
|
The commercial loan is
prepayable only at the option of the borrower.
|
|
2. A fixed-rate debt
instrument issued at a discount that is callable
at par value at any time during its 10-year
term.
|
No.
|
The fixed-rate debt instrument
is callable at par value only by the issuer.
|
|
3. A fixed-rate 10-year bond
that contains a call option that permits the
issuer to prepay the bond at any time after
issuance by paying the investor an amount equal to
all the future contractual cash flows discounted
at the then-current Treasury rate plus 45 basis
points. The spread over the Treasury rate for the
borrower at the issuance of the bond was 300 basis
points.
|
No.
|
The fixed-rate 10-year bond is
callable only at the option of the issuer.
|
|
4. A 5-year debt instrument
issued at par that has a quarterly coupon equal to
15 percent minus 3 times 3-month LIBOR and that
includes a call provision that allows the issuer
to call the debt at any time at a specified
premium over par.
|
No.
|
The instrument is callable
only by the issuer, so the embedded call option
feature will not be subject to the conditions in
paragraph 815-15-25-26(b). However, the conditions
in the paragraph are still applicable to the
levered index feature of the debt.
|
|
5. A fixed rate debt
instrument is issued at par and is callable at any
time during its 10-year term. If the debt is
called, the investor receives the greater of the
par value of the debt or the market value of
100,000 shares of XYZ common stock (an unrelated
entity).
|
No.
|
The instrument is callable
only by the issuer, so the embedded call option
feature will not be subject to the conditions in
paragraph 815-15-25-26(b). However, the embedded
call option is not considered clearly and closely
related to the debt host contract because the
payoff is based on an equity price.
|
|
6. A mortgage-backed security
is issued, whereby cash flows associated with
principal payments (including full or partial
prepayments and related penalties) received on the
related mortgage loans are passed through to the
mortgage-backed security investors.
|
Not applicable (see
comments).
|
Although the related mortgage
loans are prepayable, and thus each contain a
separate embedded call option, the mortgage-backed
security itself does not contain an embedded call
option. While the mortgage-backed security
investor is subject to prepayment risk, the
mortgage-backed security issuer has the obligation
(not the option) to pass through cash flows from
the related mortgage loans to the mortgage-backed
security investors. Therefore, mortgage-backed
securities are not within the scope of this
guidance. Paragraphs 815-15-25-33 through 25-36
address the application of paragraph
815-15-25-26(b) to securitized interests in
prepayable financial assets.
|
8.4.1.3.5 Interest Rate Caps, Floors, and Collars
ASC 815-15
25-32 Floors or caps (or
collars, which are combinations of caps and
floors) on interest rates and the interest rate on
a debt instrument are considered to be clearly and
closely related unless the conditions in either
paragraph 815-15-25-26(a) or 815-15-25-26(b) are
met, in which circumstance the floors or the caps
are not considered to be clearly and closely
related.
Caps, floors, or collars on floating-rate interest
payments are considered clearly and closely related to a debt host
contract unless the negative-yield test or the double-double test (ASC
815-15-25-26) is passed (see Sections 8.4.1.3.3 and 8.4.1.3.4).
Example 8-6
Debt With
Embedded Floor
Company A issues five-year
variable-rate debt to the public that is indexed
to the LIBOR rate (LIBOR plus 1 percent). LIBOR is
currently 6 percent. The investors required that A
pay not less than 5 percent at any time during the
term of the debt. The agreement that A will not
pay an interest rate less than 5 percent on its
variable-rate debt represents a floor. If A were
to issue a five-year variable-rate debt without a
floor, it would pay LIBOR plus 2 percent. The
floor would not pass the negative-yield test (ASC
815-15-25-26(a); see Section
8.4.1.3.3) because it could not result
in a failure of the investor to recover
substantially all of its initial investment. The
floor would not pass the double-double test
(ASC-815-25-26(b); see Section
8.4.1.3.4) because it could not result
in a rate of return that is more than double the
initial rate of return of 8 percent (LIBOR at
inception plus 2 percent). The floor, when
in-the-money, will only result in a rate of 5
percent.
Example 8-7
Debt With
Embedded Cap
On January 1, 20X1, Company X
purchases a bond at par that pays LIBOR. The bond
also incorporates an interest rate cap provision
under which if LIBOR equals or exceeds 8 percent
as of any interest rate reset date, X will receive
a return of 10 percent. On the date on which X
purchases the bond, it also could purchase at par
a variable-rate bond not containing a cap that
pays LIBOR minus 1 percent from a debtor that has
the same credit quality as the issuer of X’s bond.
As of January 1, 20X1, LIBOR is 5 percent. The
bond cannot contractually be settled such that X
would not recover substantially all of its initial
recorded investment in the bond (i.e., the
negative-yield test in ASC 815-15-25-26(a) is not
passed; see Section
8.4.1.3.3). To perform the first step
of the double-double test (ASC 815-15-25-26(b);
see Section
8.4.1.3.4), X must determine whether
there is any interest rate scenario, no matter how
remote, under which the embedded derivative (the
cap) would at least double its initial rate of
return on the host contract. This analysis is
summarized in the following table:
|
A
LIBOR
Interest Rate Range
|
B
Return
Reflecting the Effect of Cap
|
C
Initial
Rate of Return on Host (LIBOR Minus 1%)
|
D
Initial
Rate of Return on Host Doubled
|
Is the ASC 815-15-25-26(b)(1)
Test Met — Is B > D?
|
|---|---|---|---|---|
|
0–7.99%
8% and up
|
0–7.99%
10%
|
4%
4%
|
8%
8%
|
No
Yes
|
Since the first step suggests
that there is a possible scenario in which X could
double its initial rate of return on the host
contract, X must perform the second step in ASC
815-15-25-26(b) to determine whether the embedded
cap is clearly and closely related to the debt
host contract. For this test, X must determine,
for any of the possible interest rate scenarios
identified above under which X’s initial rate of
return on the host contract would be doubled,
whether the embedded cap would simultaneously
result in a rate of return that is at least twice
what otherwise would be the then-current market
return (under the relevant future interest rate
scenario) for a contract that has the same terms
as the host contract and that involves a debtor
with a credit quality similar to the issuer’s
credit quality at inception. Company X’s analysis
for this test can be summarized as follows:
|
A
Interest
Rate Scenario Identified in the ASC
815-15-25-26(b)(1) Test for Which the Cap Would at
Least Double the Investor’s Initial Rate of Return
on the Host Contract
|
B
Return
Reflecting the Effect of the Cap Under the
Interest Rate Scenario in A
|
C
Current
Market Rate for a Contract Having the Same Terms
as the Host Contract Under the Interest Rate in A
(LIBOR Minus 1%)
|
Is the ASC 815-15-25-26(b)(2)
Test Met — Is B at Least Twice C for Any
Scenario?
|
|---|---|---|---|
|
8% and up
|
10%
|
7% and up
|
No
|
Since the second step suggests
that there is no possible scenario in which the
investor would achieve a rate of return that is at
least twice what otherwise would be the
then-current market return, the embedded cap is
considered clearly and closely related to the debt
host contract under the double-double test (ASC
815-15-25-26(b); see Section
8.4.1.3.4).
Example 8-8
Debt With
LIBOR-Indexed Interest Rate Adjustment
On January 1, 20X0, an entity
issues a variable-rate debt instrument at par,
maturing on January 1, 20X5. The interest rate is
three-month LIBOR plus 0.40 percent as long as
three-month LIBOR remains at or above 6.00
percent. In periods in which three-month LIBOR
drops below 6.00 percent, the interest rate on the
debt is calculated as follows: three-month LIBOR
plus 0.40 percent – [2 × (6.00% – 3-month LIBOR)].
The following table illustrates the interest rate
on the debt under certain conditions:
For the embedded derivative to
be considered clearly and closely related to the
debt host, the hybrid instrument cannot
contractually be settled in such a way that the
investor would not recover substantially all of
its initial recorded investment (ASC
815-15-25-26(a); see Section
8.4.1.3.3). In this case, it is
possible for the investor in the debt to incur an
unlimited negative return, thus not recovering
substantially all of its original investment.
Therefore, the embedded floor would not be
considered clearly and closely related to the debt
host.
However, if the agreement were
to contain a provision that guaranteed a
cumulative minimum rate of return to the investor
over the life of the debt, thereby eliminating the
circumstance in which the debt could contractually
be settled in such a way that the investor would
not recover substantially all of its initial
recorded investment, the embedded derivative could
not cause the investor not to recover
substantially all of its initial recorded
investment. For example, the agreement could
contain a minimum interest rate clause such that
if the defined interest rate is less than zero,
negative interest accrues. However, accrued
negative interest may only be applied to (1)
future interest payments required under this debt
or (2) the principal amount only to the extent of
interest previously paid under the debt agreement,
provided that any accrued interest remains at
maturity of the debt. Therefore, the instrument
cannot contractually be settled in such a way that
the investor would not recover substantially all
of its initial recorded investment. The leveraged
interest rate terms and floor would be considered
clearly and closely related to the debt (provided
that under ASC 815-15-25-26(b)’s double-double
test [see Section
8.4.1.3.4], those embedded features are
clearly and closely related to the debt host). A
cap on a leveraged interest rate index would be
similarly analyzed under ASC 815-15-25-26 through
25-29.
8.4.1.3.6 Interest Rate Tenor Mismatch (Including Constant Maturity Rates)
The contractual interest rate of many debt securities is
based on a reference index. It is not uncommon for the contractual terms
of some securities to require the contractual interest rate to reset
more frequently than the term of the index the securities are referenced
to. One example is a debt security whose interest rate resets every six
months to a 10-year index (i.e., a constant maturity rate). Such an
interest rate index should be evaluated under ASC 815-15-25-26.
Example 8-9
Debt With Interest Rate Tenor Mismatch
Assume that a 30-year note has
an initial yield of 4 percent and that the
contractual interest rate resets semiannually to a
10-year index interest rate plus 100 basis points
rather than to the six-month rate. The initial
yield on a security that resets to the six-month
rate, but that otherwise has terms that are
identical to those of the 30-year note, is 3
percent.
Because the interest rate resets
semiannually to a point further out than the next
reset date on the interest rate curve (i.e., a
10-year rate vs. a six-month rate), there are
possible future interest rate scenarios under
which the initial rate of return on the host
contract and the then-current market rate would be
doubled. The application of the double-double test
(ASC 815-15-25-26(b); see Section
8.4.1.3.4) is shown in the table
below.
|
Step 1: Is there a possible
interest rate scenario (even though it may be
remote) under which the embedded derivative would
at least double the investor’s initial rate of
return on the host contract?
|
Yes. It is possible that the
10-year index rate could be more than double the
investor’s initial rate of return on the host
contract, which is 3 percent.
|
|
Step 2: For any of the
possible interest rate scenarios under which the
investor’s initial rate of return on the host
contract would be doubled, could the embedded
derivative at the same time result in a rate of
return that is at least twice what otherwise would
be the then-current market return (under the
relevant future interest rate scenario) for a
contract that has the same terms as the host
contract and that involves a debtor with a credit
quality similar to the issuer’s credit quality at
inception?
|
Yes. It is possible that the
10-year index rate could be more than double the
six-month rate on the same date; therefore, the
embedded derivative could result in a rate of
return that is at least twice the then-current
market return for a contract that has the same
terms as the host contract, which resets to the
current six-month rate. Note that it is irrelevant
whether it is probable that the 10-year rate will
rise to more than twice the six-month rate.
|
Because both conditions in ASC
815-15-25-26(b) are met, the embedded interest
rate index is not considered clearly and closely
related to the debt host of the 30-year note. If
the instrument contains a cap that is less than
double the initial rate of return on the host
contract, however, the conditions in ASC
815-15-25-26(b) would not be met.
8.4.1.3.7 Choose-Your-Rate Option
Variable-rate credit facilities often include an option
for the debtor to change the interest rate index that is used as the
basis for calculating interest rate payments on outstanding debt (e.g.,
an option to switch from one benchmark interest rate to another
benchmark interest rate). Such a feature is clearly and closely related
to its debt host contract unless the negative-yield test or the
double-double test (ASC 815-40-15-26) is passed (see Sections
8.4.1.3.3 and 8.4.1.3.4, respectively).
8.4.1.3.8 Examples
ASC 815-15-55 contains additional illustrative examples
of the application of ASC 815-15-25-26.
8.4.1.4 Derivative Analysis
The table below presents an analysis of whether an embedded feature that is
based solely on an interest rate or interest rate index and could adjust the
payments of a debt host contract meets the definition of a derivative (see
Section 8.3.4). Note, however, that an entity should always
consider the terms and conditions of a specific feature in light of the
applicable accounting guidance before reaching a conclusion.
|
Characteristics of a Derivative
|
Characteristic Present?
|
Analysis
|
|---|---|---|
|
Underlying and notional amount or payment provision
(see Section
8.3.4.2)
|
Yes
|
An embedded feature that could
adjust the payments of a debt host contract solely
on the basis of an interest rate or interest rate
index typically has both an underlying (i.e., the
interest rate or interest rate index) and a notional
amount (i.e., the amount on which the interest rate
adjustment is based, such as the debt’s outstanding
amount) or payment provision (e.g., a fixed cash
payment contingent on an interest rate or interest
rate index).
|
|
Initial net investment (see Section 8.3.4.3)
|
Yes
|
The initial net investment in an embedded feature is
its fair value (i.e., the amount that would need to
be paid to acquire the interest-rate-related feature
on a stand-alone basis without the host contract).
Generally, an embedded feature that could adjust the
cash flows of a debt host contract solely on the
basis of an interest rate or interest rate index has
an initial net investment that is smaller than would
be required for a direct investment that has the
same exposure to changes in interest rates (since
the investment in the debt host contract does not
form part of the initial net investment for the
embedded feature).
|
|
Net settlement (see Section 8.3.4.4)
|
Yes
|
An embedded feature that adjusts the payments of a
debt host contract solely on the basis of an
interest rate or interest rate index meets the net
settlement condition (neither party is required to
deliver an asset that is associated with the
underlying and whose principal amount, stated
amount, face value, number of shares, or other
denomination is equal to the feature’s notional
amount).
|
As shown in the table above, an embedded feature that is based solely on an
interest rate or interest rate index and could adjust the payments of a debt
host contract typically meets the definition of a derivative. Therefore, the
analysis of whether it must be bifurcated as a derivative tends to focus on
whether the feature is considered clearly and closely related to the debt
host contract (see Section 8.4.1.3)
unless the debtor has elected to account for the debt under the fair value
option in ASC 815-15 or ASC 825-10 (see Section
8.3.3).
8.4.2 Credit-Risk-Related Features
8.4.2.1 Background
Examples of contractual provisions in debt contracts that could adjust
payments on the basis of a measure of credit risk include:
-
A provision that requires the debtor to pay additional interest (e.g., 2 percent per annum) upon the debtor’s event of default.
-
A feature that adjusts interest payments on the basis of a measure of the debtor’s creditworthiness (e.g., a table that specifies different margins over a benchmark interest rate on the basis of a measure of the debtor’s working capital).
-
A feature that adjusts principal or interest payments on the basis of the credit risk of a third party.
This section does not address features that could accelerate the repayment of
the outstanding amount of the debt in cash upon the occurrence or
nonoccurrence of a specified event such as an event of default. Such
features should be evaluated as contingent redemption features (see
Section 8.4.4).
8.4.2.2 Bifurcation Analysis
The table below presents an overview of the bifurcation analysis of a
credit-risk-related feature embedded in a debt host contract. However, an
entity should always consider the terms and conditions of a specific feature
in light of all the relevant accounting guidance before reaching a
conclusion.
|
Bifurcation Condition
|
Condition Met?
|
Analysis
|
|---|---|---|
|
Not clearly and closely related (see Section 8.3.2)
|
It depends
|
A credit-sensitive payment that is based solely on
the creditworthiness of the debtor is clearly and
closely related to a debt host (see
Section 8.4.2.3). However,
the creditworthiness of a third party is not clearly
and closely related to a debt host.
|
|
Hybrid instrument not measured at fair value on a
recurring basis (see Section 8.3.3)
|
It depends
|
Debt is not measured at fair value on a recurring
basis unless the issuer elects the fair value option
in ASC 815-15 or ASC 825-10 (see Sections 4.4 and
8.5.6). The fair value option
cannot be elected for debt that contains a
separately recognized equity component at
inception.
|
|
Meets the definition of a derivative (see Section 8.3.4)
|
Yes
|
A credit-risk-related feature that adjusts the
payments of a debt host contract meets the
definition of a derivative (see Section 8.4.2.4).
|
|
Meets a scope exception (see Section 8.3.5)
|
It depends
|
Typically, no specific scope exception is available
for a credit-risk-related feature that is based on
the debtor’s creditworthiness (see Section 8.3.5).
However, in some situations the scope exception for
financial guarantee contracts may apply (see
Section 8.4.2.5).
|
As shown in the table above, a debtor’s determination of
whether an embedded credit-risk-related feature must be bifurcated as a
derivative tends to focus on whether the feature is considered clearly and
closely related to the debt host contract (see the next section) unless the
debtor has elected to account for the debt under the fair value option in
ASC 815-15 or ASC 825-10 (see Section 8.3.3). If the
credit-risk-related feature is based on the credit risk of a third party,
the debtor should also evaluate whether the feature can be net settled (see
Section
8.4.2.4) and whether it qualifies for the scope exception for
financial guarantee contracts (see Section 8.4.2.5).
8.4.2.3 Clearly-and-Closely-Related Analysis
ASC 815-15
25-46 The creditworthiness
of the debtor and the interest rate on a debt
instrument shall be considered to be clearly and
closely related. Thus, for debt instruments that
have the interest rate reset in the event of any of
the following conditions, the related embedded
derivative shall not be separated from the host
contract:
-
Default (such as violation of a credit-risk-related covenant)
-
A change in the debtor’s published credit rating
-
A change in the debtor’s creditworthiness indicated by a change in its spread over U.S. Treasury bonds.
25-47 If an instrument
incorporates a credit risk exposure that is
different from the risk exposure arising from the
creditworthiness of the obligor under that
instrument, such that the value of the instrument is
affected by an event of default or a change in
creditworthiness of a third party (that is, an
entity that is not the obligor), then the economic
characteristics and risks of the embedded credit
derivative are not clearly and closely related to
the economic characteristics and risks of the host
contract, even though the obligor may own securities
issued by that third party. This guidance shall be
applied to all other arrangements that incorporate
credit risk exposures that are unrelated or only
partially related to the creditworthiness of the
issuer of that instrument. This guidance does not
affect the accounting for a nonrecourse debt
arrangement (that is, a debt arrangement in which,
in the event that the debtor does not make the
payments due under the loan, the creditor has
recourse solely to the specified property pledged as
collateral).
A credit-sensitive payment is considered clearly and closely related to a
debt host contract under ASC 815-15-25-46 and 25-47 if it is triggered by,
and directionally consistent with, a measure of the debtor’s
creditworthiness, such as one or more of the following:
-
The debtor’s failure to pay amounts due on a timely basis (e.g., additional interest on late payments).
-
The debtor’s failure to comply with credit-risk-related debt covenants (e.g., additional interest that becomes payable if there is a material adverse change in the debtor’s creditworthiness).
-
A change in the debtor’s published credit rating (e.g., additional interest that becomes payable upon a credit rating downgrade).
-
A change in observable interest rate spreads over a risk-free interest rate (e.g., U.S. Treasury rates) for debt instruments with similar credit risk (e.g., an interest rate that varies on the basis of observable credit spreads on identical or similar debt securities issued by the debtor or other similar debtors).
-
A change in another measure of the debtor’s creditworthiness (e.g., a specified interest margin that varies on the basis of a measure of the debtor’s working capital).
However, a provision that requires an adjustment on the basis of the
creditworthiness of a third party (e.g., the third party’s default) is not
clearly and closely related to a host debt contract.
Debt contracts often contain provisions that require the debtor to pay
additional interest upon the occurrence of an “event of default.” To
determine whether such a provision is clearly and closely related to the
debt host, the debtor must evaluate how the debt terms define an event of
default. The table below discusses common situations that may be described
as events of default and whether such triggering events would be considered
clearly and closely related to a debt host.
|
Triggering Event
|
Clearly and Closely Related?
|
|---|---|
|
Any representation or warranty made by the debtor is
not correct
|
Yes
|
|
The debtor’s failure to perform or comply with
financial or nonfinancial covenants
|
Yes, unless the covenants include
items that do not affect the issuer’s credit
risk
|
|
The debtor’s bankruptcy or insolvency
|
Yes
|
|
Cross default on the debtor’s other indebtedness
|
Yes, unless the default on the other indebtedness
arises from events that are not credit-related
|
|
Invalidity or failure of debtor to maintain loan or
collateral documents
|
Yes
|
|
The debtor’s nonpayment of principal or interest when
due
|
Yes
|
|
Judgments or orders against the debtor exceeding a
specific amount
|
Yes
|
|
Revocation of the debtor’s license or permit to
perform business operations that results in a
material adverse effect
|
Yes
|
|
Criminal events of the debtor
|
Yes
|
|
A change of control of the debtor
|
No
|
|
Key-person event
|
Depends on facts and circumstances
|
|
The debtor suffers a credit rating downgrade
|
Yes
|
|
An observable increase in the debtor’s current
interest rate spread over a risk-free interest
rate
| Yes |
Example 8-10
Debt With Interest Rate Adjustment
Company ABC is rated BBB. Company ABC issues $100
million in 8 percent fixed-rate bonds. The bonds
include a provision that requires the interest rate
to reset to 10 percent if ABC’s credit rating is
downgraded to a single B at any time during the term
of the bonds. The embedded derivative that resets
the interest rate of the bonds is clearly and
closely related to the debt host because it is based
on the issuer’s credit rating.
However, if ABC’s bonds include a provision that
requires the interest rate to reset to 10 percent if
Company XYZ’s (an unrelated party’s) credit rating
is downgraded to a single B at any time during the
term of the bonds, the reset feature is not clearly
and closely related to the debt host.
ASC 815-15
Case A: Credit-Linked Note
55-103 Entity A issues to an
investor a fixed-rate, 10-year, $10 million
credit-linked note that provides for periodic
interest payments and the repayment of principal at
maturity. However, upon default of a specified
reference security (an Entity X subordinated debt
obligation) the redemption value of the note may be
zero or there may be some claim to the recovery
value of the reference security (depending on the
terms of the specific arrangement). Generally, the
term reference security refers to the
security whose credit rating or default determines
the cash flows under a credit derivative. Usually,
the terms of credit-linked notes explicitly
reference Committee on Uniform Security
Identification Procedures (CUSIP) numbers of
securities in the marketplace. In an event of
default of the specified reference security, there
is no recourse to the general credit of the obligor
(Entity A). In exchange for accepting the default
risk of the reference security, the note entitles
the investor to an enhanced yield. The transaction
results in the investor selling credit protection
and Entity A buying credit protection.
55-104 The credit-linked
note includes an embedded credit derivative. The
credit risk exposure of the reference security
(Entity X) and the risk exposure arising from the
creditworthiness of the obligor (Entity A) are not
clearly and closely related. Thus, the economic
characteristics and risks of the embedded derivative
are not clearly and closely related to the economic
characteristics and risks of the debt host contract
and, accordingly, the criterion in paragraph
815-15-25-1(a) is met.
55-105 Paragraph
815-15-25-6 explains that the fair value election
for hybrid financial instruments that otherwise
would require bifurcation does not apply to hybrid
financial instruments that are described in
paragraph 825-10-50-8, which include insurance
contracts as discussed in Section 944-20-15, other
than financial guarantees and investment
contracts.
55-106 Consideration
should be given to whether the embedded derivative
could possibly not be subject to this Topic as a
financial guarantee under paragraph 815-10-15-58
and, in that circumstance, the embedded derivative
would not warrant bifurcation.
Case M: Credit-Sensitive Bond
55-200 A credit-sensitive
bond has a coupon rate of interest that resets based
on changes in the issuer’s credit rating.
55-201 A credit-sensitive
bond can be viewed as combining a fixed-rate bond
with a conditional exchange contract (or option
contract) that entitles the investor to a higher
rate of interest if the credit rating of the issuer
declines. Because the creditworthiness of the debtor
and the interest rate on a debt instrument are
clearly and closely related, the embedded derivative
should not be separated from the host contract.
8.4.2.4 Derivative Analysis
The table below presents an analysis of whether a credit-risk-related
embedded feature that could adjust the payments on a debt host contract
meets the definition of a derivative (see Section
8.3.4). Note, however, that an entity should always consider
the terms and conditions of a specific feature in light of the applicable
accounting guidance before reaching a conclusion.
|
Characteristics of a Derivative
|
Characteristic Present?
|
Analysis
|
|---|---|---|
|
Underlying and notional amount or payment provision
(see Section
8.3.4.2)
|
Yes
|
A credit-risk-related feature that could adjust the
payments of a debt host contract generally has both
an underlying (e.g., an event of default or the
issuer’s credit rating) and a notional amount (i.e.,
the amount on which the adjustment is based, such as
the debt’s outstanding amount) or payment provision
(e.g., a fixed cash payment).
|
|
Initial net investment (see Section 8.3.4.3)
|
Yes
|
The initial net investment in an embedded feature is
its fair value (i.e., the amount that would need to
be paid to acquire the credit-risk-related feature
on a stand-alone basis without the host contract).
Generally, a credit-risk-related feature has an
initial net investment that is smaller than would be
required for a direct investment that has the same
exposure to changes in credit risk (since the
investment in the debt host contract does not form
part of the initial net investment for the embedded
feature).
|
|
Net settlement (see Section 8.3.4.4)
|
Yes
|
A credit-risk-related embedded feature that adjusts
the payments of a debt host contract meets the net
settlement condition (neither party is required to
deliver an asset that is associated with the
underlying and whose principal amount, stated
amount, face value, number of shares, or other
denomination is equal to the feature’s notional
amount).
|
As shown in the table above, a credit-risk-related embedded feature that
could adjust the payments of a debt host contract on the basis of the
debtor’s creditworthiness meets the definition of a derivative. Therefore,
the analysis of whether such a feature must be bifurcated as a derivative
tends to focus on whether the feature is considered clearly and closely
related to the debt host contract (see Section
8.4.2.3) unless the debtor has elected to account for the
debt under the fair value option in ASC 815-15 or ASC 825-10 (see Section 8.3.3).
8.4.2.5 Scope Exception for Financial Guarantee Contracts
ASC 815-10
15-58 Financial guarantee
contracts are not subject to this Subtopic only if
they meet all of the following conditions:
-
They provide for payments to be made solely to reimburse the guaranteed party for failure of the debtor to satisfy its required payment obligations under a nonderivative contract, either:
-
At prespecified payment dates
-
At accelerated payment dates as a result of either the occurrence of an event of default (as defined in the financial obligation covered by the guarantee contract) or notice of acceleration being made to the debtor by the creditor.
-
-
Payment under the financial guarantee contract is made only if the debtor’s obligation to make payments as a result of conditions as described in (a) is past due.
-
The guaranteed party is, as a precondition in the contract (or in the back-to-back arrangement, if applicable) for receiving payment of any claim under the guarantee, exposed to the risk of nonpayment both at inception of the financial guarantee contract and throughout its term either through direct legal ownership of the guaranteed obligation or through a back-to-back arrangement with another party that is required by the back-to-back arrangement to maintain direct ownership of the guaranteed obligation.
In contrast, financial guarantee contracts are
subject to this Subtopic if they do not meet all
three criteria, for example, if they provide for
payments to be made in response to changes in
another underlying such as a decrease in a specified
debtor’s creditworthiness.
Credit Derivatives
55-45 Many different types
of contracts are indexed to the creditworthiness of
a specified entity or group of entities, but not all
of them are derivative instruments. Credit-indexed
contracts that have certain characteristics
described in paragraph 815-10-15-58 are guarantees
and are not subject to the requirements of this
Subtopic. Credit-indexed contracts (often referred
to as credit derivatives) that do not have the
characteristics necessary to qualify for the
exception in that paragraph are subject to the
requirements of this Subtopic. One example of the
latter is a credit-indexed contract that requires a
payment due to changes in the creditworthiness of a
specified entity even if neither party incurs a loss
due to the change (other than a loss caused by the
payment under the credit-indexed contract).
As noted in ASC 815-15-55-106 (see Section
8.4.2.3), a debtor should consider whether an embedded credit
derivative in a credit-linked note qualifies for the scope exception for
certain financial guarantee contracts in ASC 815-10-15-58. To qualify for
this scope exception, the embedded feature must meet all of the conditions
in ASC 815-10-15-58. For example, the scope exception is only available if
the guaranteed party (i.e., the issuer of the credit-linked note) as a
precondition for payment (e.g., a reduction in the contractually required
cash flows of the credit-linked note) is contractually required to either
(1) hold the third-party debt or (2) be exposed to the risk of nonpayment on
the third-party debt through a back-to-back arrangement with another party
under which that other party is contractually required to hold the
third-party debt. Further, the scope exception is only available if the
feature solely reimburses the guaranteed party (i.e., the issuer of the
credit-linked note) for overdue payments on the third-party debt. For
example, the scope exception is not available if the guarantee payments are
made on the basis of (1) events of default other than past-due payments on
the third-party debt or (2) changes in the credit rating of the third-party
debtor.
8.4.3 Inflation-Indexed Payments
8.4.3.1 Background
This section discusses the analysis of whether an inflation-indexed payment
feature embedded in a debt host contract should be separated as a derivative
(e.g., inflation-linked bonds). The discussion does not address features
that could accelerate the repayment of the outstanding amount of the debt in
cash upon the occurrence or nonoccurrence of a specified event (e.g., an
acceleration feature that is triggered by a specified measure of inflation).
Such features should be evaluated as contingent redemption features (see
Section 8.4.4).
8.4.3.2 Bifurcation Analysis
The table below presents an overview of the bifurcation analysis of an
inflation-indexed payment feature embedded in a debt host contract. However,
an entity should always consider the terms and conditions of a specific
feature in light of all the relevant accounting guidance before reaching a
conclusion.
|
Bifurcation Condition
|
Condition Met?
|
Analysis
|
|---|---|---|
|
Not clearly and closely related (see Section 8.3.2)
|
It depends
|
The rate of inflation in the economic environment for
the currency in which the debt is denominated is
clearly and closely related to the debt host unless
the feature is leveraged (see Section 8.4.3.3). The
rate of inflation in other economic environments is
not clearly and closely related to a debt host.
|
|
Hybrid instrument not measured at fair value on a
recurring basis (see Section 8.3.3)
|
It depends
|
Debt is not measured at fair value on a recurring
basis unless the issuer elects the fair value option
in ASC 815-15 or ASC 825-10 (see Sections 4.4 and
8.5.6). However, the fair
value option cannot be elected for debt that
contains a separately recognized equity component at
inception.
|
|
Meets the definition of a derivative (see Section 8.3.4)
|
Yes
|
An inflation-indexed payment feature that adjusts the
payments of a debt host contract meets the
definition of a derivative (see Section
8.4.3.4).
|
|
Meets a scope exception (see Section 8.3.5)
|
No
|
No specific scope exception is available for
inflation-indexed payment features embedded in debt
host contracts (see Section 8.3.5).
|
As shown in the table above, a debtor’s determination of whether an
inflation-indexed feature that could adjust the payments of a debt host
contract must be bifurcated as a derivative tends to focus on whether the
feature is considered clearly and closely related to the debt host contract
(see Section 8.4.3.3) unless the
debtor has elected to account for the debt under the fair value option in
ASC 815-15 or ASC 825-10 (see Section
8.3.3). Typically, such features meet the definition of a
derivative (see Section 8.4.3.4) and are not exempt
from the scope of derivative accounting.
8.4.3.3 Clearly-and-Closely-Related Analysis
ASC 815-15
25-50 The interest rate
and the rate of inflation in the economic
environment for the currency in which a debt
instrument is denominated shall be considered to be
clearly and closely related. Thus, nonleveraged
inflation-indexed contracts (debt instruments,
capitalized lease obligations, pension obligations,
and so forth) shall not have the inflation-related
embedded derivative separated from the host
contract.
Under ASC 815-15-25-50, the indexation of principal or interest payments to
an inflation rate (e.g., U.S. CPI or U.K. RPI) is considered clearly and
closely related to a debt host contract if (1) the inflation rate is
appropriate for the economic environment for the currency in which the debt
is denominated and (2) the feature is not leveraged (e.g., interest payments
that are computed on the basis of two times CPI would not be considered
clearly and closely related to a debt host contract). For example, payments
indexed to an unleveraged measure of U.S. CPI would be considered clearly
and closely related to USD-denominated debt. Conversely, the rate of
inflation in a different economic environment (e.g., EUR-denominated debt
that has principal or interest payments indexed to U.S. CPI) is not clearly
and closely related to the debt host.
Example 8-11
Debt With Embedded Inflation Index Feature
A U.S. company issues U.S. dollar–denominated bonds.
There is an embedded inflation index that requires
the bond issuer to pay the change in the Mexican CPI
every two years. The embedded inflation-indexed
derivative is not clearly and closely related to the
bond because it is not the rate of inflation of the
United States, the economic environment in which the
bond was issued. However, if the bond issuer was
required to pay the change in U.S. CPI every two
years, the embedded derivative would be clearly and
closely related and, therefore, would not need to be
accounted for separately.
ASC 815-15
Case N: Inflation Bond
55-202 An inflation bond
has a contractual principal amount that is indexed
to the inflation rate but cannot decrease below par;
the coupon rate is typically below that of
traditional bonds of similar maturity.
55-203 An inflation bond
can be viewed as a fixed-rate bond for which a
portion of the coupon interest rate has been
exchanged for a conditional exchange contract (or
option contract) indexed to the consumer price
index, or other index of inflation in the economic
environment for the currency in which the bond is
denominated, that entitles the investor to payment
of additional principal based on increases in the
referenced index. Such rates of inflation and
interest rates on the debt instrument are considered
to be clearly and closely related. Therefore, the
embedded derivative should not be separated from the
host contract.
8.4.3.4 Derivative Analysis
The table below presents an analysis of whether an
inflation-indexed feature that could adjust the cash flows of a debt host
contract meets the definition of a derivative (see Section 8.3.4). Note, however, that an
entity should always consider the terms and conditions of a specific feature
in light of the applicable accounting guidance before reaching a
conclusion.
|
Characteristics of a Derivative
|
Characteristic Present?
|
Analysis
|
|---|---|---|
|
Underlying and notional amount or payment provision
(see Section
8.3.4.2)
|
Yes
|
An inflation-indexed payment feature that could
adjust the payments of a debt host contract has both
an underlying (i.e., the applicable measure of
inflation, such as the change in CPI) and a notional
amount (i.e., the amount on which the adjustment is
based, such as the debt’s outstanding amount) or
payment provision (e.g., a fixed cash payment).
|
|
Initial net investment (see Section 8.3.4.3)
|
Yes
|
The initial net investment in an embedded feature is
its fair value (i.e., the amount that would need to
be paid to acquire the inflation-indexed feature on
a stand-alone basis without the host contract).
Generally, an inflation-indexed feature has an
initial net investment that is smaller than would be
required for a direct investment that has the same
exposure to changes in the inflation rate (since the
investment in the debt host contract does not form
part of the initial net investment for the embedded
feature).
|
|
Net settlement (see Section 8.3.4.4)
|
Yes
|
A feature that adjusts the payments of a debt host
contract on the basis of an inflation index meets
the net settlement condition (neither party is
required to deliver an asset that is associated with
the underlying and whose principal amount, stated
amount, face value, number of shares, or other
denomination is equal to the feature’s notional
amount).
|
As shown in the table above, an inflation-indexed feature embedded in a debt
host contract typically meets the definition of a derivative. Therefore, the
analysis of whether such a feature must be bifurcated as a derivative tends
to focus on whether the feature is considered clearly and closely related to
the debt host contract (see Section
8.4.3.3) unless the debtor has elected to account for the
debt under the fair value option in ASC 815-15 or ASC 825-10 (see Section 8.3.3).
8.4.4 Call, Put, and Other Redemption Features
8.4.4.1 Background
Debt contracts often contain features that could permit the issuer to call
(or prepay) the outstanding amount or the holder to put (or accelerate the
repayment of) the outstanding amount. Debt contracts might also contain
features that trigger an acceleration of the due date for the repayment of
the debt upon the occurrence or nonoccurrence of a specified event or events
(e.g., an event of default or change of control).
8.4.4.2 Bifurcation Analysis
The table below presents an overview of the bifurcation analysis of
redemption features embedded in a debt host contract. However, an entity
should always consider the terms and conditions of a specific feature in
light of all the relevant accounting guidance before reaching a
conclusion.
|
Bifurcation Condition
|
Condition Met?
|
Analysis
|
|---|---|---|
|
Not clearly and closely related (see Section 8.3.2)
|
It depends
|
The debtor should evaluate whether the redemption
feature is clearly and closely related to the debt
host under the four-step decision sequence in ASC
815-15-25-41 (see Section
8.4.4.3).
|
|
Hybrid instrument not measured at fair value on a
recurring basis (see Section 8.3.3)
|
It depends
|
Debt is not measured at fair value on a recurring
basis unless the issuer elects the fair value option
in ASC 815-15 or ASC 825-10 (see Sections 4.4 and
8.5.6). The fair value option
cannot be elected for debt that contains a
separately recognized equity component at
inception.
|
|
Meets the definition of a derivative (see Section 8.3.4)
|
Yes
|
A redemption feature embedded in a debt host meets
the definition of a derivative irrespective of
whether the debt host contract is readily
convertible to cash (see Section
8.4.4.4).
|
|
Meets a scope exception (see Section 8.3.5)
|
No
|
There is no specific scope exception for redemption
features embedded in a debt host.
|
As shown in the table above, a debtor’s determination of
whether a redemption feature must be bifurcated as a derivative tends to
focus on whether the feature is considered clearly and closely related to
the debt host contract (see the next section) unless the debtor has elected
to account for the debt under the fair value option in ASC 815-15 or ASC
825-10 (see Section
8.3.3). Such features meet the definition of a derivative
(see Section
8.4.4.4) and are not exempt from the scope of derivative
accounting.
8.4.4.3 Clearly-and-Closely-Related Analysis
ASC Master Glossary
Prepayable
Able to be settled by either party before its
scheduled maturity.
ASC 815-15
25-41 Call (put) options
that do not accelerate the repayment of principal on
a debt instrument but instead require a cash
settlement that is equal to the price of the option
at the date of exercise would not be considered to
be clearly and closely related to the debt
instrument in which it is embedded.
25-42 The following
four-step decision sequence shall be followed in
determining whether call (put) options that can
accelerate the settlement of debt instruments shall
be considered to be clearly and closely related to
the debt host contract:
Step 1: Is the amount paid upon settlement
(also referred to as the payoff) adjusted based on
changes in an index? If yes, continue to Step 2.
If no, continue to Step 3.
Step 2: Is the payoff indexed to an
underlying other than interest rates or credit
risk? If yes, then that embedded feature is not
clearly and closely related to the debt host
contract and further analysis under Steps 3 and 4
is not required. If no, then that embedded feature
shall be analyzed further under Steps 3 and
4.
Step 3: Does the debt involve a substantial
premium or discount? If yes, continue to Step 4.
If no, further analysis of the contract under
paragraph 815-15-25-26 is required, if
applicable.
Step 4: Does a contingently exercisable call
(put) option accelerate the repayment of the
contractual principal amount? If yes, the call
(put) option is not clearly and closely related to
the debt instrument. If not contingently
exercisable, further analysis of the contract
under paragraph 815-15-25-26 is required, if
applicable.
ASC 815-15-25-41 and 25-42
address whether embedded call or put options are clearly and closely related
to a debt host contract and apply to all features that can accelerate the
settlement of a debt instrument whether such acceleration is optional or
mandatory and regardless of how such features are described in the debt’s
contractual terms. ASC 815-15-25-42 identifies four steps that should be
performed in the analysis of whether a feature that can accelerate the
settlement of a debt instrument is clearly and closely related to a debt
host contract:
In practice, a discount or premium that is 10 percent or more is considered
“substantial” in the analysis performed under step 3. In determining whether
a substantial premium or discount exists, an entity should compare the
debt’s initial net carrying amount to the potential payoff if the embedded
call, put, or other redemption feature is triggered. Accordingly, an entity
should base its analysis on the amount allocated to the debt for accounting
purposes rather than the total cash proceeds (e.g., if debt was issued with
detachable warrants, the amount allocated to the warrants could cause a
discount on the debt). Nevertheless, an entity should not consider a
discount that results from one of the following in its determination of
whether the debt involves a substantial discount or premium under ASC 815-15-25-42:
-
Third-party debt issuance costs that have been deducted from the initial carrying amount (see Section 5.3.3).
-
A discount that results from the separation of an embedded derivative under ASC 815-15.
An entity should consider the payoff of the embedded feature being analyzed
in determining whether the debt instrument was issued at a substantial
premium or discount. For example, if a debt instrument that was issued at
par contains a put option that allows the investor to redeem the instrument
at 112 percent of par value, the debt instrument would be considered to
involve a substantial premium. Similarly, if a debt instrument was issued at
90 percent of par and is redeemable at par, the debt is considered to
involve a substantial discount. However, unpaid accrued interest does not
form part of the analysis of whether a substantial premium or discount
exists.
The following table outlines
and illustrates the application of the four steps in ASC 815-15-25-42:
|
Steps
|
Examples of Terms That Would Result in a “Yes”
Answer
|
Examples of Terms That Would Result in a “No”
Answer
|
|---|---|---|
|
“Step 1: Is the amount paid upon settlement (also
referred to as the payoff) adjusted based on changes
in an index? If yes, continue to Step 2. If no,
continue to Step 3.”
|
|
|
|
“Step 2: Is the payoff indexed to an underlying other
than interest rates or credit risk? If yes, then
that embedded feature is not clearly and closely
related to the debt host contract and further
analysis under Steps 3 and 4 is not required. If no,
then that embedded feature shall be analyzed further
under Steps 3 and 4.”
|
|
|
|
“Step 3: Does the debt involve a substantial premium
or discount? If yes, continue to Step 4. If no,
further analysis of the contract under paragraph
815-15-25-26 is required, if applicable” (see
Section 8.4.1).
|
|
|
|
“Step 4: Does a contingently exercisable call (put)
option accelerate the repayment of the contractual
principal amount? If yes, the call (put) option is
not clearly and closely related to the debt
instrument. If not contingently exercisable, further
analysis of the contract under paragraph
815-15-25-26 is required, if applicable” (see
Section 8.4.1).
|
|
|
As noted in steps 2, 3, and 4 of the decision sequence in ASC 815-15-25-42,
an entity might be required to consider the applicability of ASC
815-15-25-26 to an embedded call, put, or other redemption feature. ASC
815-15-25-26 applies to embedded derivatives “in which the only underlying
is an interest rate or interest rate index . . . that alters net interest
payments that otherwise would be paid or received on an interest-bearing
[debt] host contract” (see Section 8.4.1.3). An option that can be exercised only upon
the occurrence or nonoccurrence of a specified event (e.g., an IPO or a
change in control at the issuer) would always have a second underlying (the
occurrence or nonoccurrence of the specified event). The existence of this
second underlying would exclude such a contract from the scope of ASC
815-15-25-26 unless the event is solely related to interest rates (e.g., a
call that may only be exercised when LIBOR is at or above 5 percent) because
the underlying would never be only an interest rate or interest rate index
(see Section 8.4.1.3.2).
Example 8-12
Debt That Is Puttable Upon a Change in
Control
Entity A issues a 10-year note at par, which becomes
puttable to the issuer at 102 percent of par plus
accrued interest, if a change in control occurs at
A.
As shown in the table below, A must apply the
four-step decision sequence in ASC 815-15-25-42 to
evaluate whether the embedded put option is clearly
and closely related to the debt host.
|
Example
|
Indexed Payoff? (Steps 1 and 2)
|
Substantial Discount or Premium? (Step 3)
|
Contingently Exercisable? (Step 4)
|
Embedded Option Clearly and Closely
Related?
|
|---|---|---|---|---|
|
Debt issued at par is puttable at 102 percent
of par, plus accrued interest, in the event of a
change in control at A.
|
No. The amount paid upon settlement is not
“adjusted based on changes in an index.” The
payoff amount is fixed at 102 percent of par, plus
accrued interest.
|
No. The debt is issued at par and puttable for
a premium that is not substantial.
|
N/A. Analysis is not required because the
answer to step 3 is no (i.e., no substantial
discount or premium).
|
The embedded put option is clearly and closely
related to the debt host. ASC 815-15-25-26 does
not apply, because the change in control is
considered a second underlying that is not an
interest rate or an interest rate index.
|
Example 8-13
Interest Make-Whole Premium That Becomes Payable
Upon Exercise of Call Option
Entity X has issued a debt security, which includes a
call option that permits X to prepay the outstanding
amount of principal and accrued interest at any time
before the debt’s maturity. If X calls the debt
security before its maturity date, it is required to
also pay an interest make-whole premium equal to the
present value of the debt’s remaining interest cash
flows discounted at a fixed spread over the current
U.S. Treasury rate as of the date on which the debt
is settled. However, X could not be required to pay
an interest make-whole premium in excess of 5
percent of the principal amount.
The interest make-whole premium is considered an
integral component of the call option; it is not a
distinct embedded feature that requires separate
evaluation under ASC 815-15 (see Section 8.2.3). When assessing whether
the call option is clearly and closely related to
its host, the issuer first should look to the
four-step decision sequence in ASC 815-15-25-42.
|
Example
|
Indexed Payoff? (Steps 1 and 2)
|
Substantial Discount or Premium? (Step 3)
|
Contingently Exercisable? (Step 4)
|
Embedded Option Clearly and Closely
Related?
|
|---|---|---|---|---|
|
Debt security issued at par is callable at par
plus an interest make-whole premium that may not
exceed 5 percent of the principal amount.
|
Yes. The amount paid upon settlement is
adjusted on the basis of changes in the
then-current U.S. Treasury rate. The calculation
of the interest make-whole premium includes the
U.S. Treasury rate.
The payoff is not, however, indexed to an
underlying other than interest rates or credit
risk.
|
No. The debt was issued at par and the interest
make-whole premium cannot exceed 5 percent of the
principal amount.
|
N/A. Analysis is not required because the
answer to the question in step 3 is no (i.e., no
substantial discount or premium).
|
ASC 815-15-25-26 applies since the interest
make-whole premium is indexed to an interest
rate.
Under ASC 815-15-25-26(a), there is no
circumstance in which the investor would not
contractually recover its initial investment if
the issuer exercises the call option because the
repayment amount will exceed the principal amount,
and the debt was issued at par.
ASC 815-15-25-26(b) does not
apply. ASC 815-15-25-37 states that this condition
does “not apply to an embedded call option in a
hybrid instrument containing a debt host contract
if the right to accelerate the settlement of the
debt can be exercised only by the debtor.”
The embedded call option, including the
interest make-whole provision, is clearly and
closely related to the debt host.
|
ASC 815-15
55-13 The following table
demonstrates the application of the four-step
decision sequence in paragraph 815-15-25-42 for
determining whether call options and put options
that can accelerate the settlement of debt
instruments should be considered to be clearly and
closely related to the debt host contract under the
criterion in paragraph 815-15-25-1(a).
|
Instrument
|
Indexed Payoff? (Steps 1 and 2)
|
Substantial Discount or Premium? (Step 3)
|
Contingently Exercisable? (Step 4)
|
Embedded Option Clearly and Closely
Related?
|
|---|---|---|---|---|
|
1. Debt that is issued at a substantial
discount is callable at any time during its
10-year term. If the debt is called, the investor
receives the par value of the debt plus any unpaid
and accrued interest.
|
No.
|
Yes.
|
No.
|
The embedded call option is clearly and closely
related to the debt host contract because the
payoff is not indexed, and the call option is not
contingently exercisable.
|
|
2. Debt that is issued at par is callable at
any time during its term. If the debt is called,
the investor receives the greater of the par value
of the debt or the market value of 100,000 shares
of XYZ common stock (an unrelated entity).
|
Yes, based on an equity price.
|
N/A. Analysis not required.
|
N/A. Analysis not required.
|
The embedded call option is not clearly and
closely related to the debt host contract because
the payoff is indexed to an equity price.
|
|
3. Debt that is issued at par is puttable if
the Standard and Poor’s S&P 500 Index
increases by at least 20 percent. If the debt is
put, the investor receives the par amount of the
debt adjusted for the percentage increase in the
S&P 500.
|
Yes, based on an equity index
(S&P 500).
|
N/A. Analysis not required.
|
N/A. Analysis not required.
|
The embedded put option is not clearly and
closely related to the debt host contract because
the payoff is indexed to an equity price.
|
|
4. Debt that is issued at a substantial
discount is puttable at par if London Interbank
Offered Rate (LIBOR) either increases or decreases
by 150 basis points.
|
No.
|
Yes.
|
Yes, contingent on a movement of LIBOR of at
least 150 basis points.
|
The put option is not clearly and closely
related to the debt host contract because the debt
was issued at a substantial discount and the put
option is contingently exercisable.
|
|
5. Debt that is issued at a substantial
discount is puttable at par in the event of a
change in control.
|
No.
|
Yes.
|
Yes, contingent on a change in control.
|
The put option is not clearly and closely
related to the debt host contract because the debt
was issued at a substantial discount and the put
option is contingently exercisable.
|
|
6. Zero coupon debt is issued at a substantial
discount and is callable in the event of a change
in control. If the debt is called, the issuer pays
the accreted value (calculated per amortization
table based on the effective interest rate
method).
|
No.
|
Yes.
|
Yes, contingent on a change in control, but
since the debt is callable at accreted value, the
call option does not accelerate the repayment of
principal.
|
The call option is clearly and closely related
to the debt host contract. Although the debt was
issued at a substantial discount and the call
option is contingently exercisable, the call
option does not accelerate the repayment of
principal because the debt is callable at the
accreted value.
|
|
7. Debt that is issued at par is puttable at
par in the event that the issuer has an initial
public offering.
|
No.
|
No.
|
N/A. Analysis not required.
|
The embedded put option is clearly and closely
related to the debt host contract because the debt
was issued at par (not at a substantial discount)
and is puttable at par. Paragraph 815-15-25-26
does not apply.
|
|
8. Debt that is issued at par is puttable if
the price of the common stock of Entity XYZ (an
entity unrelated to the issuer or investor)
changes by 20 percent. If the debt is put, the
investor will be repaid based on the value of
Entity XYZ’s common stock.
|
Yes, based on an equity price (price of Entity
XYZ’s common stock).
|
N/A. Analysis not required.
|
N/A. Analysis not required.
|
The embedded put option is not clearly and
closely related to the debt host contract because
the payoff is indexed to an equity price.
|
|
9. Debt is issued at a slight discount and is
puttable if interest rates move 200 basis points.
If the debt is put, the investor will be repaid
based on the S&P 500.
|
Yes, based on an equity index (S&P
500).
|
N/A. Analysis not required.
|
N/A. Analysis not required.
|
The embedded put option is not clearly and
closely related to the debt host contract because
the payoff is based on an equity index.
|
8.4.4.4 Derivative Analysis
8.4.4.4.1 General
The table below presents an analysis of whether a redemption feature
embedded in a debt host contract meets the definition of a derivative
(see Section 8.3.4). Note, however, that an entity should
always consider the terms and conditions of a specific feature in light
of the applicable accounting guidance before reaching a conclusion.
|
Characteristics of a Derivative
|
Characteristic Present?
|
Analysis
|
|---|---|---|
|
Underlying and notional amount or payment
provision (see Section 8.3.4.2)
|
Yes
|
A redemption feature has both an underlying
(interest rates and, if applicable, the occurrence
or nonoccurrence of any exercise contingency and
any other underlyings that adjust the redemption
amount) and a notional amount (the debt’s
principal amount) or payment provision.
|
|
Initial net investment (see Section 8.3.4.3)
|
Yes
|
The initial net investment in an embedded feature
is its fair value (i.e., the amount that would
need to be paid to acquire the redemption feature
on a stand-alone basis without the host contract).
Generally, a redemption feature has an initial net
investment that is smaller than would be required
for a direct investment that pays the redemption
amount (since the investment in the debt host
contract does not form part of the initial net
investment for the embedded feature).
|
|
Net settlement (see Section 8.3.4.4)
|
Yes
|
The potential settlement that
would occur upon the exercise of the redemption
feature in a debt host contract always meets the
net settlement condition because neither party is
required to deliver an asset that is associated
with the underlying (see Section
8.4.4.4.2).
|
As shown in the table above, a redemption feature embedded in a debt host
contract meets the definition of a derivative. Therefore, the analysis
of whether such a feature must be bifurcated as a derivative tends to
focus on whether the feature is considered clearly and closely related
to the debt host contract (see Section 8.4.4.3) unless the debtor has elected to
account for the debt under the fair value option in ASC 815-15 or ASC
825-10 (see Section 8.3.3).
8.4.4.4.2 Net Settlement Analysis
ASC 815-10
Net Settlement of a Debt Instrument Through
Exercise of an Embedded Put Option or Call
Option
15-107 The potential
settlement of the debtor’s obligation to the
creditor that would occur upon exercise of a put
option or call option embedded in a debt
instrument meets the net settlement criterion as
discussed beginning in paragraph 815-10-15-100
because neither party is required to deliver an
asset that is associated with the underlying.
Specifically:
-
The debtor does not receive an asset when it settles the debt obligation in conjunction with exercise of the put option or call option.
-
The creditor does not receive an asset associated with the underlying.
15-108 The guidance in the
preceding paragraph shall be applied under both of
the following circumstances:
-
When applying paragraph 815-15-25-1(c) to a put option or call option (including a prepayment option) embedded in a debt instrument
-
When analyzing the net settlement criterion (see guidance beginning in paragraph 815-10-15-100) for a freestanding call option held by the debtor on its own debt instrument and for a freestanding put option issued by the debtor on its own debt instrument.
15-109 The guidance in
paragraph 815-10-15-107 shall not be applied under
either of the following circumstances:
-
To put or call options that are added to a debt instrument by a third party contemporaneously with or after the issuance of a debt instrument. (In that circumstance, see paragraph 815-10-15-6.)
-
By analogy to an embedded put or call option in a hybrid instrument that does not contain a debt host contract.
ASC 815-10-15-107 through 15-109 indicate that the
potential settlement of a debtor’s obligation to the creditor that would
occur upon the exercise of a put option or call option (including a
prepayment option) embedded in a debt instrument meets the net
settlement condition in ASC 815-10-15-100, which states, in part, that
“neither party is required to deliver an asset that is associated with
the underlying and that has a principal amount, stated amount, face
value, number of shares, or other denomination that is equal to the
notional amount.”
Accordingly, a call, put, or other redemption feature
that is embedded in a debt host meets the net settlement characteristic
in the definition of a derivative irrespective of whether the debt host
contract is readily convertible to cash. For instance, such a feature is
considered to meet the net settlement characteristic even if it is
embedded in a loan or debt security that does not have an observable
price. Further, a call, put, or other redemption feature embedded in a
debt host meets the net settlement characteristic even if it is settled
in a form other than cash.
Traditionally, the settlement of a debt obligation upon the exercise of a
put or call results in the creditor’s receipt of cash in exchange for
tendering the debt obligation. However, in some circumstances, the
debtor either is required or has the option to settle the redemption by
delivering a number of shares of its own stock with a value equal to a
predetermined dollar amount. An embedded redemption feature in a hybrid
financial instrument with a debt host that may be settled with the
issuer’s shares always meets the net settlement characteristic under the
guidance in ASC 815-10-15-107 on put or call options in debt host
contracts (see also Section 8.4.7.2.5). In the evaluation under ASC
815-10-15-107(b) of a share-settled put, call, or redemption feature
embedded in a debt host contract, the assets being delivered to the
holder upon the settlement of the feature are shares of the issuer. Such
shares are not associated with the embedded feature’s underlying because
the monetary value of the shares to be delivered does not vary on the
basis of the share price. In other words, the holder is indifferent to
changes in value of any of the equity shares until the feature is
settled. Therefore, the net settlement criterion is met regardless of
whether the underlying shares are readily convertible to cash. The
guidance in ASC 815-10-15-107 through 15-109 does not apply to calls,
puts, and other redemption features that are embedded in equity host
contracts.
Example 8-14
Notes That Are Automatically Converted Into
Shares Upon a Qualifying Equity Offering
Company XYZ issues $1 million of notes to an
investor group. According to the terms of the
notes, XYZ is required to pay interest
semiannually at a rate of 8 percent per annum.
Principal on the notes is due at maturity, which
is two years after issuance. Upon a qualifying
equity offering (one in which XYZ raises at least
$10 million of equity), the notes are
automatically converted into shares sold in the
qualifying equity offering. The conversion price
equals 80 percent of the price per share of the
qualifying equity offering. For example, if XYZ
issued $10 million of Series D preferred stock at
$10 per share, the notes would be converted into
Series D preferred stock at $8 per share.
The automatic conversion upon a qualifying equity
offering is economically a contingent redemption
of the notes for $1.25 million. However, the
investors do not receive $1.25 million in cash;
rather, the redemption feature is settled in
shares of XYZ with a value of $1.25 million.
The redemption feature would not
be considered clearly and closely related to the
debt host because it is a contingent redemption
and involves a significant premium relative to the
amount paid by the investors — $1.25 million
compared with $1 million (see ASC 815-15-25-40).
Assuming that the debt is not remeasured at fair
value with changes in fair value recognized in
earnings, XYZ would be required to bifurcate the
redemption option because a separate instrument
with the same terms would be subject to derivative
accounting under ASC 815.
In the evaluation of the net settlement condition
under ASC 815-10-15-107(b), the assets being
delivered to the holder of the debt instrument are
shares of the issuer, which are not associated
with any underlying because the value of the
shares to be delivered is a fixed dollar amount.
In other words, even though the shares are related
to the event that triggers redemption (i.e., the
shares delivered are the same shares issued in the
qualifying equity offering) and an event is
considered an underlying, the holder is
indifferent to changes in value of any of the
equity shares of the issuer in the time between
the issuance of the debt and the triggering of the
redemption feature because the holder will receive
a fixed dollar amount once the redemption is
triggered. Therefore, with respect to the
condition in ASC 815-10-15-107(b), the shares are
not associated with any underlying, regardless of
whether the underlying shares are readily
convertible to cash. Thus, the net settlement
condition is met and the embedded redemption
feature related to the automatic conversion upon a
qualifying equity offering must be bifurcated from
the host contract and accounted for as a
derivative liability.
8.4.5 Term Extension Features
8.4.5.1 Background
Term extension features embedded in a debt host contract
include those that give either party the right to extend the debt’s
remaining term or automatically extend the term upon the occurrence of a
specified event.
8.4.5.2 Bifurcation Analysis
The table below presents an overview of the bifurcation analysis of a term
extension feature embedded in a debt host contract. However, an entity
should always consider the terms and conditions of a specific feature in
light of all the relevant accounting guidance before reaching a
conclusion.
|
Bifurcation Condition
|
Condition Met?
|
Analysis
|
|---|---|---|
|
Not clearly and closely related (see Section 8.3.2)
|
It depends
|
A term extension feature is not clearly and closely
related to a debt host unless the interest rate is
concurrently reset to a current market rate and the
debt initially did not involve a significant
discount (see Section
8.4.5.3).
|
|
Hybrid instrument not measured at fair value on a
recurring basis (see Section 8.3.3)
|
It depends
|
Debt is not measured at fair value on a recurring
basis unless the issuer elects the fair value option
in ASC 815-15 or ASC 825-10 (see Sections 4.4 and
8.5.6). However, the fair
value option cannot be elected for debt that
contains a separately recognized equity component at
inception.
|
|
Meets the definition of a derivative (see Section 8.3.4)
|
It depends
|
The evaluation of whether a term extension feature
meets the definition of a derivative depends on
whether it meets the net settlement characteristic
in the definition of a derivative (see
Section 8.4.5.4).
|
|
Meets a scope exception (see Section 8.3.5)
|
Generally, yes
|
A term extension feature embedded in a debt host
contract often qualifies for the loan commitment
scope exception (see Section
8.4.5.5). However, this scope exception
is not available if the term extension option is
held by the creditor.
|
As shown in the table above, a term extension feature in a
debt host would not be bifurcated if (1) the feature is considered clearly
and closely related to the debt host contract (see the next section), (2)
the debtor has elected to account for the debt under the fair value option
in ASC 815-15 or ASC 825-10 (see Section 8.3.3), (3) the feature does
not meet the definition of a derivative (see Section 8.4.5.4), or (4) the feature
meets the scope exception for loan commitments (see Section 8.4.5.5).
8.4.5.3 Clearly-and-Closely-Related Analysis
ASC 815-15
25-44 An embedded
derivative that either (a) unilaterally enables one
party to extend significantly the remaining term to
maturity or (b) automatically extends significantly
the remaining term triggered by specific events or
conditions is not clearly and closely related to the
interest rate on a debt instrument unless the
interest rate is concurrently reset to the
approximate current market rate for the extended
term and the debt instrument initially involved no
significant discount. Thus, if there is no reset of
interest rates, the embedded derivative is not
clearly and closely related to the host contract.
That is, a term-extending option cannot be used to
circumvent the restriction in paragraph 815-15-25-26
regarding the investor’s not recovering
substantially all of its initial recorded
investment.
Under ASC 815-15-25-44, a term extension feature is clearly and closely
related to a debt host only if (1) the interest rate is adjusted to the
approximate current market rate of interest for the extended term at the
time the term is extended and (2) the debt did not initially involve a
significant discount.
Example 8-15
Debt With Extension Option
Company XYZ issues five-year, variable-rate debt that
pays three-month LIBOR plus 250 basis points on a
quarterly basis. At the end of five years, XYZ has
an option to extend the debt for another three years
and, if the option is exercised, XYZ will continue
to pay three-month LIBOR plus 250 basis points for
the extended term.
Although the debt continues to vary on the basis of
three-month LIBOR if the term of the debt is
extended, the interest rate does not reset to
current market rates because the credit spread is
not adjusted. At the end of the original five-year
term, the current market rate for an issuer with the
creditworthiness of XYZ may be different than
three-month LIBOR plus 250 basis points (e.g., the
current market rate for XYZ debt could be LIBOR plus
750 basis points), even if the creditworthiness of
XYZ has not changed. Therefore, because XYZ has the
option to extend the maturity of the debt
significantly and the interest rate in its entirety
does not reset to market, the term-extending option
is not clearly and closely related to the debt
host.
Note that the analysis of whether a term extension feature is clearly and
closely related to a debt host is different from the analysis of whether an
embedded prepayment (or call) option is clearly and closely related to a
debt host (see Section 8.4.4) even
though economically such features may be similar.
Example 8-16
Bonds With Extension Options
Entity ABC issues two series of bonds that are
publicly traded. One bond has a five-year term and a
6 percent fixed coupon rate and grants the
bondholder an option to extend the debt for another
three years at a 6 percent fixed interest rate. The
second bond has an eight-year term and a 6 percent
fixed coupon rate and grants the bondholder an
option to put the debt back to ABC at the end of
five years. Although these two bonds are
economically similar, they are analyzed differently
under ASC 815. The first bond is analyzed as a
five-year debt host contract with an embedded term
extension feature. The second bond is analyzed as an
eight-year debt host contract with an embedded put
option.
The term-extending option in the first bond extends the
maturity of the debt significantly but does not reset the interest rate to a
market rate. The term-extending option, therefore, is not clearly and
closely related to the debt host and may need to be bifurcated from the host
contract and accounted for separately if it meets the other criteria in ASC
815-15-25-1. The embedded put option in the second bond would not be
evaluated under the guidance on term extension options. Instead, it would be
evaluated under the guidance on embedded put options (see Section 8.4.4).
8.4.5.4 Derivative Analysis
The table below presents an analysis of whether a term extension feature
embedded in a debt host contract meets the definition of a derivative (see
Section 8.3.4). Note, however,
that an entity should always consider the terms and conditions of a specific
feature in light of the applicable accounting guidance before reaching a
conclusion.
|
Characteristics of a Derivative
|
Characteristic Present?
|
Analysis
|
|---|---|---|
|
Underlying and notional amount or payment provision
(see Section
8.3.4.2)
|
Yes
|
A term extension feature in a debt host contract has
both an underlying (interest rates and, if
applicable, the occurrence or nonoccurrence of any
exercise contingency) and a notional amount (the
principal amount subject to extension) or payment
provision.
|
|
Initial net investment (see Section 8.3.4.3)
|
Yes
|
The initial net investment in an embedded feature is
its fair value (i.e., the amount that would need to
be paid to acquire the term extension feature on a
stand-alone basis without the debt host contract).
Generally, a term extension feature has an initial
net investment that is smaller than would be
required for a direct investment in the amount of
debt that is subject to the term extension (since
the investment in the debt host contract does not
form part of the initial net investment for the
embedded feature).
|
|
Net settlement (see Section 8.3.4.4)
|
It depends
|
Typically, the debtor would evaluate whether the debt
contract that will be extended is readily
convertible to cash (see below).
|
Generally, the analysis of whether an embedded term extension feature meets
the definition of a derivative focuses on whether the feature meets the net
settlement characteristic. If a term extension feature does not contain an
explicit net settlement provision or a market mechanism to facilitate net
settlement (both of which would be uncommon), the evaluation depends on
whether the instrument whose maturity is being extended is readily
convertible to cash (e.g., publicly traded debt that may be sold in
increments that can be rapidly absorbed by the market without significantly
affecting the price). If the underlying debt is not readily convertible to
cash, the embedded term extension feature should not be bifurcated as a
derivative because it does not permit net settlement and therefore does not
meet the definition of a derivative.
8.4.5.5 Scope Exception for Loan Commitments
Because a term extension feature is a legally binding commitment to extend
the term of the debt on the basis of prespecified terms and conditions, it
is economically equivalent to a loan commitment for the term extension
period. Therefore, the loan commitment scope exception in ASC 815-10-15-69
through 15-71 (see Section 8.4.6.5) can be applied to a
term extension feature that gives the debtor the unilateral option to extend
the maturity of nonconvertible debt.
In a typical loan commitment, a potential creditor agrees to the terms under
which a potential debtor may borrow money. However, the potential debtor is
not legally obligated to borrow money under those terms or even from that
creditor. Therefore, if the creditor has the option to extend the maturity
of the debt, the instrument is not the equivalent of a loan commitment and
thus would not qualify for the exception.
8.4.6 Embedded Loan Commitments (Including PIK Interest Features)
8.4.6.1 Background
A credit facility or tranche debt financing might include both an initial
term loan and commitments to obtain additional term loans on specified dates
in the future. Further, some debt instruments contain a PIK interest
feature, which requires or permits the debtor to pay interest in the form of
additional debt that has the same terms as the original debt instrument. In
substance, a PIK interest feature is a loan commitment since it permits or
requires the debtor to issue additional debt on specified terms to settle
future interest payments.
Note that the discussion in this section only applies if the debtor has
determined that the debt and the loan commitments represent one combined
unit of account (see Section 3.3). If
the loan commitments represent separate units of account (e.g., the
commitments are legally detachable and separately exercisable from the
debt), the loan commitments should not be evaluated as features embedded in
the debt but as freestanding loan commitments (see Section 2.3.3).
8.4.6.2 Bifurcation Analysis
The table below presents an overview of the bifurcation analysis of a loan
commitment embedded in a debt host contract. However, an entity should
always consider the terms and conditions of a specific feature in light of
all the relevant accounting guidance before reaching a conclusion.
|
Bifurcation Condition
|
Condition Met?
|
Analysis
|
|---|---|---|
|
Not clearly and closely related (see Section 8.3.2)
|
It depends
|
A loan commitment whose features are not clearly and
closely related to a debt instrument would not be
clearly and closely related to the debt host
contract (see Section
8.4.6.3).
|
|
Hybrid instrument not measured at fair value on a
recurring basis (see Section 8.3.3)
|
It depends
|
Debt is not measured at fair value on a recurring
basis unless the issuer elects the fair value option
in ASC 815-15 or ASC 825-10 (see Sections 4.4 and
8.5.6). However, the fair
value option cannot be elected for debt that
contains a separately recognized equity component at
inception.
|
|
Meets the definition of a derivative (see Section 8.3.4)
|
It depends
|
The evaluation of whether a loan commitment meets the
definition of a derivative depends on whether it
meets the net settlement characteristic in the
definition of a derivative (see Section
8.4.6.4).
|
|
Meets a scope exception (see Section 8.3.5)
|
It depends
|
The debtor should evaluate whether the commitment
qualifies for the loan commitment scope exception
(see Section 8.4.6.5). This
scope exception is not available if the commitment
is held by the potential creditor or investor.
|
8.4.6.3 Clearly-and-Closely-Related Analysis
A loan commitment is not clearly and closely related to a debt host contract
if it includes features that are not clearly and closely related to a debt
instrument. For example, a commitment to issue both debt and warrants on the
debtor’s equity shares or a commitment to issue debt that is convertible
into the debtor’s equity shares would not be clearly and closely related to
a debt host contract since the debtor’s stock price is not clearly and
closely related to a debt host.
8.4.6.4 Derivative Analysis
The table below presents an analysis of whether a loan commitment embedded in
a debt host contract meets the definition of a derivative (see Section 8.3.4). Note, however, that an
entity should always consider the terms and conditions of a specific feature
in light of the applicable accounting guidance before reaching a
conclusion.
|
Characteristics of a Derivative
|
Characteristic Present?
|
Analysis
|
|---|---|---|
|
Underlying and notional amount or payment provision
(see Section
8.3.4.2)
|
Yes
|
A loan commitment embedded in a debt host contract
has both an underlying (interest rates and, if
applicable, the occurrence or nonoccurrence of any
exercise contingency and other underlyings) and a
notional amount (the committed amount of debt) or
payment provision.
|
|
Initial net investment (see Section 8.3.4.3)
|
Yes
|
The initial net investment in an embedded feature is
its fair value (i.e., the amount that would need to
be paid to acquire the loan commitment on a
stand-alone basis without the debt host contract).
Generally, an embedded loan commitment feature has
an initial net investment that is smaller than the
committed amount of debt.
|
|
Net settlement (see Section 8.3.4.4)
|
It depends
|
The debtor should evaluate whether the debt that
would be funded upon settlement of the loan
commitment is readily convertible to cash (see
below).
|
Generally, an analysis of whether an embedded loan commitment meets the
definition of a derivative focuses on whether it meets the net settlement
characteristic in the definition of a derivative (see Section 8.3.4.4). If the loan commitment
does not contain an explicit net settlement provision or a market mechanism
to facilitate net settlement (both of which would be uncommon), the
evaluation of whether the feature meets the net settlement characteristic
depends on whether the debt that would be funded is readily convertible to
cash (e.g., publicly traded debt that may be sold in increments that can be
rapidly absorbed by the market without significantly affecting the price).
If the underlying debt is not readily convertible to cash, the embedded loan
commitment should not be bifurcated as a derivative because it does not
permit net settlement and therefore does not meet the definition of a
derivative.
8.4.6.5 Scope Exception for Loan Commitments
ASC 815-10-15-69 through 15-71 contain a scope exception
related to the derivative accounting requirements in ASC 815 for “a
commitment to originate a loan” for the holder of the commitment (i.e., the
potential borrower; see Section
2.3.3). This scope exception applies irrespective of whether (1)
the commitment is contingent and (2) the loan is revolving or nonrevolving.
Commitments to issue debt securities (e.g., tranche debt issuances) also
qualify for this scope exception. 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.” We
informally discussed with members of the SEC staff the application of this
scope exception to commitments to issue debt securities. The staff concurred
that it is appropriate to apply the loan commitment exception 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.
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 creditor could force the
potential debtor to enter into a loan but does not give the potential debtor
a right to elect to borrow money from the potential creditor.
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 need to be bifurcated as a derivative once the loan is
funded. It may therefore be prudent for an entity to further evaluate
whether the loan commitment 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 the loan commitment
should not be accounted for as a derivative even if the scope exception for
loan commitments is considered inapplicable.
8.4.7 Equity Features (Including Conversion, Exchange, and Indexed Features)
8.4.7.1 Background
This section discusses the analysis of whether equity features, including
features that involve conversion of debt into the debtor’s equity shares or
third-party stock as well as payment features indexed to a stock price or
stock price index, should be separated from a debt host contract and
accounted for as derivatives under ASC 815-15.
8.4.7.2 Bifurcation Analysis
8.4.7.2.1 General
The bifurcation analysis differs depending on whether
the equity feature economically is an equity conversion feature
settleable in the debtor’s equity shares (see the next section), an
exchange feature settleable in the equity shares of a third party (see
Section
8.4.7.2.3), or a payment feature indexed to a stock price
or stock price index (see Section 8.4.7.2.4). The analysis
of a feature that economically represents a share-settled redemption or
indexation feature whose monetary value does not vary on the basis of a
stock price is discussed separately (see Section 8.4.7.2.5). Such features
do not represent conversion or exchange options since their monetary
value is not indexed to the fair value of the shares delivered upon
settlement.
8.4.7.2.2 Equity Conversion Feature
Debt instruments often contain features that require or permit the debt
to be converted into the debtor’s equity shares. The table below
presents an overview of the bifurcation analysis of equity conversion
features embedded in a debt host contract that are settleable in the
debtor’s equity shares, including the shares of a substantive
consolidated entity. The table does not apply to an embedded feature
that economically represents a share-settled redemption or indexation
feature whose monetary value does not vary on the basis of the debtor’s
stock price (see Section 8.4.7.2.5). Further, an
entity should always consider the terms and conditions of a specific
feature in light of all the relevant accounting guidance before reaching
a conclusion.
|
Bifurcation Condition
|
Condition Met?
|
Analysis
|
|---|---|---|
|
Not clearly and closely related (see Section 8.3.2)
|
Yes
|
A change in the debtor’s stock price is not
clearly and closely related to a debt host (see
Section 8.4.7.3.1).
|
|
Hybrid instrument not measured at fair value on a
recurring basis (see Section 8.3.3)
|
It depends
|
Debt is not measured at fair value on a recurring
basis unless the issuer elects the fair value
option in ASC 815-15 or ASC 825-10 (see Sections 4.4 and
8.5.6). However, the fair
value option cannot be elected for debt that
contains a separately recognized equity component
at inception.
|
|
Meets the definition of a derivative (see
Section
8.3.4)
|
It depends
|
The debtor should evaluate whether the equity
conversion feature meets the net settlement
characteristic in the definition of a derivative
(see Sections
8.4.7.4 and
8.4.7.5).
|
|
Meets a scope exception (see Section 8.3.5)
|
It depends
|
The issuer should evaluate whether the equity
conversion feature meets the scope exception for
certain contracts on own equity (see
Section 8.4.7.6) or
share-based payment transactions (see
Section 8.4.7.7).
|
As shown in the table above, the analysis of whether an equity conversion
feature should be bifurcated from a debt host contract under ASC 815-15
usually centers on whether the feature meets (1) the net settlement
characteristic in the definition of a derivative (see Sections
8.4.7.4 and 8.4.7.5) and, if so, (2)
the scope exception in ASC 815-10-15-74(a) for certain contracts issued
by the reporting entity that are both indexed to its own stock and
classified in stockholders’ equity in its statement of financial
position (see Section 8.4.7.6).
A conversion feature might begin or cease to meet the
bifurcation criteria under ASC 815-15 after the initial recognition of
the instrument in which it is embedded. For instance, the assessment of
whether a feature meets the scope exception for own equity may change if
the entity authorizes the issuance of additional shares (see Section 5.4 of
Deloitte’s Roadmap Contracts on an Entity’s Own Equity). The
accounting analysis might also change if a conversion feature becomes
readily convertible to cash because a market develops for the underlying
shares (see Section
8.4.7.5.6). The issuer must monitor such changes on an
ongoing basis.
ASC 815-15
Case U: Convertible Debt Instrument
55-217 In a convertible
debt instrument, an investor receives a
below-market interest rate and receives the option
to convert its debt instrument into the equity of
the issuer at an established conversion rate. The
terms of the conversion require that the issuer
deliver shares of stock to the investor.
55-218 This instrument
essentially contains a call option on the issuer’s
stock. Under the provisions of this Subtopic, the
accounting by the issuer and investor can differ.
The issuer’s accounting depends on whether a
separate instrument with the same terms as the
embedded written option would be a derivative
instrument pursuant to Section 815-10-15. Assuming
the option is indexed to the issuer’s own stock
and a separate instrument with the same terms
would be classified in stockholders’ equity in the
statement of financial position, the written
option is not considered to be a derivative
instrument for the issuer under paragraph
815-10-15-74(a) and should not be separated from
the host contract.
55-219 In contrast, if the
terms of the conversion allow for a cash
settlement rather than delivery of the issuer’s
shares at the investor’s option, the exception in
paragraph 815-10-15-74(a) for the issuer does not
apply because the contract would not be classified
in stockholders’ equity in the issuer’s statement
of financial position. In that circumstance, the
issuer should separate the embedded derivative
from the host contract and account for it pursuant
to the provisions of this Subtopic because both of
the following conditions exist:
-
An option based on the entity’s stock price is not clearly and closely related to an interest-bearing debt instrument.
-
The option would not be considered an equity instrument of the issuer (see paragraph 815-40-25-4(a)(2)).
55-220 Similarly, if the
convertible debt is indexed to another entity’s
publicly traded common stock, the issuer should
separate the embedded derivative from the host
contract and account for it pursuant to the
provisions of this Subtopic because both of the
following conditions exist:
-
An option based on another entity’s stock price is not clearly and closely related to an investment in an interest-bearing note.
-
The option would not be considered an equity instrument of the issuer.
55-221 The exception in
paragraph 815-10-15-74 does not apply to the
investor’s accounting. Therefore, in both
circumstances described, the investor should
separate the embedded option contract from the
host contract and account for the embedded option
contract pursuant to the provisions of this
Subtopic because the option contract is based on
the price of another entity’s equity instrument
and thus is not clearly and closely related to an
investment in an interest-bearing note. However,
if the terms of conversion do not allow for a cash
settlement and if the common stock delivered upon
conversion is privately held (that is, is not
readily convertible to cash), the embedded
derivative would not be separated from the host
contract because it would not meet the criteria
for net settlement as discussed beginning in
paragraph 815-10-15-99.
The description of the accounting for an equity conversion feature in a
debt host in ASC 815-15-55-217 through 55-221 contains certain unstated,
simplified assumptions that are not always applicable. Therefore, an
entity cannot rely solely on those paragraphs in its accounting analysis
for an equity conversion feature and must also consider other guidance
in ASC 815. In particular, it is assumed in ASC 815-15-55-218 that the
debtor can apply the scope exception in ASC 815-10-15-74(a) to the
conversion feature, but this is not always an appropriate assumption
(see Section 8.4.7.6). Further, it is assumed in
ASC 815-15-55-219 that the hybrid instrument is not accounted for at
fair value, with changes in fair value recognized in net income.
However, if the hybrid instrument is accounted for at fair value, with
changes in fair value recognized in earnings, bifurcation would not be
appropriate (see Section
8.3.3).
8.4.7.2.3 Exchange Feature Involving Third-Party Stock
ASC 470-20 — SEC Materials — SEC Staff
Guidance
Comments Made by SEC Observer at Emerging
Issues Task Force (EITF) Meetings
SEC Observer Comment: Debt Exchangeable for the
Stock of Another Entity
S99-1 The following is the
text of the SEC Observer Comment: Debt
Exchangeable for the Stock of Another Entity.
An issue
has been discussed involving an enterprise that
holds investments in common stock of other
enterprises and issues debt securities that permit
the holder to acquire a fixed number of shares of
such common stock. These types of transactions are
commonly affected through the sale of either debt
with detachable warrants that can be exchanged for
the stock investment or debt without detachable
warrants (the debt itself must be exchanged for
the stock investment — also referred to as
“exchangeable” debt). Those debt issues differ
from traditional warrants or convertible
instruments because the traditional instruments
involve exchanges for the equity securities of the
issuer. There have been questions as to whether
the exchangeable debt should be treated similar to
traditional convertibles as specified in Subtopic
470-20 or whether the transaction requires
separate accounting for the exchangeability
feature. The SEC staff believes that Subtopic
470-20 does not apply to the accounting for debt
that is exchangeable for the stock of another
entity and therefore separation of the debt
element and exchangeability feature is
required.
A debt instrument may contain a feature that requires or permits its
exchange into the shares of a third party. For example, a debt
instrument may give the holder the option to require that the issuer
deliver a fixed number of shares of a third party’s common stock in lieu
of repaying the debt’s principal amount at maturity. Although from the
holder’s perspective, the economic characteristics and risks of an
investment in such a debt instrument are similar to those of an
investment in convertible debt, the issuer should not analyze the
exchange feature as an equity conversion feature that potentially could
qualify for the scope exception for certain contracts on own equity
since it is not settled in the debtor’s equity shares.
In consolidated financial statements, a debt instrument
issued by a parent entity or its subsidiary that is exchangeable into
the subsidiary’s equity shares is analyzed in a manner similar to a
contract that is convertible into the parent’s equity shares, provided
that the subsidiary is a substantive entity (see Section 2.6.1 of
Deloitte’s Roadmap Contracts on an Entity’s Own Equity). This is
true irrespective of whether the instrument is issued by the parent or
subsidiary. Therefore, the exchange feature would be analyzed as an
equity conversion feature involving the company’s own stock under ASC
815-15 (see Section
8.4.7.2.2).
In the subsidiary’s separate financial statements, the
parent’s equity is not considered equity of the subsidiary. Therefore, a
debt instrument that is issued by a subsidiary and exchangeable into the
parent’s equity shares would not be analyzed as an instrument that is
convertible into the issuer’s equity shares in the subsidiary’s separate
financial statements (see Section 2.6.2 of Deloitte’s
Roadmap Contracts
on an Entity’s Own Equity). In the parent’s
consolidated financial statements, however, the same instrument would be
analyzed as a debt instrument that is convertible into the issuer’s
equity shares, as discussed above.
Equity shares issued by an equity method investee are
not considered part of the entity’s own equity. Therefore, debt
instruments that are exchangeable into the shares of an equity method
investee are analyzed as an exchange feature that is settleable in
third-party stock under ASC 815-15.
The table below presents an overview of the bifurcation analysis of a
feature that requires or permits a debt contract to be exchanged for
shares of stock issued by a third party (other than shares of stock
issued by a substantive consolidated entity). The table does not apply
to a feature that economically represents a share-settled redemption or
indexation feature whose monetary value does not vary on the basis of
the third party’s stock price (see Section 8.4.7.2.5). An entity
should always consider the terms and conditions of a specific feature in
light of all the relevant accounting guidance before reaching a
conclusion.
|
Bifurcation Condition
|
Condition Met?
|
Analysis
|
|---|---|---|
|
Not clearly and closely related (see Section 8.3.2)
|
Yes
|
The changes in the fair value of an equity
interest are not clearly and closely related to a
debt host (see Section
8.4.7.3.2).
|
|
Hybrid instrument not measured at fair value on a
recurring basis (see Section 8.3.3)
|
It depends
|
Debt is not measured at fair value on a recurring
basis unless the issuer elects the fair value
option in ASC 815-15 or ASC 825-10 (see Sections 4.4 and
8.5.6). However, the fair
value option cannot be elected for debt that
contains a separately recognized equity component
at inception.
|
|
Meets the definition of a derivative (see
Section
8.3.4)
|
It depends
|
The debtor should evaluate whether the feature
meets the net settlement characteristic in the
definition of a derivative (see Sections
8.4.7.4 and
8.4.7.5).
|
|
Meets a scope exception (see Section 8.3.5)
|
No
|
There is no specific scope exception available
for features that involve the exchange of debt for
shares issued by a third party (other than shares
of stock issued by a substantive consolidated
entity).
|
As shown in the table above, a debtor’s determination of whether an
exchange feature settleable in third-party stock must be bifurcated as a
derivative tends to focus on whether the feature meets the net
settlement characteristic in the definition of a derivative (see
Sections 8.4.7.4 and
8.4.7.5) unless the debtor has elected to
account for the debt under the fair value option in ASC 815-15 or ASC
825-10 (see Section 8.3.3). Such
features are not clearly and closely related to a debt host contract
(see Section 8.4.7.3.2) and are not exempt from the
scope of derivative accounting.
8.4.7.2.4 Equity-Indexed Payment Features
The table below presents an overview of the bifurcation analysis of an
equity-indexed payment feature embedded in a debt host contract (e.g., a
debt contract with principal or interest payments indexed to the S&P
500 Index). An entity should always consider the terms and conditions of
a specific feature in light of all the relevant accounting guidance
before reaching a conclusion.
|
Bifurcation Condition
|
Condition Met?
|
Analysis
|
|---|---|---|
|
Not clearly and closely related (see Section 8.3.2)
|
Yes
|
The changes in the fair value of an equity
interest are not clearly and closely related to a
debt host (see Section
8.4.7.3.2).
|
|
Hybrid instrument not measured at fair value on a
recurring basis (see Section 8.3.3)
|
It depends
|
Debt is not measured at fair value on a recurring
basis unless the issuer elects the fair value
option in ASC 815-15 or ASC 825-10 (see Sections 4.4 and
8.5.6). However, the fair
value option cannot be elected for debt that
contains a separately recognized equity component
at inception.
|
|
Meets the definition of a derivative (see
Section
8.3.4)
|
Yes
|
An equity-indexed payment feature meets the
definition of a derivative (see Section
8.4.7.4.2).
|
|
Meets a scope exception (see Section 8.3.5)
|
No
|
There is no specific scope exception available
for an equity-indexed payment feature embedded in
a debt host.
|
As shown in the table above, an equity-indexed payment feature typically
must be bifurcated as a derivative unless the debtor has elected to
account for the debt under the fair value option in ASC 815-15 or ASC
825-10 (see Section 8.3.3).
8.4.7.2.5 Share-Settled Redemption Features
A financial instrument may contain a term that is described as an equity
conversion or exchange feature but economically represents a
share-settled redemption or indexation provision whose monetary value
does not vary on the basis of a stock price or stock price index. The
number of equity shares is variable and is calculated 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).
Even if the terms of the instrument refer to the
share-settled feature as an equity conversion or exchange feature, the
issuer should not analyze it as such since it does not have the economic
payoff profile of an equity conversion or exchange 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.
(If the instrument is issued in the form of an equity share [e.g.,
preferred stock], the issuer should also evaluate whether the feature
results in the requirement to classify the instrument as a liability
under ASC 480; see Chapter 6 of Deloitte’s Roadmap Distinguishing
Liabilities From Equity.)
Example 8-17
Debt Settleable for Variable Number of Shares
Upon a Qualified Equity Financing
A debt instrument includes a feature that must be
“converted” into the debtor’s common stock upon a
qualified equity financing. The conversion price
is defined as (1) the outstanding amount of
principal and interest divided by (2) the price of
a share of common stock in the qualified equity
offering. Although the contract refers to the
feature as a conversion feature and it must be
settled in shares of common stock, the instrument
should not be analyzed as a debt instrument with
an equity conversion feature because the monetary
value of the shares delivered upon conversion is
unrelated to the fair value of the issuer’s equity
shares. Instead, under ASC 815-15, this feature
should be evaluated as a contingent redemption
option; it would not be evaluated as a conversion
feature even though it is settled in the debtor’s
equity shares (see Section 8.4.4).
Example 8-18
Debt Indexed to S&P 500 Index
A debt instrument with a principal amount of $1
million contains a “conversion” feature that
requires the issuer to settle, at the holder’s
option, the instrument in a variable number of
common shares equal in value to $1 million
adjusted for changes in the S&P 500 Index.
Under ASC 815-15, this feature would not be
analyzed as an equity conversion feature. Instead,
it should be evaluated as a payment feature
indexed to the S&P 500 Index (see Section
8.4.7.2.4).
A share-settled redemption or indexation feature meets
the net settlement characteristic in the definition of a derivative
irrespective of whether the shares that will be delivered upon
settlement are readily convertible to cash. Because the monetary amount
of the obligation does not depend on the share price, neither party is
required to deliver an asset (1) that is associated with the underlying
and (2) whose principal amount, stated amount, face value, number of
shares, or other denomination is equal to the notional amount (see
Section
8.4.4.4.2). In the evaluation of whether the net
settlement criterion in ASC 815-10-15-107(b) has been met, the assets
being delivered to the holder upon the feature’s settlement are treated
as shares of the issuer. Such shares are not associated with the
embedded feature’s underlying because the monetary value of the shares
to be delivered does not vary on the basis of the share price. In other
words, the holder is indifferent to changes in value of any of the
equity shares until the feature is settled. Therefore, the net
settlement criterion is met regardless of whether the underlying shares
are readily convertible to cash.
8.4.7.3 Clearly-and-Closely-Related Analysis
8.4.7.3.1 Equity Conversion or Exchange Features
ASC 815-15
25-51 The changes in fair
value of an equity interest and the interest rates
on a debt instrument are not clearly and closely
related. Thus, for a debt security that is
convertible into a specified number of shares of
the debtor’s common stock or another entity’s
common stock, the embedded derivative (that is,
the conversion option) shall be separated from the
debt host contract and accounted for as a
derivative instrument provided that the conversion
option would, as a freestanding instrument, be a
derivative instrument subject to the requirements
of this Subtopic. (For example, if the common
stock was not readily convertible to cash, a
conversion option that requires purchase of the
common stock would not be accounted for as a
derivative instrument.) That accounting applies
only to the holder (investor) if the debt is
convertible to the debtor’s common stock because,
under paragraph 815-10-15-74(a), a separate option
with the same terms would not be a derivative
instrument for the issuer.
A conversion or exchange feature whose value varies on the basis of
changes in the equity instruments that would be issued upon conversion
is not clearly and closely related to a debt host because the economic
characteristics and risks of an equity instrument differs from the
economic characteristics and risks of a debt instrument. Such a feature
is not clearly and closely related to a debt host irrespective of
whether it is considered indexed to the entity’s own equity under ASC
815-40 (see Section 8.4.7.6).
The accounting for an equity conversion feature in a
debt host in ASC 815-15-25-51 is premised on certain unstated,
simplified assumptions that are not always applicable. Therefore, an
entity cannot rely solely on that paragraph in its accounting analysis
for an equity conversion feature and must also consider other guidance
in ASC 815. For example, it is assumed in the second sentence in ASC
815-15-25-51 that the hybrid instrument is not accounted for at fair
value, with changes in fair value recognized in net income. However, if
the hybrid instrument is accounted for at fair value, with changes in
fair value recognized in earnings, bifurcation would not be required
(see Section
8.3.3). Further, it is assumed in the final sentence in
ASC 815-15-25-51 that the equity conversion feature meets the scope
exception in ASC 815-10-15-74(a), which is not always an appropriate
assumption (see Section 8.4.7.6).
8.4.7.3.2 Equity-Indexed Payment Feature
ASC 815-15
25-49 The changes in fair
value of an equity interest and the interest yield
on a debt instrument are not clearly and closely
related. Thus, an equity-related derivative
instrument embedded in an equity-indexed debt
instrument (whether based on the price of a
specific common stock or on an index that is based
on a basket of equity instruments) shall be
separated from the host contract and accounted for
as a derivative instrument.
Example 7: Clearly and Closely Related
Criterion — Characterizing a Debt Host
55-117 This Example
illustrates the application of the clearly and
closely related criterion in paragraph
815-15-25-1(a) to the determination of what is the
host contract and what is the embedded derivative
composing the illustrative hybrid instrument. This
Example has the following assumptions:
-
An entity (Entity A) issues a 5-year debt instrument with a principal amount of $1,000,000 indexed to the stock of an unrelated publicly traded entity (Entity B).
-
At maturity, the holder of the instrument will receive the principal amount plus any appreciation or minus any depreciation in the fair value of 10,000 shares of Entity B, with changes in fair value measured from the issuance date of the debt instrument.
-
No separate interest payments are made.
-
The market price of Entity B shares to which the debt instrument is indexed is $100 per share at the issuance date.
55-118 The instrument is not
itself a derivative instrument because it requires
an initial net investment equal to the notional
amount. The host contract is a debt instrument
because the instrument has a stated maturity and
because the holder has none of the rights of a
shareholder, such as the ability to vote the
shares and receive distributions to shareholders.
The embedded derivative is an equity-based
derivative that has as its underlying the fair
value of the stock of Entity B. As a result of the
host instrument being a debt instrument and the
embedded derivative having an equity-based return,
the embedded derivative is not clearly and closely
related to the host contract and must be separated
from the host contract and accounted for as a
derivative by both the issuer and the holder of
the hybrid instrument. (Paragraph 815-15-25-4
allows for a fair value election for hybrid
financial instruments that otherwise would require
bifurcation. Hybrid financial instruments that are
elected to be accounted for in their entirety at
fair value cannot be used as a hedging instrument
in a Topic 815 hedging relationship.)
Example 8: Clearly and Closely Related
Criterion — Debt Instrument Incorporating
Equity-Based Return
55-119 This Example
illustrates the application of the clearly and
closely related criterion in paragraph
815-15-25-1(a). Even though an overall hybrid
instrument that provides for repayment of
principal may include a return based on the market
price (the underlying as defined) of XYZ
Corporation common stock, the host contract does
not involve any existing or potential residual
interest rights (that is, rights of ownership) and
thus would not be an equity instrument. The host
contract would instead be considered a debt
instrument, and the embedded derivative that
incorporates the equity-based return would not be
clearly and closely related to the host
contract.
Case H: Equity-Indexed Note
55-189 An equity-indexed
note is a bond for which the return of interest,
principal, or both is tied to a specified equity
security or index, for instance, the Standard and
Poor’s 500 S&P 500 Index. This instrument may
contain a fixed or varying coupon rate and may
place all or a portion of principal at risk.
55-190 An equity-indexed
note essentially combines an interest-bearing
instrument with a series of forward exchange
contracts or option contracts. Often, a portion of
the coupon interest rate is, in effect, used to
purchase options that provide some form of floor
on the potential loss of principal that would
result from a decline in the referenced equity
index. Because forward or option contracts for
which the underlying is an equity index are not
clearly and closely related to an investment in an
interest-bearing note, those embedded derivatives
should be separated from the host contract and
accounted for by both parties pursuant to the
provisions of this Subtopic.
Case I: Variable Principal Redemption Bond
55-191 A variable
principal redemption bond’s principal redemption
value at maturity depends on the change in an
underlying index over a predetermined observation
period. A typical circumstance would be a bond
that guarantees a minimum par redemption value of
100 percent and provides the potential for a
supplemental principal payment at maturity as
compensation for the below-market rate of interest
offered with the instrument.
55-192 Assume that a
supplemental principal payment will be paid to the
investor, at maturity, if the final S&P 500
closing value (determined at a specified date) is
less than its initial value at date of issuance
and the 10-year U.S. Treasury constant maturities
is greater than 2 percent as of a specified date.
In all circumstances, the minimum principal
redemption will be 100 percent of par.
55-193 A variable
principal redemption bond essentially combines an
interest-bearing investment with an option that is
purchased with a portion of the bond’s coupon
interest payments. Because the embedded option
entitling the investor to an additional return is
partially contingent on the S&P 500 index
closing above a specified amount, it is not
clearly and closely related to an investment in a
debt instrument. Therefore, the embedded option
should be separated from the host contract and
accounted for by both parties pursuant to the
provisions of this Subtopic.
Case P: Specific Equity-Linked Bond
55-207 A specific
equity-linked bond pays a coupon slightly below
that of traditional bonds of similar maturity;
however, the principal amount is linked to the
stock market performance of an equity investee of
the issuer. The issuer may settle the obligation
by delivering the shares of the equity investee or
may deliver the equivalent fair value in cash.
55-208 A specific
equity-linked bond can be viewed as combining an
interest-bearing instrument with, depending on its
terms, a series of forward exchange contracts or
option contracts based on an equity instrument.
Often, a portion of the coupon interest rate is
used to purchase options that provide some form of
floor on the loss of principal due to a decline in
the price of the referenced equity instrument. The
forward or option contracts do not qualify for the
exception in paragraph 815-10-15-59(b) because the
shares in the equity investee owned by the issuer
meet the definition of a financial instrument.
Because forward or option contracts for which the
underlying is the price of a specific equity
instrument are not clearly and closely related to
an investment in an interest-bearing note, the
embedded derivative should be separated from the
host contract and accounted for by both parties
pursuant to the provisions of this Subtopic.
In a manner similar to an equity conversion or exchange feature (see
Section 8.4.7.3.1), a feature
that adjusts the contractual payments on the basis of a stock price or
stock price index is not clearly and closely related to a debt host.
Accordingly, a contractual provision in a debt host that involve
payments that are indexed to a stock price or stock price index must be
bifurcated as a derivative if the other bifurcation conditions in ASC
815-15-25-1 are also met.
Example 8-19
Debt With Principal Amount That Is Indexed to
Stock Price
Company ABC issues $100 million of five-year
debt. The debt pays an annual coupon of 6 percent
and is indexed to the price of 1 million shares of
Company XYZ’s common stock. Company XYZ is listed
on the New York Stock Exchange and, on the date on
which the debt is issued, its stock price is $100
per share. At debt maturity, if XYZ’s common stock
has appreciated in value to $200 per share, ABC
will pay $200 million; however, if the value of
XYZ’s stock has depreciated to $50 per share at
maturity, ABC will pay $50 million.
Although the return on the debt is linked to an
equity instrument (XYZ’s stock), the host contract
is considered a debt host because the instrument
is legal form debt with a stated maturity and no
shareholder rights. The embedded equity forward is
not clearly and closely related to the debt host;
therefore, the embedded derivative must be
bifurcated and accounted for at fair value unless
the issuer elects to measure the entire hybrid
financial instrument at fair value, with changes
in fair value recognized in earnings.
If ABC was required to deliver
XYZ’s shares to the investor instead of adjusting
the amount of cash paid at maturity of the debt,
ABC would need to assess whether XYZ’s shares are
readily convertible to cash (i.e., whether the 1
million shares significantly affect the market
price of XYZ) to determine whether the embedded
equity forward meets the definition of a
derivative instrument. See the next section (and
Section 8.4.7.5) for more
information.
8.4.7.4 Derivative Analysis
8.4.7.4.1 Equity Conversion or Exchange Feature
The table below presents an analysis of whether an equity conversion or
exchange feature meets the definition of a derivative (see Section 8.3.4). Note, however, that an
entity should always consider the terms and conditions of a specific
feature in light of the applicable accounting guidance before reaching a
conclusion.
|
Characteristics of a Derivative
|
Characteristic Present?
|
Analysis
|
|---|---|---|
|
Underlying and notional amount or payment
provision (see Section
8.3.4.2)
|
Yes
|
An equity conversion or exchange feature has both
an underlying (the fair value of the equity
instruments that would be issued upon conversion
and, if applicable, the occurrence or
nonoccurrence of any exercise contingency) and a
notional amount (the number of shares that would
be issued upon conversion).
|
|
Initial net investment (see Section 8.3.4.3)
|
Yes
|
The initial net investment in an embedded feature
is its fair value (i.e., the amount that would
need to be paid to acquire the equity conversion
feature on a stand-alone basis without the host
contract). Generally, an equity conversion or
exchange feature has an initial net investment
that is smaller than would be required for a
direct investment that has the same exposure to
changes in the stock price (since the investment
in the debt host contract does not form part of
the initial net investment for the embedded
feature).
|
|
Net settlement (see Section 8.3.4.4)
|
It depends
|
The net settlement characteristic is met if
either (1) the equity conversion or exchange
feature can be explicitly net settled (e.g., its
fair value can be settled net in shares or net in
cash) or (2) the shares that would be issued upon
conversion are readily convertible to cash. The
net settlement characteristic is not met if the
equity conversion or exchange feature must be
gross physically settled and the shares that would
be delivered upon conversion are not readily
convertible to cash. For a detailed discussion of
the net settlement analysis, see Section
8.4.7.5.
|
Generally, an analysis of whether an equity conversion or exchange
feature meets the definition of a derivative focuses on whether it meets
the net settlement characteristic (see Section
8.4.7.5).
8.4.7.4.2 Equity-Indexed Payment Feature
The table below presents an analysis of whether an equity-indexed payment
feature meets the definition of a derivative (see Section 8.3.4). Note, however, that an
entity should always consider the terms and conditions of a specific
feature in light of the applicable accounting guidance before reaching a
conclusion.
|
Characteristics of a Derivative
|
Characteristic Present?
|
Analysis
|
|---|---|---|
|
Underlying and notional amount or payment
provision (see Section
8.3.4.2)
|
Yes
|
An equity-indexed payment feature has both an
underlying (a stock price or stock price index)
and a notional amount (the debt’s principal
amount) or payment provision.
|
|
Initial net investment (see Section 8.3.4.3)
|
Yes
|
The initial net investment in an embedded feature
is its fair value (i.e., the amount that would
need to be paid to acquire the equity-indexed
payment feature on a stand-alone basis without the
host contract). Generally, an equity-indexed
payment feature has an initial net investment that
is smaller than would be required for a direct
investment that has the same exposure to changes
in the stock price or stock price index (since the
investment in the debt host contract does not form
part of the initial net investment for the
embedded feature).
|
|
Net settlement (see Section 8.3.4.4)
|
Yes
|
A feature that adjusts the payments of a debt
host contract on the basis of a stock price or
stock price index meets the net settlement
condition since neither party is required to
deliver an asset that is associated with the
underlying and whose principal amount, stated
amount, face value, number of shares, or other
denomination is equal to the feature’s notional
amount. (If the feature must be settled by
delivery of the underlying shares of stock,
however, the considerations in Section
8.4.7.5 apply.)
|
As shown in the table above, an equity-indexed payment
feature embedded in a debt host contract typically meets the definition
of a derivative. Because such a feature is not clearly and closely
related to a debt host and does not qualify for any scope exception, it
must be bifurcated as a derivative unless the debtor has elected to
account for the debt under the fair value option in ASC 815-15 or ASC
825-10 (see Section
8.3.3).
8.4.7.5 Net Settlement Analysis
8.4.7.5.1 Background
An equity conversion or exchange feature (see Sections
8.4.7.2.2 and 8.4.7.2.3) embedded in a debt host
contract does not meet the definition of a derivative instrument on a
stand-alone basis unless it satisfies the net settlement characteristic
in that definition. In evaluating whether an embedded conversion or
exchange feature can be explicitly net settled, the entity should
consider all of the debt instrument’s terms (e.g., redemption and
liquidation features). Different considerations apply in the following
situations:
-
The feature must or may be settled in cash (see Section 8.4.7.5.2).
-
The feature must or may be settled net in shares (see Section 8.4.7.5.3).
-
The feature requires physical settlement in stock that is not restricted (see Section 8.4.7.5.4).
-
The feature requires physical settlement in restricted stock (see Section 8.4.7.5.5).
These considerations do not apply to an equity-indexed payment feature
that adjusts the payments of a debt host contract on the basis of a
stock price or stock price index unless it is settled by delivery of the
feature’s underlying shares of stock. Such a feature meets the net
settlement characteristic irrespective of whether it is settled in cash
or other assets (including those that are not readily convertible to
cash) since neither party is required to deliver an asset whose
principal amount, stated amount, face value, number of shares, or other
denomination is equal to the feature’s notional amount (see Section 8.4.7.4.2).
8.4.7.5.2 Features That Must or May Be Settled in Cash Upon Settlement
A conversion or exchange feature that must be net cash
settled or can be settled in cash at either party’s election meets the
net settlement characteristic. Convertible debt instruments often
specify that, upon conversion, the issuer or the investor may elect to
have the instrument settle in an amount of cash that is equal to the
value of the shares that would be received upon conversion (in exchange
for the convertible instrument) instead of having shares delivered. For
example, conversion features embedded in convertible instruments in the
form of Instruments A, B, C, or X (see Section 2.3.2.2) meet the net
settlement characteristic in the definition of a derivative irrespective
of whether the underlying shares are readily convertible to cash, since
such instruments either require or permit the conversion value or the
conversion spread to be settled in cash.
In other cases, a conversion or exchange feature that is
embedded in a debt host meets the net settlement characteristic even if,
according to the feature’s stated terms, physical delivery is required
of shares that are not readily convertible to cash. For example, a
convertible instrument may be redeemable by the holder and, upon
redemption, the holder may receive cash equal to the greater of (1) the
face value plus accrued interest or (2) the value of the shares that
would be received had the holder exercised the conversion option (this
alternative is sometimes described as cash equal to the fair value of
the convertible instrument, which is presumably equal to the combined
fair value of the debt host and embedded conversion option). The
conversion option, by its terms, may only be settled physically.
However, the redemption feature permits net cash settlement of the
conversion option; therefore, the conversion option meets the net
settlement characteristic.
A conversion or exchange feature that is embedded in a debt host is
considered to meet the net settlement characteristic in the definition
of a derivative even if the ability to net cash settle the feature is
contingent on the occurrence or nonoccurrence of an event (e.g., an IPO
or a change of control). For example, the terms of a convertible debt
instrument might specify that an equity conversion feature must be
settled in shares, which are not readily convertible to cash. However,
the terms may also specify that if an IPO were to occur, the holder may
elect to have the instrument settle in an amount of cash that is equal
to the fair value of the shares that would be otherwise received upon
conversion instead of having shares delivered. In this scenario, the
conversion feature meets the net settlement characteristic because it
can be explicitly net cash settled upon an IPO.
Sometimes, a conversion or exchange feature embedded in a debt host can
be effectively net cash settled through the conversion and subsequent
redemption of the shares that are delivered upon conversion. If the
shares that will be delivered upon the settlement of a conversion or
exchange feature have redemption or liquidation terms that apply in
scenarios other than an ordinary liquidation, the issuer should
carefully evaluate those terms to determine whether the embedded feature
can be effectively net cash settled. For example, a debt instrument may
be convertible by the holder into preferred stock (which is not readily
convertible to cash) upon a change of control. If the terms of the
preferred stock permit the holder to redeem it for cash or other assets
upon a change of control, the conversion feature meets the net
settlement characteristic in the definition of a derivative. If,
however, the holder is required, upon conversion, to own preferred
shares that are not readily convertible to cash for a substantive period
before they can be redeemed and the investor is exposed to changes in
the value of the preferred shares, the net settlement characteristic is
not met.
8.4.7.5.3 Net-Share-Settled Features
ASC 815-10
15-102 The net settlement
criterion as described in paragraph
815-10-15-83(c) and related paragraphs in this
Subsection is met if a contract provides for net
share settlement at the election of either party.
Therefore, if either counterparty could net share
settle a contract, then it would be considered to
have the net settlement characteristic of a
derivative instrument regardless of whether the
net shares received were readily convertible to
cash as described in paragraph 815-10-15-119 or
were restricted for more than 31 days as discussed
beginning in paragraph 815-10-15-130. While this
conclusion applies to both investors and issuers
of contracts, issuers of those net share settled
contracts shall consider whether such contracts
qualify for the scope exception in paragraph
815-10-15-74(a). See Example 5 (paragraph
815-10-55-90).
Example 5: Net Settlement Under Contract
Terms — Net Share Settlement
55-90 This Example
illustrates the concept of net share settlement.
Entity A has a warrant to buy 100 shares of the
common stock of Entity X at $10 a share. Entity X
is a privately held entity. The warrant provides
Entity X with the choice of settling the contract
physically (gross 100 shares) or on a net share
basis. The stock price increases to $20 a share.
Instead of Entity A paying $1,000 cash and taking
full physical delivery of the 100 shares, the
contract is net share settled and Entity A
receives 50 shares of stock without having to pay
any cash for them. (Net share settlement is
sometimes described as a cashless exercise.) The
50 shares are computed as the warrant’s $1,000
fair value upon exercise divided by the $20 stock
price per share at that date.
A conversion or exchange feature that can be settled net in shares meets
the net settlement characteristic even if the shares are not readily
convertible to cash. For example, a convertible debt instrument might
specify that, upon conversion, the outstanding amount of principal and
interest will be settled in cash, and the conversion spread in shares.
In this scenario, the conversion feature is net share settled and meets
the net settlement characteristic of a derivative.
8.4.7.5.4 Physically Settled Features
ASC 815-10
15-130 A security that is
publicly traded but for which the market is not
very active is readily convertible to cash if the
number of shares or other units of the security to
be exchanged is small relative to the daily
transaction volume. That same security would not
be readily convertible if the number of shares to
be exchanged is large relative to the daily
transaction volume.
A conversion or exchange feature that is embedded in a
debt host and that requires physical settlement in equity shares upon
settlement meets the net settlement characteristic if the shares that
would be issued upon settlement are readily convertible to cash (see
Section
8.3.4.4.4). If the terms of the shares that would be
delivered upon conversion permit the holder to redeem them for cash upon
conversion, the feature meets the net settlement characteristic even if
the shares are not currently readily convertible to cash (see Section 8.4.7.5.2). An equity conversion
feature that is embedded in a debt host and fails to meet any of the
conditions for equity classification in ASC 815-40-25 (e.g., sufficient
authorized and unissued shares; see Section 8.4.7.6.5) would typically
possess the net settlement characteristic because it would be presumed
that the entity would be required to net cash settle the feature.
A share of a company’s stock is considered to be readily convertible to
cash if the share price is quoted in an active market that can rapidly
absorb the smallest increment of shares available for exchange under the
contract without any significant impact on the quoted price. Typically,
shares traded in a public market are readily convertible to cash unless
the smallest number of shares that can be exchanged under the contract
is large relative to the daily trading volume of the shares (see below)
or the costs of converting the shares into cash (e.g., sales commissions
on the quoted price) are in excess of 10 percent of the stock price at
the inception of the contract (see Section 8.3.4.4.4). However,
shares are not considered readily convertible to cash if the sale or
transfer of the issued shares is restricted for a period of 32 days or
more from the date on which a conversion feature is exercised (see
Section
8.4.7.5.5).
ASC 815-10
Example 7: Net Settlement — Readily
Convertible to Cash — Effect of Daily Transaction
Volumes
55-99 The following Cases
illustrate consideration of the relevance of daily
transaction volumes to the characteristic of net
settlement in deciding whether, from the
investor’s perspective, the convertible bond
contains an embedded derivative that must be
accounted for separately:
-
Single bond with multiple conversion options (Case A)
-
Multiple bonds each having single conversion option (Case B).
55-100 The Cases
illustrate that the form of the financial
instrument is important; paragraph 815-10-15-123
explains that individual instruments cannot be
combined for evaluation purposes to circumvent
compliance with the criteria beginning in
paragraph 815-10-15-119. Further, paragraph
815-10-15-111(c) explains that contracts shall be
evaluated on an individual basis, not on an
aggregate-holdings basis.
Case A: Single Bond With
Multiple Conversion Options
55-101 Investor A holds a
convertible bond classified as an
available-for-sale security under Topic 320. The
bond has all of the following additional
characteristics:
-
It is not exchange-traded and can be converted into common stock of the debtor, which is traded on an exchange.
-
It has a face amount of $100 million and is convertible into 10 million shares of common stock.
-
It may be converted in full or in increments of $1,000 immediately or at any time during the next 2 years.
-
If it were converted in a $1,000 increment, Investor A would receive 100 shares of common stock.
55-102 Assume further that
the market condition for the debtor’s stock is
such that up to 500,000 shares of its stock can be
sold rapidly without the share price being
significantly affected.
55-103 The embedded
conversion option meets the criteria in paragraph
815-10-15-83(a) through (b) but does not meet the
criteria in paragraphs 815-10-15-100 and
815-10-15-110, in part because the option is not
traded and it cannot be separated and transferred
to another party.
55-104 It is clear that
the embedded equity conversion feature is not
clearly and closely related to the debt host
instrument.
55-105 The bond may be
converted in $1,000 increments and those
increments, by themselves, may be sold rapidly
without significantly affecting price, in which
case the criteria discussed beginning in paragraph
815-10-15-119 would be met. However, if the holder
simultaneously converted the entire bond, or a
significant portion of the bond, the shares
received could not be readily converted to cash
without incurring a significant block
discount.
55-106 From Investor A’s
perspective, the conversion option should be
accounted for as a compound embedded derivative in
its entirety, separately from the debt host,
because the conversion feature allows the holder
to convert the convertible bond in 100,000
increments and the shares converted in each
increment are readily convertible to cash under
the criteria discussed beginning in paragraph
815-10-15-119. Investor A need not determine
whether the entire bond, if converted, could be
sold without affecting the price.
55-107 Because the $100
million bond is convertible in increments of
$1,000, the convertible bond is essentially
embedded with 100,000 equity conversion options,
each with a notional amount of 100 shares. Each of
the equity conversion options individually has the
characteristic of net settlement discussed
beginning in paragraph 815-10-15-119 because the
100 shares to be delivered are readily convertible
to cash. Because the equity conversion options are
not clearly and closely related to the host debt
instrument, they must be separately accounted for.
However, because an entity cannot identify more
than 1 embedded derivative that warrants separate
accounting, the 100,000 equity conversion options
must be bifurcated as a single compound
derivative. (Paragraphs 815-15-25-7 through 25-10
say an entity is not permitted to account
separately for more than one derivative feature
embedded in a single hybrid instrument.)
55-108 There is a
substantive difference between a $100 million
convertible debt instrument that can be converted
into equity shares only at one time in its
entirety and a similar instrument that can be
converted in increments of $1,000 of tendered
debt; the analysis of the latter should not
presume equality with the former.
Case B: Multiple Bonds Each Having Single
Conversion Option
55-109 Investor B has
100,000 individual $1,000 bonds that each convert
into 100 shares of common stock. Assume those
bonds are individual instruments but they were
issued concurrently to Investor B.
55-110 From Investor B’s
perspective, the individual bonds each contain an
embedded derivative that must be separately
accounted for. Each individual bond is convertible
into 100 shares, and the market would absorb 100
shares without significantly affecting the price
of the stock.
As discussed in Section 8.3.4.4,
the evaluation of whether an embedded feature is readily convertible to
cash is performed on the basis of the smallest increment in which it can
be settled under its contractual terms. ASC 815-10-55-101 through 55-108
contain an illustration of a $100 million bond that is convertible into
10 million shares of stock when the market can rapidly absorb 500,000
shares without a significant effect on the share price. If the terms of
that bond permit the holder to convert the bond in $1,000 increments for
100 shares each, the embedded conversion feature would be considered
readily convertible to cash under ASC 815-10-55-119 even though the
aggregate number of shares that would be issued if the holder converted
the entire bond could not be readily converted to cash without incurring
a significant block discount. If, under the above terms, the bond could
only be converted at one time in its entirety, the equity conversion
feature would not meet the net settlement characteristic since the stock
market could not rapidly absorb 500,000 shares without a significant
effect on the share price.
8.4.7.5.5 Features Physically Settled in Restricted Stock
ASC 815-10
15-131 Shares of stock in
a publicly traded entity to be received upon the
exercise of a stock purchase warrant do not meet
the characteristic of being readily convertible to
cash if both of the following conditions exist:
-
The stock purchase warrant is issued by an entity for only its own stock (or stock of its consolidated subsidiaries).
-
The sale or transfer of the issued shares is restricted (other than in connection with being pledged as collateral) for a period of 32 days or more from the date the stock purchase warrant is exercised.
15-132 Restrictions
imposed by a stock purchase warrant on the sale or
transfer of shares of stock that are received from
the exercise of that warrant issued by an entity
for other than its own stock (whether those
restrictions are for more or less than 32 days) do
not affect the determination of whether those
shares are readily convertible to cash. The
accounting for restricted stock to be received
upon exercise of a stock purchase warrant shall
not be analogized to any other type of
contract.
15-133 Newly outstanding
shares of common stock in a publicly traded
company to be received upon exercise of a stock
purchase warrant cannot be considered readily
convertible to cash if, upon issuance of the
shares, the sale or transfer of the shares is
restricted (other than in connection with being
pledged as collateral) for more than 31 days from
the date the stock purchase warrant is exercised
(not the date the warrant is issued), unless the
holder has the power by contract or otherwise to
cause the requirement to be met within 31 days of
the date the stock purchase warrant is
exercised.
15-134 In contrast, if the
sale of an actively traded security is restricted
for 31 days or less from the date the stock
purchase warrants are exercised, that limitation
is not considered sufficiently significant to
serve as an impediment to considering the shares
to be received upon exercise of those stock
purchase warrants as readily convertible to
cash.
15-135 The guidance that a
restriction for more than 31 days prevents the
shares from being considered readily convertible
to cash applies only to stock purchase warrants
issued by an entity for its own shares of stock,
in which case the shares being issued upon
exercise are newly outstanding (including issuance
of treasury shares) and are restricted with
respect to their sale or transfer for a specified
period of time beginning on the date the stock
purchase warrant is exercised.
15-136 However, even if
the sale or transfer of the shares is restricted
for 31 days or less after the stock purchase
warrant is exercised, an entity still must
evaluate both of the following criteria:
-
Whether an active market can rapidly absorb the quantity of stock to be received upon exercise of the warrant without significantly affecting the price
-
Whether the other estimated costs to convert the stock to cash are expected to be not significant. (The assessment of the significance of those conversion costs shall be performed only at inception of the contract.)
Thus, the guidance in paragraph 815-10-15-122
shall be applied to those stock purchase warrants
with sale or transfer restrictions of 31 days or
less on the shares of stock.
15-137 If the shares of an
actively traded common stock to be received upon
exercise of the stock purchase warrant can be
reasonably expected to qualify for sale within 31
days of their receipt, such as may be the case
under SEC Rule 144, Selling Restricted and Control
Securities, or similar rules of the SEC, any
initial sales restriction is not an impediment to
considering those shares as readily convertible
to cash, as that phrase is used in paragraph
815-10-15-119. (However, a restriction on the sale
or transfer of shares of stock that are received
from an entity other than the issuer of that stock
through the exercise of another option or the
settlement of a forward contract is not an
impediment to considering those shares readily
convertible to cash, regardless of whether the
restriction is for a period that is more or less
than 32 days from the date of exercise or
settlement.)
The shares that would be delivered upon the settlement of a conversion
feature are not considered readily convertible to cash if (1) their sale
or transfer is restricted for a period of 32 days or more from the date
on which the feature is exercised and (2) the holder does not have “the
power by contract or otherwise to cause the requirement to be met within
31 days.” If the shares to be delivered are actively traded and can
reasonably be expected to qualify for sale within 31 days, however, they
may be considered readily convertible to cash even if their sale or
transfer is restricted (see ASC 815-10-15-137). Note, however, that the
guidance on restricted stock does not apply to exchange features that
restrict the sale or transfer of third-party stock that would be
delivered upon settlement of an exchange feature (see ASC
815-10-15-132).
8.4.7.5.6 Ongoing Assessment
ASC 815-10
Case B: Initial Public Offering Makes Shares
Readily Convertible to Cash After Contract
Inception
55-87 A nontransferable
forward contract on a nonpublic entity’s stock
that provides only for gross physical settlement
is generally not a derivative instrument because
the net settlement criteria are not met. If the
entity, at some point in the future, accomplishes
an initial public offering of its shares and the
original contract is still outstanding, the shares
to be delivered would be considered to be readily
convertible to cash (assuming that the shares
under the contract could be rapidly absorbed in
the market without significantly affecting the
price).
Case C: Increased Trading Activity Makes Shares
Readily Convertible to Cash After Contract
Inception
55-88 A nontransferable
forward contract on a public entity’s stock
provides for delivery on a single date of a
significant number of shares that, at the
inception of the contract, would significantly
affect the price of the public entity’s stock in
the market if sold within a few days. As a result,
the contract does not satisfy the
readily-convertible-to-cash criterion. However, at
some later date, the trading activity of the
public entity’s stock increases significantly.
Upon a subsequent evaluation of whether the shares
are readily convertible to cash, the number of
shares to be delivered would be minimal in
relation to the new average daily trading volume
such that the contract would then satisfy the net
settlement characteristic.
Case D: Delisting Makes Shares Not Readily
Convertible to Cash After Contract Inception
55-89 A nontransferable
forward contract on a public entity’s stock meets
the net settlement criteria (as discussed
beginning in paragraph 815-10-15-119) in that, at
inception of the contract, the shares are expected
to be readily convertible to cash when delivered
under the contract. Assume that there is no other
way that the contract meets the net settlement
criteria. The public entity subsequently becomes
delisted from the stock exchange, thus causing the
shares to be delivered under the contract to no
longer be readily convertible to cash.
An entity should continually reassess whether an
embedded feature meets the net settlement characteristic in the
definition of a derivative (see Sections 8.3.4.4.5 and 8.5.4). ASC 815-10-55-87 through 55-89
highlight that such reassessment might be required for the stock
underlying a contract upon its IPO, a change in its market activity, or
its delisting.
8.4.7.6 Scope Exception for Certain Own Equity Contracts
8.4.7.6.1 General
ASC 815-10
15-74 Notwithstanding the
conditions of paragraphs 815-10-15-13 through
15-139, the reporting entity shall not consider
the following contracts to be derivative
instruments for purposes of this Subtopic:
- Contracts issued or held by
that reporting entity that are both:
-
Indexed to its own stock (see Section 815-40-15)
-
Classified in stockholders’ equity in its statement of financial position (see Section 815-40-25). . . .
-
15-75A For purposes of
evaluating whether a financial instrument meets
the scope exception in paragraph
815-10-15-74(a)(1), a down round feature shall be
excluded from the consideration of whether the
instrument is indexed to the entity’s own
stock.
15-76 Temporary equity is
considered stockholders’ equity for purposes of
the scope exception in paragraph 815-10-15-74(a)
even if it is required to be displayed outside of
the permanent equity section.
15-77 For guidance on
determining whether a freestanding financial
instrument or embedded feature is not precluded
from qualifying for the first part of the scope
exception in paragraph 815-10-15-74(a), see the
guidance beginning in paragraph 815-40-15-5. For
guidance on determining whether a freestanding
financial instrument or embedded feature qualifies
for the second part of the scope exception in
paragraph 815-10-15-74(a), see the guidance
beginning in paragraph 815-40-25-1.
15-78 Paragraph 815-40-25-39
explains that, for purposes of evaluating under
this Subtopic whether an embedded derivative
indexed to an entity’s own stock would be
classified in stockholders’ equity if
freestanding, the additional considerations
necessary for equity classifications beginning in
paragraph 815-40-25-7 do not apply if the hybrid
contract is a convertible debt instrument in which
the holder may only realize the value of the
conversion option by exercising the option and
receiving the entire proceeds in a fixed number of
shares or the equivalent amount of cash (at the
discretion of the issuer).
ASC 815-15
25-14 The criterion in
paragraph 815-15-25-1(c) is not met if the
separate instrument with the same terms as the
embedded derivative would be classified as a
liability (or an asset in some circumstances)
under the provisions of Topic 480 but would be
classified in stockholders’ equity absent the
provisions in that Topic. For purposes of
analyzing the application of paragraph
815-10-15-74(a) to an embedded derivative as
though it were a separate instrument, paragraphs
480-10-25-4 through 25-14 shall be disregarded.
Those embedded features are analyzed by applying
other applicable guidance (such as the guidance in
Subtopic 815-40 on contracts in entity’s own
equity).
25-15 Paragraph 815-40-25-39
states that, for purposes of evaluating under
paragraph 815-15-25-1 whether an embedded
derivative indexed to an entity’s own stock would
be classified in stockholders’ equity if
freestanding, the additional considerations
necessary for equity classification beginning in
paragraph 815-40-25-7 do not apply if the hybrid
contract is a convertible debt instrument (see
paragraph 815-40-25-41) in which the holder may
only realize the value of the conversion option by
exercising the option and receiving the entire
proceeds in a fixed number of shares or the
equivalent amount of cash (at the discretion of
the issuer). However, paragraph 815-40-25-40
states that those additional considerations do
apply when an issuer is evaluating whether any
embedded derivative other than those discussed in
paragraph 815-40-25-39 is an equity instrument and
thereby excluded from the scope of this
Subtopic.
The determination of whether an embedded equity
conversion feature meets the scope exception in ASC 815-10-15-74(a) for
certain contracts on the entity’s own equity includes an evaluation of
whether the feature is considered indexed to own equity under ASC
815-40-15 (see Section
8.4.7.6.2) and, if so, whether the feature meets
additional equity classification conditions in ASC 815-40-25 (see
Section
8.4.7.6.5). This section provides a brief overview of
those requirements. For a comprehensive discussion of the application of
this guidance, see Deloitte’s Roadmap Contracts on an Entity’s Own
Equity.
Connecting the Dots
An issuer of convertible debt must evaluate
whether it is required to separately recognize the embedded
conversion feature as a derivative instrument under ASC 815-15.
Therefore, entities that issue convertible debt have to apply
the guidance in ASC 815-40 (which is complex; see the next
section) to determine whether an embedded conversion option that
meets the characteristics of a derivative must be separated and
accounted for as a derivative liability.
8.4.7.6.2 Determining Whether the Feature Is Indexed to Own Equity Under ASC 815-40-15
ASC 815-40
15-7 An entity shall
evaluate whether an equity-linked financial
instrument (or embedded feature), as discussed in
paragraphs 815-40-15-5 through 15-8 is considered
indexed to its own stock within the meaning of
this Subtopic and paragraph 815-10-15-74(a) using
the following two-step approach:
-
Evaluate the instrument’s contingent exercise provisions, if any.
-
Evaluate the instrument’s settlement provisions.
One of the conditions that must be met for an equity conversion feature
to qualify for the exception related to derivative accounting in ASC
815-10-15-74(a) is that it must be indexed to the entity’s own stock
under ASC 815-40-15. An entity performs a two-step analysis to determine
whether this condition has been satisfied:
-
Step 1 — Evaluate whether the feature contains any exercise contingencies and, if so, whether they disqualify the feature from being considered indexed to the entity’s own equity (see Section 8.4.7.6.3).
-
Step 2 — Assess whether the settlement terms preclude the feature from being considered indexed to the entity’s own equity (see Section 8.4.7.6.4).
8.4.7.6.3 Step 1 of Indexation Analysis
ASC Master Glossary
Exercise Contingency
A provision that entitles the entity (or the
counterparty) to exercise an equity-linked
financial instrument (or embedded feature) based
on changes in an underlying, including the
occurrence (or nonoccurrence) of a specified
event. Provisions that accelerate the timing of
the entity’s (or the counterparty’s) ability to
exercise an instrument and provisions that extend
the length of time that an instrument is
exercisable are examples of exercise
contingencies.
ASC 815-40
15-7A An exercise
contingency shall not preclude an instrument (or
embedded feature) from being considered indexed to
an entity’s own stock provided that it is not
based on either of the following:
-
An observable market, other than the market for the issuer’s stock (if applicable)
-
An observable index, other than an index calculated or measured solely by reference to the issuer’s own operations (for example, sales revenue of the issuer; earnings before interest, taxes, depreciation, and amortization of the issuer; net income of the issuer; or total equity of the issuer).
If the evaluation of Step 1 (this paragraph) does
not preclude an instrument from being considered
indexed to the entity’s own stock, the analysis
shall proceed to Step 2 (see paragraph
815-40-15-7C).
The following provisions
are examples of exercise contingencies:
|
Type
|
Description
|
Examples
|
|---|---|---|
|
Exercise condition
|
A provision that affects whether the conversion
feature becomes exercisable.
|
A conversion feature that becomes exercisable
upon an IPO.
|
|
Settlement condition
|
A provision that affects whether a conversion
feature is settled.
|
A conversion feature that is contingent on
whether revenue has exceeded a specified
threshold.
|
|
Acceleration provision
|
A provision that accelerates the timing of either
the entity’s or the counterparty’s ability to
exercise the conversion feature or that
accelerates the timing of its settlement.
|
The counterparty’s right to exercise the
conversion feature is accelerated upon a merger
event, tender offer, hedging disruption, loss of
stock borrow, nationalization, or delisting.
|
|
Extension provision
|
A provision that extends the timing of either the
entity’s or the counterparty’s ability to exercise
the conversion feature or extends the timing of
its settlement.
|
A provision that extends the expiration date of a
conversion feature upon an IPO.
|
|
Deferral provision
|
A provision that defers the timing of either the
entity’s or the counterparty’s ability to exercise
the conversion feature or defers the timing of its
settlement.
|
A provision that delays the counterparty’s
ability to exercise a conversion feature if the
entity lacks sufficient registered shares or that
defers settlement if the counterparty’s ownership
of shares exceeds a specified level or the
counterparty needs time to unwind related
hedges.
|
|
Termination provision
|
A provision that results in the conversion
feature’s termination (also sometimes called
“cancellation,” “forfeiture,” or “knock-out”
provision).
|
A provision that terminates the conversion
feature upon a change in control, IPO, or
insolvency.
|
Some, but not all, conversion features contain exercise contingencies.
The mere passage of time is not considered an exercise contingency, nor
is a contingency that affects the calculation of the settlement amount
of an instrument if the contingency does not alter the availability or
timing of settlement (e.g., the occurrence of a specified event that
affects the strike price of an equity conversion feature that was
currently exercisable).
Exercise contingencies that are based on an observable market or an
observable index preclude an equity conversion feature from being
considered indexed to an entity’s own equity unless they are based on
either of the following:
- The market for the issuer’s stock, such as the following:
-
A provision that permits the instrument to be converted if the entity’s stock price exceeds a certain dollar amount (a market price trigger).
-
A provision that permits the instrument to be converted into the entity’s equity shares if the instrument trades for an amount that is less than a specified percentage (e.g., 98 percent) of its if-converted value (a parity provision).
-
- An index calculated solely by reference to the issuer’s own operations, such as sales of at least $100 million.
An exercise contingency that is based on something other than an
observable market or observable index does not preclude an equity
conversion feature from being considered indexed to an entity’s own
equity under step 1 of the indexation analysis.
The table below contains
additional examples of exercise contingencies and their evaluation under
step 1 of the indexation analysis.
|
Exercise Contingencies That Do Not
Preclude Equity Classification
|
Exercise Contingencies That Preclude Equity
Classification
|
|---|---|
|
|
For a comprehensive discussion of step 1 of the
indexation analysis under ASC 815-40-15, see Section 4.2 of Deloitte’s Roadmap
Contracts on an
Entity’s Own Equity.
8.4.7.6.4 Step 2 of Indexation Analysis
ASC 815-40
15-7C Unless paragraph
815-40-15-7A precludes it, an instrument (or
embedded feature) shall be considered indexed to
an entity’s own stock if its settlement amount
will equal the difference between the
following:
-
The fair value of a fixed number of the entity’s equity shares
-
A fixed monetary amount or a fixed amount of a debt instrument issued by the entity.
For example, an issued share
option that gives the counterparty a right to buy
a fixed number of the entity’s shares for a fixed
price or for a fixed stated principal amount of a
bond issued by the entity shall be considered
indexed to the entity’s own stock.
15-7D An instrument’s strike
price or the number of shares used to calculate
the settlement amount are not fixed if its terms
provide for any potential adjustment, regardless
of the probability of such adjustment(s) or
whether such adjustments are in the entity’s
control. If the instrument’s strike price or the
number of shares used to calculate the settlement
amount are not fixed, the instrument (or embedded
feature) shall still be considered indexed to an
entity’s own stock if the only variables that
could affect the settlement amount would be inputs
to the fair value of a fixed-for-fixed forward or
option on equity shares (provided that paragraph
815-40-15-7A does not preclude such a
conclusion).
15-7E A fixed-for-fixed
forward or option on equity shares has a
settlement amount that is equal to the difference
between the price of a fixed number of equity
shares and a fixed strike price. The fair value
inputs of a fixed-for-fixed forward or option on
equity shares may include the entity’s stock price
and additional variables, including all of the
following:
-
Strike price of the instrument
-
Term of the instrument
-
Expected dividends or other dilutive activities
-
Stock borrow cost
-
Interest rates
-
Stock price volatility
-
The entity’s credit spread
-
The ability to maintain a standard hedge position in the underlying shares.
Determinations and adjustments
related to the settlement amount (including the
determination of the ability to maintain a
standard hedge position) shall be commercially
reasonable.
15-7F An instrument (or
embedded feature) shall not be considered indexed
to the entity’s own stock if its settlement amount
is affected by variables that are extraneous to
the pricing of a fixed-for-fixed option or forward
contract on equity shares. An instrument (or
embedded feature) shall not be considered indexed
to the entity’s own stock if either:
-
The instrument’s settlement calculation incorporates variables other than those used to determine the fair value of a fixed-for-fixed forward or option on equity shares.
-
The instrument contains a feature (such as a leverage factor) that increases exposure to the additional variables listed in the preceding paragraph in a manner that is inconsistent with a fixed-for-fixed forward or option on equity shares.
15-7G Standard pricing models
for equity-linked financial instruments contain
certain implicit assumptions. One such assumption is
that the stock price exposure inherent in those
instruments can be hedged by entering into an
offsetting position in the underlying equity shares.
For example, the Black-Scholes-Merton option-pricing
model assumes that the underlying shares can be sold
short without transaction costs and that stock price
changes will be continuous. Accordingly, for
purposes of applying Step 2, fair value inputs
include adjustments to neutralize the effects of
events that can cause stock price discontinuities.
For example, a merger announcement may cause an
immediate jump (up or down) in the price of shares
underlying an equity-linked option contract. A
holder of that instrument would not be able to
continuously adjust its hedge position in the
underlying shares due to the discontinuous stock
price change. As a result, changes in the fair value
of an equity-linked instrument and changes in the
fair value of an offsetting hedge position in the
underlying shares will differ, creating a gain or
loss for the instrument holder as a result of the
merger announcement. Therefore, inclusion of
provisions that adjust the terms of the instrument
to offset the net gain or loss resulting from a
merger announcement or similar event do not preclude
an equity-linked instrument (or embedded feature)
from being considered indexed to an entity’s own
stock.
15-7H Some equity-linked
financial instruments contain provisions that
provide an entity with the ability to unilaterally
modify the terms of the instrument at any time,
provided that such modification benefits the
counterparty. For example, the terms of a
convertible debt instrument may explicitly permit
the issuer to reduce the conversion price at any
time to induce conversion of the instrument. For
purposes of applying Step 2, such provisions do
not affect the determination of whether an
instrument (or embedded feature) is considered
indexed to an entity’s own stock.
If, after performing step 1 of the indexation analysis, an entity
concludes that an equity conversion feature’s exercise contingency
provisions (if any) do not preclude a conclusion that the feature is
indexed to the entity’s own stock, the entity must perform step 2 to
evaluate the instrument’s settlement terms. Under step 2, an equity
conversion feature is considered indexed to the entity’s own stock if
either of the following two conditions is met:
-
The equity conversion feature is a “fixed-for-fixed” forward or option on equity shares. That is, the feature’s settlement amount will always equal the difference between (1) the fair value of a fixed number of the entity’s equity shares and (2) a fixed monetary amount denominated in the reporting entity’s functional currency.
-
The equity conversion feature is not fixed for fixed, but the only variables that could affect the feature’s settlement amount are inputs used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares.
Most equity conversion features contain provisions that adjust the
conversion terms upon the occurrence of certain events. In applying step
2, an entity is required to consider any potential settlement adjustment
provisions regardless of the likelihood of the occurrence of the
associated event. Certain adjustments will disqualify the feature from
being considered indexed to the entity’s own equity; therefore, the
scope exception in ASC 815-10-15-74(a) may not be applied.
There are two types of inputs that may adjust the settlement amount of an
equity conversion feature:
-
An explicit input is an underlying (other than the occurrence or nonoccurrence of a specified event) that could affect the settlement amount (i.e., the conversion price or the number of equity shares used to calculate the settlement amount). Examples of explicit inputs include a specific interest rate, security price, commodity price, foreign exchange rate, inflation rate, credit rating, prepayment index, or other index or indexes of specified prices or rates.
-
An implicit input is an assumption about the occurrence or nonoccurrence of a specified event that could affect the settlement amount (i.e., the conversion price or the number of equity shares used to calculate the settlement amount). For example, there may be an implicit assumption in the pricing of the feature that no dilutive event affecting the underlying equity securities will occur (e.g., stock split). Other examples of implicit inputs include the occurrence or nonoccurrence of the following events:
-
An IPO or a subsequent offering of securities by the issuer.
-
A tender offer for the securities of the issuer.
-
A change of control or merger involving the issuer.
-
Bankruptcy or insolvency of the issuer.
-
The incurrence of transaction costs to dispose of equity securities received upon settlement of an equity-linked option.
-
8.4.7.6.4.1 Explicit Inputs
To evaluate whether an adjustment to the settlement amount that is
based on an explicit input precludes an equity conversion feature
from being considered indexed to an entity’s own stock, the entity
considers the questions below, assessing each explicit input
separately. If, because of an adjustment that is based on an
explicit input, an entity determines that the feature is not indexed
to the entity’s own stock, the equity conversion feature does not
qualify for the scope exception in ASC 815-10-15-74(a):
-
Is the explicit input used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares?For the equity conversion feature to be considered indexed to the entity’s stock, the answer must be yes. If the answer is no, the equity conversion feature does not qualify for the scope exception in ASC 815-10-15-74(a) irrespective of whether it meets the other conditions for equity classification.If the settlement terms are adjusted in response to changes in an input used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares, those adjustments do not necessarily preclude an entity from considering the feature to be indexed to the reporting entity’s stock. If, however, the settlement amount varies in response to changes in explicit inputs other than those used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares (i.e., extraneous variables), the feature is not considered indexed to the reporting entity’s stock.The table below lists examples of explicit inputs that may or may not preclude equity classification if an adjustment is made to the settlement amount in response to a change in the explicit input.Permissible (Equity Classification Not Precluded)Not Permissible (Equity Classification Precluded)
-
The issuer’s stock price (including a weighted-average price over a reasonable period; see Section 4.3.5.1 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
-
The stock price of a consolidated subsidiary that is a substantive entity (see Section 2.6.1 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
-
The conversion price
-
The term of the instrument
-
Expected dividends (see Section 4.3.5.3 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
-
Cost of borrowing the entity’s stock (cost of stock borrow; see Section 4.3.5.4 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
-
Risk-free interest rates (i.e., LIBOR, the federal funds rate, or the U.S. Treasury rate; see Sections 4.3.5.2, 4.3.5.9, and 4.3.5.10 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
-
Stock price volatility (see Section 4.3.5.5 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
-
The entity’s credit spread
-
Revenue, net income, EBITDA, or other operating metric of the issuer (unless the formula is designed to equal or closely approximate the fair value of the entity’s stock; see Section 4.3.5.6 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
-
The authorized and unissued common shares of the issuer
-
The number of outstanding common shares of the issuer (unless the terms of the instrument are adjusted solely to offset the effect of a dilutive event)
-
A commodity price (e.g., gold; see Section 4.3.5.5 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
-
A foreign currency index or rate (see Section 4.3.8 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
-
An inflation rate
-
Stock option exercise behavior (see Section 4.3.5.8 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
-
-
Could a change in the explicit input (other than the reporting entity’s stock price) affect the settlement amount in a manner inconsistent with how a change in the input would affect the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares?For an equity conversion feature to be indexed to the entity’s stock, the answer must be no. If the answer is yes, the equity conversion feature does not qualify for the scope exception in ASC 815-10-15-74(a) irrespective of whether it meets the other conditions for equity classification.An adjustment in response to a change in an explicit input does not necessarily need to reflect the whole effect that the variable would have had on the fair value of a fixed-for-fixed forward or option on equity shares. If, however, an equity conversion contains leverage that results in greater exposure to an input (other than the reporting entity’s stock price) than the exposure to the input in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares, the feature is considered not indexed to the reporting entity’s stock. Similarly, if a change in an explicit input (other than a change based solely on the reporting entity’s stock price) affects the settlement amount of the feature in a manner inconsistent with the effect that the underlying would have on the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares (e.g., the underlying affects the settlement amount inversely), the feature is considered not indexed to the entity’s own equity.
-
Could a change in the explicit input (other than the reporting entity’s stock price) result in a settlement at a fixed monetary amount?For an equity conversion feature to be indexed to the entity’s stock, the answer must be no. If the answer is yes, the equity conversion feature does not qualify for the scope exception in ASC 815-10-15-74(a) irrespective of whether it meets the other conditions for equity classification. Note, however, that an equity conversion feature that settles at a fixed monetary amount generally should be evaluated as a share-settled redemption feature, not as a conversion feature (see Sections 8.2.2 and 8.4.7.2.5).
8.4.7.6.4.2 Implicit Inputs
An entity considers the three questions below when
evaluating whether adjustments to the settlement amount that are
based on an implicit input preclude the equity conversion feature
from qualifying for the scope exception in ASC 815-10-15-74(a). The
entity evaluates each implicit input separately. These
considerations are relevant regardless of whether the implicit input
(1) affects the conversion price of the equity conversion feature or
the number of equity shares used to calculate the settlement amount
or (2) results in an immediate settlement of the feature at an
adjusted settlement amount. If, because of an adjustment that is
based on an implicit input, an entity determines that the feature is
not indexed to the entity’s own stock, the equity conversion feature
does not qualify for the scope exception in ASC 815-10-15-74(a):
-
Does the adjustment to the settlement provisions result from the occurrence or nonoccurrence of a specified event that invalidates an implicit assumption used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares?For an equity conversion feature to be indexed to the entity’s stock, the answer must be yes. If the answer is no, the equity conversion feature does not qualify for the scope exception in ASC 815-10-15-74(a) irrespective of whether it meets the other conditions for equity classification.An equity conversion feature is not indexed to the entity’s stock if its terms include an adjustment in response to the occurrence or nonoccurrence of a specified event unless the occurrence or nonoccurrence of the event is inconsistent with an implicit assumption in a standard valuation model used to determine the fair value of a fixed-for-fixed forward or option on equity shares.The table below lists examples of events in response to which adjustments to the settlement amount may or may not preclude equity classification.Permissible (Equity Classification Not Precluded)Not Permissible (Equity Classification Precluded)
-
Dilutive events affecting the underlying shares (e.g., a stock split, subdivision, combination, reclassification, or recapitalization; see Section 4.3.7.1 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
-
A down-round protection feature (see Section 4.3.7.2 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
-
The counterparty in a gain position does not receive the full monetary value it is due upon settlement depending on the form of settlement (e.g., as a result of transaction costs related to the disposition of shares received or a discount in the value of unregistered shares; see Sections 4.3.7.6, 4.3.7.7, and 4.3.7.8 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
-
The counterparty is unable to participate in any extraordinary distribution of cash or noncash consideration or other similar event in which all holders of underlying shares may participate (e.g., a tender offer made by a third party)
-
The counterparty is not able to realize the remaining time value inherent in the contract (i.e., loss of time value upon early settlement; see Section 4.3.7.10 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
-
The counterparty is unable to maintain a standard hedge position in the underlying shares (e.g., loss of stock borrow)
-
The counterparty experiences a hedge disruption event because of discontinuities in the price of the underlying shares (e.g., as a result of a merger event or change in control, tender offer, termination of trading, governmental or political event, or natural disaster; see Section 4.3.7.5 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
-
Occurrence or nonoccurrence of an IPO (unless the adjustment provision meets the definition of a down-round feature; see Section 4.3.7.4 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
-
A change in the entity’s number of authorized and unissued common shares
-
A change in the number of outstanding common shares that occurs as a result of a specified event other than a dilutive event
-
A provision that requires shareholder approval
-
The entity’s bankruptcy or insolvency (unless the event results in a hedging disruption)
-
Delisting of the underlying shares (unless the event results in a hedging disruption)
-
-
Is the adjustment to the settlement terms consistent with the effect that the occurrence or nonoccurrence of the specified event had on the fair value of the equity conversion feature (i.e., does the adjustment offset — at least partially — the net gain or loss on the equity conversion feature that occurs as a result of the specified event)?For an equity conversion feature to be indexed to the entity’s stock, the answer must be yes. If the answer is no, the equity conversion feature does not qualify for the scope exception in ASC 815-10-15-74(a) irrespective of whether it meets the other conditions for equity classification.An equity conversion feature is not indexed to the entity’s stock if its terms include an adjustment in response to the occurrence or nonoccurrence of a specified event that is inconsistent with an implicit assumption in a standard valuation model unless the adjustment is consistent with the effect that the occurrence or nonoccurrence of the specified event has on the fair value of the instrument. Thus, adjustments to neutralize or partially offset the effects of events that invalidate an implicit assumption in a valuation model do not preclude an equity conversion feature from being indexed to the entity’s stock. In this context, “neutralize” means that the calculation of the adjustment to the settlement terms of the equity conversion feature appropriately offsets the net gain or loss on the feature that occurred as a result of the specified event.Adjustments from implicit inputs do not necessarily have to result in a complete neutralization of the effect that the occurrence or nonoccurrence of a specified event has on the fair value of the equity conversion feature (i.e., the net gain or loss on the feature that occurs as a result of the specified event). However, an adjustment to the terms of an equity conversion feature to reflect more than 100 percent of the effect that the variable has on the fair value of a fixed-for-fixed forward or option on equity shares precludes the equity conversion feature from being indexed to the entity’s stock because the additional exposure is inconsistent with a fixed-for-fixed forward or option on equity shares.Note that a contract may be considered indexed to the entity’s stock even if no adjustments are made upon the occurrence or nonoccurrence of an event that invalidates an implicit assumption. In a fixed-for-fixed forward or option on equity shares, no adjustments are made upon the occurrence of an event that is inconsistent with any of the implicit assumptions. Instead, the counterparty to the instrument is exposed to the risk of a change in the fair value of the instrument upon the occurrence or nonoccurrence of such events. Further, an equity conversion feature may be considered indexed to the entity’s stock even if an adjustment upon the occurrence or nonoccurrence of an event that invalidates an implicit assumption only partially offsets the effect of the specified event.For an equity conversion feature to qualify as equity, an adjustment cannot compensate the counterparty for adverse changes in the entity’s share price that are not attributable to the effect of the specified event. This is because such an adjustment could “protect” the counterparty from an adverse price change that results from events other than an event that invalidates an implicit assumption. Similarly, an adjustment based on the difference between the pre-event share price and the post-event share price generally would preclude equity classification because the share price could have changed for reasons other than the event itself (ASC 815-40-55-42). The principle is that an adjustment should be designed to capture only the theoretical effect of the event that invalidates an implicit assumption (e.g., a dilutive event).A settlement of an equity conversion feature at its fair value as of the settlement date (i.e., that reflects the effect of a specified event) is not considered to have been affected by an implicit input because no additional value is exchanged between the counterparties (i.e., no adjustment is made for the net gain or loss resulting from the invalidation of an implicit input).
-
Could a change in an implicit input result in a settlement at a fixed monetary amount?For an equity conversion feature to be indexed to the entity’s stock, the answer must be no. If the answer is yes, the equity conversion feature does not qualify for the scope exception in ASC 815-10-15-74(a) irrespective of whether it meets the other conditions for equity classification.If a change in an implicit input can result in a settlement that is based on a fixed monetary amount, the equity conversion feature is not indexed to the reporting entity’s stock. This is because the occurrence of the specified event would result in a settlement amount that would be inconsistent with the effect that the event would have had on the fair value of a fixed-for-fixed forward or option on equity shares. Note, however, that an equity conversion feature that settles at a fixed monetary amount generally should be evaluated as a share-settled redemption feature, not as a conversion feature (see Sections 8.2.2 and 8.4.7.2.5).
Example 8-20
Convertible Debt With a Share-Settled
Redemption Feature
An entity has issued a debt instrument with a
principal amount of $10 million that is
automatically converted into the issuer’s equity
shares upon an IPO. The conversion price is the
lower of 80 percent of the stock price in the IPO
or $50. Although the conversion price in this
scenario is reduced to the IPO price if the IPO
price is below $50, the potential adjustment is
not a down-round feature because the associated
settlement has a monetary value equal to a fixed
monetary amount ($10,000,000 ÷ 80% = $12,500,000).
The entity should evaluate this share-settled
redemption feature in a manner similar to how it
evaluates a put or call option embedded in a debt
host contract to determine whether the feature
must be separated as a derivative under ASC 815-15
(see Section
8.4.7.2.5).
Example 8-21
Convertible Debt With Down-Round
Feature
An entity has issued a 10-year convertible debt
instrument with a principal amount of $10 million.
The conversion price is $50. If an IPO were to
occur with an IPO price of less than $50, the
conversion price would be reduced to the IPO
price. The holder is not required to convert the
debt upon an IPO; it can continue to hold the debt
and elect to convert it later. In such a scenario,
the potential adjustment to the conversion price
upon an IPO is a down-round feature because the
conversion feature has a monetary value that
varies on the basis of changes in the issuer’s
stock price both before and after the IPO.
Example 8-22
Convertible Debt With Make-Whole Conversion
Shares
Entity A has issued convertible notes. Each
note is convertible into A’s common stock at the
holder’s election at a conversion rate of 15
shares of common stock per $1,000 principal amount
of notes. The terms of the notes specify that if a
change in control or sale of substantially all of
A’s assets occurs and the holder elects to
convert, A will adjust the conversion rate by
increasing the number of shares that will be
delivered upon conversion. The number of
additional shares, if any, that will be delivered
is determined by reference to the make-whole table
below on the basis of (1) the effective date on
which the transaction occurs and (2) the stock
price as of that date. The adjustment to the
conversion rate is designed to compensate the
holder for the expected option value that the
holder would lose as a result of the transaction.
That is, the adjustment is intended to make the
holder whole for the expected loss of the time
value of money that would result from an early
exercise of the conversion option. Accordingly,
the aggregate fair value of the shares deliverable
(including the make-whole shares) upon conversion
is expected to approximate the fair value of the
conversion option on the settlement date as long
as there has been no change in relevant pricing
inputs (other than stock price and time) since the
instrument’s inception. In no event will the
conversion rate be increased to exceed 20.36
shares of common stock per $1,000 principal amount
of notes.
In the make-whole table above, the conversion
option is not precluded from being indexed to A’s
stock because the adjustment (1) results from the
occurrence of an event that invalidates an
implicit assumption used in the pricing of a
fixed-for-fixed option on equity shares (i.e.,
that the holder will realize the remaining time
value inherent in the notes), (2) is directionally
consistent with compensating the holders for lost
time value (i.e., the number of additional shares
that will be delivered is reduced as the stock
price increases and as time to maturity
decreases), (3) does not protect the holder from
an adverse price change that is unrelated to the
event, (4) is not leveraged (i.e., does not
contain compensation in excess of expected lost
time value), and (5) does not result in the
delivery of shares worth a fixed monetary
amount.
If an entity concludes that an equity conversion
feature is indexed to its own stock under ASC 815-40-15, the entity
would also need to assess whether the equity classification
conditions in ASC 815-40-25 are met to determine whether it can
apply the scope exception in ASC 815-10-15-74(a) (see the next
section).
For a comprehensive discussion of step 2 of the
indexation analysis under ASC 815-40-15, see Section 4.3
of Deloitte’s Roadmap Contracts on an Entity’s Own
Equity.
8.4.7.6.5 Determining Whether the Feature Meets the Equity Classification Conditions in ASC 815-40-25
ASC 815-40
25-7 Contracts that
include any provision that could require net cash
settlement cannot be accounted for as equity of
the entity (that is, asset or liability
classification is required for those contracts),
except in those limited circumstances in which
holders of the underlying shares also would
receive cash (as discussed in the following two
paragraphs and paragraphs 815-40-55-2 through
55-6).
25-8 Generally, if an
event that is not within the entity’s control
could require net cash settlement, then the
contract shall be classified as an asset or a
liability. However, if the net cash settlement
requirement can only be triggered in circumstances
in which the holders of the shares underlying the
contract also would receive cash, equity
classification is not precluded.
25-9 This Subtopic does
not allow for an evaluation of the likelihood that
an event would trigger cash settlement (whether
net cash or physical), except that if the payment
of cash is only required upon the final
liquidation of the entity, then that potential
outcome need not be considered when applying the
guidance in this Subtopic.
25-10 Because any contract
provision that could require net cash settlement
precludes accounting for a contract as equity of
the entity (except for those circumstances in
which the holders of the underlying shares would
receive cash, as discussed in paragraphs
815-40-25-8 through 25-9 and paragraphs
815-40-55-2 through 55-6), all of the following
conditions must be met for a contract to be
classified as equity:
-
Subparagraph superseded by Accounting Standards Update No. 2020-06.
-
Entity has sufficient authorized and unissued shares. The entity has sufficient authorized and unissued shares available to settle the contract after considering all other commitments that may require the issuance of stock during the maximum period the derivative instrument could remain outstanding.
-
Contract contains an explicit share limit. The contract contains an explicit limit on the number of shares to be delivered in a share settlement.
-
No required cash payment (with the exception of penalty payments) if entity fails to timely file. There is no requirement to net cash settle the contract in the event the entity fails to make timely filings with the Securities and Exchange Commission (SEC).
-
No cash-settled top-off or make-whole provisions. There are no cash settled top-off or make-whole provisions.
-
Subparagraph superseded by Accounting Standards Update No. 2020-06.
-
Subparagraph superseded by Accounting Standards Update No. 2020-06.
Paragraphs 815-40-25-39 through 25-42 explain the
application of these criteria to conventional
convertible debt and other hybrid instruments.
25-10A The following
conditions are not required to be considered in an
entity’s evaluation of net cash settlement (that
is, if any one of these provisions is in a
contract [or the contract is silent on these
points], they should not preclude equity
classification, except as described below):
- Whether settlement is required in registered shares, unless the contract explicitly states that an entity must settle in cash if registered shares are unavailable. Requirements to deliver registered shares do not, by themselves, imply that an entity does not have the ability to deliver shares and, thus, do not require a contract that otherwise qualifies as equity to be classified as a liability.
- Whether counterparty rights rank higher than shareholder rights. If the provisions of the contract indicate that the counterparty has rights that rank higher than the rights of a shareholder of the stock underlying the contract, this provision does not preclude equity classification.
- Whether collateral is required. A provision requiring the entity to post collateral at any time for any reason does not preclude equity classification.
For an equity conversion feature to qualify for the scope exception in
ASC 815-10-15-74(a), the feature must require or permit the debtor to
settle the feature either physically or net in shares. Any provision
that could require the issuer to net cash settle the conversion feature
precludes application of the own-equity scope exception with limited
exceptions. The likelihood of an event that would trigger a net cash
settlement does not matter.
However, a contractual term that could require the equity conversion
feature to be net cash settled is permitted if:
-
The event that would cause net cash settlement is within the entity’s control (see Section 5.2.3.1 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity).
-
The feature is required to be net cash settled only upon the final liquidation of the entity (see Section 5.2.3.2 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity).
-
The feature is required to be net cash settled only if holders of the shares underlying the contract would also receive cash in exchange for their shares (see Section 5.2.3.3 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity), such as upon a change of control (see Section 5.2.3.4 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity) or upon nationalization or expropriation (see Section 5.2.3.5 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity).
Some convertible debt instruments give the investor a share-settled
equity conversion option and a cash-settled redemption option with a
redemption amount that is the greater of the fair value of the
underlying shares or the face amount of the securities. In such a
scenario, the “greater-of” redemption option effectively gives the
security’s holder the ability to net cash settle the embedded conversion
option. Accordingly, the conversion option does not qualify as equity
under ASC 815-40.
Even if a contract ostensibly requires or permits an
entity to settle in shares, the entity cannot assume that it has the
ability to do so unless there are no circumstances in which it could be
forced to net cash settle the equity conversion feature. If such
circumstances exist, equity classification is generally prohibited
unless any of the exceptions in ASC 815-40-25-10A are met. For an entity
to conclude that it cannot be required to net cash settle a contract,
the entity must ensure that the conditions in ASC 815-40-25-10 are met.
These conditions address whether there are any circumstances under which
the issuer could be forced to net cash settle the contract given the
contract’s terms and the regulatory and legal framework.
ASC 815-40
25-39 For purposes of
evaluating under paragraph 815-15-25-1 whether an
embedded derivative indexed to an entity’s own
stock would be classified in stockholders’ equity
if freestanding, the requirements of paragraphs
815-40-25-7 through 25-30 and 815-40-55-2 through
55-6 do not apply if the hybrid contract is a
convertible debt instrument in which the holder
may only realize the value of the conversion
option by exercising the option and receiving the
entire proceeds in a fixed number of shares or the
equivalent amount of cash (at the discretion of
the issuer).
25-40 However, the
requirements of paragraphs 815-40-25-7 through
25-30 and 815-40-55-2 through 55-6 do apply if an
issuer is evaluating whether any other embedded
derivative is an equity instrument and thereby
excluded from the scope of Subtopic 815-10.
25-41 Instruments that
provide the holder with an option to convert into
a fixed number of shares (or equivalent amount of
cash at the discretion of the issuer) for which
the ability to exercise the option is based on the
passage of time or a contingent event shall
qualify for the exceptions included in paragraph
815-40-25-39. Standard antidilution provisions
contained in an instrument do not preclude a
conclusion that the instrument is convertible into
a fixed number of shares.
The conditions in ASC 815-40-25-10 do not apply to an
embedded conversion option that meets the exception for certain types of
convertible debt in ASC 815-40-25-39. Thus, a conversion option in such
a convertible debt instrument may fail to meet one or more of those
conditions and still qualify for the scope exception in ASC
815-10-15-74(a). As explained in ASC 815-40-25-39, the requirements in
ASC 815-40-25-7 through 25-30 and ASC 815-40-55-2 through 55-6 do not
apply to “a convertible debt instrument in which the holder may only
realize the value of the conversion option by exercising the option and
receiving the entire proceeds in a fixed number of shares or the
equivalent amount of cash (at the discretion of the issuer).” Thus, for
such an instrument, the issuer must have the ability to settle it gross
by delivering a fixed number of shares, although the issuer might
alternatively elect to settle the instrument in an equivalent amount of
cash. The holder’s ability to exercise the conversion option may be
“based on the passage of time or a contingent event” (ASC 815-40-25-41).
For further discussion of the evaluation of this exception, see
Section
5.5 of Deloitte’s Roadmap Contracts on an Entity’s Own
Equity.
For a comprehensive discussion of the equity
classification conditions in ASC 815-40-25, see Chapter 5 of
Deloitte’s Roadmap Contracts on an Entity’s Own Equity.
8.4.7.7 Scope Exception for Certain Share-Based Payment Transactions
ASC 815-10
15-74 Notwithstanding the
conditions of paragraphs 815-10-15-13 through
15-139, the reporting entity shall not consider the
following contracts to be derivative instruments for
purposes of this Subtopic: . . .
b. Contracts issued by the entity that are
subject to Topic 718. If any such contract ceases
to be subject to Topic 718 in accordance with
paragraphs 718-10-35-9 through 35-14, the terms of
that contract shall then be analyzed to determine
whether the contract is subject to this Subtopic.
An award that ceases to be subject to Topic 718 in
accordance with those paragraphs shall be analyzed
to determine whether it is subject to this
Subtopic. . . .
Under ASC 718, share-based payment arrangements generally
remain within the scope of ASC 718 throughout their lives, provided that
they are not modified after they are issued to grantees.
Connecting the Dots
Convertible instruments granted to nonemployees in a
share-based payment transaction remain within the scope of ASC 718
after vesting. A convertible instrument could become subject to the
guidance in U.S. GAAP that applies to financial instruments only if
(1) the instrument is modified after vesting and (2) the nonemployee
is no longer providing goods or services or is no longer a customer
(see ASC 718-10-35-10).
8.4.8 Foreign Currency Features
8.4.8.1 Background
This section discusses the analysis of whether a feature whose value changes
on the basis of changes in one or more foreign currency exchange rates
should be separated from a debt host contract and accounted for as a
derivative. For example, some debt instruments contain an option to convert
principal or interest payments or both at a fixed foreign currency exchange
rate. Further, the terms of some debt instruments (e.g., dual currency
bonds) have principal and interest payments denominated in different
currencies.
This section does not apply to a feature that does not present an exposure to
the risk of changes in the exchange rate of foreign currency that is
different from the currency in which the debt is denominated, such as
certain currency conversion convenience clauses (see Section
8.4.8.6). Further, it does not apply to debt merely by virtue
of the denomination of such debt in a currency that is different from the
debtor’s functional currency unless the debt contains one or more features
that are denominated in a currency that is different from that in which the
debt was denominated (e.g., a foreign currency option).
8.4.8.2 Bifurcation Analysis
The table below presents an overview of the bifurcation analysis of a foreign
currency feature embedded in a debt host contract. Further, an entity should
always consider the terms and conditions of a specific feature in light of
all the relevant accounting guidance before reaching a conclusion.
|
Bifurcation Condition
|
Condition Met?
|
Analysis
|
|---|---|---|
|
Not clearly and closely related (see Section 8.3.2)
|
Yes
|
A feature that presents an exposure to changes in the
exchange rate of foreign currency that is different
from the debt’s currency of denomination is not
clearly and closely related to a debt host.
|
|
Hybrid instrument not measured at fair value on a
recurring basis (see Section 8.3.3)
|
It depends
|
Debt is not measured at fair value on a recurring
basis unless the issuer elects the fair value option
in ASC 815-15 or ASC 825-10 (see Sections 4.4 and
8.5.6).
However, the fair value option cannot be elected for
debt that contains a separately recognized equity
component at inception.
|
|
Meets the definition of a derivative (see Section 8.3.4)
|
Yes
|
A feature that presents an exposure to changes in a
foreign currency exchange rate meets the definition
of a derivative (see Section 8.4.8.4).
|
|
Meets a scope exception (see Section 8.3.5)
|
It depends
|
The debtor should evaluate whether the foreign
currency feature is exempt from derivative
accounting under ASC 815-15-15-5 (see
Section 8.4.8.5).
|
As shown in the table above, a debtor’s determination of
whether a foreign currency feature must be bifurcated from a debt host
contract and accounted for as derivative tends to focus on whether the
feature meets a scope exception related to derivative accounting (see
Section
8.4.8.5) unless the debtor has elected to account for the
debt under the fair value option in ASC 815-15 or ASC 825-10 (see Section 8.3.3).
Typically, such features meet the definition of a derivative (see Section 8.4.8.4) and are not clearly and
closely related to a debt host (see the next section).
8.4.8.3 Clearly-and-Closely-Related Analysis
A feature that presents an exposure to changes in the exchange rate of
foreign currency that is different from the debt’s currency of denomination
is not clearly and closely related to a debt host. As noted in ASC
815-15-55-212, for example, a “foreign currency option is not clearly and
closely related to issuing a loan.” However, this guidance does not apply to
a feature that does not present an exposure to the risk of changes in the
exchange rate of foreign currency that is different from the currency in
which the debt is denominated (see Section
8.4.8.6).
8.4.8.4 Derivative Analysis
The table below presents an analysis of whether a foreign currency feature
embedded in a debt host contract meets the definition of a derivative. Note,
however, that an entity should always consider the terms and conditions of a
specific feature in light of the applicable accounting guidance before
reaching a conclusion.
|
Characteristics of a Derivative
|
Characteristic Present?
|
Analysis
|
|---|---|---|
|
Underlying and notional amount or payment provision
(see Section
8.3.4.2)
|
Yes
|
An embedded feature that presents an
exposure to changes in a foreign currency exchange
rate that is based on a currency that is different
from the debt’s currency of denomination has both an
underlying (the foreign currency rate) and a
notional amount (e.g., the debt’s outstanding
amount).
|
|
Initial net investment (see Section 8.3.4.3)
|
Yes
|
The initial net investment in a feature that presents
an exposure to changes in a foreign currency
exchange rate that is based on a currency that is
different from the debt’s currency of denomination
is its fair value (i.e., the amount that would need
to be paid to acquire the feature on a stand-alone
basis without the host contract). This feature has
an initial net investment that is smaller than would
be required for a direct investment that has the
same exposure to changes in foreign currency
exchange rates.
|
|
Net settlement (see Section 8.3.4.4)
|
Yes
|
A foreign currency feature meets the net settlement
condition because it is net cash settled.
|
As shown in the table above, a foreign currency feature embedded in a debt
host contract meets the definition of a derivative. Therefore, the analysis
of whether such a feature must be bifurcated as a derivative tends to focus
on whether the feature is exempt from the scope of derivative accounting
(see Section 8.4.8.5) unless the
debtor has elected to account for the debt under the fair value option in
ASC 815-15 or ASC 825-10 (see Section
8.3.3).
8.4.8.5 Exception for Certain Foreign Currency Features
ASC 815-15
15-5 Unsettled foreign
currency transactions, including financial
instruments, shall not be considered to contain
embedded foreign currency derivatives under this
Subtopic if the transactions meet all of the
following criteria:
-
They are monetary items.
-
They have their principal payments, interest payments, or both denominated in a foreign currency.
-
They are subject to the requirement in Subtopic 830-20 to recognize any foreign currency transaction gain or loss in earnings.
Case Q: Dual Currency Bond
55-209 A dual currency
bond provides for repayment of principal in U.S.
dollars and periodic interest payments denominated
in a foreign currency. In this circumstance, a U.S.
entity with the dollar as its functional currency is
borrowing funds from an independent party with those
repayment terms as described.
55-210 Because the portion of
this instrument relating to the periodic interest
payments denominated in a foreign currency is
subject to the requirement in Topic 830 to recognize
the foreign currency transaction gain or loss in
earnings, the instrument should not be considered as
containing an embedded foreign currency derivative
instrument pursuant to paragraph 815-15-15-5. In
this circumstance, the U.S. entity has the dollar as
the functional currency and is making interest
payments in a foreign currency. Remeasurement of the
liability is required using future equivalent dollar
interest payments determined by the current spot
exchange rate and discounted at the historical
effective interest rate.
Case R: Short-Term Loan With a Foreign Currency
Option
55-211 A U.S. lender
issues a loan at an above-market interest rate. The
loan is made in U.S. dollars, the borrower’s
functional currency, and the borrower has the option
to repay the loan in U.S. dollars or in a fixed
amount of a specified foreign currency.
55-212 This instrument can
be viewed as combining a loan at prevailing market
interest rates and a foreign currency option. The
lender has written a foreign currency option
exposing it to changes in foreign currency exchange
rates during the outstanding period of the loan. The
premium for the option has been paid as part of the
interest rate. Because the borrower has the option
to repay the loan in U.S. dollars or in a fixed
amount of a specified foreign currency, the
provisions of paragraph 815-15-15-5 are not relevant
to this Case. That paragraph addresses
foreign-currency-denominated interest or principal
payments but does not apply to foreign currency
options embedded in a
functional-currency-denominated debt host contract.
Because a foreign currency option is not clearly and
closely related to issuing a loan, the embedded
option should be separated from the host contract
and accounted for by both parties pursuant to the
provisions of this Subtopic. In contrast, if both
the principal payment and the interest payments on
the loan had been payable only in a fixed amount of
a specified foreign currency, there would be no
embedded foreign currency derivative pursuant to
this Subtopic.
Under ASC 815-15-15-5, debt with principal or interest
payments (or both) that are denominated in a foreign currency is deemed not
to contain an embedded foreign currency derivative if the amounts that are
denominated in a foreign currency must be remeasured at spot rates under ASC
830-20 (see Section
14.2.3). If the interest payments of a dual-currency bond
whose principal is denominated in dollars are denominated in a different
currency, for example, ASC 815-15-55-210 requires the interest payments to
be accounted for by discounting the “future equivalent dollar interest
payments determined by the current spot exchange rate” at the debt’s
original effective interest rate. Under the interest method, the principal
payment would also be discounted by using the debt’s original effective
interest rate (see Section
6.2).
The exemption in ASC 815-15-15-5 does not apply to a foreign
currency feature that is not required to be remeasured under ASC 830-20 for
changes in spot foreign currency exchange rates. For example, the exemption
does not apply to an option to pay principal or interest payments in one or
more alternative currencies other than the debt’s currency of denomination
unless the amount owed in the alternative currency is determined by applying
the current spot exchange rate at the time of payment to the amount owed in
the debt’s currency of denomination (see the next section).
8.4.8.6 Convenience Clauses That Do Not Present a Foreign Currency Exposure
Sometimes, debt contracts contain a convenience clause that permits or
requires principal or interest payments or both to be made in a currency
that is different from that in which the debt is denominated. The amount of
the payment is determined by applying the current spot foreign currency
exchange rate at the time of payment to the amount owed in the debt’s
currency of denomination. For example, the terms of a debt instrument
denominated in USD might specify that payments may be made in one or more
currencies at the current spot exchange rate at the time of payment. Such a
clause does not represent a foreign currency feature that should be
evaluated for bifurcation since its monetary value does not vary on the
basis of a foreign currency exchange rate.
8.4.9 Payment Features Indexed to Commodities or Other Nonfinancial Items
8.4.9.1 Background
This section discusses the analysis of whether payment features that are
indexed to the price or value of a commodity or other nonfinancial item
(e.g., a commodity-indexed principal or interest payment or a participating
mortgage feature) should be separated from a debt host contract and
accounted for as derivatives under ASC 815-15.
8.4.9.2 Bifurcation Analysis
The table below presents an overview of the bifurcation analysis of a payment
feature indexed to the price or value of a commodity or other nonfinancial
item. However, an entity should always consider the terms and conditions of
a specific feature in light of all the relevant accounting guidance before
reaching a conclusion.
|
Bifurcation Condition
|
Condition Met?
|
Analysis
|
|---|---|---|
|
Not clearly and closely related (see Section 8.3.2)
| Yes |
The price or value of a commodity or other
nonfinancial item is not clearly and closely related
to a debt host.
|
|
Hybrid instrument not measured at fair value on a
recurring basis (see Section 8.3.3)
|
It depends
|
Debt is not measured at fair value on a recurring
basis unless the issuer elects the fair value option
in ASC 815-15 or ASC 825-10 (see Sections 4.4 and
8.5.6).
However, the fair value option cannot be elected for
debt that contains a separately recognized equity
component at inception.
|
|
Meets the definition of a derivative (see Section 8.3.4)
|
Yes
|
Payments indexed to the price or value of a commodity
or other nonfinancial item meet the definition of a
derivative.
|
|
Meets a scope exception (see Section 8.3.5)
|
It depends
|
ASC 815 contains a scope exception related to certain
non-exchange-traded contracts with payments that are
based on the price or value of a nonfinancial item
of one of the parties to the contract provided that
the asset is not readily convertible to cash (see
Section 8.4.9.5).
|
As shown in the table above, a debtor’s determination of whether a payment
feature indexed to a commodity or other nonfinancial item must be bifurcated
as a derivative tends to focus on whether the feature is exempt from the
scope of derivative accounting (see Section 8.4.9.5),
unless the debtor has elected to account for the debt under the fair value
option in ASC 815-15 or ASC 825-10 (see Section
8.3.3). Such a feature is not clearly and closely related to
a debt host and typically meets the definition of a derivative (see
Section 8.4.9.4).
8.4.9.3 Clearly-and-Closely-Related Analysis
ASC 815-15
25-48 The changes in fair
value of a commodity (or other asset) and the
interest yield on a debt instrument are not clearly
and closely related. Thus, a commodity-related
derivative instrument embedded in a
commodity-indexed debt instrument shall be separated
from the noncommodity host contract and accounted
for as a derivative instrument.
Case J: Crude Oil Knock-In Note
55-194 An illustrative
crude oil knock-in note has a 1 percent coupon and
guarantees repayment of principal with upside
potential based on the strength of the oil
market.
55-195 A crude oil
knock-in note essentially combines an
interest-bearing instrument with a series of option
contracts. A significant portion of the coupon
interest rate is, in effect, used to purchase
options that provide the investor with potential
gains resulting from increases in specified crude
oil prices. Because the option contracts are indexed
to the price of crude oil, they are not clearly and
closely related to an investment in an
interest-bearing note. Therefore, the embedded
option contract should be separated from the host
contract and accounted for by both parties pursuant
to the provisions of this Subtopic.
Case K: Gold-Linked Bull Note
55-196 An
illustrative gold-linked bull note has a fixed 3
percent coupon and guarantees repayment of principal
with upside potential if the price of gold
increases.
55-197 A
gold-linked bull note can be viewed as combining an
interest-bearing instrument with a series of option
contracts. A portion of the coupon interest rate is,
in effect, used to purchase call options that
provide the investor with potential gains resulting
from increases in gold prices. Because the option
contracts are indexed to the price of gold, they are
not clearly and closely related to an investment in
an interest-bearing note. Therefore, the embedded
option contracts should be separated from the host
contract and accounted for by both parties pursuant
to the provisions of this Subtopic.
A feature that adjusts the payments of a debt contract on the basis of the
price or value of a commodity or other nonfinancial item is not clearly and
closely related to a debt host. This determination applies irrespective of
whether the debtor owns the commodity or other nonfinancial item.
8.4.9.4 Derivative Analysis
The table below presents an analysis of whether a payment feature indexed to
a commodity or other nonfinancial item meets the definition of a derivative
(see Section 8.3.4). Note, however,
that an entity should always consider the terms and conditions of a specific
feature in light of the applicable accounting guidance before reaching a
conclusion.
|
Characteristics of a Derivative
|
Characteristic Present?
|
Analysis
|
|---|---|---|
|
Underlying and notional amount or payment provision
(see Section
8.3.4.2)
|
Yes
|
A feature that could adjust the payments of a debt
host contract on the basis of the price or value of
a commodity or other nonfinancial item has both an
underlying (the item’s price or value) and a
notional amount (e.g., the debt’s outstanding
amount).
|
|
Initial net investment (see Section 8.3.4.3)
|
Yes
|
The initial net investment in an embedded feature is
its fair value (i.e., the amount that would need to
be paid to acquire the feature on a stand-alone
basis without the host contract). Generally, a
feature indexed to a commodity or other nonfinancial
asset has an initial net investment that is smaller
than would be required for a direct investment that
has the same exposure to changes in the price or
value of the nonfinancial asset (since the
investment in the debt host contract does not form
part of the initial net investment for the embedded
feature).
|
|
Net settlement (see Section 8.3.4.4)
|
Yes
|
Adjustments to the payments of a debt host contract
that are indexed to the price or value of a
commodity or other nonfinancial item meet the net
settlement condition since neither party is required
to deliver an asset that is associated with the
underlying and whose principal amount, stated
amount, face value, number of shares, or other
denomination is equal to the feature’s notional
amount. (If the feature must be settled by delivery
of the underlying nonfinancial item, however, the
considerations in Section
8.4.7.5 apply.)
|
As shown in the table above, a payment feature indexed to
the price or value of a nonfinancial asset typically meets the definition of
a derivative. Because such a feature is not clearly and closely related to a
debt host, the debtor must assess whether it qualifies for a scope exception
(see the next section) unless the debtor has elected to account for the debt
under the fair value option in ASC 815-15 or ASC 825-10 (see Section 8.3.3).
8.4.9.5 Scope Exception for Certain Nonfinancial Items of One of the Parties
ASC 815-10
15-59 Contracts that are
not exchange-traded are not subject to the
requirements of this Subtopic if the underlying on
which the settlement is based is any one of the
following: . . .
b. The price or value of a nonfinancial asset
of one of the parties to the contract provided
that the asset is not readily convertible to cash.
This scope exception applies only if both of the
following are true:
1. The nonfinancial
assets are unique.
2. The nonfinancial
asset related to the underlying is owned by the
party that would not benefit under the contract
from an increase in the fair value of the
nonfinancial asset. (If the contract is a call
option, the scope exception applies only if that
nonfinancial asset is owned by the party that
would not benefit under the contract from an
increase in the fair value of the nonfinancial
asset above the option’s strike price.)
c. The fair value of a nonfinancial liability
of one of the parties to the contract provided
that the liability does not require delivery of an
asset that is readily convertible to cash. . .
.
15-60 If a contract has
more than one underlying and some, but not all, of
them qualify for one of the scope exceptions in the
preceding paragraph, the application of this
Subtopic to that contract depends on its predominant
characteristics. That is, the contract is subject to
the requirements of this Subtopic if all of its
underlyings, considered in combination, behave in a
manner that is highly correlated with the behavior
of any of the component variables that do not
qualify for a scope exception.
Example 14: Certain Contracts That Are Not
Traded on an Exchange — Nonfinancial Asset of One
of the Parties to a Contract
55-142 This Example
addresses the application of the scope exception in
paragraph 815-10-15-59(b). Entity A enters into a
non-exchange-traded forward contract to buy from
Entity B 100 interchangeable (fungible) units of a
nonfinancial asset that are not readily convertible
to cash. The contract permits net settlement through
its default provisions. Entity A already owns more
than 100 units of that nonfinancial asset, but
Entity B does not own any units of that nonfinancial
asset.
55-143 The scope exception
in paragraph 815-10-15-59(b) does not apply to the
accounting for the contract for both of the
following reasons:
-
The contract’s settlement is based on an underlying associated with a nonfinancial asset that is not unique (because it is based on the price or value of an interchangeable, nonfinancial unit).
-
The entity that owns the nonfinancial asset related to the underlying (that is, Entity A) is the buyer of the units and thus would benefit from the forward contract if the price or value increases.
Consequently, neither Entity A nor Entity B qualifies
for the scope exception in paragraph
815-10-15-59(b).
ASC 815-10-15-59 contains a scope exception for certain non-exchange-traded
contracts whose settlement is based on the price or value of a nonfinancial
asset of one of the parties to the contract (i.e., property owned by the
debtor) or the fair value of a nonfinancial liability of one of the parties
to the contract. This scope exception is not available for underlyings
associated with nonfinancial assets that are readily convertible to cash or
that are not unique (e.g., fungible, interchangeable items).
Original works of art or real estate would be considered unique nonfinancial
assets (i.e., they do not have interchangeable units). Assets newly produced
on an assembly line (have not been used) and are available from multiple
sellers are not unique since a new asset is interchangeable with another new
asset from the same production. However, once the manufactured asset has
been used, the asset would be considered unique (e.g., a used car is
considered unique).
Further, the scope exception for certain nonfinancial assets of one of the
parties is only available if the nonfinancial asset is owned by the party
that would not benefit under the contract from an increase in the price or
value of the nonfinancial asset. In other words, the scope exception is not
available if the contract benefits the owner of the nonfinancial asset when
the fair value of the nonfinancial asset increases. For example, the scope
exception is not available if payments required under a debt obligation
decrease when the fair value of a nonfinancial asset owned by the debtor
increases (i.e., the owner of the nonfinancial asset — the debtor — benefits
under the contract from an increase in the fair value of the asset because
such increase results in a decrease in the payments to be made on the debt
obligation).
ASC 815-15
55-8 Under an example
participating mortgage, the investor receives a
below-market interest rate and is entitled to
participate in the appreciation in the fair value of
the project that is financed by the mortgage upon
sale of the project, at a deemed sale date, or at
the maturity or refinancing of the loan. The
mortgagor must continue to own the project over the
term of the mortgage.
55-9 This instrument has a
provision that entitles the investor to participate
in the appreciation of the referenced real estate
(the project). However, a separate contract with the
same terms would be excluded by the exception in
paragraph 815-10-15-59(b) because settlement is
based on the value of a nonfinancial asset of one of
the parties that is not readily convertible to cash.
(This Subtopic does not modify the guidance in
Subtopic 470-30.)
55-10 Paragraph
310-10-05-9 explains that loans granted to acquire
operating properties sometimes grant the lender a
right to participate in expected residual profit
from the sale or refinancing of the property. An
equity kicker (or expected residual profit) would
typically not be separated from the host contract
and accounted for as an embedded derivative because
paragraph 815-15-25-1(c) exempts a hybrid contract
from bifurcation if a separate instrument with the
same terms as the embedded equity kicker is not a
derivative instrument subject to the requirements of
this Subtopic. Under paragraph 815-10-15-59(b), an
embedded equity kicker would typically not be
subject to the requirements of this Subtopic because
the separate instrument with the same terms is not
exchange traded and is indexed to nonfinancial
assets that are not readily convertible to cash.
Similarly, if an equity kicker is based on a share
in net earnings or operating cash flows, it would
also typically qualify for the scope exception in
paragraph 815-10-15-59(d). If the embedded
derivative does not need to be accounted for
separately under this Subtopic, the Acquisition,
Development, and Construction Arrangements
Subsections of Subtopic 310-10 shall be applied.
An example of a feature for which the scope exception in ASC 815-10-15-59
would typically be available is the participation feature in a participating
mortgage, which would instead be accounted for under ASC 470-30 (see
Section 7.3).
8.4.10 Revenue-Based Payments
8.4.10.1 Background
This section discusses payment features that are based on specified volumes
of sales or service revenues. For example, some debt instruments require
payments that are indexed to revenues from the sale of goods or services or
from royalty income.
8.4.10.2 Bifurcation Analysis
The table below presents an overview of the bifurcation analysis of a payment
feature indexed to specified volumes of sales or service revenues of one of
the parties to the contract. However, an entity should always consider the
terms and conditions of a specific feature in light of all the relevant
accounting guidance before reaching a conclusion.
|
Bifurcation Condition
|
Condition Met?
|
Analysis
|
|---|---|---|
|
Not clearly and closely related (see Section 8.3.2)
|
Yes
|
Payments that are based on specified
volumes of sales or service revenues are not clearly
and closely related to a debt host (see Section
8.4.10.3).
|
|
Hybrid instrument not measured at fair value on a
recurring basis (see Section 8.3.3)
|
It depends
|
Debt is not measured at fair value on a recurring
basis unless the issuer elects the fair value option
in ASC 815-15 or ASC 825-10 (see Sections 4.4 and
8.5.6).
However, the fair value option cannot be elected for
debt that contains a separately recognized equity
component at inception.
|
|
Meets the definition of a derivative (see Section 8.3.4)
|
Yes
|
Payment features that are based on specified volumes
of sales or service revenues meet the definition of
a derivative.
|
|
Meets a scope exception (see Section 8.3.5)
|
It depends
|
ASC 815 contains a scope exception for
non-exchange-traded contracts with payments based on
specified volumes of sales or service revenues of
one of the parties to the contract (see
Section 8.4.10.5).
|
As shown in the table above, a debtor should evaluate whether a revenue-based
payment feature is exempt from the scope of derivative accounting (see
Section 8.4.10.5) since such features are not
clearly and closely related to a debt host and meet the definition of a
derivative.
8.4.10.3 Clearly-and-Closely-Related Analysis
Although ASC 815-15 does not specifically address whether a revenue-based
payment feature is clearly and closely related to a debt host, the economic
characteristics and risks of a payment feature indexed to specified volumes
or sales or service revenues would not be considered clearly and closely
related to the economic characteristics and risks of a debt instrument
(i.e., interest rates, credit risk, and inflation rates). Note that for this
purpose, a revenue-based feature does not include an underlying indexed to
interest rates.
8.4.10.4 Derivative Analysis
The table below presents an analysis of whether a payment
feature indexed to specified volumes of sales or service revenues meets the
definition of a derivative (see Section
8.3.4). Note, however, that an entity should always consider
the terms and conditions of a specific feature in light of the applicable
accounting guidance before reaching a conclusion.
|
Characteristics of a Derivative
|
Characteristic Present?
|
Analysis
|
|---|---|---|
|
Underlying and notional amount or payment provision
(see Section
8.3.4.2)
|
Yes
|
A feature that could adjust the payments of a debt
host contract on the basis of specified volumes of
sales or service revenues has both an underlying
(specified volumes of sales or service revenues) and
a notional amount (e.g., the debt’s outstanding
amount) or payment provision.
|
|
Initial net investment (see
Section
8.3.4.3)
|
Yes
|
The initial net investment in an embedded feature is
its fair value (i.e., the amount that would need to
be paid to acquire the feature on a stand-alone
basis without the host contract). Generally, a
feature that adjusts the payments of a debt host
contract on the basis of specified volumes of sales
or service revenues has an initial net investment
that is smaller than would be required for a direct
investment that has the same exposure to changes in
the value of the specified volumes of sales or
service revenues (since the investment in the debt
host contract does not form part of the initial net
investment for the embedded feature).
|
|
Net settlement (see Section 8.3.4.4)
|
Yes
|
Adjustments to the payments of a debt host contract
on the basis of specified volumes of sales or
service revenues meet the net settlement condition
because the feature is cash settled (neither party
is required to deliver an asset that is associated
with the underlying and whose principal amount,
stated amount, face value, number of shares, or
other denomination is equal to the feature’s
notional amount).
|
As shown in the table above, a payment feature indexed to
specified volumes of sales or service revenues typically meets the
definition of a derivative. However, such a feature often qualifies for a
scope exception (see the next section).
8.4.10.5 Scope Exception for Certain Revenue-Based Payments
ASC 815-10
15-59 Contracts that are
not exchange-traded are not subject to the
requirements of this Subtopic if the underlying on
which the settlement is based is any one of the
following: . . .
d. Specified volumes of sales or service
revenues of one of the parties to the contract.
(This scope exception applies to contracts with
settlements based on the volume of items sold or
services rendered, for example, royalty
agreements. This scope exception does not apply to
contracts based on changes in sales or revenues
due to changes in market prices.)
15-60 If a contract has
more than one underlying and some, but not all, of
them qualify for one of the scope exceptions in the
preceding paragraph, the application of this
Subtopic to that contract depends on its predominant
characteristics. That is, the contract is subject to
the requirements of this Subtopic if all of its
underlyings, considered in combination, behave in a
manner that is highly correlated with the behavior
of any of the component variables that do not
qualify for a scope exception.
ASC 815-10-15-59(d) provides a scope exception for derivatives in which the
underlying is based on specified volumes of sales or service revenues of one
of the parties to the contract. This scope exception in many circumstances
may be applied to contracts for which the underlying is a broad performance
measure of one of the parties to the contract (e.g., net earnings, EBITDA,
or operating cash flows). Discussions with the FASB staff have indicated
that the application of this scope exception is limited by the wording of
ASC 815-10-15-59(d), which states, in part:
This scope exception does not apply to contracts based on changes in
sales or revenues due to changes in market prices.
Accordingly, if the performance measure is based primarily or wholly on the
volume of items sold or services rendered of one of the parties to the
contract, then an embedded feature whose underlying is based on that
performance measure potentially could qualify for the ASC 815-10-15-59(d)
scope exception. However, the scope exception is not available if changes in
the performance measure are highly correlated with changes in the market
price of an asset or liability (e.g., changes in the market price of
investments held or goods sold).
Example 8-23
Debt That Contains Interest Payments Indexed to
EBITDA
Company H has issued debt that includes an additional
interest payment based on an increase in H’s EBITDA
that exceeds a specified threshold. Thus, increases
in EBITDA above the threshold increase the amount of
additional interest payments required. Company H
determined that EBITDA is not an interest-rate index
but an earnings measure that is not clearly and
closely related to the debt host. Company H
evaluates whether the additional interest payment
feature that is based on EBITDA is an embedded
derivative that must be accounted for
separately.
It would be appropriate for H to apply the scope
exception in ASC 815-10-15-59(d) as long as the
changes in EBITDA are not primarily driven by market
price changes. A contingent interest feature based
on EBITDA would not qualify for the ASC
815-10-15-59(d) scope exception if changes in EBITDA
are highly correlated with changes in the market
price of an asset or liability (e.g., changes in the
market price of investments held or goods sold).
Example 8-24
Debt With a Profit Participation Feature
A small business investment company (SBIC) issues
mandatorily redeemable participating securities. The
securities pay a return in the form of (1) a fixed
coupon rate plus (2) a profit participation rate.
The profit participation feature requires the SBIC
to pay the security holders a percentage of the
SBIC’s earnings on certain investments held. The
investments’ earnings are based primarily on
appreciation and returns generated from changes in
the value of the underlying assets. In this example,
the SBIC’s investment earnings are primarily driven
by market price changes. In addition, the profit
participation feature only applies to certain SBIC
investments rather than to total company earnings,
which would not constitute a “broad performance
measure” of one of the parties to the contract.
Therefore, the SBIC could not apply the ASC
815-10-15-59(d) scope exception.
8.4.11 Other Payment Provisions
8.4.11.1 Background
Debt instruments often contain provisions under which payments are (1) made
upon the occurrence or nonoccurrence of a specified event (e.g., the debtor
is late in filing financial statements) or (2) indexed to a variable (e.g.,
the creditor’s costs associated with a specified event) for which the
accounting is not specifically addressed in ASC 815. For example, the debtor
may be required to:
-
Pay additional interest if the debt is not freely tradable by its holders by a specified date after issuance (e.g., the debtor must pay 0.25 percent of additional interest if the debt is not freely tradable six months after issuance).
-
Pay additional interest if it has not filed in a timely manner any report or document that must be filed with the SEC (e.g., 0.25 percent of additional interest).
-
Pay additional interest if it fails to meet one or more specified environmental, social, or governance (ESG) targets (e.g., the debtor must pay additional interest of 0.50 percent if it does not use the debt proceeds to invest in renewable energy projects or fails to achieve 40 percent female representation on the debtor’s board of directors within three years of debt issuance).
-
Receive an interest rate reduction if it meets specified ESG targets (e.g., the stated interest rate is reduced by 0.25 percent if the debtor achieves a specified reduction in greenhouse gas emissions within three years of debt issuance).
-
Reimburse the creditor for increased costs as result of a specified event (e.g., a change in law or hedge disruption event).
-
Reimburse the creditor for taxes on interest payments.
Because payment provisions that are contingent on filing with the SEC on time
or on the ability to freely trade the debt 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 (see Section 3.3.3.2).
Example 8-25
Debt That Requires Additional Interest to Be Paid
Upon the Occurrence of Certain Events
The terms of a debt contract require the issuer to
pay additional interest at a rate equal to 0.50
percent per annum of the principal amount
outstanding for each day during which (1) the debtor
has failed to file any document or report that the
debtor is required to file with the SEC under
Section 13 or 15(d) of the Securities Exchange Act
of 1934 or (2) the debt is not otherwise freely
tradable (e.g., eligible for sale and transfer under
SEC Rule 144) as a result of restrictions in U.S.
securities laws (e.g., a registration requirement
under the Securities Act of 1933) or the terms of
the debt indenture.
Example 8-26
Debt That Requires Additional Interest to Be Paid
if Resale Is Restricted
A debt instrument was issued in accordance with an
exemption from registration under the Securities Act
of 1933. The terms of a debt contract require the
issuer to pay additional interest at a rate equal to
0.50 percent per annum if, or for as long as, a
restrictive legend on the debt has not been removed,
the debt is assigned a restricted CUSIP number, or
the debt is not otherwise freely tradable.
8.4.11.2 Bifurcation Analysis
The table below presents an overview of the bifurcation analysis of a payment
provision that is contingent on the occurrence or nonoccurrence of a
specified event (e.g., late filings) or is indexed to a variable (e.g., the
creditor’s costs associated with a specified event) for which the accounting
is not specifically addressed in ASC 815.
|
Bifurcation Condition
|
Condition Met?
|
Analysis
|
|---|---|---|
|
Not clearly and closely related (see Section 8.3.2)
|
Yes
|
Payments that are contingent on, or indexed to, an
underlying other than interest rates, the debtor’s
creditworthiness, or inflation are considered not
clearly and closely related to a debt host.
|
|
Hybrid instrument not measured at fair value on a
recurring basis (see Section 8.3.3)
|
It depends
|
Debt is not measured at fair value on a recurring
basis unless the issuer elects the fair value option
in ASC 815-15 or ASC 825-10 (see Sections 4.4 and
8.5.6). However, the fair
value option cannot be elected for debt that
contains a separately recognized equity component at
inception.
|
|
Meets the definition of a derivative (see Section 8.3.4)
|
Yes
|
Generally, a feature that adjusts the payments on a
debt host contract meets the definition of a
derivative (see Section
8.4.11.4).
|
|
Meets a scope exception (see Section 8.3.5)
|
Generally, no
|
Although the debtor should evaluate whether any
specific scope exception is available (see Section 8.3.5), often
a scope exception is not available.
|
8.4.11.3 Clearly-and-Closely-Related Analysis
If an embedded feature is not addressed in ASC 815, an
entity must apply judgment and consider the purpose of the
clearly-and-closely-related criterion (e.g., whether the feature bears a
close economic relationship to the host contract or is dissimilar) and
analogous guidance for other types of features.
Generally, payments that are contingent on (or indexed to)
an underlying other than interest rates (see Section 8.4.1), the debtor’s
creditworthiness (see Section 8.4.2), or inflation (see Section 8.4.3) are considered not
clearly and closely related to a debt host. In practice, the following types
of payment features are typically determined to be not clearly and closely
related to a debt host:
-
Additional interest features that are triggered if debt is not freely tradeable by a specified date or if the issuer does not file financial statements on time with the SEC.
-
Additional interest features that are triggered if specified ESG targets are not met.
-
Interest rate reductions that apply if specified ESG targets are met.
-
Reimbursement of creditor-related costs.
-
Reimbursement of taxes that the creditor owes to the government on interest paid.
-
Interest or principal payments that are indexed to certain ESG targets.
8.4.11.4 Derivative Analysis
The table below presents an analysis of whether a payment provision that is
contingent on the occurrence or nonoccurrence of a specified event (e.g.,
late filings) or is indexed to a variable (e.g., the creditor’s costs
associated with a specified event) for which the accounting is not
specifically addressed in ASC 815 meets the definition of a derivative (see
Section 8.3.4). Note, however,
that an entity should always consider the terms and conditions of a specific
feature in light of the applicable accounting guidance before reaching a
conclusion.
|
Characteristics of a Derivative
|
Characteristic Present?
|
Analysis
|
|---|---|---|
|
Underlying and notional amount or payment provision
(see Section
8.3.4.2)
|
Yes
|
A feature that could adjust the payments of a debt
host contract on the basis of a specified event or
variable has both an underlying (the specified event
or variable) and a notional amount (e.g., the debt’s
outstanding amount) or payment provision.
|
|
Initial net investment (see Section 8.3.4.3)
|
Yes
|
The initial net investment in an embedded feature is
its fair value (i.e., the amount that would need to
be paid to acquire the feature on a stand-alone
basis without the host contract). Generally, a
feature that adjusts the payments of a debt host
contract has an initial net investment that is
smaller than would be required for a direct
investment that has the same exposure to changes in
the value of the specified event or variable (since
the investment in the debt host contract does not
form part of the initial net investment for the
embedded feature).
|
|
Net settlement (see Section 8.3.4.4)
|
Yes
|
A feature that adjusts payments of a
debt host contract on the basis of a specified event
or variable meets the net settlement condition
because the feature is cash settled (neither party
is required to deliver an asset that is associated
with the underlying and whose principal amount,
stated amount, face value, number of shares, or
other denomination is equal to the feature’s
notional amount).
|
As shown in the table above, a payment feature that is contingent on a
specified event or indexed to a specified variable typically meets the
definition of a derivative.
8.4.11.5 Additional Considerations
An entity should always consider the terms and conditions of
a specific feature in light of all the relevant accounting guidance before
reaching a conclusion about a payment provision (e.g., whether an exception
to the guidance on derivative accounting is available; see Section 8.3.5). An entity is not required to
recognize a derivative related to normal contractual remedies for a breach
of contract whose occurrence the entity can prevent. For example, an entity
is not required to separate an indemnification clause that holds each party
harmless against damages, losses, or claims resulting from the breach of
contract or gross negligence.
Depending on the likelihood that a payment feature will be
triggered and, if so, on its potential amount, the fair value of a payment
feature embedded in debt host might be minimal (e.g., a feature in which a
minor adjustment must be made to the interest rate upon an event whose
likelihood of occurring is remote). In practice, therefore, entities
sometimes determine and document that they are not required to make
accounting entries upon debt issuance to recognize a feature that must be
bifurcated as a derivative under ASC 815-15. Any such conclusion must be
appropriately supported on the basis of materiality. A determination that a
feature has a minimal fair value at inception does not negate the
requirement to account for it as a derivative. Accordingly, if an entity
makes such a determination, it should also monitor its facts and
circumstances in each reporting period to evaluate whether the feature’s
fair value or change to it is significant and therefore must, under U.S.
GAAP requirements, be reflected in the entity’s financial statements. For
instance, if a feature that must be bifurcated as a derivative liability is
determined to have a fair value that is not materially different from zero
when debt is issued and the fair value increases to $50,000 during the next
reporting period, the change in fair value from zero to $50,000 should be
reflected as a loss during that reporting period; the change cannot be
recognized as a debt discount after the issuance of the debt.
The entity should also consider the appropriate level of
aggregation in identifying and evaluating embedded features (see Section 8.2). The
terms of a debt contract might contain a cap on the total amount of
additional interest that would be paid under additional interest provisions.
For example, the debt terms might specify that in no event will additional
interest be paid at a rate in excess of 0.50 percent regardless of the
number of events or circumstances giving rise to the requirement to pay such
additional interest. This means that the total amount of additional interest
that might have to be paid on the debt is not necessarily simply the sum of
the additional interest that might need to be paid under each of the
provisions that triggers such additional interest payments. For instance, if
one or more additional interest features have been triggered such that the
total amount of additional interest payable is equal to the cap, there would
be no incremental amount payable if another such feature is triggered. In
this circumstance, the potential payoff of each additional interest
provision and the payoffs under the other provisions to which the cap
applies are interdependent. Under the payoff profile approach for
identifying embedded features (see Sections 8.2.2 and 8.2.3), it is
appropriate to evaluate such additional interest features as one combined
embedded feature rather than as separate embedded features for each of the
triggers. As a consequence, an additional interest feature that would have
been considered clearly and closely related to a debt host if it had been
evaluated on a stand-alone basis (e.g., an additional interest feature
triggered by a change in the issuer’s creditworthiness; see Section 8.4.2) might
have to be combined with other additional interest features that are not
considered clearly and closely related to a debt host in the evaluation of
whether the combined feature is clearly and closely related to the debt
host.
8.4.12 Other Considerations
8.4.12.1 Background
This section addresses considerations applicable to:
-
Registration payment arrangements (see the next section).
-
Payments based on climatic, geological, or other physical variables (see Section 8.4.12.3).
-
Payments based on disaster experience (see Section 8.4.12.4).
8.4.12.2 Registration Payment Arrangements
ASC 815-10
15-82 Registration payment
arrangements within the scope of Subtopic 825-20 are
not subject to the requirements of this Subtopic.
The exception in this paragraph applies to both the
issuer that accounts for the arrangement pursuant to
that Subtopic and the counterparty.
A registration payment arrangement within the scope of ASC 825-20 should not
be evaluated under ASC 815 even if it is embedded in a debt host contract.
Instead, it is accounted for as a separate unit of account under ASC 825-20
(see Section 3.3.3.2).
8.4.12.3 Payments Based on Climatic, Geological, or Other Physical Variables
ASC 815-10
15-59 Contracts that are not
exchange-traded are not subject to the requirements
of this Subtopic if the underlying on which the
settlement is based is any one of the following:
- A climatic or geological variable or other physical variable. Climatic, geological, and other physical variables include things like the number of inches of rainfall or snow in a particular area and the severity of an earthquake as measured by the Richter scale. (See Example 13 [paragraph 815-10-55-135].) . . .
15-60 If a contract has more
than one underlying and some, but not all, of them
qualify for one of the scope exceptions in the
preceding paragraph, the application of this
Subtopic to that contract depends on its predominant
characteristics. That is, the contract is subject to
the requirements of this Subtopic if all of its
underlyings, considered in combination, behave in a
manner that is highly correlated with the behavior
of any of the component variables that do not
qualify for a scope exception.
ASC 815-10-15-59(a) includes a scope exception for non-exchange-traded
contracts whose settlement is based on a climatic, geological, or other
physical variable. Examples of payment features that may qualify for this
exception include those based on measures of rainfall, snow, wind velocity,
floodwater, or the severity of an earthquake or the occurrence of a
hurricane. However, this scope exception is not available if the payment
feature is also indexed to a financial variable, such as the dollar amount
of hurricane losses (see ASC 815-10-55-137). Nevertheless, such a feature
may be exempt from ASC 815 under the scope exception in ASC 815-10-15-52
through 15-57 for insurance contracts if “it entitles the holder to be
compensated only if, as a result of an identifiable insurable event (other
than a change in price), the holder incurs a liability or there is an
adverse change in the value of a specific asset or liability for which the
holder is at risk” (e.g., a decline in revenue as a result of a hurricane
event). ASC 815-10-55-135 through 55-141 provide three examples of contracts
that illustrate how to distinguish between physical and financial
variables.
8.4.12.4 Payments Indexed to Disaster Experience
ASC 815-15
Case O: Disaster Bond
55-204 A disaster bond
pays a coupon above that of an otherwise comparable
traditional bond; however, all or a substantial
portion of the principal amount is subject to loss
if a specified disaster experience occurs.
55-205 A disaster bond can
be viewed as a fixed-rate bond combined with a
conditional exchange contract (an option contract).
The investor receives an additional coupon interest
payment in return for giving the issuer an option
indexed to industry loss experience on a specified
disaster. Because the option contract is indexed to
the specified disaster experience, it cannot be
viewed as being clearly and closely related to an
investment in a fixed-rate bond. Therefore, the
embedded derivative should be separated from the
host contract and accounted for by both parties
pursuant to the provisions of this Subtopic.
55-206 However, if the
embedded derivative entitles the holder of the
option (that is, the issuer of the disaster bond) to
be compensated only for changes in the value of
specified assets or liabilities for which the holder
is at risk (including the liability for insurance
claims payable due to the specified disaster) as a
result of an identified insurable event (see
paragraphs 815-10-15-53 through 15-54), a separate
instrument with the same terms as the embedded
derivative would not meet the definition of a
derivative instrument in Section 815-10-15. In that
circumstance, because the criterion in paragraph
815-15-25-1(c) would not be met, there is no
embedded derivative to be separated from the host
contract, and the disaster bond would not be subject
to the requirements of this Subtopic. The investor
is essentially providing a form of insurance or
reinsurance coverage to the issuer.
Sometimes, the terms of a debt instrument specify that the debtor’s
obligation to pay the amount outstanding is extinguished if a specified
disaster experience occurs. Although a payment feature that is indexed to
disaster experience is not clearly and closely related to a host debt
contract, such a feature may be exempt from ASC 815 under the scope
exception in ASC 815-10-15-52 through 15-57 for insurance contracts if “it
entitles the holder to be compensated only if, as a result of an
identifiable insurable event (other than a change in price), the holder
incurs a liability or there is an adverse change in the value of a specific
asset or liability for which the holder is at risk.”
8.5 Accounting for Embedded Derivatives
8.5.1 Background
This section discusses the guidance that a debtor applies when it has determined
that an embedded feature must be separated from its host contract and accounted
for as a derivative under ASC 815. It addresses:
-
Initial recognition, including the identification of the terms of the debt host contract and the embedded derivative (see the next section).
-
Measurement, including the allocation of debt proceeds between the host debt contract and the embedded derivative, and subsequent measurement (see Section 8.5.3).
-
Embedded derivative reassessment requirements (see Section 8.5.4).
-
The accounting that applies if an entity is unable to reliably identify and measure an embedded feature that must be accounted for as a derivative (see Section 8.5.5).
-
The fair value election for hybrid financial instruments (see Section 8.5.6).
8.5.2 Initial Recognition
8.5.2.1 General
ASC 815-10
25-1 An entity shall
recognize all of its derivative instruments in its
statement of financial position as either assets or
liabilities depending on the rights or obligations
under the contracts.
If a separated embedded derivative represents a non-option
feature (e.g., an embedded forward or swap), its terms are identified in a
manner that results in a fair value of zero for the derivative at initial
recognition (see the next section). An option-based derivative is separated
on the basis of the stated terms of the hybrid instrument, which usually
results in the attribution of an initial fair value other than zero to the
embedded derivative (see Section 8.5.2.3). If a host contract contains multiple
embedded features that require bifurcation, they are separated as one
compound embedded derivative (see Section 8.5.2.4). An entity cannot
impute terms that are not clearly present in the hybrid instrument (see
Section
8.3.2.4).
8.5.2.2 Identification of the Terms of a Non-Option Embedded Derivative
ASC 815-15
30-4 In separating a
non-option embedded derivative from the host
contract under paragraph 815-15-25-1, the terms of
that non-option embedded derivative shall be
determined in a manner that results in its fair
value generally being equal to zero at the inception
of the hybrid instrument. Because a loan and an
embedded derivative can be bundled in a structured
note that could have almost an infinite variety of
stated terms, it is inappropriate to necessarily
attribute significance to every one of the note’s
stated terms in determining the terms of the
non-option embedded derivative. If a non-option
embedded derivative has stated terms that are
off-market at inception, that amount shall be
quantified and allocated to the host contract
because it effectively represents a borrowing. (This
paragraph does not address the bifurcation of the
embedded derivative by a holder who has acquired the
hybrid instrument from a third party after the
inception of that hybrid instrument.) The non-option
embedded derivative shall contain a notional amount
and an underlying consistent with the terms of the
hybrid instrument. Artificial terms shall not be
created to introduce leverage, asymmetry, or some
other risk exposure not already present in the
hybrid instrument. Generally, the appropriate terms
for the non-option embedded derivative will be
readily apparent. Often, simply adjusting the
referenced forward price (pursuant to documented
legal terms) to be at the market for the purpose of
separately accounting for the embedded derivative
will result in that non-option embedded derivative
having a fair value of zero at inception of the
hybrid instrument.
Example 12: Separating a Non-Option Embedded
Derivative
55-160 This Example
illustrates the application of paragraph 815-15-30-4
and assumes that the illustrative non-option
embedded derivative is a plain-vanilla forward
contract with symmetrical risk exposure and that the
hybrid instrument was newly entered into by the
parties to the contract. Assume that the hybrid
instrument is not a derivative instrument in its
entirety.
55-161 Entity A plans to
advance Entity X $900 for 1 year at a 6 percent
interest rate and concurrently enter into an
equity-based derivative instrument in which it will
receive any increase or pay any decrease in the
current market price ($200) of XYZ Corporation’s
common stock. Those two transactions (that is, the
loan and the derivative instrument) can be bundled
in a structured note that could have almost an
infinite variety of terms. The following presents 5
possible contractual terms for the structured note
that would be purchased by Entity A for $900:
- Note 1: Entity A is entitled to receive at the end of 1 year $954 plus any excess (or minus any shortfall) of the current per-share market price of XYZ Corporation’s common stock over (or under) $200.
- Note 2: Entity A is entitled to receive at the end of 1 year $955 plus any excess (or minus any shortfall) of the current per-share market price of XYZ Corporation’s common stock over (or under) $201.
- Note 3: Entity A is entitled to receive at the end of 1 year $755 plus any excess (or minus any shortfall) of the current per-share market price of XYZ Corporation’s common stock over (or under) $1.
- Note 4: Entity A is entitled to receive at the end of 1 year $1,054 plus any excess (or minus any shortfall) of the current per-share market price of XYZ Corporation’s common stock over (or under) $300.
- Note 5: Entity A is entitled to receive at the end of 1 year $1,060 plus any excess (or minus any shortfall) of the current per-share market price of XYZ Corporation’s common stock over (or under) $306.
55-162 All of these five
terms of a structured note will provide the same
cash flows, given a specified market price of XYZ
Corporation’s common stock. If the market price of
XYZ Corporation’s common stock at the end of 1 year
is still $200, Entity A will receive $954 under all
5 note terms. If the market price of XYZ
Corporation’s common stock at the end of 1 year
increases to $306, Entity A will receive $1,060
under all 5 note terms.
55-163 For simplicity in
constructing this Example, it is assumed that an
equity-based cash-settled forward contract with a
strike price equal to the stock’s current market
price has a zero fair value. In many circumstances,
a zero-value forward contract can have a strike
price greater or less than the stock’s current
market price.
55-164 The differences in
the terms for these five notes are totally arbitrary
because those differences have no effect on the
ultimate cash flows under the structured note; thus,
those differences are nonsubstantive and should have
no influence on how the terms of an embedded
derivative are identified. Therefore, the separation
of the hybrid instrument into an embedded derivative
and a host debt instrument should be the same for
all five terms described above for the structured
note (because they are merely different descriptions
of the same ultimate cash flows). That bifurcation
would generally result in the structured note being
accounted for as a debt host contract with an
initial carrying amount of $900 and a fixed annual
rate of interest of 6 percent and an embedded
forward contract with a $200 forward price, which
results in an initial fair value of zero. Instead,
if the five notes were bifurcated based on all their
contractual terms, such bifurcation would be the
equivalent of simply marking an arbitrary portion of
a debt instrument to market based on nonsubstantive
arbitrary differences in those contractual terms —
an inappropriate outcome.
An embedded derivative that does not involve any optionality
(i.e., an embedded forward or swap) is separated from the debt host contract
in a manner such that its fair value is zero when the debt is first
recognized (i.e., it is assumed that the entity received or paid no amount
for the embedded feature). All of the proceeds of the hybrid debt instrument
are allocated to the debt host contract; none are allocated to the embedded
derivative upon initial recognition of the hybrid debt instrument (see
Section
8.5.3.1).
Accordingly, the debtor cannot necessarily rely on the stated terms of the
embedded feature for separation purposes. If the stated terms imply that the
embedded feature would have some fair value at inception, those terms are
redefined and calibrated so that the embedded feature instead has zero fair
value at inception. For example, a stated forward price might need to be
increased or decreased for separation purposes with an equal and offsetting
adjustment to the manner in which the terms of the host contract are
identified. The purpose of this requirement is to ensure that a debt
component in a hybrid financial instrument is not attributed to an embedded
derivative. If a non-option embedded derivative were to be separated on
terms that result in an initial fair value other than zero (i.e., on
“off-market” terms), the amount attributed to the embedded derivative
effectively represents a debt element since the off-market element is
“repaid” at maturity.
8.5.2.3 Identification of the Terms of an Option-Based Embedded Derivative
ASC 815-15
30-6 The terms of an
option-based embedded derivative shall not be
adjusted to result in the embedded derivative being
at the money at the inception of the hybrid
instrument. In separating an option-based embedded
derivative from the host contract under paragraph
815-15-25-1, the strike price of the embedded
derivative shall be based on the stated terms
documented in the hybrid instrument. As a result,
the option-based embedded derivative at inception
may have a strike price that does not equal the
market price of the asset associated with the
underlying. The guidance in this paragraph addresses
both of the following:
-
The bifurcation of the option-based embedded derivative by a holder who has acquired the hybrid instrument from a third party either at inception or after inception of that hybrid instrument
-
The bifurcation of the option-based embedded derivative by the issuer when separate accounting for that embedded derivative is required.
An embedded derivative that involves optionality is
separated on the basis of the stated terms of the hybrid instrument (e.g.,
the strike price specified in the hybrid instrument). Under ASC 815-15-30-6,
an entity is not permitted to identify terms of an option-based embedded
derivative that are different from those in the hybrid instrument. For
example, an entity cannot adjust the manner in which the option is
identified so as to achieve an intrinsic option value of zero at inception.
Economically, an embedded derivative that involves optionality is different
from a non-option embedded derivative because it is possible that the option
will never be exercised.
8.5.2.4 Multiple Embedded Derivative Features
ASC 815-15
25-7 If a hybrid instrument
contains more than one embedded derivative feature
that would individually warrant separate accounting
as a derivative instrument under paragraph
815-15-25-1, those embedded derivative features
shall be bundled together as a single, compound
embedded derivative that shall then be bifurcated
and accounted for separately from the host contract
under this Subtopic unless a fair value election is
made pursuant to paragraph 815-15-25-4.
25-8 An entity shall not
separate a compound embedded derivative into
components representing different risks (for
example, based on the risks discussed in paragraphs
815-20-25-12[f] and 815-20-25-15[i]) and then
account for those components separately.
25-9 If a
compound embedded derivative comprises multiple
embedded derivative features that all involve the
same risk exposure (for example, the risk of changes
in market interest rates, the creditworthiness of
the obligor, or foreign currency exchange rates),
but those embedded derivative features differ from
one another by including or excluding optionality or
by including a different optionality exposure, an
entity shall not separate that compound embedded
derivative into components that would be accounted
for separately.
25-10 If
some of the embedded derivative features in a hybrid
instrument are clearly and closely related to the
economic characteristics and risks of the host
contract, those embedded derivative features shall
not be included in the compound embedded derivative
that is bifurcated from the host contract and
separately accounted for.
If a hybrid contract contains more than one embedded feature
that requires bifurcation under ASC 815-15-25-1, those embedded derivatives
must be bundled together as a single compound embedded derivative. For
example, an entity cannot separate multiple embedded derivatives and
designate only some as hedging instruments. The compound embedded derivative
that is separated should not include embedded features that are evaluated
separately and do not qualify for separation (e.g., features that are
considered clearly and closely related to the debt host).
8.5.3 Measurement
8.5.3.1 Initial Measurement (Including Allocation)
ASC 815-10
30-1 All derivative
instruments shall be measured initially at fair
value.
ASC 815-15
30-2 The allocation method
that records the embedded derivative at fair value
and determines the initial carrying value assigned
to the host contract as the difference between the
basis of the hybrid instrument and the fair value of
the embedded derivative shall be used to determine
the carrying values of the host contract component
and the embedded derivative component of a hybrid
instrument if separate accounting for the embedded
derivative is required by this Subtopic. (Note that
Section 815-15-25 allows for a fair value election
for hybrid financial instruments that otherwise
would require bifurcation.)
30-3 The objective is to
estimate the fair value of the derivative features
separately from the fair value of the nonderivative
portions of the contract. Estimates of fair value
shall reflect all relevant features of each
component. For example, an embedded purchased option
that expires if the contract in which it is embedded
is prepaid would have a different value than an
option whose term is a specified period that is not
subject to truncation.
An entity is required to use a “with-and-without” method
(see Section
3.4.2.2) to allocate the cost basis between a bifurcated
derivative and the host contract. Under this method, (1) a portion of the
basis of the hybrid instrument (e.g., debt proceeds allocable to a hybrid
debt instrument) equal to the fair value of the derivative component is
allocated to the bifurcated derivative and then (2) the remaining carrying
amount of the hybrid instrument is allocated to the host contract.
Application of this method will not result in recognition of an immediate
gain or loss in earnings related to the derivative because the initial
carrying amount of the derivative will be its fair value.
Example 8-27
Initial Recognition of Embedded Derivative
Company ABC issues $100 million of 10-year, 4 percent
fixed-rate convertible debt in $1,000 denominations.
Each $1,000 bond is convertible into 20 common
shares of ABC stock. Assume that the conversion
option meets the definition of a derivative
instrument and must be bifurcated and accounted for
separately. At issuance, the fair value of the
conversion option is $100 per $1,000 bond or $10
million in aggregate. The issuer would initially
recognize the conversion option liability at $10
million and the host debt instrument at $90
million.
At the 2014 AICPA Conference on Current SEC and PCAOB Developments, staff
from the SEC’s OCA discussed situations in which entities enter into
financing arrangements in which the total net proceeds received for an
issued hybrid instrument are less than the fair value of the related
financial liabilities that must be measured at fair value (see Section 3.4.3.1). These scenarios can occur
if an entity wishes to align itself with a strategic investor or needs
financing because of financial difficulties. For example, an entity that
wants to align itself with a specific investor may issue $15 million of
convertible debt at par and be required to bifurcate an in-the-money
conversion option with a fair value of $20 million.
When a reporting entity issues a hybrid instrument and must recognize related
financial liabilities (e.g., an embedded derivative that must be bifurcated)
at fair values that exceed the total net proceeds received, the entity
should perform a detailed analysis of the financing transaction. Its
analysis should include:
-
Verifying that the financial liabilities that must be measured at fair value are appropriately valued under ASC 820.
-
Determining whether the transaction was conducted at arm’s length and whether the parties involved are related parties under ASC 850.
-
Evaluating all elements of the transaction to determine whether there are any other rights or privileges received that should be recognized as an asset under other applicable guidance.
If, after performing this analysis, the entity concludes that the amount of
financial liabilities measured at fair value still exceeds the total net
proceeds received, it should recognize the excess as a loss in earnings. In
addition, the entity should disclose the nature of the transaction in the
financial statement footnotes, including (1) the reasons why the entity
entered into the transaction and (2) the benefits received. If, however, the
entity determines that the transaction was not conducted at arm’s length or
was executed with a related party, it should consider consulting with the
SEC staff or the entity’s accounting advisers before reaching a conclusion
about the appropriate accounting treatment.
8.5.3.2 Subsequent Measurement
ASC 815-10
35-1 All derivative
instruments shall be measured subsequently at fair
value.
When a debtor is required to bifurcate an embedded derivative from a debt
instrument, it accounts for the debt host contract under the requirements
that apply to such contracts; that is, typically under the interest method
in ASC 835-30 (see Section 6.2). The
accounting for the debt host contract is based on the contractual cash flows
that remain after separation of the cash flows attributable to the embedded
derivative. For example, the application of the interest method to the debt
host contract depends on the amount of proceeds and subsequent contractual
cash flows that are attributed to the debt host contract. The embedded
derivative is accounted for at fair value, with changes in fair value
recognized in earnings (unless it is designated as a hedging instrument in a
qualifying cash flow hedge or net investment hedge under ASC 815, in which
case fair value changes are recognized in OCI).
8.5.4 Reassessment
8.5.4.1 General
ASC 815-10
25-2 If a contract that
did not meet the definition of a derivative
instrument at acquisition by the entity meets the
definition of a derivative instrument after
acquisition by the entity, the contract shall be
recognized immediately as either an asset or
liability with the offsetting entry recorded in
earnings.
25-3 If a contract ceases
to be a derivative instrument pursuant to this
Subtopic and an asset or liability had been recorded
for that contract, the carrying amount of that
contract becomes its cost basis and the entity shall
apply other generally accepted accounting principles
(GAAP) that are applicable to that contract
prospectively from the date that the contract ceased
to be a derivative instrument. If the derivative
instrument had been designated in a cash flow
hedging relationship and a gain or loss is recorded
in accumulated other comprehensive income, then the
guidance in Sections 815-30-35 and 815-30-40 shall
be applied accordingly.
30-3 A contract recognized
under paragraph 815-10-25-2 because it meets the
definition of a derivative instrument after
acquisition by an entity shall be measured initially
at its then-current fair value.
ASC 815-40
35-8 The classification of
a contract (including freestanding financial
instruments and embedded features) shall be
reassessed at each balance sheet date. If the
classification required under this Subtopic changes
as a result of events during the period (if, for
example, as a result of voluntary issuances of stock
the number of authorized but unissued shares is
insufficient to satisfy the maximum number of shares
that could be required to net share settle the
contract [see discussion in paragraph
815-40-25-20]), the contract shall be reclassified
as of the date of the event that caused the
reclassification. There is no limit on the number of
times a contract may be reclassified.
50-3 Contracts within the
scope of this Subtopic may be required to be
reclassified into (or out of) equity during the life
of the instrument (in whole or in part) pursuant to
the provisions of paragraphs 815-40-35-8 through
35-13. An issuer shall disclose contract
reclassifications (including partial
reclassifications), the reason for the
reclassification, and the effect on the issuer’s
financial statements.
A debtor should continually reassess whether an embedded
feature qualifies as a derivative and, if so, for any derivative scope
exception. For example, an entity is required to reassess whether the net
settlement characteristic in the definition of a derivative is met (see
Section
8.3.4.4.5). If an embedded feature begins or ceases to meet
the definition of a derivative or any scope exception, the analysis of
whether the feature should be separated and accounted for as a derivative
under ASC 815 is affected.
If debt is modified or exchanged and is treated as an
extinguishment, the debtor should reperform its analysis of whether any
embedded features must be separated from the debt under ASC 815-15. Even if
the modification or exchange is not treated as an extinguishment of the
original debt for accounting purposes (see Chapter 10), reperformance of the
analysis may be necessary because the contractual arrangement has been
changed. If separation of an embedded derivative is required after the
initial recognition of a debt instrument, the feature is bifurcated and
recognized at fair value at the time it begins to meet the bifurcation
criteria (see Section
8.3). A portion of the current carrying amount of the debt
instrument equal to the current fair value of the feature as of the
reclassification date is reallocated to the embedded derivative in a manner
consistent with the allocation guidance in ASC 815-15-30-2 (see Section 8.5.3.1).
Conversely, if separation of an embedded feature is no
longer required after the initial recognition of a debt instrument, the
embedded derivative is recombined with its host contract at its current fair
value at the time it ceases to meet the bifurcation criteria. However,
special guidance applies to bifurcated equity conversion features (see
Section 8.5.4.3).
8.5.4.2 Conversion Feature Ceases to Qualify for the Own Equity Scope Exception
ASC 815-40
35-9 . . . If an embedded
feature no longer qualifies for the derivatives
scope exception under this Subtopic, the feature
shall be separated from its host contract and
accounted for as a derivative instrument in
accordance with Subtopic 815-10 and Subtopic 815-15
(if all of the criteria in paragraph 815-15-25-1 are
met).
If separation of an embedded equity conversion feature is
required after the initial recognition of a convertible debt instrument, the
feature is bifurcated and recognized at fair value at the time it begins to
meet the bifurcation criteria (see Section
8.3). A portion of the current carrying amount of the debt
instrument equal to the current fair value of the embedded derivative
feature as of the reclassification date is reallocated to the embedded
derivative in a manner consistent with the allocation guidance in ASC
815-15-30-2 (see Section 8.5.3.1). The
entity also should provide the disclosures required by ASC 815-40-50-3.
8.5.4.3 Conversion Feature Ceases to Be Bifurcated as a Derivative
ASC 815-15
35-4 If an embedded
conversion option in a convertible debt instrument
no longer meets the bifurcation criteria in this
Subtopic, an issuer shall account for the previously
bifurcated conversion option by reclassifying the
carrying amount of the liability for the conversion
option (that is, its fair value on the date of
reclassification) to shareholders’ equity. Any debt
discount recognized when the conversion option was
bifurcated from the convertible debt instrument
shall continue to be amortized.
40-1 If a holder exercises
a conversion option for which the carrying amount
has previously been reclassified to shareholders’
equity pursuant to paragraph 815-15-35-4, the issuer
shall recognize any unamortized discount remaining
at the date of conversion immediately as interest
expense.
40-4 If a convertible debt
instrument with a conversion option for which the
carrying amount has previously been reclassified to
shareholders’ equity pursuant to the guidance in
paragraph 815-15-35-4 is extinguished for cash (or
other assets) before its stated maturity date, the
entity shall do both of the following:
-
The portion of the reacquisition price equal to the fair value of the conversion option at the date of the extinguishment shall be allocated to equity.
-
The remaining reacquisition price shall be allocated to the extinguishment of the debt to determine the amount of gain or loss.
50-3 An issuer shall
disclose both of the following for the period in
which an embedded conversion option previously
accounted for as a derivative instrument under this
Subtopic no longer meets the separation criteria
under this Subtopic:
-
A description of the principal changes causing the embedded conversion option to no longer require bifurcation under this Subtopic
-
The amount of the liability for the conversion option reclassified to stockholders’ equity.
ASC 815-40
35-10 . . . An embedded
derivative that qualifies for the derivatives scope
exception upon reassessment under this Subtopic that
was separated from its host contract and accounted
for as a derivative instrument in accordance with
Subtopic 815-10 shall be reclassified to equity. The
previously bifurcated embedded derivative shall not
be recombined with its host contract.
If a previously bifurcated embedded conversion option in
convertible debt ceases to meet the ASC 815-15 bifurcation criteria, any
previously recognized gains and losses should not be reversed. Instead, the
carrying amount of the embedded derivative (i.e., the feature’s fair value
as of the date of the reclassification) should be reclassified to
shareholders’ equity (see Section 6.4 of Deloitte’s Roadmap Contracts on an Entity’s Own
Equity). The entity also should provide the disclosures
required by ASC 815-15-50-3 and ASC 815-40-50-3.
Example 8-28
Convertible Debt With a Conversion Option That No
Longer Requires Bifurcation
On January 1, 20X5, Company ABC
issues a 10-year note that has a $1,000 par value,
accrues interest at an annual rate of 4 percent, and
is convertible into 100 shares of ABC common stock.
The fair value of one share of ABC’s common stock is
$8.50 on the issue date. Upon conversion, ABC must
settle the accreted value of the note in cash and
has the option to settle the conversion spread in
either cash or common stock (commonly referred to as
Instrument C). After considering its potential share
requirements for other existing commitments, ABC
concludes that it cannot assert that it has a
sufficient number of authorized but unissued common
shares available to share settle the conversion
option; accordingly, the conversion option does not
qualify for equity classification under ASC 815-40.
After applying ASC 815-40 and ASC 815-15-25-1, ABC
concludes that the conversion option must be
bifurcated and accounted for as a separate
derivative.
At inception, on January 1, 20X5, ABC records the
entry below to bifurcate the embedded derivative.
Assume that the fair value of the conversion option
on that date is $50.
As of each quarterly reporting date, ABC determines
that continued bifurcation of the conversion option
is required. For each quarterly reporting period,
the derivative (which is not designated as a hedging
instrument) is marked to fair value, with the
changes in fair value recognized in earnings.
Company ABC also recognizes its contractual interest
expense on the note, and the debt discount created
by the bifurcation of the embedded conversion option
is amortized to interest expense. The following
journal entries reflect the cumulative activity
booked during the year ended December 31, 20X5 (each
journal entry represents the sum of the quarterly
journal entries):
As of December 31, 20X5, the carrying amounts of the
debt host contract and the conversion liability are
$955 and $200, respectively.
On January 1, 20X6, ABC obtains shareholder approval
to increase the number of its authorized common
shares to a level sufficient for it to assert that
it has the ability to share settle the conversion
option. On the basis of this approval, ABC concludes
that the conversion option now qualifies for equity
classification under ASC 815-40 and that the
bifurcated derivative liability no longer needs to
be accounted for as a separate derivative under ASC
815-15-25-1.
Company ABC believes that no modification of terms
occurred. Rather, an event extraneous to the note
(obtaining shareholder approval to increase
authorized common shares) has caused the embedded
conversion option to no longer meet the conditions
for bifurcation.
Company ABC records the following entry on January 1,
20X6 (assume no changes in fair values from December
31, 20X5, to January 1, 20X6).
Note that the debt discount will
continue to be amortized over the remaining term of
the debt since this discount reflects the issuer’s
economic borrowing costs related to the convertible
debt instrument. Company ABC also would be required
to provide the disclosures described in ASC
815-15-50-3 and ASC 815-40-50-3.
8.5.5 Inability to Reliably Identify and Measure Embedded Derivative
8.5.5.1 Recognition and Measurement
ASC 815-15
30-1 An entity shall
measure both of the following initially at fair
value: . . .
b. An entire hybrid instrument if an entity
cannot reliably identify and measure the embedded
derivative that paragraph 815-15-25-1 requires be
separated from the host contract.
35-2 If an entity cannot
reliably identify and measure the embedded
derivative that paragraph 815-15-25-1 requires be
separated from the host contract, the entire
contract shall be measured subsequently at fair
value with gain or loss recognized in earnings.
Paragraph 815-20-25-71(a)(4) states that the entire
contract shall not be designated as a hedging
instrument pursuant to Subtopic 815-20.
In the unusual situation in which an entity cannot reliably
identify and measure an embedded feature that is required to be separated as
a derivative, the entity must record the entire hybrid instrument at fair
value and recognize changes in fair value through earnings. In practice,
this provision is rarely applied. Under no circumstance can such an
instrument be designated as a hedging instrument under ASC 815-20.
8.5.5.2 Presentation
ASC 815-15
45-1 In each statement of
financial position presented, an entity shall report
hybrid financial instruments measured at fair value
under the election and under the practicability
exception in paragraph 815-15-30-1 in a manner that
separates those reported fair values from the
carrying amounts of assets and liabilities
subsequently measured using another measurement
attribute on the face of the statement of financial
position. To accomplish that separate reporting, an
entity may do either of the following:
-
Display separate line items for the fair value and non-fair-value carrying amounts
-
Present the aggregate of the fair value and non-fair-value amounts and parenthetically disclose the amount of fair value included in the aggregate amount.
If a debtor accounts for debt at fair value because it either cannot reliably
identify and measure an embedded derivative (see Section 8.5.5.1) or has applied the fair value option under
ASC 815-15 or ASC 825-10 to the debt (see Sections 4.4 and 8.5.6, respectively),
it must report the related fair value amounts separately on the face of the
balance sheet under ASC 815-15-45-1.
8.5.5.3 Disclosure
ASC 815-15
50-1 For those hybrid
financial instruments measured at fair value under
the election and under the practicability exception
in paragraph 815-15-30-1, an entity shall also
disclose the information specified in paragraphs
825-10-50-28 through 50-32.
50-2 An entity shall
provide information that will allow users to
understand the effect of changes in the fair value
of hybrid financial instruments measured at fair
value under the election and under the
practicability exception in paragraph 815-15-30-1 on
earnings (or other performance indicators for
entities that do not report earnings).
If a debtor accounts for debt at fair value because it cannot reliably
identify and measure an embedded derivative (see Section 8.5.5.1), it must provide the disclosures that are
required for financial liabilities for which the fair value option in ASC
825-10 has been elected (see Section 14.4.11).
8.5.6 Fair Value Election for Hybrid Financial Instruments
8.5.6.1 Eligibility
ASC 815-15
25-4 An
entity that initially recognizes a hybrid financial
instrument that under paragraph 815-15-25-1 would be
required to be separated into a host contract and a
derivative instrument may irrevocably elect to
initially and subsequently measure that hybrid
financial instrument in its entirety at fair value
(with changes in fair value recognized in earnings
and, if paragraph 825-10-45-5 is applicable, other
comprehensive income). A financial instrument shall
be evaluated to determine that it has an embedded
derivative requiring bifurcation before the
instrument can become a candidate for the fair value
election.
25-5 The fair value election
shall be supported by concurrent documentation or a
preexisting documented policy for automatic
election. That recognized hybrid financial
instrument could be an asset or a liability and it
could be acquired or issued by the entity. The fair
value election is also available when a previously
recognized financial instrument is subject to a
remeasurement event (new basis event) and the
separate recognition of an embedded derivative. The
fair value election may be made instrument by
instrument. For purposes of this paragraph, a
remeasurement event (new basis event) is an event
identified in generally accepted accounting
principles, other than the recording of a credit
loss under Topic 326, or measurement of an
impairment loss through earnings under Topic 321 on
equity investments, that requires a financial
instrument to be remeasured to its fair value at the
time of the event but does not require that
instrument to be reported at fair value on a
continuous basis with the change in fair value
recognized in earnings. Examples of remeasurement
events are business combinations and significant
modifications of debt as defined in Subtopic
470-50.
25-6 The fair
value election shall not be applied to the hybrid
instruments described in paragraph 825-10-50-8.
Under ASC 815-15-25-1, an entity may be required to bifurcate and separately
account for an embedded derivative contained within a hybrid instrument. In
lieu of such separation, ASC 815-15-25-4 allows an entity to account for the
entire hybrid instrument at fair value, provided that the instrument is a
financial asset or financial liability, with changes recognized in earnings
and, if applicable, OCI.
The fair value election in ASC 815-15 can be made on an
instrument-by-instrument basis, or an entity can elect this option for all
qualifying hybrid financial instruments on some other basis, such as an
entity-wide policy decision or a type-of-instrument basis. In all scenarios,
the fair value election under ASC 815-15 must be supported with appropriate
concurrent documentation that eliminates any question regarding whether the
entity elected to apply fair value measurement to a particular
instrument.
For the following reasons, the fair value election in ASC 815-15 applies to a
narrower population (scope) of items than the fair value option in ASC 825-10:
-
The fair value election in ASC 815-15 applies only to hybrid financial instruments for which bifurcation of an embedded derivative would otherwise be required. An entity that elects the fair value option in ASC 825-10 is not required to determine that an embedded derivative would need to be accounted for separately under ASC 815-15.
-
ASC 815-15-25-6 prohibits the fair value election for any hybrid instrument that is discussed in ASC 825-10-50-8, which describes 15 items for which public business entities are not required to provide fair value disclosures. The scope of ASC 825-10-50-8 is more restrictive than the scope of the fair value option in ASC 825-10-15-4 and 15-5 (see Section 4.4.2).
Like ASC 825, ASC 815-15 allows the fair value election for an eligible item
only upon (1) initial recognition or (2) the occurrence of a subsequent
remeasurement event (i.e., a subsequent remeasurement of the entire
instrument at fair value under other U.S. GAAP). Therefore, under both ASC
815-15 and ASC 825, an entity is prohibited from making the fair value
election upon determining that an embedded derivative that was previously
not bifurcated under ASC 815-15 subsequently must be bifurcated (e.g., a
hybrid financial instrument containing an embedded derivative that meets the
net settlement condition in ASC 815-10-15-83(c) after initial
recognition).
There are no situations in which an entity could make the fair value election
for a hybrid instrument under ASC 815-15 but would be prohibited from
electing the fair value option for the same instrument under ASC 825-10. In
addition, regardless of whether the entity applies the fair value accounting
guidance in ASC 815-15 or ASC 825, the hybrid financial instrument cannot be
designated as a hedging instrument under ASC 815-20. Furthermore, the
documentation and disclosure requirements related to the fair value election
in ASC 815-15 are the same as those related to the fair value option in ASC
825-10.
Since the fair value election under ASC 815-15 applies to a
narrower population of items than does the fair value option under ASC 825,
entities can effectively disregard the fair value election guidance in ASC
815-15-25-4. While ASC 815-15 requires an entity to first determine that a
hybrid financial instrument contains an embedded derivative for which
bifurcation would otherwise be required under ASC 815-15, the entity can
bypass this assessment because — regardless of whether such bifurcation is
required — the hybrid financial instruments that are eligible for the fair
value election in ASC 815-15 are also eligible for the fair value option in
ASC 825-10 (and the fair value option in ASC 825 can be elected regardless
of whether an entity has identified an embedded derivative for which
bifurcation would otherwise be required). Furthermore, the disclosure
requirements applicable to a hybrid financial instrument for which the fair
value election is made under ASC 815-15 are consistent with those in ASC
825-10 (see Section
14.4.11). Irrespective of whether it elects fair value
accounting under ASC 815-15 or ASC 825-10, an entity is subject to the
applicable incremental disclosure requirements for (1) derivatives in ASC
815 and (2) items for which the fair value option has been elected in ASC
825-10. We believe that the guidance on fair value elections in ASC 815-15
was retained in U.S. GAAP because that guidance was available (and may have
been used) before the fair value option in ASC 825-10 became effective.
Thus, entities may still have hybrid financial instruments that are being
recognized at fair value in their entirety in accordance with ASC 815-15
because those instruments were issued before the effective date of the fair
value option guidance in ASC 825-10.
8.5.6.2 Measurement
ASC 815-15
30-1 An entity shall
measure both of the following initially at fair
value:
-
A hybrid financial instrument that under paragraph 815-15-25-1 would be required to be separated into a host contract and a derivative instrument that an entity irrevocably elects to initially and subsequently measure in its entirety at fair value (with changes in fair value recognized in earnings) . . .
35-1 If an entity
irrevocably elected to initially and subsequently
measure a hybrid financial instrument in its
entirety at fair value, changes in fair value for
that hybrid financial instrument shall be recognized
in earnings. Paragraph 815-20-25-71(a)(3) states
that the entire contract shall not be designated as
a hedging instrument pursuant to Subtopic
815-20.
If an entity elects the fair value option in ASC 815-15 for a hybrid
financial instrument, no embedded feature should be separated as a
derivative (see Section 8.3.3). The
accounting for the hybrid financial instrument is the same as if the fair
value option in ASC 825-10 had been applied (see Section 6.3).
8.5.6.3 Presentation
ASC 815-15
45-1 In each statement of
financial position presented, an entity shall report
hybrid financial instruments measured at fair value
under the election and under the practicability
exception in paragraph 815-15-30-1 in a manner that
separates those reported fair values from the
carrying amounts of assets and liabilities
subsequently measured using another measurement
attribute on the face of the statement of financial
position. To accomplish that separate reporting, an
entity may do either of the following:
-
Display separate line items for the fair value and non-fair-value carrying amounts
-
Present the aggregate of the fair value and non-fair-value amounts and parenthetically disclose the amount of fair value included in the aggregate amount.
45-2 If an entity has
designated a financial liability under the fair
value election in accordance with paragraphs
815-15-25-4 through 25-6, the entity shall apply the
guidance in paragraph 825-10-45-5 on the
presentation of changes in the liability’s fair
value that result from changes in
instrument-specific credit risk.
If a debtor accounts for debt at fair value because it either (1) has applied
the fair value option in ASC 815-15 or ASC 825-10 to the debt or (2) cannot
reliably identify and measure an embedded derivative that must be separated
(see Section 8.5.5), it must report
the related fair value amounts separately on the face of the balance sheet
under ASC 815-15-25-45-1. The requirements in ASC 825-10 related to the
presentation of changes in a liability’s fair value that result from changes
in instrument-specific credit risk (see Section
6.3.2) apply also to financial liabilities for which the fair
value option in ASC 815-15 has been applied.
8.5.6.4 Disclosure
ASC 815-15
50-1 For those hybrid
financial instruments measured at fair value under
the election and under the practicability exception
in paragraph 815-15-30-1, an entity shall also
disclose the information specified in paragraphs
825-10-50-28 through 50-32.
50-2 An entity shall
provide information that will allow users to
understand the effect of changes in the fair value
of hybrid financial instruments measured at fair
value under the election and under the
practicability exception in paragraph 815-15-30-1 on
earnings (or other performance indicators for
entities that do not report earnings).
If a debtor elects the fair value option in ASC 815-15, it must provide the
disclosures that are required for financial liabilities for which the fair
value option in ASC 825-10 has been elected (see Section
14.4.11).
Chapter 9 — Debt Extinguishments
Chapter 9 — Debt Extinguishments
9.1 Background
A debtor accounts for debt as extinguished when the debt has been
repaid or the debtor is legally released from its repayment obligation (see
Section 9.2). The
debtor generally recognizes a gain or loss for the difference between the
reacquisition price and the net carrying amount of the debt upon an extinguishment
(see Section 9.3.1).
However, not all extinguishments are accounted for in the same manner (see Sections 9.3.2 through
9.3.8). In certain circumstances, financial liabilities for prepaid
stored-value products are derecognized even though they have not been legally
extinguished (see Section
9.4). Further, some debt modifications are accounted for as debt
extinguishments even though the debt is still outstanding (see Section 10.4.2).
9.2 Extinguishment Conditions
9.2.1 Background
ASC 405-20-40-1 identifies the two circumstances in which a liability should be
considered extinguished:
-
“The debtor pays the creditor and is relieved of its obligation” (see Section 9.2.3). For instance, a debtor may settle all or a portion of a liability by delivering cash, other financial assets, its own equity shares, goods, or services to the creditor.
-
“The debtor is legally released [as] the primary obligor . . . either judicially or by the creditor” (see Section 9.2.4). For instance, debt may be extinguished through a court order, the creditor forgiving the debt, or the assumption of the debt obligation by a third party.
9.2.2 Scope
ASC 405-20
05-1 This Subtopic addresses
extinguishments of liabilities. This Subtopic does not
address debt conversions or troubled debt
restructurings. The accounting guidance for those areas
is addressed in Subtopics 470-20 and 470-60.
05-2 An entity may settle a
liability by transferring assets to the creditor or
otherwise obtaining an unconditional release.
Alternatively, an entity may enter into other
arrangements designed to set aside assets dedicated to
eventually settling a liability. Accounting for those
arrangements has raised issues about when a liability
should be considered extinguished. This Subtopic
establishes standards for resolving those issues.
15-2 The guidance in this
Subtopic applies to extinguishments of all liabilities,
including both financial and nonfinancial liabilities,
unless derecognition of a financial or nonfinancial
liability is addressed in another Topic (for example,
the derecognition guidance for gaming chips in Subtopic
924-405 on casinos or the breakage guidance in Topic 606
on revenue from contracts with customers). Derivative
instruments that are nonfinancial liabilities (for
example, a written commodity option) are included in the
scope of this Subtopic.
ASC 470-50
05-1 This Subtopic discusses
the accounting for all extinguishments of debt
instruments, except debt that is extinguished through a
troubled debt restructuring (see Subtopic 470-60) or a
conversion of debt to equity securities of the debtor
pursuant to conversion privileges provided in terms of
the debt at issuance (see Subtopic 470-20).
15-3 The guidance in this
Subtopic does not apply to the following transactions
and activities:
-
Conversions of debt into equity securities of the debtor pursuant to conversion privileges provided in the terms of the debt at issuance. Additionally, the guidance in this Subtopic does not apply to conversions of convertible debt instruments pursuant to terms that reflect changes made by the debtor to the conversion privileges provided in the debt at issuance (including changes that involve the payment of consideration) for the purpose of inducing conversion. Guidance on conversions of debt instruments (including induced conversions) is contained in paragraphs 470-20-40-13 and 470-20-40-15.
-
Extinguishments of debt through a troubled debt restructuring. (See Section 470-60-15 for guidance on determining whether a modification or exchange of debt instruments is a troubled debt restructuring. If it is determined that the modification or exchange does not result in a troubled debt restructuring, the guidance in this Subtopic shall be applied.)
-
Transactions entered into between a debtor or a debtor’s agent and a third party that is not the creditor.
15-4 The general guidance
for the extinguishment of liabilities is contained in
Subtopic 405-20 and defines transactions that the debtor
shall recognize as an extinguishment of a liability.
ASC 405-20 applies to financial liabilities, such as debt, and
nonfinancial liabilities, except for liabilities that are subject to specific
derecognition requirements. For example, liabilities resulting from prepaid
stored-value products are subject to different derecognition guidance (see
Section 9.4).
As discussed in Chapter 10, ASC 470-50 contains guidance
on the accounting for modifications and exchanges of debt instruments in which
the identity of the creditor has not changed. Under that guidance, a debt
modification is accounted for as an extinguishment if the modified terms are
substantially different from the original terms even if the original debt has
not been legally extinguished (see Section 10.4.2). Extinguishment accounting
is not applied to an exchange of debt instruments whose terms are not
substantially different regardless of whether the original debt has been legally
extinguished (see Section
10.4.1). Debt may or may not be considered extinguished when
there is a change in the creditor (see Section 10.2.8).
Although ASC 405-20 does not apply to debt conversions, extinguishment accounting
does apply to certain exchanges of debt into the issuer’s equity shares.
Examples include:
-
The settlement of debt through the issuance of equity shares if the issuer is using its own shares as a means of currency to settle the debt’s value (e.g., the number of shares delivered is determined to have a value equal to the monetary amount of the debt obligation; see Section 9.3.3).
-
A conversion that occurs upon the issuer’s exercise of a call option if the instrument did not contain a substantive conversion feature as of its issuance date (see Section 12.3.3).
-
A conversion that occurs in accordance with changed conversion privileges that do not meet the criteria for induced conversion accounting (see Section 12.3.4).
-
A conversion that occurs in accordance with the original terms of a conversion feature that represents a share-settled redemption or indexation feature (e.g., the number of shares delivered is determined to have a fair value equal to the redemption amount; see Section 8.4.7.2.5).
Further, it may be appropriate to apply extinguishment
accounting to conversions of convertible debt for which the conversion feature
was separated as a derivative instrument under ASC 815-15 (see Section 12.4).
The accounting for TDRs is addressed in ASC 470-60 (see
Chapter 11).
9.2.3 Condition 1 — Settlement
9.2.3.1 General Considerations
ASC 405-20
40-1 Unless addressed by
other guidance (for example, paragraphs 405-20-40-3
through 40-4 or paragraphs 606-10-55-46 through
55-49), a debtor shall derecognize a liability if
and only if it has been extinguished. A liability
has been extinguished if either of the following
conditions is met:
-
The debtor pays the creditor and is relieved of its obligation for the liability. Paying the creditor includes the following:
-
Delivery of cash
-
Delivery of other financial assets
-
Delivery of goods or services
-
Reacquisition by the debtor of its outstanding debt securities whether the securities are cancelled or held as so-called treasury bonds. . . .
-
As noted in Section
9.2.1, one scenario in which debt is extinguished under ASC
405-20 is when the debtor is relieved of its obligation through a debt
repayment. Examples include:
-
The debtor repays the principal amount and any accrued interest at the debt’s contractual maturity date.
-
The debtor settles the debt after exercising a call or prepayment feature embedded in the debt.
-
The debtor settles the debt after the investor exercises a put feature embedded in the debt.
-
The debtor settles the debt after a contingent redemption or acceleration feature is triggered.
-
The debtor repurchases outstanding debt securities in a public market for the debt.
-
The entity’s stockholders or other related parties repay the debt (see Section 9.3.7).
Although not specifically stated in ASC 405-20-40-1, debt
might be extinguished by the delivery of the debtor’s equity shares (see the
next section). When debt is settled by the delivery of noncash financial
assets, the debtor should consider whether the conditions for sale
accounting in ASC 860 are met for the transferred financial assets (see
Section
9.2.3.3). Debt that has been settled should be accounted for
as extinguished even if the debtor expects or intends to reissue the debt
(see Section
9.2.3.4). However, an intention or commitment to settle debt
does not represent a debt extinguishment (see Sections 9.2.3.5 and 9.2.3.6). Special considerations are
necessary if a debtor acquires a participating interest in its own debt (see
Section
9.2.3.7). The settlement of debt after the balance sheet date
represents a nonrecognized subsequent event (see Section 9.2.3.8).
9.2.3.2 Settlement in Equity Shares
Under certain GAAP (such as ASC 470-50-40-3), debt can be
extinguished by the issuance of common or preferred stock (see Section 9.3.3). For example, an entity might
settle debt by issuing equity shares to the creditor that have a value that
is equal to the amount due. As discussed in Chapter 12, however, the accounting guidance on debt
extinguishments does not apply to certain conversions of debt into the
issuer’s equity shares.
9.2.3.3 Settlement Involving Transfer of Noncash Financial Assets
ASC 405-20
55-5 A cash payment or
conveyance of noncash financial assets from a debtor
to a creditor results in full or partial settlement
of the creditor’s receivable from the debtor.
Whether or not that settlement is an extinguishment
is governed by paragraph 405-20-40-1. However, if a
noncash financial asset was conveyed to the creditor
in full or partial settlement of a creditor’s
receivable, it would be rare to conclude that debt
has been extinguished if the criteria of paragraph
860-10-40-5 were not also met.
The extinguishment conditions in ASC 405-20-40-1 apply irrespective of
whether the consideration transferred to repay the debt is in the form of
cash or noncash assets. For example, a debtor’s transfer of noncash
financial assets (e.g., debt or equity securities) to settle all or a
portion of the debt should be evaluated under those conditions.
If, however, a debtor conveys noncash financial assets to a
creditor to settle debt and the transferred financial assets do not meet the
conditions for sale accounting in ASC 860-10-40-5 (see Deloitte’s Roadmap
Transfers and
Servicing of Financial Assets), the debtor would be
unable to derecognize those transferred assets. As a result, the debtor
would either not meet the extinguishment conditions in ASC 405-20-40-1 or
would have to recognize another similar liability in accordance with the
secured borrowing accounting guidance in ASC 860-30 (see also Section 9.2.4.2).
9.2.3.4 Debt Held for Resale
Under ASC 405-20-40-1(a)(4), debt is considered extinguished
if the debtor or its agent buys it back such that the debtor no longer has
an obligation to another party. Repurchased debt (or so-called “treasury
bonds”) does not qualify as an asset even if it (1) has not been formally
retired, (2) is held in treasury and the entity expects to resell it on a
future date, (3) is part of a debt issuance that is trading in a public
market, or (4) will be held for only a short period.
9.2.3.5 Intention, Commitment, or Offer to Extinguish Debt
ASC 470-50
55-9 The following
situations do not result in an extinguishment and
would not result in gain or loss recognition under
either paragraph 405-20-40-1 or this Subtopic:
-
An announcement of intent by the debtor to call a debt instrument at the first call date . . . .
A debtor’s expectation, intention, offer, or firm commitment
to settle debt on a future date does not satisfy either extinguishment
condition in ASC 405-20-40-1. (However, if the creditor commits to settle
debt on terms different from those in the original terms of the debt, the
issuer should consider whether the commitment represents a modification to
the debt terms that should be accounted for as an extinguishment under ASC
470-50 [see Section 10.2.3].) A debtor should not write
off any remaining unamortized premium, discount, or debt issuance costs
before debt is considered extinguished for accounting purposes.
Although an extinguishment gain or loss should not be
recognized before the extinguishment of debt, the debtor should disclose the
terms of the redemption transaction and the anticipated gain or loss in the
notes to any interim or annual financial statements issued for periods
before the extinguishment. Further, an irrevocable notice to repay the debt
before its maturity date may affect the debt’s classification as current or
noncurrent under ASC 470-10 (see Chapter
13).
9.2.3.6 Exercise of Contractual Redemption Feature
An intention or commitment to exercise a contractual redemption feature does
not represent a debt extinguishment under ASC 405-20. For instance, a debt
agreement may contain a redemption provision that permits the issuer to
redeem the debt on specified terms (e.g., at a price equal to 110 percent of
par value plus accrued and unpaid interest) before the debt’s contractual
maturity date. Often, such a provision requires the debtor to give notice of
legally binding and irrevocable redemption sometime before the actual
redemption date. However, the redemption notice would not represent an
extinguishment of the debt because it does not legally relieve the debtor of
its obligation to pay the debt.
Example 9-1
Irrevocable
Notice of Debt Redemption
Entity A has issued, and has
outstanding, $500 million of senior secured notes
with a stated maturity of December 31, 2020. The
original terms permit A to redeem the notes at a
price equal to 113 percent of par value plus accrued
and unpaid interest. During the second quarter of
2012, A decides to redeem the notes in accordance
with the redemption provisions in the original terms
of the debt. On June 30, 2012, A exercises its right
under the original terms of the notes to redeem the
notes on July 30, 2012. Entity A provides an
irrevocable notice of the early redemption to the
debt holders on June 30, 2012. Entity A’s early
redemption is expected to generate an extinguishment
loss of approximately $65 million. The redemption
notice is legally binding and irrevocable. Since A
exercised its right to redeem the notes early, it
reclassified the carrying amount of the notes from
long-term to short-term liabilities.
Entity A’s fiscal year-end is
December 31, 2012, and its second quarter financial
reporting period ended on June 30, 2012, the date of
the irrevocable notice to redeem the notes.
Entity A should record an
extinguishment gain or loss when the debt has been
extinguished for accounting purposes (i.e., in July
2012). The notes are considered extinguished on the
date A pays the debt holders and is legally relieved
of its obligation. Although the extinguishment loss
should not be recognized in the interim financial
statements for the second quarter ended June 30,
2012, A should disclose the terms of the redemption
transaction and the expected or actual loss, as
applicable, in the notes to those interim financial
statements.
The exercise of an early redemption provision is not
considered a modification or exchange of a debt instrument that should be
evaluated under ASC 470-50-40 since such redemption occurs under the debt
instrument’s original contractual terms (see Section
10.2.7).
9.2.3.7 Debtor Purchases a Participating Interest in Its Own Debt
Sometimes, a debtor acquires a participating interest in its own outstanding
debt. In such circumstances, the debtor should evaluate whether it should
derecognize an equivalent portion of the debt.
Example 9-2
Participating
Interest in an Entity’s Own Debt
On January 1, 20X1, Entity B enters
into a note payable with Bank C that contains the
following terms:
-
The principal amount of $500 million is repayable in full on December 31, 20X6.
-
Interest is payable quarterly at a per annum rate of LIBOR plus 100 basis points.
-
Entity B has the option to prepay the note at any time, in full or in part, without penalty.
-
The note is collateralized by a retail office property owned by B.
On June 15, 20X2, the net carrying
amount of the note payable on B’s balance sheet is
$500 million. Entity B has excess cash of $100
million that is available for investment. If B uses
this cash to partially prepay the note, there are no
prepayment penalties payable to C; however, there is
a local transfer tax that becomes payable. Entity B
can avoid this transfer tax by purchasing a
participating interest in the note from C.
Therefore, in lieu of partially prepaying its note
payable, B pays C $100 million in return for a
participating interest in the note. For simplicity,
assume that there are no fees or costs incurred by B
to acquire the participating interest.
Entity B has concluded that the
conditions in ASC 210-20-45-1 for offsetting the
participating interest with the note payable on the
balance sheet are not met.
Bank C has concluded that the
transfer of the participating interest qualifies for
derecognition under ASC 860-10-40-5 and 40-6A. As a
result, C recognizes the receipt of the $100 million
as a partial sale of its $500 million note
receivable from B.
Entity B cannot recognize the $100
million payment to C for a participating interest in
its own debt as an asset. Entity B’s purchase of a
participating interest in its note payable to C is
addressed by ASC 405-20-40-1(a)(4). That is, the
participating interest transaction represents the
reacquisition by B of a portion of its outstanding
debt. Therefore, B must treat the payment of $100
million as a partial extinguishment of its liability
for the note payable. This results in B’s reporting
a $400 million obligation on its balance sheet.
Since B paid $100 million to “extinguish” $100
million of its previously recognized liability, and
the carrying amount of that liability is equal to
its principal amount (i.e., there are no unamortized
premiums, discounts, or issuance costs), there is no
gain or loss to be recognized. For income statement
reporting purposes in periods after the purchase of
the participating interest, B should reflect the
interest “earned” on the participating interest as a
reduction of the interest “paid” on the note
payable. Accordingly, B will recognize interest
expense on the net $400 million obligation.
The accounting by B will be
symmetrical to the accounting by C. That is, after
the participating interest transaction, B reflects a
$400 million note payable and C reflects a $400
million note receivable. This symmetry in accounting
is consistent with the symmetrical accounting for
the transferor and transferee under ASC 860.
The above example discusses a transaction that involves a
participating interest in an issuer’s own debt and is not intended to
address a similar transaction that does not meet the definition of a
participating interest in ASC 860-10-40-6A (see Deloitte’s Roadmap Transfers and Servicing of
Financial Assets). For instance, an entity could
purchase an interest in its own debt that pays an interest rate that is
lower than the interest rate on the debt itself. Such a scenario may occur
for various reasons (e.g., the rate differential might reflect a financing
of the fees imposed by the creditor to enter into the transaction or a
financing of the premium that would otherwise be payable because of a
decline in market rates of interest since the origination date of the note).
9.2.3.8 Subsequent Events
An extinguishment of debt after the balance sheet date but
before the financial statements are issued (or available to be issued; see
Section 13.3.4.9) is a nonrecognized subsequent
event under ASC 855. Accordingly, the debt is treated as outstanding in the
financial statements. The debtor should consider whether disclosure of the
subsequent event is required under ASC 855-10.
9.2.4 Condition 2 — Legal Release
9.2.4.1 General Considerations
ASC 405-20
40-1 Unless addressed by
other guidance (for example, paragraphs 405-20-40-3
through 40-4 or paragraphs 606-10-55-46 through
55-49), a debtor shall derecognize a liability if
and only if it has been extinguished. A liability
has been extinguished if either of the following
conditions is met: . . .
b. The debtor is legally released from being
the primary obligor under the liability, either
judicially or by the creditor. For purposes of
applying this Subtopic, a sale and related
assumption effectively accomplish a legal release
if nonrecourse debt (such as certain mortgage
loans) is assumed by a third party in conjunction
with the sale of an asset that serves as sole
collateral for that debt.
As noted in Section
9.2.1, the second scenario in which debt is considered
extinguished under ASC 405-20-40-1 occurs when the debtor is legally
released as the primary obligor on the debt. Circumstances that may qualify
as debt extinguishments under this guidance include those in which:
-
The debtor is judicially released, such as the cancellation of debt in a bankruptcy.
-
The debtor is legally released by the creditor, such as legal defeasances involving the establishment of a trust that will repay the debt (see Section 9.2.4.2). Since creditors rarely forgive debt without a reason, the debtor should consider whether a debt forgiveness was due to the debtor’s financial difficulties (see Chapter 11) or whether other rights or privileges were exchanged that should be given accounting recognition.
-
A third party assumes the debtor’s nonrecourse debt when the debtor sells an asset that serves as sole collateral for that debt (e.g., certain mortgage loans).
-
The debtor becomes secondarily liable as a guarantor (see Section 9.2.4.4).
The determination of whether a debtor has been legally
released as the primary obligor under ASC 405-20-40-1(b) is a legal
determination that may need to be made on the basis of a legal opinion (see
Section 9.2.4.2).
The following do not qualify as debt extinguishments because the debtor has
not been legally relieved of its obligation:
-
In-substance defeasances of debt involving the establishment of a trust that will repay the debt if the debtor is not legally released of its obligation (see Section 9.2.4.3).
-
The issuer’s intention, expectation, or offer to repay the debt (see Section 9.2.3.5).
-
The issuer’s irrevocable notice to the holder that it will repay debt in accordance with its contractual terms (see Section 9.2.3.6).
-
The debtor’s extinguishment of the debt after the balance sheet date but before the financial statements are issued (see Section 9.2.3.8).
9.2.4.2 Legal Defeasance
ASC 405-20
55-9
In a legal defeasance, generally the creditor
legally releases the debtor from being the primary
obligor under the liability. Liabilities are
extinguished by legal defeasances if the condition
in paragraph 405-20-40-1(b) is satisfied. Whether
the debtor has in fact been released and the
condition in that paragraph has been met is a matter
of law. Conversely, in an in-substance defeasance,
the debtor is not released from the debt by putting
assets in the trust. For the reasons identified in
paragraph 405-20-55-4, an in-substance defeasance is
different from a legal defeasance and the liability
is not extinguished.
Sometimes, a creditor agrees to release a debtor from being the primary
obligor under a debt arrangement even though the debtor has not repaid the
creditor. For example, the creditor might agree to release the debtor from
its obligation if the debtor (1) sets up an irrevocable trust for the
benefit of the creditor (a “defeasance trust”) and (2) the debtor transfers
a sufficient amount of cash or other high-quality assets to the trust so
that the trust will be able to repay the principal and interest payments on
the debt. Further, sometimes debt indentures permit the debtor to legally
defease the debt by transferring to a trust either (1) enough cash to
purchase Treasury securities that will mature on or before each remaining
payment date (interest and principal) in an amount necessary to service
those remaining payments or (2) such securities directly. The trust
irrevocably pledges the cash flows from the securities to retire the debt.
In these scenarios, debt extinguishment accounting applies
if (1) the debtor is not required to consolidate the trust and (2) the
arrangement legally releases the debtor from being the primary obligor under
the debt. However, if the debtor’s transfer of assets to the trust does not
qualify for derecognition under ASC 860-10 (see Deloitte’s Roadmap Transfers and Servicing of
Financial Assets), the debtor would be required to
recognize another similar liability to the defeasance trust under the ASC
860-30 accounting requirements for transfers of financial assets that do not
qualify for sale accounting. If the debtor is required to consolidate the
trust, the debt would continue to be reported in the debtor’s consolidated
financial statements (see Deloitte’s Roadmap Consolidation — Identifying a Controlling
Financial Interest).
ASC 405-20-40-1(b) specifies that in a transfer of noncash financial assets,
the debtor would derecognize the liability if the debtor “is legally
released from being the primary obligor under the liability.” Accordingly,
the debtor would need to obtain a legal opinion indicating that it, as well
as any of its consolidated affiliates, has been released as the primary
obligor. The debtor would need to obtain such an opinion even if (1) the
debt indenture contains provisions that legally release the obligor if the
defeasance trust is properly structured or (2) the debt indenture does not
require a legal opinion to be obtained.
If a debtor transfers cash to a defeasance trust, the cash is typically
derecognized because transfers of cash are not subject to the sale
accounting requirements in ASC 860-10-40-5.
Connecting the Dots
Entities often finance acquisitions, fixed-asset additions, and
renovations with long-term debt issued through municipal or
industrial revenue bonds. Typically, a qualified governmental agency
(the issuer) issues the bond and lends the proceeds to the entity
(the obligor). Although the conduit bonds are in the issuer’s name,
the obligor is solely responsible for repaying the bonds. Obligors
sometimes benefit from defeasing the debt before its scheduled
retirement. In a defeasance, the bond obligor or its agent purchases
securities to deposit into a trust that irrevocably pledges the cash
flows from the securities to retire the conduit bonds. The obligor
has no continuing involvement with the transferred assets and is not
required to consolidate the trusts.
In such circumstances, the debtor would derecognize both (1) its bond
obligations and (2) the securities that it has deposited into the
trust to service the bonds if the transaction satisfies the
derecognition criteria in both ASC 405-20 for liabilities and ASC
860 for financial assets. ASC 405-20-40-1(b) states that in a
transfer of noncash financial assets, the obligor can derecognize
the bond liability if the obligor “is legally released from being
the primary obligor under the liability.” Accordingly, the debtor
should obtain a legal opinion even if (1) the municipal bond
indentures contain provisions that legally release the obligor if
defeasance is properly structured or (2) the bond indenture does not
require a legal opinion to be obtained. The debtor also needs to
consider the derecognition criteria in ASC 860-10-40-5 for the
transfer of a financial asset. Like ASC 405-20-40-1, ASC 860-10-40-5
calls for a legal conclusion — in this instance, regarding whether
the transfer isolates the noncash financial assets from the
obligor.
9.2.4.3 In-Substance Defeasance
ASC Master Glossary
In-Substance
Defeasance
Placement by the debtor of amounts
equal to the principal, interest, and prepayment
penalties related to a debt instrument in an
irrevocable trust established for the benefit of the
creditor.
ASC 405-20
55-3 In an in-substance
defeasance transaction, a debtor transfers
essentially risk-free assets to an irrevocable
defeasance trust and the cash flows from those
assets approximate the scheduled interest and
principal payments of the debt being extinguished.
55-4 An in-substance
defeasance transaction does not meet the
derecognition criteria in either Section 405-20-40
for the liability or in Section 860-10-40 for the
asset. The transaction does not meet the criteria
because of the following:
-
The debtor is not released from the debt by putting assets in the trust; if the assets in the trust prove insufficient, for example, because a default by the debtor accelerates its debt, the debtor must make up the difference.
-
The lender is not limited to the cash flows from the assets in trust.
-
The lender does not have the ability to dispose of the assets at will or to terminate the trust.
-
If the assets in the trust exceed what is necessary to meet scheduled principal and interest payments, the transferor can remove the assets.
-
Subparagraph superseded by Accounting Standards Update No. 2012-04.
-
The debtor does not surrender control of the benefits of the assets because those assets are still being used for the debtor’s benefit, to extinguish its debt, and because no asset can be an asset of more than one entity, those benefits must still be the debtor’s assets.
ASC 470-50
55-9 The following situations do
not result in an extinguishment and would not result
in gain or loss recognition under either paragraph
405-20-40-1 or this Subtopic: . . .
b. In-substance defeasance . . . .
In an in-substance defeasance, a debtor establishes an irrevocable trust for
the benefit of the creditor and transfers to the trust an amount of cash or
other assets that is sufficient for repayment of the debt. Unlike a legal
defeasance, an in-substance defeasance does not legally release the debtor
as the primary obligor under the debt and therefore the debt cannot be
treated as extinguished in accordance with ASC 405-20-40-1(b). In the
absence of legal release, extinguishment accounting is not appropriate even
if the issuer has notified the holder that the third party has assumed the
obligation.
ASC 405-20
50-1 See paragraph
470-50-50-1 for a disclosure requirement for debt
considered to be extinguished by in-substance
defeasance. In addition, see paragraph 860-30-50-1A
for disclosure requirements for assets that are set
aside solely for the purpose of satisfying scheduled
payments of a specific obligation.
ASC 470-50
50-1 If debt was
considered to be extinguished by in-substance
defeasance under the provisions of FASB Statement
No. 76, Extinguishment of Debt, before the
effective date of FASB Statement No. 125,
Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of
Liabilities, a general description of the
transaction and the amount of debt that is
considered extinguished at the end of each period
that debt remains outstanding shall be disclosed.
ASC 860-30
50-1A
An entity shall disclose all of the following for
collateral: . . .
b. As of the date of the latest
statement of financial position presented, both of
the following:
1. The carrying amount and classifications of
both of the following:
i. Any assets pledged as
collateral that are not reclassified and
separately reported in the statement of financial
position in accordance with paragraph
860-30-25-5(a)
ii. Associated
liabilities.
2. Qualitative information about the
relationship(s) between those assets and
associated liabilities; for example, if assets are
restricted solely to satisfy a specific
obligation, a description of the nature of
restrictions placed on those assets. . . .
If an in-substance defeasance trust does not have the right
to sell or repledge assets that a debtor has set aside to satisfy a specific
obligation, ASC 860-30-50-1A requires the debtor to disclose the carrying
amount and classification of those assets and the associated liabilities as
well as a description of the nature of the restrictions placed on the
assets. ASC 470-50-50-1 requires an entity to disclose a general description
of an in-substance defeasance transaction that occurred before December 31,
1996 (i.e., the effective date of certain legacy U.S. GAAP guidance), that
the entity was allowed to recognize as an extinguishment before such date.
This disclosure would only be required if the related debt was still
outstanding (i.e., has not been legally extinguished).
9.2.4.4 Original Debtor Becomes Guarantor
ASC 405-20
40-2 If a creditor
releases a debtor from primary obligation on the
condition that a third party assumes the obligation
and that the original debtor becomes secondarily
liable, that release extinguishes the original
debtor’s liability. However, in those circumstances,
whether or not explicit consideration was paid for
that guarantee, the original debtor becomes a
guarantor. As a guarantor, it shall recognize a
guarantee obligation in the same manner as would a
guarantor that had never been primarily liable to
that creditor, with due regard for the likelihood
that the third party will carry out its obligations.
The guarantee obligation shall be initially measured
at fair value, and that amount reduces the gain or
increases the loss recognized on extinguishment. See
Topic 460 for accounting guidance related to
guarantees.
Sometimes, another entity assumes primary responsibility for
an issuer’s debt instrument and the original issuer becomes legally
obligated to make payments on the debt only if the party that has assumed
primary responsibility for the debt fails to make payments. In this
circumstance, the debtor applies extinguishment accounting to the debt and
recognizes a new financial liability for the guarantee obligation at fair
value in accordance with ASC 460. The initial fair value amount recognized
for the guarantee obligation adjusts the debt extinguishment gain or loss.
Subsequently, the guarantee is accounted for in accordance with ASC
460-10-35. See Chapter
5 of Deloitte’s Roadmap Contingencies, Loss Recoveries, and
Guarantees for further discussion of the recognition
and measurement of guarantee liabilities.
Example 9-3
Primary Obligor on Debt Becomes Secondarily
Liable
Entity D issues debt to Entity E. Subsequently,
Entities D, E, and F execute an agreement under
which (1) F assumes primary responsibility for D’s
obligation to E, (2) D is relieved of that
responsibility, and (3) D becomes secondarily liable
to E if F fails to pay E. Further, D transfers
nonmonetary assets with a fair value of $9.8 million
to F as consideration for assuming primary
responsibility for the debt obligation. As of the
date of the agreement, the current carrying amount
of the debt is $10 million and the fair value of D’s
new obligation is $300,000. The asset transfer
qualifies for derecognition under ASC 860-10.
Because the fair value of the transferred assets
equals their carrying amount, there is no gain or
loss on the asset transfer. In this scenario, D
would recognize the following accounting entry:
9.3 Extinguishment Accounting
9.3.1 General
9.3.1.1 Background
ASC 470-50
40-1 As indicated in
paragraph 470-50-15-4, the general guidance for the
extinguishment of liabilities is contained in
Subtopic 405-20 and defines transactions that the
debtor shall recognize as an extinguishment of a
liability.
40-2 A difference between
the reacquisition price of debt and the net carrying
amount of the extinguished debt shall be recognized
currently in income of the period of extinguishment
as losses or gains and identified as a separate
item. Gains and losses shall not be amortized to
future periods. If upon extinguishment of debt the
parties also exchange unstated (or stated) rights or
privileges, the portion of the consideration
exchanged allocable to such unstated (or stated)
rights or privileges shall be given appropriate
accounting recognition. Moreover, extinguishment
transactions between related entities may be in
essence capital transactions.
Under ASC 470-50-40-2, any difference between the debt’s
reacquisition price (see the next section) and its net carrying amount (see
Section
9.3.1.3) is recognized as an extinguishment gain or loss in
earnings. It is not appropriate to defer recognition of such gain or loss to
a future period. For example, a debtor cannot amortize the gain or loss over
the remaining life of the extinguished debt or replacement debt issued to
fund the proceeds of the extinguishment.
In addition, ASC 470-50-40-2 requires entities to identify
debt extinguishment gains and losses as a separate item. Because a debt
extinguishment gain or loss is akin to a financing activity, it generally
should be classified as part of nonoperating income in the income
statement.
9.3.1.2 Reacquisition Price
ASC Master Glossary
Reacquisition Price of Debt
The amount paid on extinguishment, including a call
premium and miscellaneous costs of reacquisition. If
extinguishment is achieved by a direct exchange of
new securities, the reacquisition price is the total
present value of the new securities.
The debt’s reacquisition price is the fair value of the
consideration transferred to the creditor (e.g., the amount of cash paid or
the fair value of any instruments, goods, or services transferred) to
extinguish the debt as well as any reacquisition costs (e.g., third-party
fees paid). As an exception, the reacquisition price is the fair value of
the debt if common or preferred stock is used to settle the debt and the
fair value of the debt is more clearly evident than the fair value of the
stock (see Section
9.3.3). If the debtor issues new debt to the same creditor to
settle debt or modifies existing debt, it should evaluate the transaction
under the guidance on debt modifications and exchanges in ASC 470-50 (see
Chapter
10). If the modification or exchange is accounted for as an
extinguishment, the reacquisition price is the fair value of the new debt
adjusted for the fair value of any other consideration paid to, or received
from, the creditor and issuance costs (see Section 10.4.2).
If a debt extinguishment is part of a larger transaction
that includes elements not related to the debt extinguishment, those other
elements should be given separate accounting recognition. If a portion of
the consideration paid by the debtor is related to an asset acquisition or
the repurchase of the debtor’s outstanding equity shares, for example, that
portion does not form part of the debt’s reacquisition price. In this
scenario, the consideration paid is allocated between the debt
extinguishment and the other items purchased in the transaction. Similarly,
the debtor would need to allocate the consideration paid if it reacquires
both debt and outstanding equity shares or contracts on its own equity
(e.g., warrants) in the same transaction. The debtor should apply an
allocation method, such as relative fair value or a with-and-without method,
as appropriate (see Sections 3.4 and
3.5 for analogous guidance).
If an entity extinguishes debt by transferring a noncash
asset, the debt’s reacquisition price is the asset’s fair value as of the
date of extinguishment. The debt extinguishment gain or loss is calculated
on the basis of the difference between the asset’s fair value and the debt’s
net carrying amount. The difference between the net carrying amount and the
fair value of the asset transferred to extinguish the debt is recognized as
a realized gain or loss in earnings. For example, if an entity transferred
available-for-sale debt securities to extinguish debt, it would remeasure
those securities immediately before the transfer and then reclassify any
unrealized gain or loss in OCI to earnings in the same manner as if it sold
those securities to third parties. (Note, however, that when noncash
financial assets are transferred to extinguish debt, the debtor must ensure
that derecognition of those assets is appropriate under other applicable
GAAP; see also Sections 9.2.3.3 and
9.2.4.2.)
The gain or loss on an extinguishment of debt in which the
debtor transfers its own equity shares is generally calculated on the basis
of a comparison of the fair value of the equity shares transferred and the
net carrying amount of the debt; however, there is one exception that
applies in certain situations (see Section
9.3.3 for further discussion).
9.3.1.3 Net Carrying Amount
ASC Master Glossary
Net Carrying Amount of Debt
Net carrying amount of debt is the amount due at
maturity, adjusted for unamortized premium,
discount, and cost of issuance.
The net carrying amount of debt that is accounted for at
amortized cost equals the amount due at maturity adjusted for any remaining
unamortized premium or discount or debt issuance costs as of the
extinguishment date as determined by using the interest method. It includes
any accrued interest to the extinguishment date even if such interest is
forfeited upon settlement (i.e., accrued interest is not reversed). Further,
the net carrying amount reflects any adjustment to the debt resulting from
the application of fair value hedge accounting (see Section 14.2.1.2). If
debt contains a bifurcated embedded derivative (e.g., a bifurcated
conversion option or bifurcated share-settled put option; see Chapter 8), an entity
remeasures the embedded derivative to fair value as of the extinguishment
date and includes such fair value in the net carrying amount before
calculating the extinguishment gain or loss. Special considerations are
necessary if the debt is accounted for at fair value under the fair value
option (see Section
9.3.2).
Example 9-4
Loss on Early Extinguishment of Debt
On January 1, 20X0, Entity G borrowed $10 million
from Bank H for 20 years at an interest rate of 6
percent per annum, which is accounted for at
amortized cost. As part of the borrowing
transaction, G paid lender fees of $50,000 to H and
attorney fees of $20,000 to third parties. Entity G
is permitted to prepay the debt at any time for
$10.5 million. Entity G determined that the
prepayment did not require bifurcation as an
embedded derivative under ASC 815-15. Upon issuance,
G recognized the following accounting entry:
On January 1, 20X5, G exercised its
prepayment option and repaid the debt for $10.5
million. Under the interest method (see Section 6.2), the
debt’s net carrying amount as of the extinguishment
date was $9,986,528, consisting of the stated
principal amount of $10 million less $9,623 of
remaining unamortized discount and $3,849 of
remaining unamortized debt issuance costs. Because G
paid an amount in excess of the debt’s net carrying
amount, the difference caused a debt extinguishment
loss of $513,472 ($10,500,000 – $9,986,528). Entity
G recognized the following accounting entry:
If only a portion of an outstanding issue of debt is
extinguished, any remaining unamortized discount or
premium or issuance costs is allocated between the
portion of the debt extinguished and the portion
that remains outstanding. Such allocation is
typically made on the basis of the relative net
carrying amounts. The calculation of the gain or
loss on the portion of the debt extinguished
reflects the amount of remaining unamortized
discount or premium or issuance costs allocated to
that portion. The amount of the remaining
unamortized discount or premium or issuance costs
allocated to the debt that remains outstanding
continues to be amortized over the remaining life of
that debt.
Example 9-5
Gain on Early Extinguishment of Debt
On January 1, 20X0, Entity J issued debt with a
principal amount of $100 million in a public
offering for proceeds of $102 million, which is
accounted for at amortized cost. The debt has a term
of 6 years and pays interest at 8 percent per annum.
Upon issuance, J makes the following accounting
entry:
On January 1, 20X2, J repurchases
half of the debt for $50.5 million. The remaining
unamortized debt premium on the entire debt issuance
is $1,427,964. Accordingly, J allocates that amount
between the portion extinguished and the portion
that remains outstanding. The difference between the
reacquisition price and the net carrying amount of
the extinguished portion results in an
extinguishment gain of $213,982 ($101,427,964 ÷ 2 –
$50,500,000 = $213,982). Entity J recognizes the
following accounting entry:
9.3.2 Extinguishments of Debt for Which the Fair Value Option Has Been Elected
ASC 470-50
40-2A In an early
extinguishment of debt for which the fair value option
has been elected in accordance with Subtopic 815-15 on
embedded derivatives or Subtopic 825-10 on financial
instruments, the net carrying amount of the extinguished
debt shall be equal to its fair value at the
reacquisition date. In accordance with paragraph
825-10-45-6, upon extinguishment an entity shall include
in net income the cumulative amount of the gain or loss
previously recorded in other comprehensive income for
the extinguished debt that resulted from changes in
instrument-specific credit risk.
ASC 825-10
45-6 Upon derecognition of
a financial liability designated under the fair value
option in accordance with this Subtopic, an entity shall
include in net income the cumulative amount of the gain
or loss on the financial liability that resulted from
changes in instrument-specific credit risk.
If an entity accounts for debt at fair value by using the fair
value option in ASC 815-15 (see Section 8.5.6) or in ASC 825-10 (see
Section 4.4),
the debt’s net carrying amount is its fair value on the reacquisition date as
long as the extinguishment is not a TDR. Upon the debt’s extinguishment, the
debtor is required to include in net income the cumulative amount of any changes
in fair value that are attributable to instrument-specific credit risk and that
have been recognized in accumulated other comprehensive income (AOCI). If the
debt is repaid at its principal amount at maturity, there would typically not be
any remaining component in AOCI related to the cumulative changes in fair value
of the financial liability attributable to instrument-specific credit risk (see
Section 6.3.2).
However, if the debt is extinguished before its stated maturity, there will
generally be a component in AOCI that must be reclassified to earnings upon debt
extinguishment.
9.3.3 Extinguishments Effected Through the Issuance of Shares
ASC 470-50
15-2 The guidance in this
Subtopic applies, in part, to the following transactions
and activities:
- Extinguishments of debt effected by issuance of common or preferred stock, including redeemable and fixed-maturity preferred stock, that do not represent the exercise of a conversion right contained in the terms of the debt at issuance.
40-3 In an early
extinguishment of debt through exchange for common or
preferred stock, the reacquisition price of the
extinguished debt shall be determined by the value of
the common or preferred stock issued or the value of the
debt — whichever is more clearly evident.
Extinguishment accounting applies if a debtor settles
outstanding debt by delivering equity-classified shares of common or preferred
stock and such settlement is not accounted for as a conversion (see Chapter 12). However, if
the shares issued must be classified as liabilities under ASC 480 (e.g., they
meet the definition of a mandatorily redeemable financial instrument and are not
exempt from the scope of ASC 480; see Deloitte’s Roadmap Distinguishing Liabilities From
Equity), the existing debt should be accounted for as
extinguished only if the instruments have substantially different terms, as
determined under ASC 470-50 (see Section 10.4.2).
If extinguishment accounting applies, the reacquisition price of the extinguished
debt is whichever is more clearly evident of either the fair value of the shares
issued or the fair value of the debt at the time of the extinguishment. However,
under the original terms of some debt instruments, the debtor may deliver a
variable number of shares whose value is computed to equal a fixed monetary
amount that is based on an average stock price as of a determination date that
precedes settlement (e.g., the most recent 20-day volume-weighted average price)
rather than the stock price on the settlement date. In such circumstances, in
accordance with ASC 480-10-55-22, the debtor should not recognize a gain or loss
for a difference between (1) the settlement-date fair value of the shares
delivered and (2) the fixed monetary amount. However, an extinguishment gain or
loss would still exist for any difference between the fixed monetary amount and
the net carrying amount of the debt. The guidance in ASC 480-10-55-22 may not be
applied when the settlement does not occur in accordance with the contractual
terms of the debt instrument.
For discussion of the accounting for an extinguishment of convertible debt, see
Section 9.3.5.
9.3.4 Extinguishments of Hedged Debt
If a debtor extinguishes debt that has been designated as a hedged item in a fair
value hedge (e.g., a fair value hedge of fixed-rate debt), the debt’s net
carrying amount would have been adjusted for the change in the debt’s fair value
attributable to the hedged risk (see Section 14.2.1.2).
Further, the debtor would have been permitted or, if hedge accounting had
ceased, required to amortize such fair value adjustments (see ASC 815-25-35-9
and 35-9A). Fair value hedge accounting adjustments are accounted for in the
same manner as other components of the debt’s carrying amount (see ASC
815-25-35-8). Upon the debt’s extinguishment, therefore, the extinguishment gain
or loss is calculated on the basis of the net carrying amount as of the
extinguishment date after the application of fair value hedge accounting.
If a debtor extinguishes debt that has been designated in a cash flow hedge
(e.g., a cash flow hedge of floating-rate debt), the debtor may have deferred
amounts in AOCI related to the change in the fair value of the designated
hedging instrument that was included in the assessment of hedge effectiveness
(see Section 14.2.1.3). Such amounts must be reclassified
to earnings if the debt is extinguished (i.e., the debt is settled before
maturity); however, such reclassification gain or loss is not classified as part
of the debt extinguishment gain or loss (see ASC 815-30-35-44).
9.3.5 Extinguishments of Convertible Debt
9.3.5.1 Background
The accounting for extinguishments of convertible debt (e.g., the repurchase
of convertible debt for cash or the settlement of a share-settled redemption
feature) depends on whether the debt contains a separately recognized equity
component.
9.3.5.2 Convertible Debt Without a Separately Recognized Equity Component
ASC 470-50
40-4 The extinguishment of
convertible debt does not change the character of
the security as between debt and equity at that
time. Therefore, a difference between the cash
acquisition price of the debt and its net carrying
amount shall be recognized currently in income in
the period of extinguishment as losses or gains.
If a debtor extinguishes convertible debt that does not contain a separately
recognized equity component, the extinguishment gain or loss is calculated
as the difference between the debt’s net carrying amount (including the fair
value of any bifurcated embedded derivative as of the extinguishment date)
and the reacquisition price (see Section
9.3.1.2). This accounting applies even if the debtor pays an
amount significantly in excess of the debt’s net carrying amount as a result
of the fair value of the conversion feature.
Example 9-6
Redemption of Convertible Debt
Entity K has outstanding convertible debt with a net
carrying amount of $1,000. The conversion feature is
deeply in-the-money because of an increase in K’s
stock price after the debt was issued. Entity K pays
$2,200 to repurchase the debt, which is also the
current fair value of the debt. Entity K recognizes
the following accounting entry:
9.3.5.3 Convertible Debt With a Separately Recognized Equity Component
ASC 815-15
40-4 If a convertible debt
instrument with a conversion option for which the
carrying amount has previously been reclassified to
shareholders’ equity pursuant to the guidance in
paragraph 815-15-35-4 is extinguished for cash (or
other assets) before its stated maturity date, the
entity shall do both of the following:
- The portion of the reacquisition price equal to the fair value of the conversion option at the date of the extinguishment shall be allocated to equity.
- The remaining reacquisition price shall be allocated to the extinguishment of the debt to determine the amount of gain or loss.
A convertible debt instrument will have a separately
recognized equity component only in the following circumstances:
-
The convertible debt instrument was issued at a substantial premium (see Section 7.6.3).
-
The convertible debt instrument was modified or exchanged in a transaction that did not result in an extinguishment but increased the fair value of the embedded conversion option (Section 10.4.3).
-
The embedded conversion option in a convertible debt instrument was previously reclassified from a derivative liability to equity (Section 8.5.4.3).
In these circumstances, any extinguishment of the convertible debt instrument
includes settlement of both the liability for the convertible debt
instrument and the separate amount recognized in equity. Therefore, the
total reacquisition price must be allocated between these two components.
If the equity component is the result of the
reclassification of an embedded conversion feature from a derivative
liability to equity, the amount allocated to the reacquisition of the equity
component equals the fair value of the conversion option on the date of the
extinguishment, in accordance with ASC 815-15-40-4. Although not
specifically addressed in the Codification, if the separately recognized
equity component resulted from (1) a modification or exchange that increased
the fair value of the conversion option or (2) a substantial issuance
premium, a portion of the reacquisition price equal to the amount that was
previously recognized for that separate equity component is allocated to the
reacquisition of such equity component, and the remaining portion of the
reacquisition price is allocated to the liability for the convertible debt
instrument.1 The amount allocated to the equity component does not result in a gain
or loss because ASC 260-10-S99-2 does not apply to the settlement of the
equity component if the convertible debt instrument permitted conversion
into the issuer’s common stock. However, the amount allocated to the equity
component will indirectly affect the extinguishment gain or loss since it
reduces the amount allocated to the extinguished debt component.
9.3.6 Debt Tendered Upon Exercise of Detachable Warrants
ASC 470-50
40-5 The guidance in this
Subtopic does not apply to debt tendered to exercise
detachable warrants that were originally issued with
that debt if the debt is permitted to be tendered
towards the exercise price of the warrants under the
terms of the securities at issuance. The tendering of
the debt in such a case would be accounted for in the
same manner as a conversion.
When debt is tendered upon the exercise of detachable warrants, the transaction
is accounted for as a conversion (see Chapter 12) and not as an extinguishment if (1) the warrants
were originally issued with that debt, (2) the original terms permit the debt to
be tendered toward the exercise price of the warrants, and (3) the warrants are
classified in equity.
Example 9-7
Debt Tendered Upon Exercise of Detachable Warrants
Entity M issues debt with detachable
warrants for total proceeds of $10 million, which equals
the par amount of the debt, and it elects not to apply
the fair value option to the debt. Entity M determines
that the warrants qualify as an equity instrument
because they are exercisable by the holder into 150,000
shares of M’s common stock (par value of $1 per share)
for $20 per share, payable in cash or by tendering an
equivalent principal amount of the debt. Upon the debt’s
issuance, M allocates the proceeds between the debt and
warrants on a relative-fair-value basis in accordance
with ASC 470-20-25-2 (see Section 3.4.2.2). It allocates $8.5
million to the debt and $1.5 million to the warrants and
recognizes the following accounting entry:
Three years later, the holder exercises all of the
warrants in return for tendering the debt. The remaining
unamortized debt discount is $1 million. Entity M
recognizes the following accounting entry:
9.3.7 Extinguishments Involving Related Parties
9.3.7.1 Background
Special considerations are necessary for certain debt
extinguishment transactions involving related parties, including
extinguishments of debt owed to related parties, an affiliated entity’s
acquisition of the entity’s debt from a third party, and the repayment of
debt by a related party.
9.3.7.2 Extinguishments of Debt Owed to Related Parties
ASC 470-50
40-2 . . . [E]xtinguishment
transactions between related entities may be in
essence capital transactions.
The guidance in ASC 470-50-40-2 has generally been
interpreted to suggest that there is a rebuttable assumption that debt
extinguishment “gains” in transactions with related parties (e.g., the
investor is a significant shareholder, part of management, or an affiliate
of the issuer) should be recognized as equity contributions (i.e., in APIC
and not in earnings) unless there is substantive evidence that the entity
would have obtained the same economic outcome in an arm’s-length
transaction. For example, if an entity’s outstanding debt is forgiven by a
related party, the credit recognized to reflect the forgiveness should be
reflected as an addition to equity. However, the guidance in ASC 470-50-40-2
does not apply when debt issued to a related party is settled in accordance
with its contractual terms. In these situations, if there is an equity
transaction associated with the debt issuance, it would be recognized upon
issuance, not settlement, of the debt.
If a subsidiary’s debt is forgiven by its parent for no consideration, the
subsidiary should record that forgiveness as a capital contribution from its
parent. Evidence that an extinguishment transaction was at arm’s length
includes a debt settlement that involves related parties and significant
third-party investors that receive the same settlement terms (e.g., same
reacquisition price).
Generally, debt extinguishment losses in transactions with related parties
are recognized in earnings. However, a loss may be recognized in equity as
an in-substance dividend if it represents a pro rata distribution to all
shareholders.
Example 9-8
Extinguishment of Debt Owed to a Related Party
Entity N has outstanding debt with a net carrying
amount of $100 that is owed to Investor O, which is
a significant shareholder. Entity N settles the debt
with O for $95. Entity N would not have been able to
obtain the same terms from an unrelated party.
Accordingly, it records the following accounting
entry to reflect the forgiveness of a portion of the
debt and a corresponding capital contribution from
O:
In his remarks at the 2010 AICPA Conference on Current SEC
and PCAOB Developments, then SEC Professional Accounting Fellow Sagar Teotia
addressed how the SEC staff expects issuers to determine whether an
extinguishment transaction with a related party represents a capital
transaction. He noted that “the staff has not formed any bright line views
on these types of transactions and analyzes these questions individually on
a specific facts and circumstances basis.” Mr. Teotia provided the following
example (footnote omitted):
A Company has non-convertible debt outstanding to a
related party (An executive of the Company who is also a significant
shareholder). [At] a later date the related party accepts an offer
from the Company to exchange the debt for the Company’s common
stock. At the date of exchange, . . . the value of the common stock
that was accepted by the related party was significantly lower than
the carrying value of the Company’s debt.
At issue is whether the Company’s exchange of common
stock for the debt held by the related party should be accounted for
as an early extinguishment gain or as a capital contribution. . .
.
Based on its analysis, which included the
information provided in response to [the] questions [below], the
staff believed the substance of the transaction was in essence a
capital contribution from a related party.
Further, Mr. Teotia provided the following examples of questions the SEC
staff has asked registrants related to this analysis:
-
What was the role of the related party in the transaction?
-
Why would the related party accept the Company’s offer which resulted in the related party accepting common stock that was significantly lower in value than the carrying value of the debt?
-
Was the substance of the arrangement a forgiveness of debt that was owed to a related party?
Mr. Teotia emphasized that the “staff believes that a full analysis is
required in assessing the substance of these types of transactions.
Accordingly, the staff would expect that registrants consider all of the
facts and circumstances and related party relationships in a particular
transaction when making its accounting assessment.”
9.3.7.3 Debt Acquired by Affiliated Entity
In consolidated financial statements, an entity’s debt is extinguished if it
is held by another member of the same consolidated group. For example, if a
parent holds debt issued by its subsidiary, the debt is extinguished in the
parent’s consolidated financial statements.
If another member of a consolidated group to which the entity belongs
acquires the entity’s debt from a third party, the debt is accounted for as
being extinguished in any consolidated financial statements that include
both entities. For example, if a parent acquires debt issued by its
subsidiary from a third party, the debt is accounted for as if it had been
extinguished in the parent’s consolidated financial statements. Note,
however, that the debt would still be included in separate financial
statements of the debtor if those financial statements do not include the
consolidation of the entity that acquired the debt.
Example 9-9
Parent Acquisition of Subsidiary Debt
Parent P owns an 85 percent interest in the common
stock of Subsidiary S. Subsidiary S is included in
P’s consolidated financial statements and has debt
outstanding that trades in an active, public market.
Subsidiary S’s debt is currently trading at a
discount to its par amount. Parent P has purchased
some but not all of S’s debt in the public market.
Parent P intends to temporarily hold the debt and
either (1) sell it to S or (2) resell it back into
the public market.
In P’s consolidated financial statements, the
acquisition of S’s debt should be accounted for as
an extinguishment of debt. Although from S’s
perspective the debt remains outstanding, the debt
has been reacquired by the consolidated entity and,
therefore, has been extinguished in the consolidated
financial statements of P. Any difference between
the carrying amount and the reacquisition price
should be accounted for as an extinguishment gain or
loss in the consolidated financial statements.
No portion of the extinguishment gain or loss
recognized in P’s consolidated financial statements
would be allocated to the noncontrolling interest in
S upon P’s purchase of the debt. The holders of the
noncontrolling interest in S will not realize any
extinguishment gain or loss until S reacquires the
debt.
In S’s separate financial statements, a debt
extinguishment has not occurred and no accounting
entry would be recorded. Further, S has not been
released from the debt and, accordingly, should
continue to reflect the entire balance as
outstanding.
If S subsequently reacquires the debt from P in a
transaction based on the current fair value of the
debt in the public market, S should recognize an
extinguishment gain or loss in its separate
financial statements on the basis of the difference
between the carrying amount of the debt and the
reacquisition price paid by S. If S’s reacquisition
of its debt from P does not occur on the basis of
the current fair value of the debt, the difference
between the current fair value of the debt and the
reacquisition price paid by S should be treated as a
capital transaction or as an expense. For example,
the difference would be treated as a capital
contribution if P were to settle for less than the
current fair value of the debt (thereby forgiving a
portion of the debt).
9.3.7.4 Debt Extinguished by Related Party
Nonauthoritative AICPA Guidance
Technical Q&As Section 4160, “Contributed
Capital”
.01 Payment of Corporate Debt by
Stockholders
Inquiry — Three shareholders own stock in
Corporations A and B. They agree to personally pay a
debt of Corporation A by giving the creditor stock
in Corporation B. How should this transaction be
recorded on the books of Corporation A?
Reply — The payments by the three stockholders
of Corporation A’s debt would represent an
additional contribution by the stockholders to
Corporation A. This can be recorded as a credit to
“additional capital.”
If a related party (e.g., a significant shareholder) repays an entity’s debt
and thereby relieves the entity of its obligation to pay it, the entity
should record the transaction as a capital contribution from the related
party.
Example 9-10
Debt Repaid by a Related Party
Entity T has outstanding debt with a net carrying
amount of $100. Investor U, a significant
shareholder, repays the debt, which relieves T of
its obligation to pay it. Entity T does not pay U
for the extinguishment. Accordingly, T should record
a capital contribution for the benefit received from
U:
9.3.8 Rate-Regulated Entities
ASC 980-470
40-1 Subtopic 470-50
requires recognition in income of a gain or loss on an
early extinguishment of debt in the period in which the
debt is extinguished. For rate-making purposes, the
difference between the entity’s net carrying amount of
the extinguished debt and the reacquisition price may be
amortized as an adjustment of interest expense over some
future period.
40-2 If the debt is
reacquired for an amount in excess of the entity’s net
carrying amount, the regulator’s decision to increase
future rates by amortizing the difference for
rate-making purposes provides reasonable assurance of
the existence of an asset (see paragraph 980-340-25-1).
Accordingly, the regulated entity shall capitalize the
excess cost and amortize it over the period during which
it will be allowed for rate-making purposes.
40-3 If the debt is
reacquired for an amount that is less than the entity’s
net carrying amount, the regulator’s decision to reduce
future rates by amortizing the difference for
rate-making purposes imposes a liability on the
regulated entity (see paragraph 980-405-25-1(c)).
Accordingly, the entity would record the difference as a
liability and amortize it over the period during which
permitted rates will be reduced.
ASC 980-470 exempts rate-regulated entities from the requirement to recognize
debt extinguishment gains and losses in earnings; such entities may instead
amortize gains and losses as an adjustment to interest expense. If the regulator
decides to increase future rates for an extinguishment loss, the debtor records
an asset and amortizes it over the period in which it is permitted to do so for
rate-making purposes. If the regulator decides to reduce future rates for an
extinguishment gain, the debtor records a liability and amortizes it over the
period in which permitted rates are reduced.
Footnotes
1
Allocating to the separately recognized equity
component an amount equal to the amount initially recognized for
that component is different from accounting for a redemption of a
convertible debt instrument that contains an embedded conversion
option that has been reclassified from a derivative liability to a
separate component of equity. This difference is justified because
in these situations, only a portion of the entire fair value of the
embedded conversion option, as opposed to its entire fair value, is
recognized as a separate component of equity.
9.4 Derecognition of Liabilities for Prepaid Stored-Value Products
9.4.1 Background
Prepaid stored-value products are products with a preloaded monetary value
(e.g., a gift card, phone card, or traveler’s check) that are commonly accepted
as a means of payment for goods or services. For example, a prepaid stored-value
product might be issued by a financial services company and used as a means of
payment at network-accepting merchant locations. Sometimes, the holder also has
an option to redeem all or part of the stored monetary value for cash. Unlike a
credit card, which is backed by a line of credit, or a debit card, which is
linked to a bank account, a prepaid stored-value product typically is prefunded
by the initial holder of the product (e.g., through a cash payment).
When an entity sells a prepaid stored-value product, it incurs a liability for
the obligation associated with the stored monetary value. If the holder uses all
or a portion of the product’s stored monetary value to buy goods or services
from a third party, the issuer must reimburse the third party. When the issuer
settles all or part of its obligation to the third-party provider, a
corresponding portion of the issuer’s liability is extinguished. However, the
issuer often expects “breakage,” which refers to the portion of the stored
monetary value that will never be used by holders. For instance, some holders
might misplace the product and others might decide not to use the full amount if
the remaining balance is small.
ASC 606-10 includes breakage guidance for liabilities associated with revenue
contracts with customers (e.g., a retailer’s obligation for a gift certificate
that a customer can redeem for goods or services at that retailer). However, ASC
606-10 does not apply to liabilities that meet the definition of a financial
liability (such as contractual obligations to pay cash; see Section 2.3.4). Although the holder of a prepaid
stored-value product can redeem it for goods or services with a merchant, the
issuer has an obligation to pay cash to the merchant. Since a derecognition
approach on the basis of a settlement or legal release of an obligation may not
reflect the economics of prepaid stored-value products, such liabilities are
exempt from the general extinguishment accounting guidance in ASC 405-20-40-1.
9.4.2 Scope
ASC 405-20
40-3 Prepaid stored-value
products are products in physical and digital forms with
stored monetary values that are issued for the purpose
of being commonly accepted as payment for goods or
services. While the holder of a prepaid stored-value
product also may be permitted to redeem the product for
cash, prepaid stored-value products do not include
products that only can be redeemed by the product holder
for cash (for example, nonrecourse debt, bearer bonds,
or trade payables). Examples of prepaid stored-value
products include prepaid gift cards issued on a specific
payment network and redeemable at network-accepting
merchant locations, prepaid telecommunication cards, and
traveler’s checks. The derecognition guidance in
paragraph 405-20-40-4 does not apply to liabilities
related to either of the following:
- Prepaid stored-value products (or portions of those products) for which any breakage (that is, the portion of the dollar value of prepaid stored-value products that ultimately is not redeemed by product holders for cash or not used to purchase goods and/or services) must be remitted in accordance with unclaimed property laws
- Prepaid stored-value products that are attached to a segregated bank account like a customer depository account.
The guidance also does not apply to customer loyalty
programs or transactions within the scope of other
Topics (for example, Topic 606 on revenue from contracts
with customers).
The guidance in ASC 405-20 on prepaid stored-value products does not apply to:
-
Financial liabilities that can be redeemed for cash only (e.g., nonrecourse debt, bearer bonds, and trade payables). The extinguishment conditions in ASC 405-20-40-1 (see Section 9.3) apply to such liabilities.
-
Financial liabilities “for which any breakage . . . must be remitted in accordance with unclaimed property laws.” Since unclaimed property laws vary among jurisdictions, an issuer may have breakage liabilities that are subject to different legal requirements. The determination of whether unclaimed property laws apply to a specific breakage liability is a legal question that may need to be evaluated with the assistance of legal specialists.
-
Financial liabilities related to “[p]repaid stored-value products that are attached to a segregated bank account like a customer depository account.” For example, the guidance does not apply to a debit card that is attached to a bank account.
-
Obligations under customer loyalty programs, such as frequent flier miles and credit card reward programs (see Deloitte’s Roadmap Revenue Recognition).
-
Transactions within the scope of other GAAP, such as closed-system prepaid gift cards that are issued by a merchant to permit the holder to purchase goods or services from that merchant in the future; see Deloitte’s Roadmap Revenue Recognition.
9.4.3 Accounting
ASC 405-20
40-4 If an entity expects to
be entitled to a breakage amount for a liability
resulting from the sale of a prepaid stored-value
product in the scope of paragraph 405-20-40-3, the
entity shall derecognize the amount related to the
expected breakage in proportion to the pattern of rights
expected to be exercised by the product holder only to
the extent that it is probable that a significant
reversal of the recognized breakage amount will not
subsequently occur. If an entity does not expect to be
entitled to a breakage amount for prepaid stored-value
products in the scope of paragraph 405-20-40-3, the
entity shall derecognize the amount related to breakage
when the likelihood of the product holder exercising its
remaining rights becomes remote. At the end of each
period, an entity shall update the estimated breakage
amount to represent faithfully the circumstances present
at the end of the period and the changes in
circumstances during the period. Changes to an entity’s
estimated breakage amount shall be accounted for as a
change in accounting estimate in accordance with
paragraphs 250-10-45-17 through 45-20.
50-2 An entity that
recognizes a breakage amount in accordance with
paragraph 405-20-40-4 shall disclose the methodology
used to recognize breakage and significant judgments
made in applying the breakage methodology.
ASC 405-20 requires an issuer to recognize breakage associated
with prepaid stored-value products (see Section 9.4.2) in a manner similar to
breakage associated with revenue transactions within the scope of ASC 606-10
(see Deloitte’s Roadmap Revenue Recognition). Under the breakage guidance in
ASC 405-20, an issuer of a prepaid stored-value product must first determine
whether it expects to be entitled to a breakage amount. Expected breakage
amounts can only be recognized to the extent that it is probable that a
significant reversal of the recognized breakage amount will not subsequently be
required. In evaluating whether it is entitled to a breakage amount, the issuer
may, by analogy to ASC 606-10-55-48, consider factors similar to those in ASC
606-10-32-12. That guidance provides examples of “[f]actors that could increase
the likelihood or the magnitude of a . . . reversal,” including the
following:
-
“The uncertainty about the amount . . . is not expected to be resolved for a long period of time.”
-
“The entity’s experience (or other evidence) with similar types of contracts is limited, or that experience (or other evidence) has limited predictive value.”
If the issuer expects to be entitled to a breakage amount, it derecognizes a
portion of its liability for the prepaid stored-value product over time to
reflect expected breakage amounts. Breakage is not recognized immediately upon
issuance of the prepaid stored-value product. Instead, expected breakage amounts
are recognized over time in proportion to the pattern of rights expected to be
exercised by the holder (i.e., in proportion to amounts redeemed). At the end of
each reporting period, the issuer updates its breakage estimates to reflect
current circumstances and accounts for the changes as a change in accounting
estimate under ASC 250-10-45-17 through 45-20.
Example 9-11
Derecognition of Prepaid Gift Cards — Breakage
Anticipated
On the basis of a portfolio assessment, an issuer of
prepaid gift cards within the scope of ASC 405-20
expects breakage of 20 percent of the initial dollar
balance on each card. Upon issuance of a gift card, the
issuer recognizes the full stated balance as the initial
carrying amount of its liability for the gift card. Each
time holders redeem gift cards and the issuer pays its
associated obligation, the issuer derecognizes a portion
of its liability for prepaid gift cards equal to the
amount extinguished, plus an additional amount equal to
25 percent of amounts redeemed, to reflect expected
breakage (20% ÷ 80%). When a gift card holder redeems
$80 of the card balance to purchase goods or services
from a third-party merchant, the issuer reimburses the
merchant in $80 of cash. Accordingly, the issuer
derecognizes $80 of its liability to reflect the amount
extinguished and derecognizes another $20 to reflect
expected breakage (25% × $80). When a gift card holder
redeems another $160, another $40 of breakage is
recognized (25% × $160). If the pattern of rights
expected to be exercised by holders slows so that
expected breakage declines to 70 percent of initial
dollar balances, the issuer accounts for the change as a
change in estimate under ASC 250-10.
If the issuer does not expect to be entitled to a breakage amount, it
derecognizes a portion of its liability to reflect such an amount only when the
likelihood that the holder will exercise its remaining rights becomes remote.
Example 9-12
Derecognition of Prepaid Gift Cards — Breakage Not
Anticipated
An issuer of prepaid gift cards within the scope of ASC
405-20 does not expect to be entitled to any breakage.
Upon the cards’ issuance, the issuer recognizes the full
stated balance as a liability. Over time, the issuer
derecognizes any amount that it settles. Any remaining
unused balance is derecognized only when the likelihood
is remote that such amounts will ultimately be redeemed.
Chapter 10 — Debt Modifications and Exchanges
Chapter 10 — Debt Modifications and Exchanges
10.1 Background
This chapter discusses the accounting for modifications and exchanges of debt, lines
of credit, revolving debt, and term loan commitments.
10.2 Scope
10.2.1 General
ASC 470-50
05-2 This Subtopic . . .
provides guidance on whether an exchange of debt
instruments with the same creditor constitutes an
extinguishment and whether a modification of a debt
instrument should be accounted for in the same manner as
an extinguishment.
40-8 Transactions involving
the modification or exchange of debt instruments shall
only result in gain or loss recognition by the debtor if
the conditions for extinguishment of debt described in
paragraph 405-20-40-1 are satisfied or if the guidance
in this Subtopic requires that accounting.
ASC 470-50-40-6 through 40-20 address the debtor’s accounting for (1)
modifications of the terms of existing debt instruments and (2) exchanges of
debt instruments with the same creditor. This guidance, which applies to all
entities, also addresses:
-
The contemporaneous exchange of cash and debt instruments with the same creditor (see Section 10.2.2).
-
A binding commitment to modify, exchange, or redeem debt on terms that differ from the original debt terms (see Section 10.2.3).
-
The payment of consent fees to obtain a waiver of a covenant violation (see Section 10.2.4).
-
For consolidated financial statements, the exchange of debt issued by one entity within the consolidated group for debt issued by another entity within that group (see Section 10.2.10).
-
An exchange of debt for liability-classified shares of common or preferred stock (see Section 10.2.12).
ASC 470-50-40-21 through 40-23 contain separate guidance for the evaluation of
modifications and exchanges of line-of-credit and revolving-debt arrangements
(see Section 10.6).
ASC 470-50 does not address:
-
Nonbinding offers to modify, exchange, or redeem debt (see Section 10.2.3).
-
TDRs (see Section 10.2.5 and Chapter 11).
-
Debt modifications or exchanges at or near the maturity date of the original debt (see Section 10.2.6).
-
Prespecified changes in cash flows as a result of the application of contractual provisions (e.g., the exercise of a contractual redemption feature; see Section 10.2.7).
-
Transactions among debt holders (see Section 10.2.8).
-
Transactions with parties other than the creditor (see Section 10.2.9).
-
Conversions of debt into equity-classified shares of preferred or common stock (see Section 10.2.11).
-
Exchanges of debt for equity-classified common or preferred shares (see Section 10.2.12).
-
The creditor’s accounting for modifications and exchanges of investments in debt instruments.
-
Modifications or exchanges of derivatives (e.g., forwards, swaps, warrants, or options).
Further, a debtor may elect not to apply the guidance in ASC 470-50 to certain
market issuances of new debt to replace old debt (see Section
10.2.13).
ASC 848 permits debtors to elect not to apply extinguishment
accounting to certain debt modifications made in connection with reference-rate
reform even if ASC 470-50 would have required such accounting to be applied (see
Section
14.2.5).
10.2.2 Contemporaneous Exchange of Cash and Debt Instruments
ASC 470-50
40-9 Transactions involving
contemporaneous exchanges of cash between the same
debtor and creditor in connection with the issuance of a
new debt obligation and satisfaction of an existing debt
obligation by the debtor would only be accounted for as
debt extinguishments if the debt instruments have
substantially different terms, as defined in this
Subtopic.
When a debtor repays debt for cash, the debt is generally
considered extinguished (see Section 9.2). However, if a debtor (or its agent; see Section 10.5) repays outstanding debt for cash
and contemporaneously issues new debt to the same creditor for cash, the net
effect of the two transactions is an exchange of debt instruments. Therefore,
the transactions generally need to be analyzed on a combined basis in accordance
with the guidance in ASC 470-50.
In evaluating multiple transactions between the same debtor and creditor under
ASC 470-50-40-9, an entity must consider whether the transactions were executed
both contemporaneously and in contemplation of each other (i.e., contingent on
one another). While it would generally be difficult to establish that
contemporaneous transactions between a debtor and a creditor were not contingent
on one another, the relevant facts and circumstances must be evaluated. For
example, the following factors may suggest that two transactions should not be combined:
-
Lack of legal or contractual linkage between the transactions.
-
A sufficient period has elapsed between the two transactions during which the debtor and creditor are exposed to the risk that the second transaction will not take place (i.e., the second transaction is not firmly committed).
Under ASC 470-50, a debtor accounts for an exchange of debt instruments as an
extinguishment of the existing debt instrument if the debt instruments have
substantially different terms (see Section 10.4.2). A
contemporaneous exchange of cash and debt instruments with the same creditor is
accounted for as a modification of the original debt if the terms are not
substantially different (see Section 10.4.3).
ASC 470-50-40-9 does not apply when new debt is issued to a
different creditor. When a debtor or its agent repays debt by using proceeds
from debt issued to a different creditor, the original debt is accounted for as
extinguished even if there have been no or only insignificant changes to the
debt terms.
10.2.3 Intention, Offer, or Commitment to Modify, Exchange, or Redeem Debt
ASC 470-50
55-8 This Subtopic applies
to transactions in which the terms of a debt instrument
are modified through execution of a binding contract
between the debtor and creditor that requires a debt
instrument to be redeemed at a future date for a
specified amount.
55-9 The following
situations do not result in an extinguishment and would
not result in gain or loss recognition under either
paragraph 405-20-40-1 or this Subtopic:
- An announcement of intent by the debtor to call a debt instrument at the first call date . . . .
If a debtor (or its agent; see Section
10.5) enters into a binding agreement with a creditor to redeem or
exchange debt or otherwise modify its terms, the binding agreement represents a
debt modification that should be evaluated under ASC 470-50. Therefore, the
debtor should determine whether the debt terms as modified by the binding
agreement are substantially different from the original debt terms (see
Section 10.4).
The debtor’s mere announcement that it expects or intends to
modify, exchange, or redeem debt is not evaluated as a modification or exchange
under ASC 470-50. If a debtor provides the creditor with an offer to redeem the
debt or otherwise modify the debt terms or exchange the debt and the creditor
has not accepted the offer, a debt modification generally has not occurred.
Therefore, ASC 470-50 does not apply. However, if a creditor accepts the offer
and the revised debt terms therefore become binding on both the debtor and
creditor, the debtor should determine whether the revised debt terms are
substantially different from the terms of the original debt instrument (see
Section
10.3).
10.2.4 Consent Fees Paid by a Debtor to Obtain a Covenant Waiver
An entity might pay fees or other consideration, such as
warrants, to a creditor to compensate for a violation of a debt covenant. If the
fee was not part of the original debt terms but was negotiated at the time of
the violation, it represents a modification that should be evaluated under ASC
470-50. Such fees and other noncash consideration should be reflected in the
performance of the 10 percent cash flow test (see Section 10.3.3.2.4).
If a modification or exchange is accounted for as a debt extinguishment, the
debtor should apply the guidance in ASC 470-50-40-17(a) on debt extinguishments
and include the fee paid in the calculation of the debt extinguishment gain or
loss (see Section 10.4.2). Otherwise, it applies ASC
470-50-40-17(b), which states that an entity should defer such fees along with
any existing unamortized premium and discount and use the interest method to
amortize them as an adjustment to interest expense over the remaining life of
the modified debt instrument (see Section 10.4.3).
10.2.5 Troubled Debt Restructurings
ASC 470-50
15-3 The guidance in this
Subtopic does not apply to the following transactions
and activities: . . .
b. Extinguishments of debt through a troubled
debt restructuring. (See Section 470-60-15 for
guidance on determining whether a modification or
exchange of debt instruments is a troubled debt
restructuring. If it is determined that the
modification or exchange does not result in a
troubled debt restructuring, the guidance in this
Subtopic shall be applied.) . . .
ASC 470-50 does not apply to modifications or exchanges that qualify as TDRs. For
a detailed discussion of the scope of the TDR guidance, see Section 11.2.
ASC 470-60
55-5 The following model
should be applied by a debtor when determining whether a
modification or an exchange of debt instruments is
within the scope of this Subtopic.
10.2.6 Modifications or Exchanges at or Near the Debt’s Maturity
ASC 470-50 does not apply to the modification of debt or to its
exchange with an existing creditor at or near (i.e., within three months of) the
debt’s stated maturity unless (1) the modification or exchange represents a TDR
or (2) the borrower would be unable to repay the debt or refinance it with
another lender (e.g., in the absence of the modification or exchange, the
borrower would default on the repayment at maturity). Such modifications or
exchanges should be treated as extinguishments (see Section 9.3) unless they are not
substantive (e.g., the maturity date of a debt instrument is extended for a week
for administrative reasons). The debtor recognizes the new debt instrument at
fair value and the difference between this amount and the net carrying amount of
the extinguished debt is recognized as an extinguishment gain or loss.
10.2.7 Application of Contractual Provisions
Prespecified changes to the cash flows of a debt instrument that result from the
application of an existing contractual term (e.g., the exercise of an option or
trigger of a contingent payment feature under a debt instrument’s original
terms) generally do not represent debt modifications. For instance, the exercise
of a prepayment option that permits the debtor to prepay all or a portion of the
debt’s principal balance is not evaluated as a modification. Similarly, the
exercise of a right to convert a variable-rate debt instrument into a fixed-rate
instrument or the payment of contingent interest upon the occurrence of an event
of default is not treated as a debt modification. Changes to the cash flows of a
debt instrument that result solely from the application of contractual terms of
a debt instrument should be reflected in the application of the interest method
(see Section 6.2) and should also be evaluated for separation under
ASC 815-15 (see Chapter 8). Special considerations are necessary if a debtor or
creditor exercises a contractual provision in conjunction with a modification or
exchange (see Section 10.3.3.2.3).
Example 10-1
Change in Terms of Auction Rate Securities
Company B has issued various series of auction rate
securities (ARSs). The ARSs were not issued at a
discount or premium, and the terms of the securities
require the coupon rate to reset through a Dutch auction
process. Once reset, the coupon rate will remain the
same until the next auction.
The period between auctions is referred to as the “reset
frequency” or “mode.” The terms of the agreement allow B
to change the mode from three to six months by providing
the holders of the securities with notice of B’s
intention to do so 30 days before the effective date of
the mode change.
Recently, the auction for B’s debt securities failed,
which has triggered a provision in the agreement that
automatically increases the coupon rate for each debt
security in the series to a penalty rate of 20 percent.
In accordance with the terms of the agreement, B has
notified the holders of the debt securities of its
intention to increase the mode from three to six
months.
Company B’s decision to increase the mode from three to
six months does not represent a modification to the
agreement that should be accounted for in accordance
with ASC 470-50, because the agreement allows B to
change the mode from three to six months.
Whether the extension of the mode of an ARS is a
modification depends on whether the agreement allows the
issuer to unilaterally extend the mode or the range over
which the mode may be extended. If an agreement allows
extension of the mode and the new mode is within the
allowable range, the extension is not considered a
modification that requires further analysis.
However, if the agreement does not allow the issuer to
unilaterally extend the mode, or if the mode is
extending beyond the allowable range, the issuer should
determine whether the extension is a modification
requiring analysis under ASC 470-50. For example, if the
agreement allows an extension of the mode but the new
reset frequency is not within the agreement’s allowable
range, the extension would be a modification of the
original indenture and would require analysis under ASC
470-50.
10.2.8 Transactions Among Debt Holders
ASC 470-50
40-7 Transactions among debt
holders do not result in a modification of the original
debt’s terms or an exchange of debt instruments between
the debtor and the debt holders and do not impact the
accounting by the debtor.
55-6 If a debt instrument is
transferred from one debt holder to another in
connection with a modification or exchange, including
transfers from an intermediary acting as principal to
another debt holder, the debtor is not impacted by the
exchange as long as the funds do not pass through the
debtor or its agent.
ASC 470-50 does not apply to transactions in which the debtor is not a party.
When a creditor sells or otherwise transfers debt to a different entity without
any involvement of the debtor, there is no accounting required by the debtor
(i.e., the debt is not accounted for as having been modified or extinguished
even though the creditor has changed).
However, if a debtor or its agent receives or pays cash in connection with a
transfer of debt between debt holders (e.g., as a transfer consent fee) or the
terms are modified in connection with such a transfer (e.g., to remove transfer
restrictions), the debtor should consider whether the substance of the
transaction is a repayment of the existing debt by using proceeds from debt
issued to a different creditor (which would be accounted for as an
extinguishment of the original debt; see Section
9.3) or a modification of the debt terms (which would be
evaluated under ASC 470-50). If a holder of debt initiates the transaction and
pays the debtor a fee solely to remove a transfer restriction in connection with
its transfer of the debt to a different holder, the substance of the transaction
is likely that of a modification of existing debt, which should be evaluated to
determine whether it should be accounted for as a modification or extinguishment
under ASC 470-50. However, if a debtor initiates the transaction and the funds
pass through the debtor or its agent, the substance of the transaction may be
that of a repayment of the existing debt and the issuance of new debt to a
different holder.
If a contractual modification and transfer of a debt instrument, in substance,
represents a market issuance of new debt to replace old debt, the debtor may
elect to treat it as an extinguishment of the original debt even if no funds
pass through the debtor or its agent. This guidance is only applicable if the
terms of the new debt are equivalent to those of an arm’s-length market offering
(e.g., market yield and credit spread) that is independent of the redemption of
the old debt (see Section 10.2.13).
10.2.9 Transactions With Third Parties
ASC 470-50
15-3 The guidance in this
Subtopic does not apply to the following transactions
and activities: . . .
c. Transactions entered into between a debtor
or a debtor’s agent and a third party that is not
the creditor.
55-9 The following
situations do not result in an extinguishment and would
not result in gain or loss recognition under either
paragraph 405-20-40-1 or this Subtopic: . . .
c. An agreement with a creditor that a debt
instrument issued by the debtor and held by a
different party will be redeemed.
ASC 470-50 does not apply to transactions between the debtor (or
its agent) and a party other than the holder of the debt unless that other party
is acting as an agent in the transaction (see Section 10.5.2). For example, if a debtor
enters into a call option or forward purchase agreement that would result in a
debt redemption upon settlement, that transaction would not be evaluated under
ASC 470-50 if the counterparty does not hold the debt that is subject to
redemption.
10.2.10 Exchanges of Debt Issued by Different Entities Within a Consolidated Group
In consolidated financial statements, the debt of any entity within the
consolidated group represents debt of the reporting entity. If debt issued by
one entity within the group (e.g., a subsidiary) is exchanged for debt issued by
another entity within the group (e.g., the parent), that debt exchange should be
evaluated under ASC 470-50 to determine whether extinguishment or modification
accounting is appropriate in the consolidated financial statements that include
both of those entities. However, ASC 470-50 does not apply to financial
statements that do not include both entities.
10.2.11 Convertible Debt
ASC 470-50
15-3 The guidance in this
Subtopic does not apply to the following transactions
and activities:
- Conversions of debt into equity securities of the debtor pursuant to conversion privileges provided in the terms of the debt at issuance. Additionally, the guidance in this Subtopic does not apply to conversions of convertible debt instruments pursuant to terms that reflect changes made by the debtor to the conversion privileges provided in the debt at issuance (including changes that involve the payment of consideration) for the purpose of inducing conversion. Guidance on conversions of debt instruments (including induced conversions) is contained in paragraphs 470-20-40-13 and 470-20-40-15. . . .
If an issuer modifies or exchanges an outstanding convertible debt instrument, it
should assess whether the transaction should be accounted for as a modification
or an extinguishment of the original instrument under ASC 470-50. This guidance
does not apply to:
-
Conversions that occur under the original terms of the instrument (see Chapter 12).
-
Changes to the terms of the conversion privileges that represent an induced conversion under ASC 470-20 (see Section 12.3.4).
-
Conversion price adjustments that are made in accordance with the original terms of the instrument. For example, an adjustment under a down-round protection feature is not evaluated as a modification under ASC 470-50. Instead, the issuer should evaluate such provisions under other applicable GAAP.
10.2.12 Exchanges of Debt for Common or Preferred Stock
ASC 470-50
15-2 The guidance in this
Subtopic applies, in part, to the following transactions
and activities:
-
Extinguishments of debt effected by issuance of common or preferred stock, including redeemable and fixed-maturity preferred stock, that do not represent the exercise of a conversion right contained in the terms of the debt at issuance.
If a debtor settles outstanding debt by issuing equity-classified shares
(including equity instruments classified in temporary equity), the guidance on
modifications and exchanges in ASC 470-50 does not apply. Instead, the exchange
is accounted for as a debt extinguishment under ASC 470-50-40-3 (see
Section 9.3.3) unless it is a TDR (see Chapter 11) or represents a conversion (see
Chapter 12).
If outstanding debt is exchanged for shares that must be
classified as liabilities under ASC 480 (i.e., mandatorily redeemable financial
instruments and certain variable-share obligations; see Deloitte’s Roadmap
Distinguishing
Liabilities From Equity), the guidance on modifications
and exchanges of debt in ASC 470-50 should be applied.
10.2.13 Market Issuances of New Debt to Replace Old Debt
If a debtor issues new debt and uses some or all of the proceeds
to contemporaneously repurchase some or all of its existing debt according to
either its preexisting redemption terms or a tender offer made to all holders of
the existing debt, the debtor would not necessarily be required to view all or a
portion of those transactions as a debt exchange to which ASC 470-50 applies
even if some of the new debt is purchased by investors that held the debt that
was redeemed. Instead, it is acceptable for the debtor to evaluate the
substantive terms of the transactions to determine whether they should be
analyzed as either (1) an extinguishment of the existing debt under ASC 405-20
and the separate issuance of new debt (see Chapter 9) or (2) an exchange of debt
instruments under ASC 470-50-40-6 through 40-12 for the portion of new debt held
by continuing investors.
In evaluating whether transactions with continuing investors
should be analyzed as a debt exchange under ASC 470-50, the debtor should
consider whether the redemption of the old debt and issuance of the new debt
were negotiated together or in contemplation of one another (i.e., contingent
upon one another). While this evaluation can be complex because it involves debt
issued to multiple investors, if the facts suggest that the new debt offering
was an arm’s-length market offering that was independent of the redemption of
the old debt, it is acceptable to treat the redemption of the old debt and
issuance of new debt as separate transactions. Example 10-2 illustrates the conditions that must be met for an
entity to conclude that the repayment of existing debt and issuance of new debt
are separate transactions.
If a conclusion is reached that the repayment of the old debt is
a transaction that is separate from the issuance of the new debt, the old debt
would be considered extinguished if any of the conditions in ASC 405-20-40-1 are
met (see Section 9.2). If none of the
conditions in ASC 405-20-40-1 are met, accounting for the repayment of the old
debt and issuance of the new debt as separate transactions is unlikely to be
appropriate (i.e., an entity should apply the guidance in ASC 470-50 to
determine the appropriate accounting).
Connecting the Dots
It is always acceptable to apply ASC 470-50 on a creditor-by-creditor
basis to the extent that the same investor(s) held old debt and
purchased new debt (see Section
10.3.2). An entity’s decision to apply extinguishment
accounting to all of the old debt (when the issuance and repayment
transactions may be considered separate) as opposed to applying ASC
470-50 on a creditor-by-credit basis is an accounting policy election
that must be consistently applied.
If the redemption of old debt and the issuance of new debt were
negotiated together or in contemplation of one another (i.e., contingent
on one another), they would not be considered separate transactions.
Accordingly, an entity would apply the guidance on debt exchanges in ASC
470-50 on a creditor-by-creditor basis. Note that the mere fact that the
old debt is legally extinguished is not sufficient evidence by itself to
support a conclusion that the redemption of the old debt and issuance of
the new debt are separate transactions.
Example 10-2
Market Issuance of New Debt to Repay Outstanding
Debt
On March 1, 20X4, Entity C engages a
bank to place $300 million of new debt into the market.
Entity C plans to use the proceeds to repurchase some of
its old debt. Given the interest rate environment and
the company’s financial condition, C believes that it
can obtain a lower long-term financing cost by
undertaking these transactions. Also assume that the
following conditions exist:
-
The old debt was redeemed in accordance with either (1) a preexisting early-redemption option in the original debt agreement or (2) a tender offer to all debt holders as opposed to a separately negotiated early redemption with one or more investors in the old debt.
-
The issuance of new debt was facilitated by an agent (e.g., an underwriter) that offered the new debt to qualified investors in the marketplace, which may include (but would not be limited to) investors that held the old debt. None of the investors in the old debt were required to participate in the issuance of the new debt. In addition, the holders of the old debt were not involved in the negotiations of the terms and conditions of the new debt (unless one of the debt holders acted in a placement-agent capacity for the new debt).
-
The purchase of new debt by investors that held the old debt was an investment decision that is separate from the redemption of the old debt.
-
No preferential treatment was given to investors in the old debt (i.e., old and new investors were offered the same terms in the new debt offering).
-
There was inherently going to be overlap between the investors in the old and new debt because a large number of investors in the marketplace held the old debt.
-
New investors purchased more than an insignificant portion of the new debt.
-
The cash inflows from the issuance of the new debt and the cash outflows from the repayment of the old debt occurred on a gross, as opposed to a net, basis.
-
Entity C was not experiencing financial difficulties.
Given the above conditions, C is not
required to apply ASC 470-50 to the portion of the old
debt that has been redeemed and is held by investors in
the new debt. Instead, it may apply extinguishment
accounting to all of the old debt in accordance with ASC
405-20. It is also acceptable for C to apply ASC 470-50
on a creditor-by-creditor basis to the extent that the
same investor(s) held old debt and purchased new debt.
An entity’s decision to apply extinguishment accounting
to all of the old debt as opposed to applying ASC 470-50
on a creditor-by-creditor basis is an accounting policy
election that must be consistently applied.
Note the following about this example:
-
If any of the above conditions are not met, C should apply the guidance on modifications and exchanges of debt in ASC 470-50. In other words, market issuances of debt that are treated separately from repayments of existing debt are limited to transactions that involve either the public issuance of debt or the private issuance of debt to qualified institutional investors in accordance with an exemption from registration with the SEC. Debt syndication transactions are not expected to qualify as market issuances of debt that are separate from repayments of existing debt.
-
The above conditions focus only on whether it is acceptable to view the repayment of the old debt and issuance of new debt as separate transactions for accounting purposes. If the two transactions are treated separately, C must still conclude that one of the conditions for extinguishment accounting in ASC 405-20-40-1 is met before it can derecognize the old debt. (The same is not true if the two transactions are treated as a modification or exchange, because a legal extinguishment of the modified or exchanged debt is not required in the application of debt extinguishment accounting under ASC 470-50.)
10.3 Determining Whether Debt Terms Are Substantially Different
10.3.1 Background
If a debtor modifies or exchanges an outstanding debt instrument with the same
creditor in a transaction that is not a TDR (see Chapter 11), the accounting depends on whether the original and
new debt terms are substantially different. The guidance that applies to
modifications and exchanges is the same because they have the same economic
effect, and in both cases, the debtor continues to have debt outstanding with
the same creditor on revised terms.
Under ASC 470-50, debt terms are considered substantially different in each of
the following circumstances:
-
The 10 percent cash flow test is passed (see Section 10.3.3).
-
The fair value of an embedded conversion option changes by at least 10 percent of the carrying amount of the original debt instrument (see Section 10.3.4.2).
-
A substantive conversion option is added to, or eliminated from, the debt terms (see Section 10.3.4.3).
If the new debt terms are substantially different from the original debt terms,
the original debt is accounted for as being extinguished and a new debt
instrument is recognized (see Section 10.4.2). If the new
debt terms are not substantially different from the original debt terms, the
transaction is accounted for as a modification of the original debt terms (see
Section 10.4.3).
10.3.2 Level of Aggregation
10.3.2.1 Background
A debtor needs to determine the appropriate level of
aggregation for its analysis of any modification or exchange if a particular
debt instrument is held by more than one creditor (see the next section) or
a creditor holds more than one debt instrument (see Section 10.3.2.3).
Special considerations are necessary for loan participations and loan
syndications (see Section
10.3.2.4).
10.3.2.2 Multiple Holders of Identical Debt Instruments
ASC Master Glossary
Public Debt Issuance
A public debt issuance occurs when a debtor issues a
number of identical debt instruments to an
underwriter that sells the debt instruments (in the
form of securities) to various investors.
ASC 470-50
55-3 In a public debt
issuance, for purposes of applying the guidance in
this Subtopic, the debt instrument is the individual
security held by an investor, and the creditor is
the security holder. If an exchange or modification
offer is made to all investors and only some agree
to the exchange or modification, then the guidance
in this Subtopic shall be applied to debt
instruments held by those investors that agree to
the exchange or modification. Debt instruments held
by those investors that do not agree would not be
affected.
When identical debt instruments are held by more than one
creditor (e.g., in a public debt issuance), the debtor applies the
modification and exchange guidance in ASC 470-50 separately to the debt held
by each individual creditor (i.e., on a creditor-by-creditor basis). If all
holders do not participate in the modification or exchange, the debtor
applies ASC 470-50 only to debt held by those creditors that participate. A
debt arrangement involving multiple lenders may be structured as a loan
participation, in which case the debtor has only one creditor (see Section 10.3.2.4).
If a modification or exchange involves multiple
creditors that belong to the same consolidated group or otherwise are
under common control, the debtor should apply judgment and consider the
economic substance of the transaction to determine whether those
creditors should be treated as one or multiple creditors when applying
the guidance in ASC 470-50 (see Section
10.3.2.3). In most cases, multiple creditors that
are controlled by the same parent or entity will be treated as a single
creditor under ASC 470-50.
If a collective assessment would produce the same outcome as an individual
assessment (e.g., all holders that participate in a modification or exchange
of identical debt instruments receive the same new debt terms), a debtor
does not need to perform separate assessments for each individual creditor
that participates in the transaction to determine whether to account for
that creditor’s debt as an extinguishment. However, if different creditors
(or creditor groups) obtain different debt terms under a modification or
exchange, or the effective interest rate on debt held by different creditors
is not the same, the debtor would need to apply ASC 470-50 separately to
each creditor or creditor group.
As discussed in Section 10.2.13, a
debtor is not required to apply ASC 470-50 to certain market issuances of
new debt to replace old debt even if some creditors hold both the original
and new or modified debt.
10.3.2.3 Multiple Debt Instruments Held by the Same Creditor
Sometimes, one creditor (or multiple creditors within a
consolidated group or otherwise under common control) holds multiple debt
instruments issued by the same debtor. If a modification or exchange
involves more than one existing debt instrument (or more than one new debt
instrument), a debtor should apply judgment and consider the economic
substance of the transaction to determine whether the modification or
exchange should be evaluated on the basis of an aggregation of individual
debt instruments. In many cases, the evaluation will be performed on an
aggregated basis because either (1) it is not possible to perform the
evaluation on an individual-instrument basis (e.g., two existing debt
instruments are exchanged for one new instrument) or (2) the transaction was
negotiated as an overall package (e.g., the debtor accepts less favorable
terms on one debt instrument in exchange for more favorable terms on a
different debt instrument). Aggregating debt instruments in the application
of ASC 470-50 is consistent with the accounting for multiple transactions
executed contemporaneously or in contemplation of one another (i.e.,
contingent upon one another). While it would generally be difficult to
establish that contemporaneous transactions between a debtor and a creditor
were not contingent on one another, other relevant facts and circumstances
involving the transactions may suggest otherwise. In performing the 10
percent cash flow test, the debtor would calculate and use a composite
effective interest rate for any debt instruments that are evaluated on an
aggregated basis (see Section 10.3.3.3).
10.3.2.4 Loan Participations and Loan Syndications
ASC Master Glossary
Loan
Participation
A transaction in which a single
lender makes a large loan to a borrower and
subsequently transfers undivided interests in the
loan to groups of banks or other entities.
Loan
Syndication
A transaction in which several
lenders share in lending to a single borrower. Each
lender loans a specific amount to the borrower and
has the right to repayment from the borrower. It is
common for groups of lenders to jointly fund those
loans when the amount borrowed is greater than any
one lender is willing to lend.
ASC 470-50
55-1 Based on the definition
of a loan participation, for purposes of applying
the guidance in this Subtopic, the debt instrument
would be the contract between the debtor and the
lead bank. Participating banks are not direct
creditors but, rather, have an interest represented
by a certificate of participation. In the event of a
modification or exchange between the debtor and lead
bank, the debtor shall apply the guidance in this
Subtopic.
55-2 Based on the definition
of a loan syndication, for purposes of applying the
guidance in this Subtopic, separate debt instruments
exist between the debtor and the individual
creditors participating in the syndication. If an
exchange or modification offer is made to all
members of the syndicate and only some of the
creditors agree to the exchange or modification, the
guidance in this Subtopic would be applied to debt
instruments held by those creditors that agree to
the exchange or modification. Debt instruments held
by those creditors that do not agree would not be
affected.
Loan participations and loan syndications both involve more
than one lender. Legally, however, they are structured differently and
therefore ASC 470-50 does not treat them the same.
-
In a loan participation, the debtor legally has only one loan. That loan is subdivided by a lead lender into multiple undivided interests, which are transferred by the lead lender to individual lenders. Since the arrangement contractually is structured as only one loan, there is only one creditor under ASC 470-50. Therefore, the debtor performs the analysis under ASC 470-50 for the debt arrangement as a whole (i.e., it represents only one unit of account under ASC 470-50) even if new lenders join or existing lenders leave.
-
In a loan syndication, the debtor legally has separate loans from each member of the syndicate and each lender has a contractual right to payments from the debtor. Therefore, ASC 470-50 treats this arrangement as having multiple creditors (i.e., a separate unit of account for each lender in the syndicate). If the terms of some or all of the syndicated loans are modified, the debtor must perform separate analyses under ASC 470-50 for each member in the syndicate. If a new lender joins the syndicate and extends amounts to the debtor, the debtor treats those amounts as new debt. If the debtor pays off the debt outstanding to an existing member of the syndicate, that debt is accounted for as being extinguished (see Section 9.3). If one loan is modified, but the loans with other members in the loan syndication are not modified, ASC 470-50 is applied only to the loan that was modified.
Often a member of a loan syndication (e.g., an investment
bank) provides services that are not directly attributable to its role as a
lender in the syndication. For example, that member might arrange the
overall set-up of a loan syndication and any modifications to the terms of
each of the syndicated loans. Because the accounting for lender fees and
third-party costs are different under ASC 470-50, the debtor may need to
allocate any fees paid to that member between fees that are appropriately
characterized as creditor fees and costs for services that are not
attributable to that member’s role as a creditor (see Section
10.3.3.2.4).
10.3.3 The 10 Percent Cash Flow Test
10.3.3.1 Background
ASC 470-50
40-10 From the debtor’s
perspective, an exchange of debt instruments between
or a modification of a debt instrument by a debtor
and a creditor in a nontroubled debt situation is
deemed to have been accomplished with debt
instruments that are substantially different if the
present value of the cash flows under the terms of
the new debt instrument is at least 10 percent
different from the present value of the remaining
cash flows under the terms of the original
instrument. . . .
One circumstance in which the terms of two debt instruments
are considered substantially different under ASC 470-50 is when such terms
pass the 10 percent cash flow test. The 10 percent cash flow test involves a
comparison of the following two amounts: (1) the present value of the cash
flows under the terms of the modified or new debt instrument and (2) the
present value of the remaining cash flows under the terms of the original
instrument.1 To perform this test, the debtor must determine the timing and amount
of the future cash flows of both the original debt and the new debt
(Section
10.3.3.2) as well as the interest rate that should be used to
discount those cash flows (see Section 10.3.3.3). Special
considerations are necessary if an entity has made consecutive modifications
or exchanges within a 12-month period (Section 10.3.3.4). A modification or
exchange of a debt instrument passes the 10 percent cash flow test if the
present value of the new cash flows is at least 10 percent different from
the present value of the remaining original cash flows.
An exchange or modification of nontroubled debt that passes the 10 percent
cash flow test is accounted for as an extinguishment (see Section
10.4.2). If the 10 percent cash flow test is not passed, the
debtor should consider the guidance on embedded conversion features (see
Section 10.3.4) before determining whether
extinguishment accounting applies.
10.3.3.2 Cash Flows
10.3.3.2.1 Background
ASC 470-50 contains guidance on how a debtor should determine the cash
flows of the original and new or modified debt, including:
-
The cash flows of the new debt instrument (see Section 10.3.3.2.2).
-
The exercise of contractual provisions in connection with a modification or exchange (see Section 10.3.3.2.3).
-
The treatment of creditor fees and third-party costs (see Section 10.3.3.2.4).
-
The calculation of the cash flows on variable-rate debt (see Section 10.3.3.2.5).
-
The cash flow assumptions when debt contains an embedded put or call option (see Section 10.3.3.2.6).
-
The cash flow assumptions for debt with contingent payment features or unusual payment terms (see Section 10.3.3.2.7).
-
The treatment of sweeteners and other noncash consideration (see Section 10.3.3.2.8).
-
Changes to debt terms that do not directly affect the cash flows (see Section 10.3.3.2.9).
-
A change in the currency in which the cash flows are denominated (see Section 10.3.3.2.10).
-
The treatment of conversion features (see Section 10.3.3.2.11).
10.3.3.2.2 Cash Flows of New Debt
ASC 470-50
40-12 The following guidance
shall be used to calculate the present value of
the cash flows for purposes of applying the 10
percent cash flow test described in paragraph
470-50-40-10:
- The cash flows of the new debt instrument include all cash flows specified by the terms of the new debt instrument plus any amounts paid by the debtor to the creditor less any amounts received by the debtor from the creditor as part of the exchange or modification. For a modification or an exchange of a freestanding equity-classified written call option held by a creditor that is a part of or directly related to a modification or an exchange of an existing debt instrument held by that same creditor (see paragraphs 815-40-35-14 through 35-15 and 815-40-35-17(c)), an entity shall apply the guidance in paragraph 470-50-40-12A. . . .
40-12A
If a modification or an exchange of a freestanding
equity-classified written call option held by a
creditor is a part of or directly related to a
modification or an exchange of an existing debt
instrument held by that same creditor (see
paragraphs 815-40-35-14 through 35-15 and
815-40-35-17(c)), an increase or a decrease in the
fair value of the freestanding equity-classified
written call option held by the creditor,
calculated in accordance with paragraph
815-40-35-16, shall be included in the application
of the 10 percent cash flow test described in
paragraph 470-50-40-10.
ASC 470-50-40-12(a) requires a debtor to include all
contractual cash flows of the new debt instrument (e.g., future
principal and interest payments) as well as any amounts exchanged
between the debtor and the creditor as part of the modification or
exchange (e.g., amounts identified as fees, principal repayments, and
additional borrowings) in the calculation of the present value of the
cash flows of the new debt instrument. Any costs paid to third parties,
however, are excluded from this calculation (see Section
10.3.3.2.4). Special considerations are necessary if the
debtor and creditor exchange amounts in accordance with the contractual
provisions of the original debt in conjunction with a debt modification
or exchange (see Section 10.3.3.2.3). The debt’s fair value is not
relevant to whether the 10 percent cash flow test is passed. However,
the fair value of any noncash consideration exchanged should be
considered (see Section 10.3.3.2.8). Further, special considerations
apply if the original or new debt contains an embedded conversion
feature (see Section
10.3.4). In addition, when performing the 10 percent cash
flow test described in ASC 470-50-40-10, an entity should include any
increase or decrease in the fair value of a freestanding
equity-classified written call option held by the creditor that was
modified in conjunction with the debt modification or exchange,
calculated in accordance with ASC 815-40-35-16.
If a debtor receives cash from a creditor as part of a
modification or exchange (e.g., to increase the debt’s principal
amount), the amount received is treated as an immediate (“day 1”) cash
inflow associated with the new debt (i.e., this amount does not need to
be discounted). Therefore, this amount reduces the net present value of
the future cash flows on the new debt. Conversely, if the debtor pays
cash to the creditor (e.g., to reduce the debt’s principal amount), the
amount paid is treated as an immediate cash outflow associated with the
new debt. Accordingly, this amount increases the net present value of
the future cash flows on the new debt.
Because the calculation of the present value of the cash
flows of the new debt includes all cash flows of the new instrument and
any amounts exchanged as result of the modification or exchange, a
debtor cannot, when performing the 10 percent cash flow test, treat any
increase or decrease in the principal amount as new borrowings or as
extinguishment of a portion of the original debt that is separate from
the modification or exchange. Instead, those cash flows are included in
the 10 percent cash flow test. However, note that a principal payment or
an additional borrowing in excess of 10 percent of the present value of
the debt’s carrying amount immediately before a modification or exchange
would not itself cause the 10 percent cash flow test to be passed.
Rather, the calculation of the present value of the cash flows of the
new debt must take into account the change in the remaining future
principal and interest cash flows on a present value basis.
Example 10-3
Modification
of Debt That Includes an Additional Borrowing or
Partial Repayment
Additional Borrowing
Entity R has outstanding nonprepayable debt with
Entity Z, under which interest must be paid
quarterly at an annual rate of 10 percent (i.e.,
$2.25 million per quarter) and a $90 million
principal payment is due on December 31, 20X5. The
net carrying amount of the debt as of October 1,
20X2, is $86.4 million, which results in an
effective interest rate on the debt of 11.5
percent. Note that the carrying amount of the debt
includes a $3.6 million unamortized original issue
discount. For simplicity, it is assumed in this
example that there are no capitalized debt
issuance costs.
In a transaction that is not considered a TDR, R
and Z agree to modify the terms of the outstanding
debt on October 1, 20X2, as follows:
- Entity R issues warrants with a fair value of $1 million to Z to purchase R’s common stock.
- Entity Z lends R an additional $30 million that is due on December 31, 20X5.
- The interest rate on the debt is changed to 10.5 percent.
- Quarterly interest payments on the debt are changed to $2.0 million. As a result, the amount due at maturity increases to $137.5 million (i.e., $90 million originally due + $30 million additional principal + deferred quarterly interest payments of $17.5 million).
Using the effective interest rate on the original
debt of 11.5 percent, R calculates the net present
value of the future cash flows on the new debt to
be $116.6 million. Therefore, R determines the
change in the net present value of cash flows on
the debt as follows (all amounts rounded in
thousands):
Because the change in net present value of cash
flows is less than 10 percent, R should treat the
changes to the terms of the debt as a
modification. Note that if R had not accounted for
the additional borrowing in this manner when it
performed the 10 percent cash flow test, it would
have inappropriately concluded that the change in
terms of the debt was an extinguishment.
Partial Repayment
Assume the same facts described above regarding
the original terms of the debt instrument.
In a transaction that is not considered a TDR, R
and Z agree to modify the terms of the outstanding
debt on October 1, 20X2, as follows:
- Entity R issues warrants a fair value of $1 million to Z to purchase R’s common stock.
- Entity R repays $30 million of the principal amount of the debt.
- The interest rate on the debt is changed to 9.5 percent.
- Quarterly interest payments on the debt are changed to $1.425 million, which represents quarterly payments at the revised stated interest rate (i.e., no deferred interest payments).
Using the effective interest rate on the original
debt of 11.5 percent, R calculates the net present
value of the future cash flows on the new debt to
be $56.788 million. Therefore, R determines the
change in the net present value of cash flows on
the debt as follows (all amounts rounded in
thousands):
Because the change in net present value of cash
flows is less than 10 percent, R should treat the
changes to the terms of the debt as a
modification. Note that if R had not accounted for
the partial repayment in this manner when it
performed the 10 percent cash flow test, it would
have inappropriately concluded that the change in
terms of the debt was an extinguishment. Although
the debt is not considered extinguished under ASC
470-50, R should nevertheless account for the
partial repayment (see Section
10.4.3.2), which will result in a loss
upon partial extinguishment because R would
derecognize a portion of the unamortized original
discount pertaining to the amount repaid.
Connecting the Dots
A debtor may repay a portion of the outstanding principal amount
of a debt instrument in conjunction with a modification or
exchange that is not accounted for as an extinguishment.
Although the debtor does not consider the entire original debt
instrument extinguished for accounting purposes, it must still
recognize the principal repayment as a partial extinguishment of
the original debt instrument. That is, the debtor first
considers the principal repayment as an undiscounted increase in
the present value of the cash flows of the new debt instrument
to determine whether the original debt instrument should be
considered extinguished in its entirety as a result of the
modification or exchange. If extinguishment accounting is not
required for the original debt instrument, the debtor still
appropriately accounts for the partial repayment of the original
debt instrument. The accounting for such partial repayment
should include the derecognition of a proportionate amount of
any remaining unamortized debt premiums or discounts (including
debt issuance costs) to reflect the fact that a portion of the
original debt instrument has been repaid (see Section
10.4.3.2).
10.3.3.2.3 Exercise of Contractual Provisions in Connection With a Modification or Exchange
Although prespecified changes to the cash flows of a debt instrument that
result from existing contractual terms (e.g., a partial prepayment of
the principal amount pursuant to a contractual prepayment feature) are
not debt modifications (see Section
10.2.7), special considerations are necessary if a debtor
or creditor exercises a contractual provision in the original debt in
conjunction with a modification or exchange.
If a transaction occurs that involves both the exercise of a contractual
feature in the original debt and a modification to the debt terms, the
debtor’s or creditor’s decision to exercise the contractual feature may
be influenced by the modification of the other contractual terms. If the
interest rate on the debt is below current market rates, for example,
the debtor might agree to exercise a contractual prepayment feature that
is out-of-the-money in exchange for a reduction in the interest rate on
the remaining debt balance. Therefore, it is typically appropriate to
treat all cash flows exchanged between the debtor and the creditor,
including cash flows associated with the exercise of a contractual
feature in the original debt in conjunction with a debt modification or
exchange, as being part of the debt modification or exchange under ASC
470-50-40-12(a). In this circumstance, a partial prepayment is treated
as an immediate cash outflow associated with the new debt under the 10
percent cash flow test (see Section
10.3.3.2.2).
10.3.3.2.4 Fees and Costs
ASC 470-50
05-4 When debtors undergo
a modification or exchange of a debt instrument,
the resulting cash flows can be affected by
changes in principal amounts, interest rates, or
maturity. They can also be affected by fees
exchanged between the debtor and creditor to
effect changes in any of the following:
-
Recourse or nonrecourse features
-
Priority of the obligation
-
Collateralized (including changes in collateral) or noncollateralized features
-
Debt covenants or waivers
-
The guarantor (or elimination of the guarantor)
-
Option features.
Amounts the debtor pays to or receives from the creditor
as part of a modification or exchange, as well as other noncash
consideration exchanged in accordance with Sections 10.3.3.2.2 and 10.3.3.2.8, are included in the cash flows of the new
debt instrument as an immediate (day 1) cash flow. This includes any
fees exchanged between the debtor and the creditor as part of the
modification or exchange, such as fees paid by the debtor to obtain a
waiver of a debt covenant, fees paid by a creditor to remove a call
option, or fees related to changes in recourse provisions, collateral,
or other debt terms. However, under the 10 percent cash flow test, any
third-party fees or costs are excluded, such as fees paid to
accountants, attorneys, or financial advisers.
If a debtor pays the creditor’s advisers on behalf of
the creditor for legal, due diligence, or other costs as part of a
modification or exchange of debt, those costs should be treated
similarly to fees paid directly to the creditor. For example, if a
debtor pays a fee to an attorney that represents a group of bondholders,
the amount paid should be treated as a payment to the bondholders even
though the payment was made directly to a third party. Similarly, if a
debtor reimburses a creditor for costs related to a covenant waiver, the
debtor should treat those costs as it would any other fees paid by the
debtor to the creditor even if the debtor paid such amounts directly to
the creditor’s advisers. In other words, the costs of a creditor that
are paid by the debtor directly to a third party that performed services
for the creditor should be treated as if they were paid to the creditor
in the determination of whether a modification or exchange constitutes
an extinguishment.
In some modifications or exchanges, a counterparty may simultaneously
serve as both creditor and underwriter of debt with other creditors. For
example, in a loan syndication arrangement, the underwriter may hold a
portion of the total loan facility after the syndication. In such
circumstances, the debtor may need to allocate amounts paid to the
underwriter between fees paid to the underwriter in its capacity as a
creditor (for the portion of the debt agreement that the underwriter
receives in the syndication) and fees paid to the underwriter in its
capacity as a third party underwriting the loan facility with other
creditors. Fees paid to the creditor are included in the 10 percent cash
flow test, whereas fees paid to third parties, such as attorneys and
accountants, are excluded from it.
If a debtor pays a lead creditor an administrative fee
as compensation for serving as an administrative agent for multiple
creditors in a loan syndication and the creditor does not own a
significant portion of the entity’s outstanding debt, the administrative
fee is considered an amount paid to a third party rather than an amount
paid to a creditor. If a creditor serves as an administrative agent and
owns a significant portion of the outstanding debt that is being
modified or exchanged, the determination of whether the administrative
fee represents an amount paid to a third party, an amount paid to the
creditor, or contains elements of both will depend on the particular
facts and circumstances. A payment to an entity in its capacity as an
administrative agent is considered an amount paid to a third party
rather than an amount paid to a creditor even if the administrative
agent is also a creditor. Entities should also be mindful that a lead
creditor may be receiving fees for performing services other than
administrative agent services, so it is important to understand whether
the fees need to be allocated between costs attributable to the debt
modification or exchange and costs attributable to other services.
10.3.3.2.5 Variable-Rate Debt
ASC 470-50
40-12 The following
guidance shall be used to calculate the present
value of the cash flows for purposes of applying
the 10 percent cash flow test described in
paragraph 470-50-40-10: . . .
b. If the original debt instrument or the new
debt instrument has a floating interest rate, then
the variable rate in effect at the date of the
exchange or modification shall be used to
calculate the cash flows of the variable-rate
instrument. . . .
If debt has a variable interest rate either before or after a
modification or exchange, ASC 470-50 requires the variable rate in
effect on the date of the exchange or modification (i.e., the spot
interest rate for the applicable interest period) to be used to estimate
the future cash flows of the variable-rate instrument. The guidance does
not permit a debtor to use a yield curve of forward rates to project
future interest payments. Section 10.3.3.3
discusses the discount rate that should be used in determining the
present value of the cash flows of variable-rate debt.
10.3.3.2.6 Puttable or Callable Debt
ASC 470-50
40-12 The following
guidance shall be used to calculate the present
value of the cash flows for purposes of applying
the 10 percent cash flow test described in
paragraph 470-50-40-10: . . .
c. If either the new debt instrument or the
original debt instrument is callable or puttable,
then separate cash flow analyses shall be
performed assuming exercise and nonexercise of the
call or put. The cash flow assumptions that
generate the smaller change would be the basis for
determining whether the 10 percent threshold is
met. . . .
If the terms of the original or new debt or both permit the debtor to
prepay (call) or the creditor to demand early repayment (put) or both,
ASC 470-50 requires the debtor to perform the 10 percent cash flow test
in each possible scenario, irrespective of the intentions or
expectations of the parties regarding exercise of the options. In one
scenario, the test is applied to the cash flows that would exist if no
put or call option is exercised. In other scenarios, the test is applied
to the cash flows that would result if each option is exercised in a
manner consistent with its contractual terms (e.g., if an option can
only be exercised on a specified date, the timing of the assumed cash
flows would reflect that). The debtor should consider all possible
contractual scenarios, including by varying the prepayment date, related
penalties or premiums (if any), and other relevant terms.
In determining whether the 10 percent threshold is passed, the debtor
should use the cash flow assumptions that generate the smaller (or, if
there are more than two scenarios, smallest) change in the present
value. If there is at least one scenario in which the present value of
cash flows under the new debt instrument is less than 10 percent
different from the present value of the remaining cash flows under the
original terms, the 10 percent cash flow test is not passed.
If a debtor concludes that the difference in the present value of the
cash flows is less than 10 percent in at least one scenario, the debtor
is not required to apply the 10 percent cash flow test to the remaining
scenarios. If both the original debt and the new debt are immediately
prepayable for the same amount and no cash flows were exchanged as part
of the modification or exchange, the 10 percent cash flow test would not
be passed since the present values would be the same.
An entity should carefully consider the terms of a call or put feature
when performing the 10 percent cash flow test. For example, an entity
may need to consider the following:
-
The specific terms of prepayment provisions under the original debt instrument may differ from those under the new debt instrument. In the calculation of the present value of cash flows, a debtor should use the specific terms of the original prepayment provision to calculate the remaining cash flows under the original debt instrument and use the new prepayment terms for the new debt instrument.
-
Debt often has more than one potential prepayment date. The debtor’s scenario analysis should take into account the potential cash flows that would result on any potential prepayment date. If a put or call option is only exercisable on a specified date (or dates), the debtor would assume that it is exercised on that date (or those dates).
-
Prepayment may be prohibited for a specified period. The 10 percent cash flow test is only applied to prepayment scenarios that could occur in accordance with the debt’s contractual terms.
-
Prepayment may carry a penalty or premium, and that penalty or premium may change over time. Prepayment penalties or premiums are treated as part of the debt’s cash flows in the potential scenarios in which those penalties or premiums would apply.
-
Sometimes put or call options are contingent. The debtor should consider the facts and circumstances as of the date of the modification or exchange in evaluating whether the 10 percent cash flow test should take into account scenarios in which a contingent put or call option is exercised (see Section 10.3.3.2.7).
Note that the debtor should not consider (1) the likelihood that a
noncontingent option will be exercised or (2) its intent and ability to
exercise an option.
Example 10-4
Application of 10 Percent Cash Flow
Test
On January 1, 20X0, Company A entered into a
10-year $500,000 senior secured loan agreement
with Bank B that requires A to make quarterly
principal and interest payments to B. The
quarterly compounded contractual interest rate is
10 percent per annum, and the loan matures on
January 1, 20Y0. Company A determines that the
effective interest rate equals the contractual
interest rate. Under the terms of the loan, A can
prepay the loan in full at any time for an amount
equal to the unpaid principal and accrued interest
on the date of prepayment without any penalty. On
July 1, 20X5, A and B agree to amend the loan
agreement to ease certain financial covenants. In
return, A agrees to an increase in the contractual
interest rate to 15 percent, which reflects
changes in market rates and the modified
covenants. Company A determines that the
modification is not a TDR (see Chapter 11). After the
modification, A can still prepay the loan at any
time with no penalty.
In applying the 10 percent cash flow test to the
loan modification, A calculates the following amounts:
-
The present value of remaining cash flows under the original terms, assuming (1) exercise of the prepayment option and (2) nonexercise of the prepayment option.
-
The present value of the cash flows under the terms of the modified debt instrument, assuming (1) exercise of the prepayment option and (2) nonexercise of the prepayment option.
Because prepayment can occur at any time without
a penalty, A assumes in the present value
calculations that the prepayment occurs on the
earliest possible date (i.e., immediately after
the modification). On July 1, 20X5, the unpaid
principal amount of the original debt instrument
is $285,892. Company A performs the following
steps as part of the 10 percent cash flow test:
- Determine the present value of the cash flows
of the original debt instrument:
-
Assuming exercise of the prepayment option on July 1, 20X5, which results in a present value of remaining cash flows equal to an outflow of $285,892 (unpaid principal with no accrued interest).
-
Assuming nonexercise of the prepayment option:
-
Company A makes quarterly payments of $19,918 through January 1, 20Y0, on the basis of the original terms ($500,000 loan, maturing on January 1, 20Y0, with quarterly payments of principal and interest at 10 percent).
-
The discount rate is the effective interest rate, for accounting purposes, of the original debt instrument (i.e., 10 percent).
-
Accordingly, the present value of the cash flows of the original debt instrument is $285,892.
-
-
- Determine the present value of the cash flows
of the modified debt instrument:
-
Assuming exercise of the prepayment option on July 1, 20X5, which also results in a present value of $285,892.
-
Assuming nonexercise of the prepayment option:
-
Company A makes quarterly payments of $22,127 through maturity on January 1, 20Y0, calculated by using the contractual interest rate on the modified debt instrument of 15 percent and face amount of $285,892.
-
The discount rate is the effective interest rate, for accounting purposes, of the original debt instrument (i.e., 10 percent).
-
The present value of the interest and principal payments on the modified debt instrument at 10 percent is $317,598.
-
-
- Determine the percentage of change in the
present value of the debt:
-
Assuming exercise of the prepayment option for both the original and modified debt instrument, for which the percentage change in present value is 0 percent.
-
Assuming nonexercise of the prepayment option for the original debt instrument but exercise of the prepayment option for the modified debt instrument, for which the percentage change in present value is 0 percent.
-
Assuming exercise of the prepayment option for the original debt instrument but nonexercise on the modified debt instrument, for which the percentage change in present value is 11.1 percent.
-
Assuming nonexercise of the prepayment option on both the original and modified debt instrument, for which the percentage change in present value is 11.1 percent.
-
In A’s calculation, the present
value of the cash flows under the modified terms
is not substantially different from the present
value of the remaining cash flows under the
original terms when prepayment is assumed for both
the original and modified loan at the earliest
possible time or when prepayment is assumed on the
modified loan, but not the original loan. If no
prepayment is assumed for the original loan and
the modified loan, or when prepayment is assumed
only for the original loan, the present value of
the cash flows is substantially different. Because
a debtor uses the cash flow assumptions that
generate the smallest change to determine whether
the 10 percent threshold is passed, A concludes
that the 10 percent cash flow test in ASC 470-50
is not passed. Therefore, if neither the original
nor the modified debt contains a conversion
feature that meets the conditions in Section
10.3.4.2 or 10.3.4.3, the
terms of the modified debt are not considered
substantially different from the terms of the
original debt and the accounting treatment in
Section 10.4.3 applies.
10.3.3.2.7 Contingent or Unusual Payment Terms
ASC 470-50
40-12 The following
guidance shall be used to calculate the present
value of the cash flows for purposes of applying
the 10 percent cash flow test described in
paragraph 470-50-40-10: . . .
d. If the debt instruments contain contingent
payment terms or unusual interest rate terms,
judgment shall be used to determine the
appropriate cash flows. . . .
If debt has contingent payment terms or unusual interest rate features
before or after a modification or exchange, the debtor should consider
the facts and circumstances and use judgment to estimate the cash flows
of the instrument that has those terms. If debt contains a contingently
exercisable put or call option, the debtor should include a separate
cash flow scenario in which it is assumed that the option is exercised
as of the date (or dates) that it is contractually permitted to be
exercised if either (1) the contingency is met as of the date of the
modification or exchange or (2) it is probable that the contingency will
be met. If the likelihood that the contingency will be met is remote, it
should not be assumed under the 10 percent cash flow test that the put
or call option was exercised.
10.3.3.2.8 Sweeteners and Other Noncash Consideration Exchanged
ASC 470-60
55-12 When determining the
effect of any new or revised sweeteners (options,
warrants, guarantees, letters of credit, and so
forth), the current fair value of the new
sweetener or change in fair value of the revised
sweetener would be included in day-one cash flows.
If such sweeteners are not exercisable for a
period of time, that delay is typically considered
within the estimation of the initial fair value as
of the debt’s modification date.
Sometimes, a debt modification or exchange involves the transfer of
noncash consideration, such as the receipt, delivery, or modification of
freestanding financial instruments (e.g., warrants, options, or equity
shares), between the debtor and creditor. When performing the 10 percent
cash flow test, the debtor should treat the fair value of such noncash
consideration as an amount paid or received under ASC 470-50-40-12(a);
that is, as a day 1 cash flow. This is analogous to a debtor’s
requirement to treat the current fair value of any new sweetener (e.g.,
warrants, options, guarantees, or letters of credit) as an immediate day
1 cash flow in determining whether a creditor has granted a concession
under ASC 470-60-55-10 and ASC 470-60-55-12 (see Section
11.3.3.4). However, any noncash consideration paid to
third parties (e.g., attorneys, accountants, or financial advisers)
should not be reflected in the 10 percent cash flow test (see Section 10.3.3.2.4).
Example 10-5
Warrants Issued in Exchange for Maturity
Extension
An entity issues warrants to its
creditors in exchange for an extension of the
maturity date of a debt obligation. The warrants
are considered an amount paid to the creditors as
part of the modification; therefore, the entity
should include their fair value when performing
the 10 percent cash flow test under ASC
470-50-40-12(a). Irrespective of whether
extinguishment or modification accounting applies,
the warrants are recorded initially at fair value
with a credit to equity (APIC) or liabilities
depending on how they are classified (see
Deloitte’s Roadmaps Distinguishing
Liabilities From Equity and
Contracts on an Entity’s Own
Equity).
ASC 470-50 does not address how the addition, removal,
or modification of an embedded derivative that has been separated from a
debt instrument under ASC 815-15 should be reflected in the 10 percent
cash flow test. The debtor may treat such changes as the transfer of
noncash consideration (i.e., by imputing an immediate day 1 cash flow
for any change in the fair value of the embedded derivative in
connection with the modification or exchange). However, the 10 percent
cash flow test should not incorporate an imputed cash flow for the
change in the fair value of an embedded conversion feature. Instead,
conversion features are evaluated separately (see Section 10.3.3.2.11).
10.3.3.2.9 Changes to Debt Terms That Do Not Directly Affect the Cash Flows
A debt modification may involve changes to contractual terms that do not
directly affect the cash flows of the instrument (e.g., seniority in
liquidation or collateral). Typically, such changes would not by
themselves cause the amended debt terms to be considered substantially
different from the original debt terms, except for certain conversion
features (see Section 10.3.4).
10.3.3.2.10 Change in Currency
The new debt instrument might be denominated in a currency different from
that of the original debt instrument (e.g., USD debt that is modified to
become GBP debt). If the currency in which a debt instrument’s cash
flows is denominated has changed, the debtor needs to convert the cash
flows of the original or new debt so that the same currency is used to
perform the 10 percent cash flow test. The cash flows should be
converted by using an appropriate foreign currency exchange rate. For
example, the debtor might convert the cash flows by using the foreign
currency spot exchange rate as of the date of the modification or
exchange or it might use foreign currency forward exchange rates
applicable to each cash flow.
10.3.3.2.11 Conversion Features
ASC 470-50
40-12 The following
guidance shall be used to calculate the present
value of the cash flows for purposes of applying
the 10 percent cash flow test described in
paragraph 470-50-40-10: . . .
g. The change in the fair value of an
embedded conversion option resulting from an
exchange of debt instruments or a modification in
the terms of an existing debt instrument shall not
be included in the 10 percent cash flow test.
Rather, a separate test shall be performed by
comparing the change in the fair value of the
embedded conversion option to the carrying amount
of the original debt instrument immediately before
the modification, as specified in paragraph
470-50-40-10(a).
When a debtor performs the 10 percent cash flow test, it should not
impute any cash flows related to the modification of an embedded
conversion feature or the addition or removal of such a feature.
Instead, it should perform a separate analysis of such changes (see
Section 10.3.4). Note, however, that a
conversion feature that in substance represents a share-settled
redemption feature should be analyzed as a put or call option, not as a
conversion feature (see Sections
8.4.7.2.5 and 10.3.3.2.6).
10.3.3.3 Discount Rate
10.3.3.3.1 Background
ASC 470-50
40-12 The following
guidance shall be used to calculate the present
value of the cash flows for purposes of applying
the 10 percent cash flow test described in
paragraph 470-50-40-10: . . .
e. The discount rate to be used to calculate
the present value of the cash flows is the
effective interest rate, for accounting purposes,
of the original debt instrument. . . .
The discount rate used to calculate the present value of cash flows
before and after a modification or exchange is the effective interest
rate of the original debt instrument. In performing the 10 percent cash
flow test, an issuer is not permitted to use different interest rates to
discount the cash flows before and after the modification or exchange.
For example, an issuer could not apply the original effective interest
rate to discount the cash flows before a modification of a fixed-rate
debt instrument and a current market rate to discount the cash flows
after the modification.
10.3.3.3.2 Variable-Rate Debt
ASC 470-50 does not specifically address how the discount rate should be
determined for a variable-rate instrument (e.g., whether to use a
current spot rate or forward rates). Generally, the issuer should use
the effective interest rate immediately before the modification or
exchange to discount both the remaining cash flows of the original debt
and the cash flows of the new debt. This is analogous to the debtor’s
requirement in ASC 470-50-40-12(b) to use the variable rate in effect on
the date of the modification or exchange to project the cash flows of a
variable-rate instrument when performing the 10 percent cash flow test
(see Section 10.3.3.2.5). If the
interest rate on the original debt instrument was fixed and the interest
rate on the new debt instrument is variable, the debtor should use the
original effective interest rate to discount both the remaining cash
flows of the original debt and the cash flows of the new debt.
10.3.3.3.3 Debt Issuance Costs
ASC 470-50 does not specifically address whether the discount rate used
to perform the 10 percent cash flow test should reflect the effect of
third-party debt issuance costs that were incurred when the original
debt instrument was first issued and deducted from the debt’s initial
carrying amount. Third-party costs do not affect the cash flows between
the debtor and the creditor and must be excluded from the cash flows
used to perform the 10 percent cash flow test. Therefore, the discount
rate used in the 10 percent cash flow test should exclude the effect of
third party-debt issuance costs since such amounts have no bearing on
the relationship between the debtor and creditor and the objective of
ASC 470-50 is to determine whether a modification or exchange has
resulted in a significant change in the debtor-creditor
relationship.
10.3.3.3.4 Fair Value Hedge Adjustments
ASC 470-50 does not specifically address whether the discount rate used
to perform the 10 percent cash flow test should reflect the effect of
any fair value hedge adjustments that have been made to the debt’s
carrying amount (see Section 14.2.1.2). Fair value
hedging adjustments do not affect the cash flows between the debtor and
the creditor. In addition, ASC 470-60-55-11 suggests that hedging
effects should not be reflected in the calculation of the effective
borrowing rate used to determine whether a debt modification or exchange
involves a concession under the TDR guidance in ASC 470-60. Therefore, a
debtor should exclude the effect of a fair value hedge adjustment from
the discount rate used to perform the 10 percent cash flow test since
such amounts have no bearing on the relationship between the debtor and
creditor and the objective of ASC 470-50 is to determine whether a
modification or exchange has resulted in a significant change in the
debtor-creditor relationship.
10.3.3.3.5 Convertible Debt With a Separately Recognized Equity Component
While ASC 470-50 does not specifically address how the
separation of an equity component (see Section 7.6) affects the discount
rate used to perform the 10 percent cash flow test, it is acceptable to
discount the cash flows by using an original effective interest rate
that reflects the equity component’s separation.
10.3.3.4 Consecutive Modifications or Exchanges
ASC 470-50
40-12 The following
guidance shall be used to calculate the present
value of the cash flows for purposes of applying the
10 percent cash flow test described in paragraph
470-50-40-10: . . .
f. If within a year of the current
transaction the debt has been exchanged or
modified without being deemed to be substantially
different, then the debt terms that existed a year
ago shall be used to determine whether the current
exchange or modification is substantially
different. . . .
If debt was previously modified or exchanged within one year of the current
modification or exchange and the earlier transaction was not accounted for
as an extinguishment, the debtor is required to use the debt terms that
existed before the earliest modification or exchange within that 12-month
period to determine the present value of the remaining cash flows of the
original debt instrument. In that case, the cash flows of the new debt
instrument would include all cash flows exchanged with the creditor (e.g.,
modification fees) since the earliest modification or exchange within that
12-month period.
10.3.4 Evaluation of Embedded Conversion Features
10.3.4.1 Background
The terms of the original and new debt instruments are
considered substantially different under ASC 470-50 even if the 10 percent
cash flow test is not passed if either of the following apply:
-
The change in the fair value of an embedded conversion option due to a modification or exchange is at least 10 percent of the carrying amount of the original debt instrument immediately before the modification or exchange (see Section 10.3.4.2).
-
A substantive conversion option is added to, or eliminated from, the debt terms (see Section 10.3.4.3).
Special considerations are necessary if:
-
The embedded conversion feature must be bifurcated as an embedded derivative before or after the modification or exchange or both (see Section 10.3.4.4).
-
The convertible debt contains a separately recognized equity component (see Section 10.3.4.5).
10.3.4.2 A 10 Percent Change in Embedded Conversion Feature’s Fair Value
ASC 470-50
40-10 . . . If the terms
of a debt instrument are changed or modified and the
cash flow effect on a present value basis is less
than 10 percent, the debt instruments are not
considered to be substantially different, except in
the following two circumstances:
- A modification or an exchange affects the terms of an embedded conversion option, from which the change in the fair value of the embedded conversion option (calculated as the difference between the fair value of the embedded conversion option immediately before and after the modification or exchange) is at least 10 percent of the carrying amount of the original debt instrument immediately before the modification or exchange. . . .
The terms of two debt instruments are considered substantially different
under ASC 470-50 if the change in the fair value of an embedded conversion
option due to a modification or exchange is at least 10 percent of the
carrying amount of the original debt instrument immediately before the
modification or exchange. The change in the embedded conversion option’s
fair value is calculated by comparing its fair value immediately before and
after the modification or exchange. A share-settled redemption feature (see
Section 8.4.7.2.5) should be
evaluated as a put or call option (see Section
10.3.3.2.6) and not as a conversion feature.
Example 10-6
Modification of Conversion Option in Debt
A long-term debt instrument with a
carrying amount of $100 million contains a
conversion option that is currently
out-of-the-money. The conversion feature is not
required to be bifurcated as an embedded derivative
under ASC 815-15 and the debt does not contain a
separately recognized equity component. The debtor
and creditor agree to reduce the strike price of the
conversion option to increase the likelihood that
the creditor will elect to exercise it when the debt
matures in a few years. The reduction is not within
the scope of the guidance on induced conversions.
The fair value of the conversion option immediately
before the reduction is $2 million. Immediately
after the modification, the fair value is $16
million. Accordingly, the change in the fair value
of the conversion feature is $14 million, which
exceeds 10 percent of the carrying amount of the
original debt instrument immediately before the
modification ($14 million ÷ $100 million = 14%).
Accordingly, the debt terms are considered
substantially different, and extinguishment
accounting applies (see Section
10.4.2).
If the change in fair value of an embedded conversion
feature is less than 10 percent, the debtor must also consider whether (1)
the 10 percent cash flow test is passed (see Section 10.3.3) or (2) a substantive
conversion feature was added or removed (see Section 10.3.4.3) before determining
whether the debt terms should be considered substantially different under
ASC 470-50.
10.3.4.3 Addition or Removal of Substantive Conversion Feature
ASC 470-50
40-10 . . . If the terms
of a debt instrument are changed or modified and the
cash flow effect on a present value basis is less
than 10 percent, the debt instruments are not
considered to be substantially different, except in
the following two circumstances: . . .
b. A modification or an exchange of debt
instruments adds a substantive conversion option
or eliminates a conversion option that was
substantive at the date of the modification or
exchange. (For purposes of evaluating whether an
embedded conversion option was substantive on the
date it was added to or eliminated from a debt
instrument, see paragraphs 470-20-40-7 through
40-9.)
The terms of two debt instruments are considered substantially different
under ASC 470-50 if a substantive conversion option is added to, or
eliminated from, a debt instrument. The debtor determines whether the new or
eliminated conversion option is substantive as of the date of the
modification or exchange. In determining whether a conversion feature is
substantive, the debtor applies ASC 470-20-40-7 through 40-9 (see
Section 12.3.3.2). Under that guidance, a
conversion feature is considered substantive if it is at least reasonably
possible that it will be exercised in the future. The conversion feature
would not be considered substantive in any of the following circumstances:
-
The holder has no ability to exercise the conversion feature (i.e., it is not exercisable) unless the issuer exercises its call option.
-
It is not reasonably possible for the holder to obtain the ability to exercise the conversion feature (i.e., it is not reasonably possible that the feature will become exercisable) unless the issuer exercises its call option. For example, this would be the case if the only circumstance in which the holder can obtain a right to convert the instrument (other than the issuer’s exercise of the call option) is a specified event that does not have a reasonable possibility of occurring.
-
It is not reasonably possible that the holder will exercise the conversion feature (e.g., the conversion price is extremely high relative to the current share price as of the modification or exchange date).
A share-settled redemption feature (see Section
8.4.7.2.5) should be evaluated as a put or call option (see
Section 10.3.3.2.6) and not as a
conversion feature.
Example 10-7
Modification of Conversion Option in Debt
A long-term debt instrument with a
carrying amount of $100 million contains a
conversion option that is currently deep
out-of-the-money. The conversion option is not
required to be bifurcated as an embedded derivative
under ASC 815-15 and the debt does not contain a
separately recognized equity component. Because it
is unlikely that the creditor will elect to exercise
the conversion option, the debtor and creditor agree
to reduce the strike price of the conversion option
to make it at least reasonably possible that the
creditor will elect to exercise it in the future.
The reduction is not within the scope of the
guidance on induced conversions (see Section
12.3.4). The conversion option in the
original debt instrument is considered
nonsubstantive since it was not reasonably possible
that the creditor would exercise it. However, the
new conversion option is substantive since it is
reasonably possible that the creditor will exercise
it. Accordingly, the debt terms are considered
substantially different, and extinguishment
accounting applies (see Section
10.4.2).
If no substantive conversion feature was added or removed, the debtor must
also consider whether (1) the 10 percent cash flow test is passed (see
Section 10.3.3) or (2) the change
in fair value of an embedded conversion feature is at least 10 percent (see
Section 10.3.4.2) before
determining whether the debt terms should be considered substantially
different.
10.3.4.4 Conversion Feature That Is Bifurcated Under ASC 815-15
ASC 470-50
40-11 With respect to the
conditions in (a) and (b) in the preceding
paragraph, this guidance does not address
modifications or exchanges of debt instruments in
circumstances in which the embedded conversion
option is separately accounted for as a derivative
under Topic 815 before the modification, after the
modification, or both before and after the
modification.
ASC 470-50 does not specifically address a modification or exchange of debt
instruments that affects a conversion feature that has been bifurcated as an
embedded derivative. If an embedded conversion feature requires bifurcation
as a derivative under ASC 815-15 before and after a modification or
exchange, the guidance in ASC 470-50-40-10 does not apply since the
conversion feature is accounted for separately from the debt both before and
after the modification or exchange. If the conversion feature was not
bifurcated as a derivative before the modification or exchange, but requires
bifurcation after the modification or exchange, the debtor may analogize to
the guidance in ASC 470-50-40-10.
Similarly, if the conversion feature was bifurcated as a derivative before
the modification or exchange, but does not require bifurcation after the
modification or exchange, the debtor may also analogize to the guidance in
ASC 470-50-40-10.
10.3.4.5 Convertible Debt With a Separately Recognized Equity Component
ASC 470-50 does not specifically address how the separation
of an equity component (see Section 7.6) affects an issuer’s
assessment of an embedded conversion feature under ASC 470-50-40-10. In the
determination of whether the change in the fair value of an embedded
conversion option is at least 10 percent of the carrying amount of the
original debt instrument immediately before the modification or exchange, it
is reasonable to add back any discount created by the equity component since
the purpose is to assess the significance of the change in fair value
compared with the carrying amount of the instrument as a whole. In other
words, this test is performed as if the convertible debt instrument had
never been separated into component parts (i.e., it requires the use of a
pro forma net carrying amount of the convertible debt instrument as if
separation had not occurred).
Footnotes
1
In the absence of unamortized debt issuance costs
(see Section
10.3.3.3.3) or fair value hedge accounting
adjustments (see Section 10.3.3.3.4), this amount equals the carrying
amount of the original debt.
10.4 Accounting for Debt Modifications and Exchanges
10.4.1 Background
If the terms of a modification or exchange of debt are substantially different,
the transaction is accounted for as the extinguishment of the original debt and
the recognition of new debt, which is initially measured at its fair value
adjusted for certain third-party costs (see Section 10.4.2). If the terms of a
modification or exchange of debt are not substantially different, the new debt
is accounted for as a continuation of the original debt. Any fees or other
amounts exchanged between the debtor and creditor as part of the modification or
exchange adjust the debt’s carrying amount, whereas any third-party costs are
expensed as incurred (see Section 10.4.3).
Special considerations are necessary if a debtor incurs costs and fees directly
related to a contemplated modification or exchange before the modification or
exchange is executed (see Section 10.4.4).
The table below provides an overview of the accounting treatment.
|
New or Modified Terms Compared With Original Terms
| ||
|---|---|---|
|
Substantially Different
|
Not Substantially Different
| |
|
Criteria
|
Any of the following conditions is met:
|
All of the following conditions are met:
|
|
Is a debt extinguishment gain (or loss) recognized?
|
Yes. Computed as the net carrying amount of the original
debt less the fair value of the new debt adjusted for
amounts exchanged between the debtor and creditor as
part of the modification or exchange.
|
No. However, if the modification or exchange includes a
partial repayment of the original debt instrument, the
debtor should account for that prepayment, and a gain or
loss may be recognized for the derecognition of a
portion of the unamortized premiums or discount
(including debt issuance costs) associated with the
partial extinguishment (see Section
10.4.3.2).
|
|
Is the debt’s net carrying amount adjusted?
|
Yes. The original debt is derecognized and the new debt
is recognized at its fair value less any costs incurred
with third parties as part of the modification or
exchange.
|
Yes. The original debt’s net carrying amount is increased
for any amounts received from the creditor and reduced
for (1) any amounts paid to the creditor and (2) any
increase in the fair value of an embedded conversion
feature.
|
|
Is a new effective interest rate computed?
|
Yes. Computed on the basis of the new debt’s net carrying
amount and its future cash flows.
|
Yes. Computed on the basis of the adjusted net carrying
amount of the original debt and the revised cash
flows.
|
|
Do fees and other amounts received by the debtor from the
creditor as part of the modification or exchange have an
immediate impact on earnings?
|
Yes. They reduce the extinguishment loss or increase the
extinguishment gain, as applicable.
|
No. They increase the debt’s net carrying amount and
reduce interest expense going forward.
|
|
Do fees and other amounts paid by the debtor to the
creditor as part of the modification or exchange have an
immediate impact on earnings?
|
Yes. They increase the extinguishment loss or reduce the
extinguishment gain, as applicable.
|
No. They reduce the debt’s net carrying amount and
increase interest expense going forward.
|
|
Are third-party costs incurred in connection with the
modification or exchange recognized immediately in
earnings?
|
No. They reduce the debt’s net carrying amount and
increase interest expense going forward.
|
Yes.
|
|
Are any remaining discount or premium and debt issuance
costs associated with the original debt recognized
immediately in earnings?
|
Yes.
|
No, unless the modification or exchange involves a
partial principal payment by the debtor.
|
10.4.2 Accounting When Debt Terms Are Substantially Different
10.4.2.1 General
ASC 470-50
40-6 An exchange of debt
instruments with substantially different terms is a
debt extinguishment and shall be accounted for in
accordance with paragraph 405-20-40-1. A debtor
could achieve the same economic effect as an
exchange of a debt instrument by making a
substantial modification of terms of an existing
debt instrument. Accordingly, a substantial
modification of terms shall be accounted for like an
extinguishment.
40-13 If it is determined
that the original and new debt instruments are
substantially different, the new debt instrument
shall be initially recorded at fair value, and that
amount shall be used to determine the debt
extinguishment gain or loss to be recognized and the
effective rate of the new instrument.
Fees Between Debtor and Creditor
40-17 Fees paid by the
debtor to the creditor or received by the debtor
from the creditor (fees may be received by the
debtor from the creditor to cancel a call option
held by the debtor or to extend a no-call period) as
part of the exchange or modification shall be
accounted for as follows:
- If the exchange or modification is to be accounted for in the same manner as a debt extinguishment and the new debt instrument is initially recorded at fair value, then the fees paid or received shall be associated with the extinguishment of the old debt instrument and included in determining the debt extinguishment gain or loss to be recognized. . . .
For fees between the debtor and creditor for exchanges
of or modifications to line-of-credit or
revolving-debt arrangements, see paragraph
470-50-40-21.
40-17A An increase or a
decrease in the fair value of a freestanding
equity-classified written call option held by a
creditor (calculated in accordance with paragraph
815-40-35-16) that is modified or exchanged as a
part of or is directly related to a modification or
an exchange of a debt instrument held by that same
creditor (see paragraphs 815-40-35-14 through 35-15
and 815-40-35-17(c)) shall be accounted for in the
same manner as fees between the debtor and the
creditor as described in paragraph 470-50-40-17.
Third-Party Costs of Exchange or
Modification
40-18 Costs incurred with
third parties directly related to the exchange or
modification (such as legal fees) shall be accounted
for as follows:
- If the exchange or modification is to be accounted for in the same manner as a debt extinguishment and the new debt instrument is initially recorded at fair value, then the costs 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. . . .
For third-party costs for exchanges of or
modifications to line-of-credit or revolving-debt
arrangements, see paragraph 470-50-40-21.
40-18A An increase (but not a
decrease) in the fair value of a freestanding
equity-classified written call option held by a
third party (calculated in accordance with paragraph
815-40-35-16) that is modified or exchanged as a
part of or is directly related to a modification or
an exchange of a debt instrument (see paragraphs
815-40-35-14 through 35-15 and 815-40-35-17(c))
shall be accounted for in the same manner as
third-party costs incurred that are directly related
to the modification or exchange of a debt instrument
as described in paragraph 470-50-40-18.
When the terms of the new debt are substantially different
from those of the original debt (see Section 10.3), the debtor applies
extinguishment accounting to the original debt and recognizes the new debt
instrument at its fair value less any direct and incremental costs incurred
with third parties (i.e., debt issuance costs).2 The effective interest rate of the new debt is calculated by applying
the interest method (see Section 6.2) on the basis of the new debt’s initial net
carrying amount and its contractual cash flows.
The calculation of the extinguishment gain or loss recognized in earnings can
be summarized as follows:
-
The debt’s net carrying amount immediately before the modification or exchange.
-
Less:
-
Cash paid by the debtor to the creditor as part of the modification or exchange (e.g., amounts repaid and fees paid).
-
The fair value of any noncash consideration (e.g., warrants or preferred stock) delivered by the debtor to the creditor as part of the modification or exchange.
-
The fair value of the new debt.
-
-
Plus:
-
Cash received by the debtor from the creditor as part of the modification or exchange (e.g., additional amounts borrowed and fees received).
-
The fair value of any noncash consideration received by the debtor from the creditor (e.g., warrants or preferred stock) as part of the modification or exchange.
-
-
Equals extinguishment gain (or loss).
However, special considerations are necessary for
transactions involving related parties for which a debt extinguishment gain
may be recognized in equity (see Section 9.3.7) and convertible debt
that is convertible into the debtor’s equity shares and had a separately
recognized equity component (see Section 10.4.2.2). In addition, ASC
848 permits debtors not to apply extinguishment accounting to certain debt
modifications made in connection with reference rate reform even if such
accounting would have been required under ASC 470-50-40 (see Section 14.2.5).
Example 10-8
Modification of Debt — Extinguishment
Accounting
On January 1, 20X0, Debtor D issues debt with a
stated principal amount of $10 million to Creditor C
for proceeds of $9.7 million. Interest is payable
annually in arrears at 6 percent. The debt contains
no call or put options and matures on January 1,
20X5. Debtor D determines that the annual effective
interest rate is 6.73 percent and prepares the
following amortization schedule.
On January 1, 20X3, after D has paid $600,000 of
interest for 20X2, D and C agree to modify the debt
by extending the term for an additional three years
to January 1, 20X8, and increasing the stated
interest rate from 6 percent to 8.5 percent per
annum. Further, D pays C a fee of $130,000 and
incurs $70,000 of third-party costs (e.g., fees to
attorneys and accountants).
Debtor D performs the 10 percent cash flow test (see
Section 10.3.3). On January 1, 20X3,
the present value of the remaining original
principal and interest cash flows discounted at 6.73
percent is $9,868,181 and the present value of the
remaining modified principal and interest cash flows
(including the creditor fee of $130,000 but
excluding the third-party costs) discounted at the
same discount rate is $10,862,605. The difference in
present values is $994,424 ($10,862,605 –
$9,868,181), which is more than 10 percent of the
present value of the remaining original cash flows
($994,424 ÷ $9,868,181 = 10.1%). Therefore, the
terms of the modified debt are considered
substantially different from the terms of the
original debt.
Because the terms are considered substantially
different, extinguishment accounting applies and the
new debt is initially recognized at its fair value
as of the date of the modification. Debtor D
estimates that the fair value of the new debt under
ASC 820 is $9,400,000.
Debtor D calculates the extinguishment gain as
follows:
Debtor D makes the following accounting entries:
Debtor D then recognizes the costs incurred with
third parties as debt issuance costs as follows:
Debtor D then calculates the effective interest rate
(including the effect of third-party costs) on the
new debt and determines that it is 10.28
percent.
10.4.2.2 Conversion Features
10.4.2.2.1 Background
When a modification or exchange of convertible debt is
accounted for as an extinguishment, the debtor should determine the
appropriate accounting model to apply to the newly recognized
convertible debt instrument (see Section 7.6). The assumed proceeds
for the newly recognized convertible debt instrument are equal to the
fair value of the new debt as of the date of the modification or
exchange. In addition, as discussed below, the accounting for the
extinguishment of the original convertible debt instrument depends on
whether it contained a separately recognized equity component.
10.4.2.2.2 Convertible Debt Without a Separately Recognized Equity Component
If convertible debt without a separately recognized equity component is
accounted for as extinguished, the general accounting guidance for
extinguishments applies (see Section 10.4.2.1). If the conversion feature in the
original debt instrument was bifurcated as a derivative under ASC
815-15, the net carrying amount of the original debt instrument equals
the sum of the carrying amount of the host debt contract and the fair
value of the embedded conversion option liability as of the date of the
extinguishment. The new convertible debt instrument is recognized at
fair value less any direct and incremental issuance costs. The debtor
should apply the appropriate convertible debt accounting model to the
new instrument on the same basis as it would if the entity had issued
the instrument in a transaction that did not involve a modification or
exchange of the original convertible debt instrument.
10.4.2.2.3 Convertible Debt With a Separately Recognized Equity Component
ASC 815-15
40-4 If a convertible debt
instrument with a conversion option for which the
carrying amount has previously been reclassified
to shareholders’ equity pursuant to the guidance
in paragraph 815-15-35-4 is extinguished for cash
(or other assets) before its stated maturity date,
the entity shall do both of the following:
-
The portion of the reacquisition price equal to the fair value of the conversion option at the date of the extinguishment shall be allocated to equity.
-
The remaining reacquisition price shall be allocated to the extinguishment of the debt to determine the amount of gain or loss.
If the original debt contains an equity component that resulted from the
reclassification of an embedded conversion feature from a derivative
liability to equity (see Section 8.5.4.3), the calculation of the extinguishment
gain or loss should be adjusted by allocating an amount to the
reacquisition of the equity component equal to the fair value of the
conversion option on the date of the extinguishment in accordance with
ASC 815-15-40-4 (i.e., the fair value of the conversion option increases
the amount of any extinguishment gain and decreases the amount of any
extinguishment loss, as applicable). The Codification does not
specifically address how to measure the amount that should be allocated
to the reacquisition of an equity component that resulted from a
previous modification or exchange that increased the fair value of the
conversion feature (see Section 10.4.3.3.1) or the
issuance of convertible debt at a substantial premium to par (see
Section 7.6.3). Generally, the amount that was
previously recognized for that equity component would be allocated to
its reacquisition.
10.4.3 Accounting When Debt Terms Are Not Substantially Different
10.4.3.1 General
ASC 470-50
05-3 In circumstances
where an exchange of debt instruments or a
modification of a debt instrument does not result in
extinguishment accounting, this Subtopic provides
guidance on the appropriate accounting
treatment.
40-14 If it is determined
that the original and new debt instruments are not
substantially different, then a new effective
interest rate shall be determined based on the
carrying amount of the original debt instrument,
adjusted for an increase (but not a decrease) in the
fair value of an embedded conversion option
(calculated as the difference between the fair value
of the embedded conversion option immediately before
and after the modification or exchange) resulting
from the modification, and the revised cash
flows.
40-17 Fees paid by the
debtor to the creditor or received by the debtor
from the creditor (fees may be received by the
debtor from the creditor to cancel a call option
held by the debtor or to extend a no-call period) as
part of the exchange or modification shall be
accounted for as follows: . . .
b. If the exchange or modification is not to
be accounted for in the same manner as a debt
extinguishment, then the fees shall be associated
with the replacement or modified debt instrument
and, along with any existing unamortized premium
or discount, amortized as an adjustment of
interest expense over the remaining term of the
replacement or modified debt instrument using the
interest method.
For fees between the debtor and creditor for
exchanges of or modifications to line-of-credit or
revolving-debt arrangements, see paragraph
470-50-40-21.
40-17A An increase or a
decrease in the fair value of a freestanding
equity-classified written call option held by a
creditor (calculated in accordance with paragraph
815-40-35-16) that is modified or exchanged as a
part of or is directly related to a modification or
an exchange of a debt instrument held by that same
creditor (see paragraphs 815-40-35-14 through 35-15
and 815-40-35-17(c)) shall be accounted for in the
same manner as fees between the debtor and the
creditor as described in paragraph 470-50-40-17.
Third-Party Costs of Exchange or
Modification
40-18 Costs incurred with
third parties directly related to the exchange or
modification (such as legal fees) shall be accounted
for as follows: . . .
b. If the exchange or modification is not to
be accounted for in the same manner as a debt
extinguishment, then the costs shall be expensed
as incurred.
For third-party costs for exchanges of or
modifications to line-of-credit or revolving-debt
arrangements, see paragraph 470-50-40-21.
40-18A An increase (but not a
decrease) in the fair value of a freestanding
equity-classified written call option held by a
third party (calculated in accordance with paragraph
815-40-35-16) that is modified or exchanged as a
part of or is directly related to a modification or
an exchange of a debt instrument (see paragraphs
815-40-35-14 through 35-15 and 815-40-35-17(c))
shall be accounted for in the same manner as
third-party costs incurred that are directly related
to the modification or exchange of a debt instrument
as described in paragraph 470-50-40-18.
When the terms of the new debt are not substantially different from those of
the original debt (see Section 10.3), the modification or exchange is treated as a
continuation of the original debt instrument. The debtor adjusts the debt’s
net carrying amount, as follows:
-
The debt’s net carrying amount immediately before the modification or exchange.
-
Less:
-
Cash paid by the debtor to the creditor as part of the modification or exchange (e.g., amounts repaid and fees paid).3
-
The fair value of any noncash consideration (e.g., warrants or preferred stock) delivered by the debtor to the creditor as part of the modification or exchange.
-
The increase in the fair value of an embedded equity conversion feature, if applicable (see Section 10.4.3.3).
-
-
Plus:
-
Cash received by the debtor from the creditor as part of the modification or exchange (e.g., additional amounts borrowed and fees received).
-
The fair value of any noncash consideration received by the debtor from the creditor (e.g., warrants) as part of the modification of exchange.
-
-
Equals the debt’s adjusted net carrying amount.
ASC 470-50-40-17(b) requires any fees paid to, or received from, the creditor
as part of a modification or exchange (e.g., waiver fees) to be associated
with the modified debt and recognized as part of interest expense over the
life of the modified debt in accordance with the interest method.
Because the debt is accounted for as a continuation of the
original debt, any third-party costs incurred in connection with the
modification or exchange do not represent debt issuance costs. ASC
470-50-40-17(b) requires such costs to be immediately expensed as
incurred.
As noted in Sections 10.3.2.4 and 10.3.3.2.4, the debtor may need to allocate amounts paid to
an underwriter of a loan syndication between fees paid to the underwriter in
its capacity as a creditor (for the portion of the debt agreement that the
underwriter receives in the syndication) and fees paid to the underwriter in
its capacity as a third party underwriting the loan facility with other
creditors. Amounts paid to the underwriter in its capacity as a creditor are
treated as lender fees, whereas amounts paid to the underwriter in its
capacity as an underwriter are treated as third-party costs.
The effect of the debt modification or exchange on the
debt’s cash flows is accounted for prospectively as a yield adjustment.
Although the debt is not accounted for as extinguished, the debtor must
recalculate the effective interest rate it used in applying the interest
method (see Section
6.2) since the net carrying amount and the debt’s contractual
cash flows have changed.
Example 10-9
Modification of Debt — Modification
Accounting
On January 1, 20X0, Debtor E issues debt with a
stated principal amount of $10 million to Creditor B
for proceeds of $10.4 million. Interest is payable
annually in arrears at 9 percent. There are no call
options, put options, or conversion features in the
debt, which matures on January 1, 20X5. Debtor E
determines that the annual effective interest rate
is 8 percent and prepares the following amortization
schedule.
On January 1, 20X3, after E has paid $900,000 of
interest for 20X2, E and B agree to modify the debt
by extending the term for an additional three years
to January 1, 20X8, and reducing the stated interest
rate from 9 percent to 7.5 percent per annum.
Further, E pays B a fee of $50,000 and incurs
$85,000 of third-party costs (e.g., fees to
attorneys and accountants).
Debtor E performs the 10 percent
cash flow test (see Section 10.3.3). On January 1, 20X3,
the present value of the remaining original
principal and interest cash flows discounted at 8
percent is $10,178,648, and the present value of the
remaining modified principal and interest cash flows
(including the creditor fee of $50,000 but excluding
the third-party costs) discounted at the same
discount rate is $9,801,065. The difference in
present values is $377,583 ($10,178,648 –
$9,801,065), which is less than 10 percent of the
present value of the remaining original cash flows
($377,583 ÷ $10,178,648 = 3.7%). Therefore, the
terms of the modified debt are not considered
substantially different from the terms of the
original debt under the 10 percent cash flow test.
Further, neither the original debt nor the modified
debt is convertible into the debtor’s equity shares,
so there is no need to evaluate whether any
conversion feature causes the modified debt to be
substantially different from the original debt.
Because the terms of the modified debt are not
considered substantially different from the terms of
the original debt, the modified debt is treated as a
continuation of the original debt. However, E must
update the debt’s net carrying amount and
amortization schedule and expense the third-party
costs incurred as part of its accounting for the
modification or exchange.
The updated carrying amount is computed as
follows:
Debtor E makes the following accounting entries:
The revised effective interest rate is 7.18
percent.
10.4.3.2 Repayment of a Portion of the Principal Amount Outstanding
ASC 470-50-40-17(b) states that any remaining unamortized
premium or discount (including debt issuance costs) of the original debt
instrument should be amortized over the remaining term by using the interest
method when debt is modified or exchanged and extinguishment accounting does
not apply. However, if, in conjunction with a modification or exchange that
is not accounted for as an extinguishment under ASC 470-50, a debtor repays
a portion of the principal amount of the original debt instrument, whether
as a result of a contractual prepayment feature or negotiations between the
debtor and creditor, the debtor should derecognize a proportionate amount of
unamortized premium or discount (including debt issuance costs) in the same
manner as if the debt was partially prepaid in the absence of a modification
or exchange.4 For example, if a debtor repays $100 million of debt by paying cash
and contemporaneously issues $80 million of new debt to the same creditor in
exchange for cash and the debt instruments exchanged are not substantially
different, the debtor should still treat $20 million of the original debt as
having been extinguished under ASC 405 even though the exchange was not
accounted for as an extinguishment of the entire $100 million of debt.
Accordingly, the debtor would include a portion of the unamortized premium
or discount (including debt issuance costs) of the $20 million of debt
repaid when calculating the extinguishment gain or loss.
Example 10-10
Modification of Debt — Accounting for Partial
Repayment
Entity A has outstanding a debt instrument with a
$100 million principal amount and an unamortized
discount (including debt issuance costs) of $2.5
million. Interest on the debt is payable annually at
a rate of 10 percent. The debt is modified to reduce
the interest rate to a market rate of 8 percent and
to extend the remaining term by five years. In
return for agreeing to the modification, the
creditor requires A to repay $20 million of the
principal amount without a penalty. In conjunction
with the modification, A incurs third-party costs of
$200,000. Assume that because the original debt and
the modified debt are both prepayable, the
modification does not meet the conditions to be
accounted for as an extinguishment.
Before accounting for the partial prepayment, A
recognizes the following accounting entry:
To account for the partial
prepayment, A recognizes the following additional
accounting entry:5
Note that this additional entry is necessary because
A’s application of ASC 470-50 does not obviate its
need to apply the general debt accounting guidance
when it partially prepays the existing debt in
conjunction with the modification.
10.4.3.3 Conversion Features
10.4.3.3.1 General
ASC 470-50
40-15 If a convertible
debt instrument is modified or exchanged in a
transaction that is not accounted for as an
extinguishment, an increase in the fair value of
the embedded conversion option (calculated as the
difference between the fair value of the embedded
conversion option immediately before and after the
modification or exchange) shall reduce the
carrying amount of the debt instrument (increasing
a debt discount or reducing a debt premium) with a
corresponding increase in additional paid-in
capital. However, a decrease in the fair value of
an embedded conversion option resulting from a
modification or an exchange shall not be
recognized.
When modified or exchanged debt is convertible into the debtor’s equity
shares before and after a modification or exchange and extinguishment
accounting does not apply (see Section 10.3), the debtor is required to recognize an
increase, if any, in the fair value of the embedded conversion feature
that results from the modification or exchange. Such increase is
calculated as the amount by which the fair value of the conversion
option immediately after the modification or exchange exceeds its fair
value immediately before the modification and exchange. This amount is
recognized as a decrease in the net carrying amount of the debt and an
increase in APIC. Because the amount recorded against the debt increases
any debt discount (or reduces a debt premium), whereas the amount in
APIC is not remeasured, the effect of this accounting is to increase the
debt’s effective interest rate and the amount of interest expense
reported over the debt’s remaining life. A decrease in the conversion
feature’s fair value is not recognized.
Special considerations are necessary if the conversion
feature is bifurcated as a derivative under ASC 815-15 (see the next
section).
10.4.3.3.2 Convertible Debt With a Bifurcated Conversion Option
ASC 815-15
35-4 If an embedded
conversion option in a convertible debt instrument
no longer meets the bifurcation criteria in this
Subtopic, an issuer shall account for the
previously bifurcated conversion option by
reclassifying the carrying amount of the liability
for the conversion option (that is, its fair value
on the date of reclassification) to shareholders’
equity. Any debt discount recognized when the
conversion option was bifurcated from the
convertible debt instrument shall continue to be
amortized.
The Codification does not specifically address how to account for a
change in the fair value of a conversion feature that is bifurcated as a
derivative under ASC 815-15 either before or after a modification or
exchange.
If the conversion feature is bifurcated as a derivative
under ASC 815-15 before and after the modification or exchange, any
change in its fair value is recognized in earnings under ASC 815-15.
Therefore, the debtor should not apply the guidance in ASC 470-50-40-15
on recognizing an increase in a feature’s fair value in connection with
the modification or exchange as a reduction of the debt’s carrying
amount (see the previous section).
If the conversion feature is bifurcated as a derivative
under ASC 815-15 before the modification or exchange, but not after the
modification or exchange, one possible approach would be for the debtor
to reclassify the fair value carrying amount of the derivative liability
immediately after the modification or exchange to equity under ASC
815-15-35-4 and not apply the guidance in ASC 470-50-40-15 (see the
previous section).
If the conversion feature is bifurcated as a derivative
under ASC 815-15 after the modification or exchange, but not before the
modification or exchange, one possible approach would be for the debtor
to recognize an increase in the fair value of the embedded conversion
feature in connection with the modification or exchange as a reduction
in the debt’s net carrying amount, with an offset to APIC under ASC
470-50-40-15 (see the previous section). The fair value of the
conversion feature immediately after the modification or exchange would
then be bifurcated from the carrying amount of the debt host (see
Section
8.5.4.2).
10.4.4 Other Considerations
10.4.4.1 Costs and Fees Incurred Before a Debt Modification or Exchange
Sometimes, debtors incur fees or costs directly related to a contemplated
modification or exchange before it is executed. In a manner similar to the
accounting for debt issuance costs incurred before a debt issuance (see
Section 5.3.2), specific costs and
fees that are directly attributable to a contemplated modification or
exchange of debt may be deferred as an asset before such transaction occurs
unless (1) it is probable that modification or exchange will not occur or
(2) the fees or costs must be expensed under ASC 470-50 upon the occurrence
of the transaction. Under ASC 470-50, a fee paid to a creditor (e.g., a
waiver fee) must be expensed if the terms of the new debt are substantially
different from the terms of the original debt (see Section 10.4.2.1). Third-party costs (e.g.,
attorney fees) must be expensed if the terms of the new debt are not
substantially different from those of the original debt (see Section 10.4.3.1).
Once the modification or exchange occurs, any costs or fees that have been
deferred are reflected in the accounting for the modification or exchange
under ASC 470-50. If costs and fees have been deferred but it becomes
probable that the modification or exchange will not take place or the costs
and fees would require expense recognition upon a modification or exchange,
the amounts deferred should be charged to earnings.
10.4.4.2 Third-Party Costs
A third party, such as a legal adviser or investment banker,
often provides services to the debtor related to a debt modification or
exchange simultaneously with other unrelated services. Such fees should be
allocated between costs attributable to the debt modification or exchange
and costs attributable to other services provided by the third party on a
relative fair value basis. Under ASC 340-10-S99-2, similar accounting is
required for fees paid to an investment banker for both services related to
an acquisition and the issuance of debt securities in a business combination
(see Section
3.5.3.3).
Costs attributable to the debt modification or exchange may include:
-
Amounts paid to legal advisers for drafting modified debt agreements and providing other legal services associated with the debt modification.
-
Amounts paid to advisers for assistance with the debt negotiations.
Costs attributable to other services may include:
-
Amounts paid to legal advisers for assistance in drafting documents for a bankruptcy filing.
-
Amounts paid to legal advisers for providing advice on a corporate restructuring.
-
Amounts paid to a communications firm in connection with a corporate restructuring.
Once the entity identifies the costs attributable to the debt modification or
exchange, it should account for those costs on the basis of whether the
modification or exchange represents an extinguishment of the debt in
accordance with ASC 470-50 (see Sections
10.4.2 and 10.4.3).
Footnotes
2
Because the new debt is treated as a new issuance,
third-party costs are accounted for as debt issuance costs (see
Section
5.3.3). Any fees paid to, or received from, the
creditor as part of the modification or exchange are associated with
the extinguishment of the original debt and, therefore, affect the
calculation of the extinguishment gain or loss. This applies even if
some or all of the fees are contractually designated as being
attributable to the new debt. As noted in Sections 10.3.2.4 and
10.3.3.2.4, the debtor may need to allocate amounts
paid to an underwriter of a loan syndication between fees paid to
the underwriter in its capacity as a creditor (for the portion of
the debt agreement that the underwriter receives in the syndication)
and fees paid to the underwriter in its capacity as a third party
underwriting the loan facility with other creditors.
3
See Sections
10.3.3.2 and 10.4.3.2 for
discussions of the accounting for any unamortized
premiums, discounts, or issue costs associated
with the partial repayment of the existing debt
instrument.
4
Note that for this purpose, a payment of a fee to
the creditor in return for the modification would not need to be
treated as a partial prepayment.
5
The amount of unamortized
discount (debt issuance costs) written off is
based on the proportion of the principal amount of
the debt that was repaid (i.e., $20 million ÷ $100
million = 0.2 × $2.5 million = $500,000).
10.5 Modifications and Exchanges Involving Third-Party Intermediaries
10.5.1 Background
Sometimes, debtors involve a third-party intermediary to arrange or facilitate a
debt modification or exchange with the entity’s creditors. For example, if a
debtor wishes to replace existing debt for new debt, it might engage a bank to
seek out holders of the existing debt and offer them the new debt. The
accounting analysis of a debt modification or exchange that involves an
intermediary depends on whether the intermediary is considered a principal to
the transaction or the debtor’s agent. If the issuer concludes that the
intermediary is acting as its agent, ASC 470-50 requires the issuer to “look
through” the intermediary by treating the intermediary’s actions as its own
(i.e., the intermediary’s transactions with other parties would be considered
the debtor’s own transactions). If the issuer determines that the intermediary
is acting as a principal, the issuer would not look through the intermediary but
would instead view the intermediary as a third-party creditor (i.e., the
intermediary’s transactions with other parties would be considered transactions
among debt holders to which the debtor is not a party; see Section 10.2.8).
The next section addresses how to determine whether an
intermediary should be viewed as a principal or an agent under ASC 470-50.
Section 10.5.3
discusses the accounting for modifications or exchanges involving an
intermediary.
10.5.2 Principal-Versus-Agent Analysis
10.5.2.1 Background
ASC 470-50
55-7 Transactions between
a debtor and a third-party creditor should be
analyzed based on the guidance in paragraph
405-20-40-1 and the guidance in this Subtopic to
determine whether gain or loss recognition is
appropriate. Application of the guidance in this
Subtopic may require determination of whether a
third-party intermediary is an agent or a principal
and consideration of legal definitions may be
helpful in making that determination. Generally, an
agent acts for and on behalf of another party.
Therefore, a third-party intermediary is an agent of
a debtor if it acts on behalf of the debtor. In
addition, an evaluation of the facts and
circumstances surrounding the involvement of a
third-party intermediary should be performed. . .
.
Generally, an intermediary
is considered to be the debtor’s agent if it “acts for and on behalf of” the
debtor. For example, an intermediary would be viewed as the debtor’s agent
if the intermediary’s actions are for the debtor’s benefit and under the
debtor’s discretion and control. ASC 470-50-55-7 suggests that in evaluating
whether an intermediary is acting as a principal or an agent, a debtor may
find it helpful to consider legal definitions. Further, ASC 470-50-55-7
provides a list of indicators that a debtor must evaluate when determining
whether a third-party intermediary is acting as a principal or agent:
|
Indicators
|
Factors Suggesting That Intermediary
Is Acting as Principal
|
Factors Suggesting That Intermediary
Is Acting as Debtor’s Agent
|
Roadmap Section
|
|---|---|---|---|
|
Intermediary’s exposure to risk of loss
|
Places its own funds at risk
|
Indemnified by the debtor for any losses
| |
|
Intermediary’s level of commitment
|
Firmly committed
|
Best efforts
| |
|
Debtor’s power to direct the intermediary’s
transactions
|
Intermediary directs transactions and is subject to
loss
|
Debtor directs intermediary’s transactions
| |
|
Intermediary’s compensation
|
Varies on the basis of debt gains and losses
|
Preestablished fee
|
10.5.2.2 Intermediary’s Exposure to Risk of Loss
ASC 470-50
55-7 . . . The following
indicators should be considered in that
evaluation:
-
If the intermediary’s role is restricted to placing or reacquiring debt for the debtor without placing its own funds at risk, that would indicate that the intermediary is an agent. For example, that may be the case if the intermediary’s own funds are committed and those funds are not truly at risk because the intermediary is made whole by the debtor (and therefore is indemnified against loss by the debtor). If the intermediary places and reacquires debt for the debtor by committing its funds and is subject to the risk of loss of those funds, that would indicate that the intermediary is acting as principal. . . .
If an intermediary places its own funds at risk (i.e., it is exposed to the
risk of changes in the value of the debt), this suggests that the
intermediary is acting as a principal in its transactions with the debtor
and investors. In this circumstance, the intermediary’s transactions with
investors represent transactions among debt holders (see Section 10.2.8), which do not affect the
debtor’s accounting. If the intermediary does not place its own funds at
risk, this suggests that the intermediary is acting as the debtor’s agent in
its transactions with investors.
The following factors, if present, would suggest that the intermediary is not
placing its own funds at risk and, therefore, is the debtor’s agent:
-
The period during which the intermediary holds any new debt it acquires from the debtor before it resells it to investors is not sufficient to expose it to a significant risk of loss from changes in the debt’s value.
-
The period during which the intermediary holds any outstanding debt it acquires from investors before it resells it to the debtor is not sufficient to expose it to a significant risk of loss from changes in the debt’s value.
-
The intermediary obtains purchase commitments from investors before buying new debt from the debtor.
-
The intermediary obtains sale commitments from investors before it commits to sell outstanding debt to the debtor.
-
The intermediary obtains soft bids from investors before buying new debt from the debtor (see also Section 10.5.3.4).
-
The debtor reimburses the intermediary for any losses (or hedging costs) it incurs as a result of changes in the debt’s value in the short period during which it holds debt.
The debtor cannot assume that an intermediary is acting as a principal under
ASC 470-50-55-7 even if the intermediary is firmly committed to purchasing
new debt securities from the debtor at a specified price and the debtor is
under no obligation to indemnify the issuer against any loss. Other facts
and circumstances that may affect whether the intermediary’s own funds are
at risk must also be considered. If the intermediary obtains soft bids from
investors before it commits to purchasing debt securities from the debtor,
the intermediary’s risk of loss may be reduced to such a degree that the
intermediary should be viewed as the debtor’s agent.
In a speech at the 2003 AICPA Conference on Current SEC
Developments, then SEC Professional Accounting Fellow Robert Comerford
discussed the application of the indicators in ASC 470-50-55-7 to a modified
remarketable put bond transaction (see Section 10.5.3.4). In Mr. Comerford’s
example, the intermediary (an investment bank) has a call option that
permits it to buy the debtor’s debt securities from investors. If the
intermediary calls the debt securities, it will attempt to resell them to
new investors at a reset interest rate. Mr. Comerford suggested that if the
intermediary obtains soft bids from prospective investors before calling the
existing debt securities, the intermediary may be acting as the debtor’s
agent in exercising the call option and reselling the modified debt
securities to new investors.
Other factors may also affect the analysis, including the debtor’s
creditworthiness and the length of time between the intermediary’s purchase
of the debt from the issuer and its sale thereof to investors. Entities
should evaluate all facts and circumstances associated with the transaction
when assessing whether an intermediary is acting as an agent or a
principal.
10.5.2.3 Intermediary’s Level of Commitment
ASC 470-50
55-7 . . . The following
indicators should be considered in that evaluation:
. . .
b. In an arrangement where an intermediary
places notes issued by the debtor, if the
placement is done under a best-efforts agreement,
that would indicate that the intermediary is
acting as agent. Under a best-efforts agreement,
an agent agrees to buy only those securities that
it is able to sell to others; if the agent is
unable to remarket the debt, the issuer is
obligated to pay off the debt. The intermediary
may be acting as principal if the placement is
done on a firmly committed basis, which requires
the intermediary to hold any debt that it is
unable to sell to others. . . .
If an intermediary is firmly committed to executing transactions with the
debtor irrespective of whether it is able to arrange offsetting
transactions, this suggests that the intermediary is acting as a principal
in its transactions with the debtor. For example, the fact that the
intermediary is required to hold any new debt that it acquires from the
debtor and is unable to sell to other investors suggests that the
intermediary is acting as a principal. If the intermediary is required to
execute transactions with the debtor only if it is able to arrange
offsetting transactions with investors, this indicates that the intermediary
is acting as the debtor’s agent. For example, the intermediary is likely to
be viewed as the debtor’s agent if (1) the intermediary is required to
purchase debt from the debtor only if it is able to sell it to investors or
(2) the debtor is required to repurchase any debt securities it has sold to
the intermediary if the intermediary is unable to sell it to investors.
10.5.2.4 Debtor’s Power to Direct the Intermediary’s Transactions
ASC 470-50
55-7 . . . The following
indicators should be considered in that evaluation:
. . .
c. If the debtor directs the intermediary and
the intermediary cannot independently initiate an
exchange or modification of the debt instrument,
that would indicate that the intermediary is an
agent. The intermediary may be a principal if it
acquires debt from or exchanges debt with another
debt holder in the market and is subject to loss
as a result of the transaction. . . .
If the debtor directs the specific purchase or sale transactions that the
intermediary executes with investors, this suggests that the intermediary is
the debtor’s agent. If the intermediary makes its own independent decisions
regarding whether to execute purchase or sale transactions involving the
debt with investors and it is exposed to gains and losses on such
transactions, this suggests that the intermediary is a principal.
10.5.2.5 Intermediary’s Compensation
ASC 470-50
55-7 . . . The following
indicators should be considered in that evaluation:
. . .
d. If the only compensation derived by an
intermediary from its arrangement with the debtor
is limited to a preestablished fee, that would
indicate that the intermediary is an agent. If the
intermediary derives gains based on the value of
the security issued by the debtor, that would
indicate that the intermediary is a
principal.
If the debtor has agreed to any of the following fee or other compensation
arrangements with the intermediary, this suggests that the intermediary is
the debtor’s agent:
-
The intermediary’s compensation is limited to a predetermined fee and the intermediary is not exposed to gains or losses from its transactions with investors.
-
The intermediary’s compensation includes reimbursement by the debtor of any losses the intermediary incurs as a result of changes in the debt’s value or other hedging costs during the period in which it holds debt.
-
The intermediary’s compensation includes a premium to compensate it for potential losses and therefore its own funds are not substantively at risk.
If the intermediary is exposed to fluctuations in the debt’s value during the
period in which it holds the debt, this suggests that the intermediary is
acting as a principal.
10.5.3 Accounting for Modifications or Exchanges Involving an Intermediary
10.5.3.1 Background
The accounting for a debt modification or exchange involving
an intermediary depends on whether the intermediary is acting as a principal
(see the next section) or the debtor’s agent (see Section 10.5.3.3). At the 2003 AICPA
Conference on Current SEC Developments, the SEC staff highlighted certain
considerations related to the principal-agent analysis that apply to soft
bids and remarketable put bond transactions (see Section 10.5.3.4).
10.5.3.2 Intermediary Acting as Principal
ASC 470-50
40-20 In transactions
involving a third-party intermediary acting as
principal, the intermediary should be viewed as a
third-party creditor similar to any other creditor
in order to determine whether there has been an
exchange of debt instruments or a modification of
terms between a debtor and a creditor. Stated
another way, if a third-party intermediary acts as
principal, the analysis should not look through the
intermediary.
55-5 In transactions
involving a third-party investment banker acting as
principal, the investment banker is considered a
debt holder like other debt holders. Thus, if the
investment banker acting as principal acquires debt
instruments from other parties, the acquisition by
the investment banker does not impact the accounting
by the debtor, and exchanges or modifications
between the debtor and the investment banker shall
follow the guidance in this Subtopic.
If an intermediary is considered a principal under ASC 470-50, the debtor
treats any purchase or sale transactions that it executes with the
intermediary as transactions with a creditor. Accordingly:
-
The intermediary’s purchases and sales of the debtor’s debt with parties other than the debtor are treated as transactions among holders of the debt (see Section 10.2.8) and, accordingly, do not affect the debtor’s accounting as long as funds do not pass through the debtor.
-
The debtor evaluates whether exchanges of its outstanding debt for new debt with the intermediary (including transactions with the intermediary that involve a contemporaneous cash exchange, settlement of the original debt, and issuance of new debt) should be accounted for as an extinguishment or modification under ASC 470-50. The debtor should consider the relevant facts and circumstances to determine whether the settlement of the old debt is contemporaneous with the issuance of any new debt to the intermediary.
-
If the intermediary purchases the debtor’s new debt from the debtor for cash and does not contemporaneously settle outstanding debt with the debtor, the debtor treats the sale of new debt to the intermediary as a new debt issuance.
-
If the intermediary settles the debtor’s outstanding debt with the debtor for cash and does not contemporaneously purchase new debt from the debtor, the debtor treats the settlement as an extinguishment of the outstanding debt under ASC 405-20-40-1 (see Section 9.2).
10.5.3.3 Intermediary Acting as Agent
ASC 470-50
40-19 In transactions
involving a third-party intermediary acting as agent
on behalf of a debtor, the actions of the
intermediary shall be viewed as those of the debtor
in order to determine whether there has been an
exchange of debt instruments or a modification of
terms between a debtor and a creditor. Stated
another way, if a third-party intermediary acts as
agent, the analysis shall look through the
intermediary.
55-4 In transactions
involving a third-party investment banker acting as
agent on behalf of the debtor, the activity of the
investment banker is treated as if it were the
activity of the debtor. Thus, if the investment
banker acquires debt instruments from holders for
cash, the debtor has an extinguishment even if the
investment banker subsequently transfers a debt
instrument with the same or different terms to the
same or different investors. If the investment
banker acting as agent on behalf of the debtor
acquires instruments from holders by exchanging
those instruments for new debt, the guidance in this
Subtopic shall be applied. If the investment banker
acquires debt instruments from holders for cash and
contemporaneously issues new debt instruments for
cash, an extinguishment has occurred only if the two
debt instruments have substantially different terms,
as defined in Section 470-50-40.
If an intermediary is considered the debtor’s agent under ASC 470-50, the
debtor treats the intermediary’s purchases and sales of the debtor’s
securities as if they had been executed by the debtor itself. Accordingly:
-
If the intermediary purchases the debtor’s outstanding debt from an investor for cash and does not contemporaneously sell new debt of the debtor to the same investor, the guidance in ASC 470-50 does not apply even if the intermediary issues new debt to other investors that did not own the old debt. Instead the debtor would treat the intermediary’s purchase of the outstanding debt as an extinguishment of that debt under ASC 405-20-40-1 (see Section 9.2). The debtor should consider the relevant facts and circumstances to determine whether the settlement of the old debt is contemporaneous with the issuance of any new debt to the same investor.
-
If the intermediary exchanges the debtor’s outstanding debt for new debt with the same investor (including transactions that involve a contemporaneous cash exchange, settlement of the original debt, and issuance of new debt to the same investor), the debtor applies ASC 470-50 to determine whether the intermediary’s exchange of debt with the investor should be accounted for as a modification or extinguishment of its outstanding debt.
-
If the intermediary purchases debt from the debtor or settles the debtor’s outstanding debt with the debtor, those transactions do not affect the debtor’s accounting (however, such transactions may suggest that the intermediary is acting as a principal). Only the intermediary’s transactions with other investors on behalf of the debtor affect the debtor’s accounting for the debt.
If (1) some of the new debt is issued to investors that held the old debt,
(2) some of the new debt is issued to new investors, and (3) the settlement
of the old debt is contemporaneous with the issuance of new debt, the debtor
would be required under ASC 470-50-55-3 to determine what portion of the new
debt is acquired by investors that held the old debt (see Section 10.3.2.2). ASC 470-50 applies to
those investors that held the old debt that was replaced by the new debt,
and extinguishment accounting would apply to the portion of the old debt
that has been replaced by new debt held by new investors. However, in some
cases, it would be acceptable for the issuer to treat an issuance of new
debt as a transaction that is separate from the redemption of any existing
debt, even if some investors hold both the old and new debt and the
transactions are contemporaneous (see Section
10.2.13).
Example 10-11
Debt Settlement by the Debtor’s Agent
Company X restructured its debt facilities. Bank A,
acting as an agent of X, paid off X’s old debt and
was immediately reimbursed with proceeds from a new
X debt offering that it arranged. Because A is an
agent of X, the activity of A is treated as if it
were the activity of X. If A acquires old debt
instruments from investors for cash and
contemporaneously issues new debt instruments to the
same investors for cash, X would apply the guidance
in ASC 470-50 to determine whether it should record
an extinguishment of the old debt or account for the
transactions as a modification of its old debt.
Example 10-12
Debt Settlement by the Debtor’s Agent
On December 1, 20X0, Company C issues five-year
nonconvertible debt at par for total proceeds of $11
million. Investor Y obtains debt with a principal
amount of $6 million, and Investor Q obtains debt
with a principal amount of $5 million. The debt pays
10 percent interest annually.
On December 1, 20X2, C engages a bank to act as an
agent in the repurchase of C’s debt with Y and Q and
to help it place new nonconvertible debt. The bank
repurchases the original debt held by Y and Q for a
total cash payment of $11.567 million, of which
$6.309 million is paid to Y and $5.258 million is
paid to Q. Simultaneously, the bank places new
five-year debt of C with Q and Investor Z, a new
investor, at par for total proceeds of $18 million.
Investor Q purchases $5 million of the new debt, and
Z purchases $13 million of the new debt. The new
debt pays 8 percent interest annually.
Company C should apply extinguishment accounting to
the $6 million of original debt repurchased from Y
since Y is not a continuing creditor and the debt
has been extinguished for cash equal to $6.309
million. This component of the transaction is
outside the scope of ASC 470-50.
If the transaction qualifies as a market issuance of
new debt to replace old debt (see Section 10.2.13), C
would be permitted to treat the issuance of new debt
to Q as a transaction that is separate from the
redemption of the existing debt held by Q. In
addition, C would apply extinguishment accounting to
the $5 million of original debt repurchased from
Q.
If the transaction does not qualify as a market
issuance of new debt to replace old debt, C should
determine under ASC 470-50 whether to account for
the exchange with Q of $5 million of original debt
for $5 million of new debt as a modification or an
extinguishment of the original debt held by Q. While
Q has exchanged original debt with a principal
amount of $5 million for a cash payment equal to
$5.528 million, it has simultaneously bought new
debt from C for cash equal to $5 million. Company C
would determine whether the change in terms is
significant by assessing whether the change in
present value is greater than 10 percent. To do so,
it would take the following steps:
- Determine the present value of the cash flows
of the new debt instrument:
-
Investor Q will receive interest payments at 8 percent annually for five years ($400,000 per year).
-
Investor Q will receive a principal repayment of $5 million in five years.
-
Currently, Q receives $5,257,710 for the original debt and pays $5 million for the new debt. The net amount of $257,710 ($5,257,710 – $5,000,000) received by Q is added to the cash flows of the new debt instrument and used to perform the 10 percent cash flow test.
-
The discount rate is the effective interest rate, for accounting purposes, of the original debt instrument, which is 10 percent.
-
The present value of the interest and principal payments on the new debt discounted at 10 percent is $4,620,921.
-
Under the 10 percent cash flow test, the cash flows of the new debt instrument include all cash flows of the new debt instrument plus any amounts paid by the debtor to the creditor, less any amounts received by the debtor from the creditor as part of the exchange. Accordingly, the total present value attributable to the new debt is $4,878,631 ($4,620,921 + $257,710).
-
- Determine the present value of the remaining
cash flows of the original debt instrument:
-
Investor Q would have received interest payments at 10 percent annually for three years ($500,000 per year).
-
Investor Q would have received a principal repayment of $5 million in three years.
-
The discount rate is the effective interest rate, for accounting purposes, of the original debt instrument, which is 10 percent.
-
Accordingly, the present value of the cash flows of the original debt instrument is $5 million.
-
- Determine the percentage of change in the
present value of the debt:
-
The change in present value is $121,369 ($5,000,000 – $4,878,631).
-
The change as a percentage of the old debt is 2.43 percent ($121,369 ÷ $5,000,000).
-
Because the change is less than 10 percent and the
debt does not contain any conversion features before
or after the modification or exchange, the debt
instruments would not be considered substantially
different (see Section
10.3). Accordingly, C would apply
modification accounting to the exchange of debt with
Q (see Section
10.4.3). Investor Z is a new creditor
and, accordingly, the issuance of debt to Investor Z
is outside the scope of ASC 470-50 and should
instead be accounted for as a new debt issuance.
10.5.3.4 Modified Remarketable Put Bond Transactions
At the 2003 AICPA Conference on Current SEC Developments,
then SEC Professional Accounting Fellow Robert Comerford provided an example
of the application of ASC 470-50 to a modified remarketable put bond
transaction. Mr. Comerford’s remarks suggest that an intermediary may perform a dual
role in certain transactions involving the contemporaneous repurchase and
reissuance of debt. In his example, the intermediary acts both (1) in a
principal capacity by (a) exercising a call option attached to the debt that
permits it to purchase the debt at a specified price from third-party
investors and (b) selling the debt to the debtor and (2) as the debtor’s
agent by selling modified debt to investors:
Assume that a company issues a 5-year bond for
$1,000, which is also the bond’s face value. Two years later, the
issuer’s investment bank may call the bond from its holder for
$1,000, reset the interest rate on the bond according to a
predetermined formula and then sell the bond bearing this new
interest rate to new investors for the bond’s then-current fair
value. The predetermined formula has a fixed component plus a newly
determined spread reflecting the credit risk of the issuer as of the
reset date. If the investment bank does not call the bond the
original investor must sell the bond back to the issuer for $1,000.
The issuer’s participation on the reset date is limited to either of
the following scenarios. If the investment bank exercises its call
option and remarkets the bond the issuer must pay the bond’s new
interest rate until the bond’s final maturity date. If the
investment bank does not exercise its call, the issuer must
repurchase the bond from the original investor. . . .
[Some] issuers have considered increasing the face
value of their . . . remarketed bonds [and reducing] the interest
rate on the bonds to a market-based rate appropriate to 3-year debt
of the issuer. This matching of the remarketed bond’s new face value
with its expected issuance price has the potential to reduce the
credit spread demanded by the new investors, thus reducing the
issuer’s overall cost of funds.
However, as is often the case with structured
transactions, the little changes that I have mentioned may have
unintended consequences for the issuer. Because increasing the
remarketable put bond’s face value and reducing its coupon to a
market-based rate is not contemplated in the original terms of the
bond, these modifications require evaluation under the guidance
contained in [ASC 470-50]. . . .
The Staff believes that a thorough analysis of the
modified remarketing transaction that I have described causes the
investment bank to be viewed as playing a dual role in the
transaction. The investment bank may be viewed as that of a
principal in the first component of the transaction involving the
acquisition of the bond from the original investor, the resetting of
the bond’s interest rate pursuant to the bond’s original terms and
the subsequent tendering of these instruments back to the issuer at
a price in excess of the instrument’s face value. Once the issuer
has increased the principal amount and decreased the coupon of the
replacement bond, the investment bank’s role is that of the issuer’s
agent conducting the placement of a modified bond to a new
investor.
The Implementation Guidelines in [ASC 470-50] list
four indicators to consider when evaluating whether an intermediary
is acting as a principal or as the issuer’s agent. . . . I would
like to walk through those indicators as they pertain to the
investment bank’s role in placing the modified bonds with new
investors. [Footnote omitted]
- The first indicator involves the risk of loss, if any, that the intermediary is exposed to. Investment banks typically obtain “soft bids” for the replacement bond prior to, or concurrent with, making the decision to exercise their call option on the old bond. By obtaining soft bids the investment bank can determine whether demand for the replacement bond is sufficient to ensure its successful placement. This significantly reduces the investment bank’s exposure to market risk associated with the remarketed instruments, thus pointing towards the investment bank’s role being that of an agent.
- The second indicator examines whether the investment bank is placing the modified bond on a best efforts or a firmly committed basis. Facts and circumstances could lead one to build an argument either way.
- The third indicator considers whether the issuer directs the intermediary’s actions. Although the issuer may not have conceived the idea of increasing the face amount of the bond and decreasing the coupon, these actions require the issuer’s active involvement and ultimately its approval. Therefore, we believe the issuer essentially directs the investment bank’s actions, which suggests the investment bank is an agent.
- The final indicator relates to whether the intermediary’s compensation is limited to a pre-established fee or is derived from gains based on the value of the security to be issued by the issuer. In its capacity as placement agent for the modified bond, the investment bank typically is compensated by a pre-established fee. This further points towards the investment bank’s role being that of the issuer’s agent.
We believe that this analysis provides a firm basis
for concluding that the investment bank acts as the issuer’s agent
in the debt placement component of these modified remarketing
transactions. Because this amounts to the transaction being the
issuer’s acquisition of its own bonds from one investor coupled with
the issuance of a modified bond to a new investor, [ASC 470-50]
requires that this transaction be accounted for as the
extinguishment and de-recognition of the old bond and the
recognition of the new bond at its fair value with the difference
between these two amounts recognized in the income statement as an
extinguishment loss.
Mr. Comerford’s remarks highlight that a contemporaneous debt repurchase and
reissuance should be analyzed as a debt extinguishment under ASC 405-20 and
not as a modification or exchange under ASC 470-50 if the intermediary is
acting as a principal in the debt repurchase and as the debtor’s agent in
the debt reissuance. The intermediary’s purchase of debt securities from
investors is considered a transfer among debt holders that does not affect
the debtor’s accounting since the intermediary is acting as a principal in a
transaction to which the debtor is not a party (see Section 10.2.8). However, the debtor’s
repurchase of debt from the intermediary would be analyzed as a debt
extinguishment because the debtor is viewed as having repurchased debt from
one investor (the intermediary) by using proceeds from debt issued to other
investors (since the intermediary is acting as an agent in the debt
placement. If the intermediary instead had acted as the debtor’s agent in
both the purchase and reissuance of debt to the same investors, those
transactions would have been analyzed as a debt modification or exchange
under ASC 470-50 (see Section
10.2.2).
10.6 Modifications and Exchanges of Credit Facilities
10.6.1 Background
As discussed in Chapter 5, an entity might
incur costs and fees to obtain a commitment from a prospective creditor to
obtain funds on specified terms and conditions in the future. Such commitments
fall into two broad categories: (1) lines of credit and other revolving-debt
commitments that permit the entity to borrow, repay amounts borrowed, and
reborrow amounts previously repaid, and (2) delayed-draw term loan commitments
and other nonrevolving commitments that do not permit the entity to reborrow
amounts repaid (see Section 2.3.3). This
section discusses the accounting for modifications and exchanges of the
following types of arrangements:
-
Line-of-credit and other revolving-debt arrangements (see the next section).
-
Delayed-draw term loan commitments (see Section 10.6.3).
-
Credit facilities that include both drawn and undrawn components (see Section 10.6.4).
10.6.2 Modifications of Line-of-Credit and Other Revolving-Debt Arrangements
10.6.2.1 General
When an entity modifies or exchanges a line-of-credit or revolving-debt
arrangement with the same creditor, it should evaluate how to account for
any unamortized deferred costs associated with the existing arrangement (see
Section 5.4) as well as any fees
paid to the creditor and any costs paid to third parties in connection with
the modification or exchange. ASC 470-50-40-21 requires an entity to perform
a borrowing-capacity analysis to determine the appropriate accounting for
such modifications or exchanges (see Section
10.6.2.3).
10.6.2.2 Scope
ASC 470-50
40-22 The guidance in this
Subtopic is limited to modifications to or exchanges
of line-of-credit or revolving-debt arrangements by
a debtor and a creditor (the same parties that were
involved in the original line-of-credit or
revolving-debt arrangement) in a nontroubled
situation.
The guidance in ASC 470-50-40-21 through 40-23 applies when a debtor modifies
or exchanges a line-of-credit or revolving-debt arrangement with the same
creditor or group of creditors. If an entity terminates an existing
line-of-credit or revolving-debt arrangement and contemporaneously obtains a
new line-of-credit or revolving-debt arrangement from the same creditor or
group of creditors, for example, those transactions should be analyzed as an
exchange of the existing line-of-credit or revolving-debt arrangement under
ASC 470-50-40-21 through 40-23.
ASC 470-50-40-21 through 40-23 apply irrespective of whether a line-of-credit
or revolving-debt arrangement is replaced by a new line-of-credit or
revolving-debt arrangement or term debt. For example, if a debtor converts a
revolving-debt arrangement into a term-debt arrangement, it should perform
the borrowing-capacity test in ASC 470-50-40-21 to determine the appropriate
accounting for any deferred costs as well as any fees or costs associated
with the modification or exchange.
If, because of an entity’s violation of a covenant in a line-of-credit or
revolving-debt arrangement, outstanding amounts become repayable on demand,
the creditor might agree to waive the covenant violation in exchange for a
fee. Such a fee payment would be analyzed as a modification of the
line-of-credit or revolving-debt arrangement even if no other terms in the
arrangement are modified (see Section
10.2.4 for analogous guidance).
It would generally be acceptable to apply ASC 470-50-40-21 to all of the
elements of a modification or exchange of a line-of-credit arrangement when
the same group of individual creditors participates in both the original
arrangement and the new arrangement (i.e., there are no new creditors or
departing creditors in the overall arrangement). That is, if only a portion
of the total maximum credit availability among individual creditors within
the same creditor group has shifted, that alone would not result in a
requirement for an entity to write off any portion of the unamortized
deferred costs related to the original arrangement.
The guidance in ASC 470-50-40-21 through 40-23 does not apply if (1) the
modification represents a TDR (see Chapter
11) or (2) the debtor replaces the arrangement with a new
arrangement with a different creditor. If a debtor terminates an existing
line-of-credit or revolving-debt arrangement and obtains a new
line-of-credit or revolving-debt arrangement from a different creditor, the
debtor should write off all the unamortized deferred costs of the old
arrangement as well any costs incurred to terminate the arrangement with the
original creditor.
10.6.2.3 Borrowing-Capacity Analysis
ASC 470-50
40-21 Modifications to or
exchanges of line-of-credit or revolving-debt
arrangements resulting in either a new
line-of-credit or revolving-debt arrangement or
resulting in a traditional term-debt arrangement
shall be evaluated in the following manner:
- The debtor shall compare the product of the remaining term and the maximum available credit of the old arrangement (this product is referred to as the borrowing capacity) with the borrowing capacity of the new arrangement.
- If the borrowing capacity of the new arrangement is greater than or equal to the borrowing capacity of the old arrangement, then any unamortized deferred costs, any fees paid to the creditor, and any third-party costs incurred shall be associated with the new arrangement (that is, deferred and amortized over the term of the new arrangement).
- If the borrowing capacity of
the new arrangement is less than the borrowing
capacity of the old arrangement, then:
- Any fees paid to the creditor and any third-party costs incurred shall be associated with the new arrangement (that is, deferred and amortized over the term of the new arrangement).
- Any unamortized deferred costs relating to the old arrangement at the time of the change shall be written off in proportion to the decrease in borrowing capacity of the old arrangement. The remaining unamortized deferred costs relating to the old arrangement shall be deferred and amortized over the term of the new arrangement.
Fees between the debtor and the
creditor include an increase or a decrease in the
fair value of a freestanding equity-classified
written call option held by a creditor (calculated
in accordance with paragraph 815-40-35-16) that is
modified or exchanged as a part of or is directly
related to a modification or an exchange of a
line-of-credit or revolving-debt arrangement held by
that same creditor (see paragraphs 815-40-35-14
through 35-15 and 815-40-35-17(c)). Third-party
costs include an increase (but not a decrease) in
the fair value of a freestanding equity-classified
written call option held by a third party
(calculated in accordance with paragraph
815-40-35-16) that is modified or exchanged as a
part of or is directly related to a modification or
an exchange of a line-of-credit or revolving-debt
arrangement (see paragraphs 815-40-35-14 through
35-15 and 815-40-35-17(c)).
For fees between the debtor and the
creditor or third-party costs not related to
exchanges of or modifications to a line-of-credit or
revolving-debt arrangements resulting in either a
new line-of-credit or revolving-debt arrangement,
see paragraphs 470-50-40-17 through 40-18A.
40-23 See Example 1
(paragraph 470-50-55-10) for an illustration of this
guidance.
The accounting for a modification or exchange of a line-of-credit or
revolving-debt arrangement with the same creditor depends on whether the
debtor’s borrowing capacity has decreased. ASC 470-50-40-21 through 40-23
require the debtor to calculate the borrowing capacity by multiplying the
arrangement’s (1) remaining term and (2) maximum available credit (i.e., the
full committed amount including any amounts drawn). This calculation does
not depend on the measure of time used for the remaining term (e.g., whether
the remaining term is measured in months, quarters, or years) except that
the debtor must apply a consistent measure when calculating the borrowing
capacity of both the original and the new arrangement.
Example 10-13
Calculation of Borrowing Capacity
A revolving-debt arrangement has a
remaining term of five years. The outstanding amount
currently drawn is $10 million, and the remaining
undrawn amount is $15 million. Under ASC 470-50, the
borrowing capacity of this arrangement is $125
million, or 5 × ($10 million + $15 million).
The guidance requires any unamortized deferred costs of the old arrangement,
and any costs and fees incurred in connection with a modification or
exchange, to be deferred and amortized over the term of the new arrangement
except if the borrowing capacity under the new arrangement is less than that
under the old arrangement. In that case, unamortized deferred costs of the
old arrangement are written off in proportion to the decrease in the
borrowing capacity.
|
Borrowing Capacity Under the New Arrangement
|
Accounting for Unamortized Deferred
Costs of the Old Arrangement
|
Accounting for Costs and Fees Paid in Connection With
the Modification or Exchange
|
|---|---|---|
|
Equals or exceeds the borrowing capacity under the
old arrangement
|
Deferred and amortized over the term of the new
arrangement
|
Deferred and amortized over the term of the new
arrangement
|
|
Is less than the borrowing capacity under old
arrangement
|
Written off in proportion to the decrease in the
borrowing capacity. The remaining amount is deferred
and amortized over the term of the new
arrangement
|
Deferred and amortized over the term of the new
arrangement
|
10.6.2.4 Illustrations
ASC 470-50
Example 1: Accounting for Changes in
Line-of-Credit or Revolving-Debt
Arrangements
55-10 This Example
illustrates the application of the guidance in
paragraphs 470-50-40-21 through 40-22 for changes in
line-of-credit or revolving-debt arrangements.
55-11 Terms of original
arrangement are as follows:
-
Five-year term (three years remaining)
-
$10 million commitment amount
-
The borrowing capacity under the original arrangement at the time of the change is $30 million, the product of the remaining term (3 years) and the commitment amount ($10 million).
55-12 The following
situations represent changes that are made (with the
same creditor) to the original terms:
-
The commitment amount is increased to $15 million, the term of the new arrangement remains at 3 years (borrowing capacity is $45 million).
-
The commitment amount is decreased to $2 million, the term of the new arrangement is 5.5 years (borrowing capacity is $11 million).
-
The original revolver is replaced with a 3-year, $7.5 million term loan, with principal due at the end of 3 years (borrowing capacity is $22.5 million).
-
The original revolver is replaced with a 3-year, $10 million term loan, with principal due at the end of 3 years (borrowing capacity is $30 million).
55-13 In all of the
situations described, at the time the change is made
to the original arrangement, $150,000 of unamortized
costs relating to the original arrangement remain on
the debtor’s balance sheet; the debtor pays a fee of
$100,000 to the creditor; and the debtor incurs
third-party costs of $200,000.
The following
illustrates the various situations described in this
Example.
|
Case
|
Old Borrowing Capacity
|
New Borrowing Capacity
|
Accounting Treatment of
Unamortized Deferred Costs
|
Accounting Treatment of Fees
and Third-Party Costs Incurred
|
|---|---|---|---|---|
|
A
|
30 million
|
45 million
|
$150,000 is amortized over 3
years.
|
$300,000 is deferred and
amortized over 3 years.
|
|
B
|
30 million
|
11 million
|
63 percent of the unamortized
costs ($94,500) are written off; the remaining
costs ($55,500) are amortized over 5.5 years.
|
$300,000 is deferred and
amortized over 5.5 years.
|
|
C
|
30 million
|
22.5 million
|
25 percent of the unamortized
costs ($37,500) are written off; the remaining
costs ($112,500) are amortized over 3 years.
|
$300,00 is deferred and
amortized over 3 years.
|
|
D
|
30 million
|
30 million
|
$150,000 is amortized over 3
years.
|
$300,000 is deferred and
amortized over 3 years.
|
Example 10-14
Issuance of Warrants as Consideration for
Extension of Line of Credit
Entity C obtains an extension of the remaining term
of an existing line of credit in exchange for
equity-classified warrants on C’s common stock. No
other terms in the arrangement are modified. The
fair value of the warrants should be analyzed as the
payment of a fee to the creditor (i.e., a debit to
“deferred financing costs” and a credit to
“equity”). Because the term was extended and the
maximum available credit remained the same, the
borrowing capacity has increased. Therefore, the
fair value of the warrants should be deferred and
amortized over the term of the modified
arrangement.
Example 10-15
Treatment of Waiver Fee and Third-Party
Costs
As a result of Entity B’s violation of a covenant on
a line-of-credit arrangement, outstanding amounts
have become repayable on demand. The creditor agrees
to waive the covenant violation in exchange for a
fee. Further, B incurs legal fees in connection with
the waiver. No other terms in the arrangement are
modified and the borrowing capacity remains
unchanged. Nevertheless, the payment of the waiver
fee represents a modification of the original
arrangement under ASC 470-50-40-21 through 40-23.
Therefore, the waiver fee and the third-party legal
costs should be deferred and amortized over the term
of the new arrangement, which is equal to the
remaining term of the original arrangement.
Example 10-16
Modification That Involves a Reduction of the
Borrowing Capacity of a Line of Credit
Entity D and Bank B agree to amend the terms of D’s
revolving-debt arrangement to (1) reduce the total
amount available from $250 million to $200 million,
(2) extend the remaining term from two and a half
years to three years, (3) increase the interest
rate, and (4) modify certain covenants. In exchange
for the amendment, B charges a fee of $3 million. At
the time of the amendment, D had an asset of $5
million attributable to remaining unamortized
deferred financing costs related to the original
arrangement.
ASC 470-50-40-21(a) requires the borrowing capacity
of a revolving-debt arrangement to be calculated as
the product of the maximum borrowing capacity and
remaining term under the arrangement. Accordingly, D
determines that the borrowing capacity under the old
arrangement is $625 million ($250 million × 2½
years) and the borrowing capacity after the
amendment is $600 million ($200 million × 3
years):
Because the borrowing capacity of
the new arrangement ($600 million) is less than the
borrowing capacity of the old arrangement ($625
million), D is required under ASC 470-50-40-21(c) to
write off the existing unamortized deferred costs in
proportion to the decrease in the borrowing
capacity. The proportion written off is 4 percent,
or ($625 million – $600 million) ÷ $625 million =
4%. Accordingly, $200,000 is immediately expensed
through earnings (4% × $5 million = $200,000). The
remaining unamortized deferred costs of $4.8 million
and the modification fee of $3 million are deferred
as an asset and amortized on a straight-line basis
(see Section 5.4)
over the 36 months to the revised maturity date of
the arrangement.
Example 10-17
Modification That Involves a Reduction of the
Borrowing Capacity of a Line of Credit and
Conversion of Outstanding Amount to a Term
Loan
A revolving-debt arrangement has a
remaining term of five years and remaining
unamortized deferred costs of $10 million. The
outstanding amount currently drawn is $100 million
and the remaining amount available to be drawn is
$150 million. Under ASC 470-50-40-21(a), the
borrowing capacity of this arrangement equals $1,250
million, or 5 × ($100 million + $150 million).
The revolving-debt arrangement is modified to reduce
the remaining term to three years and the amount
available to be drawn to $100 million. Further, the
outstanding amount currently drawn as of the
modification date ($100 million) is converted into a
traditional term-debt arrangement with a maturity of
five years. The debtor pays creditor fees of $2
million and incurs third-party costs of $1 million
in connection with the modification.
Under ASC 470-50-40-21(a) and 40-22,
the borrowing capacity of the modified arrangement
is calculated to reflect the borrowing capacity of
both the modified revolving-debt arrangement and the
new term-debt arrangement. Therefore, the borrowing
capacity of the new arrangement equals $800 million,
or (3 × $100 million) + (5 × $100 million).
Because the borrowing capacity of
the new arrangement ($800 million) is less than the
borrowing capacity of the old arrangement ($1,250
million), the existing unamortized deferred costs
must be written off under ASC 470-50-40-21(c) in
proportion to the decrease in the borrowing
capacity. The proportion written off is 36 percent,
or ($1,250 million – $800 million) ÷ $1,250 million
= 36%. Accordingly, $3.6 million is immediately
expensed through earnings (36% × $10 million = $3.6
million). The remaining unamortized deferred costs
of $6.4 million and the costs and fees incurred in
connection with the modification of $3 million are
deferred.
Because some of the revolving-debt arrangement was
replaced with a traditional term-debt arrangement, a
portion of the total amount of deferred costs of
$9.4 million should be allocated to the traditional
term-debt arrangement (e.g., on a
relative-borrowing-capacity basis) and treated as an
issuance cost of the term debt in a manner similar
to a debt discount. The portion of the deferred
costs allocated to the revolving-debt arrangement is
deferred as an asset and amortized as an expense
over the remaining term of the revolving-debt
arrangement.
Example 10-18
Modification of Line of Credit That Involves
Multiple Creditors
Entity X had a revolving line-of-credit arrangement
with a remaining two-year term that contained a
total maximum available credit of $50 million (the
“original arrangement”). The total maximum credit
was provided through the following legally binding
lending commitments with three separate creditors:
-
Bank A — total lending commitment of $20 million.
-
Bank B — total lending commitment of $20 million.
-
Bank C — total lending commitment of $10 million.
Entity X replaces the original arrangement with a
revolving line-of-credit arrangement with a
five-year term that contains a total maximum
available credit of $75 million (the “new
arrangement”). The total maximum credit is provided
through the following legally binding lending
commitments with three separate creditors:
-
Bank A — total lending commitment of $25 million.
-
Bank B — total lending commitment of $25 million.
-
Bank D — total lending commitment of $25 million.
When X replaced the original arrangement, it had
recognized unamortized deferred fees of $400,000
associated with the original arrangement ($160,000
to A, $160,000 to B, and $80,000 to C) and
unamortized deferred third-party costs of $40,000.
In conjunction with the issuance of the new
arrangement, X paid fees of $1.5 million to the
creditors ($500,000 to each bank) and incurred
third-party costs of $100,000.
In accordance with ASC 470-50-40-22, X should apply
ASC 470-50-40-21 to the unamortized deferred fees
and costs associated with the original arrangement
related to the parties involved in the original
arrangement (A and B). Entity X should not apply ASC
470-50-40-21 to the unamortized deferred fees and
costs associated with the original arrangement
related to C because C is not a creditor in the new
arrangement. In addition, X should not apply ASC
470-50-40-21 to the fees and third-party costs
associated with the new arrangement related to D
because D was not a creditor in the original
arrangement.
The table below summarizes the
appropriate accounting for the fees and costs as a
result of the exchange.
|
Creditor
|
Fees and Costs Associated With the Original
Arrangement
|
Fees and Costs Associated With the New
Arrangement
|
|---|---|---|
|
Bank A
|
The borrowing capacity with Bank A increased;
therefore, under ASC 470-50-40-21, the unamortized
deferred fees of $160,000 associated with the
original arrangement are deferred and amortized
over the term of the new arrangement.
|
Under ASC 470-50-40-21, the $500,000 that X
paid to A is associated with the new arrangement
and is deferred and amortized over the term of the
new arrangement.
|
|
Bank B
|
The borrowing capacity with Bank B increased;
therefore, under ASC 470-50-40-21, the unamortized
deferred fees of $160,000 associated with the
original arrangement are deferred and amortized
over the term of the new arrangement.
|
Under ASC 470-50-40-21, the $500,000 that X
paid to B is associated with the new arrangement
and is deferred and amortized over the term of the
new arrangement.
|
|
Bank C
|
ASC 470-50-40-21 does not apply since C is not
a creditor in the new arrangement. Rather, the
termination of the lending arrangement with C is
considered an extinguishment that results in the
write-off of the $80,000 of unamortized deferred
fees associated with the original arrangement.
|
N/A
|
|
Bank D
|
N/A
|
ASC 470-50-40-21 does not apply since D was not
a creditor in the original arrangement.
Nevertheless, in accordance with ASC 835, the
$500,000 that X paid to D should be deferred and
amortized over the term of the new
arrangement.
|
|
Third-party costs
|
The unamortized costs associated with the
original arrangement should be written off in
proportion to the unamortized deferred fees
associated with the original arrangement that were
written off (20%, or $80,000 of the $400,000 that
was written off). This results in a write-off of
$8,000 of the unamortized deferred third-party
costs associated with the original
arrangement.
|
Under ASC 470-50-40-21 and ASC 835, the
$100,000 of third-party costs incurred on the new
arrangement are associated with the new
arrangement and are deferred and amortized over
the term of the new arrangement.
|
In addition, note that it would generally be
acceptable to apply ASC 470-50-40-21 to all the
elements of a modification or exchange of a
line-of-credit arrangement when the same group of
individual creditors participates in both the
original arrangement and the new arrangement (i.e.,
there are no new creditors or departing creditors in
the overall arrangement). That is, the mere shift of
a portion of the total maximum credit availability
among individual creditors within the same creditor
group would not itself require an entity to write
off any portion of the unamortized deferred costs
related to the original arrangement (see Section 10.6.2.2). If, in the example
above, A, B, and C were the creditors of the new
arrangement and individually provided a credit
availability of $55 million, $10 million, and $10
million, respectively, because the borrowing
capacity of the new arrangement in total would be
greater than that of the original arrangement in
total, X would not be required to write off any of
the unamortized deferred fees and costs related to
the original arrangement notwithstanding the fact
that $10 million of B’s original credit commitment
has been replaced by an additional credit commitment
of A.
In certain line-of-credit arrangements, the
contractual lending arrangement is between a debtor
and a lead bank. Under the definition of “loan
participation” in ASC 470-50-20 (see Section 10.3.2.4), participating banks
are not direct creditors; rather, they have an
interest represented by a certificate of
participation from the lead bank. In these
situations, the lead bank is considered the sole
creditor. Thus, in a modification or exchange of a
line-of-credit arrangement between a debtor and the
lead bank, the debtor would apply ASC 470-50-40-21
to the entire modification or exchange. Accordingly,
if A were the lead bank in both the original
arrangement and new arrangement, because the
borrowing capacity of the new arrangement would be
greater than that of the original arrangement, the
entire amount of unamortized deferred fees and costs
associated with the original arrangement and all of
the fees and costs incurred to enter the new
arrangement would be deferred and amortized over the
term of the new arrangement. The change in the
composition of the participating banks (i.e., B, C,
and D) would therefore have no effect on the
accounting.
10.6.3 Modifications of Delayed-Draw Term Loan Commitments
As discussed in Section 5.3, an entity might defer costs associated with a
delayed-draw term loan commitment as an asset before the issuance of the debt.
ASC 470-50 does not specifically address how the holder of a delayed-draw term
loan commitment should account for a modification or exchange of such a
commitment if no amount has been drawn. It is acceptable to apply the guidance
in ASC 470-50-40-21 through 40-23 (see Section 10.6.2) on modifications to line-of-credit or
revolving-debt arrangements to such modifications. For amounts that have been
drawn under a delayed-draw term loan commitment, an entity should apply the
guidance on debt modifications and exchanges in ASC 470-50-40-6 through 40-12
(see Sections 10.2 through 10.5).
10.6.4 Modifications to Credit Facilities That Include Both Drawn and Undrawn Components
Credit facilities often include a combination of term loans, delayed-draw term
loan commitments, and line-of-credit or revolving-debt arrangements. While ASC
470-50 addresses the evaluation of modifications and exchanges of term debt (see
Sections 10.2 through 10.5) and modifications of line-of-credit
and revolving-debt arrangements (see Section 10.6.2), it does not specifically address amendments to
credit facilities that include a combination of types except for modifications
of revolving-debt arrangements that are modified into, or exchanged for, term
loans (see Section 10.6.2.2).
If an outstanding term loan is modified or exchanged so that it
becomes an amount drawn under a line-of-credit or revolving-debt arrangement
with the same creditor, the debtor should apply the guidance on modifications
and exchanges of term-debt arrangements (such as the guidance in ASC
470-50-40-10 on the 10 percent cash flow test) to the associated debt (see
Sections 10.2 through 10.5). In
evaluating whether to account for the original term loan as extinguished, the
debtor would treat the amount drawn after the amendment as a term loan with
payment terms that are consistent with those of amounts drawn under the new
line-of-credit or revolving-debt arrangement.
ASC 470-50-40-21 states that it applies to “[m]odifications to
or exchanges of line-of-credit or revolving-debt arrangements resulting in
either a new line-of-credit or revolving-debt arrangement or resulting in a
traditional term-debt arrangement.” Accordingly, if a line-of-credit or
revolving-debt arrangement is modified or exchanged so that it becomes, in whole
or in part, a term-debt arrangement or delayed-draw term loan commitment with
the same creditor, the debtor should apply the guidance on modifications of
line-of-credit or revolving-debt arrangements (see Section 10.6.2). Note that it would apply
this guidance even if amounts were drawn under a line-of-credit or
revolving-debt arrangement before its modification or exchange. If the borrowing
capacity before the amendment exceeds the borrowing capacity after the
amendment, a proportionate amount of the current unamortized deferred costs
associated with the line-of-credit or revolving-debt arrangement is expensed and
the remaining amount is allocated among any continuing line-of-credit or
revolving-debt arrangement, delayed-draw term loan commitment, and term loan on
a systematic and rational basis (e.g., on the basis of relative borrowing
capacity). If the borrowing capacity after the amendment equals or
exceeds the borrowing capacity before the amendment, the current amount of
unamortized deferred costs associated with the line-of-credit or revolving-debt
arrangement is allocated among any continuing line-of-credit or revolving-debt
arrangement, delayed-draw term loan commitment, and term loan on a systematic
and rational basis (e.g., first to the continuing line-of-credit or
revolving-debt arrangement in proportion to the borrowing capacity that remains
under that component of the arrangement and then to the new term loan). Any
amounts allocated to the new term loan are accounted for as debt issuance costs
of that debt (see Section
5.3.3).
If the original credit facility includes both outstanding term debt and a line of
credit or revolving debt, it is often appropriate to analyze the modification or
exchange separately for each of those components on the basis of the above
guidance (e.g., when only one component is modified). Any amount of term debt
outstanding before the amendment that is reallocated to an amount drawn under a
line-of-credit or revolving-debt arrangement after the amendment would be
analyzed under the guidance on modifications and exchanges of term debt. Any
amount that was drawn under a line-of-credit or revolving-debt arrangement
before the amendment that becomes an amount drawn under a term-debt arrangement
after the modification or exchange is analyzed in accordance with the guidance
on modifications of line-of-credit or revolving-debt arrangements. In some
circumstances, it may be appropriate to analyze the modification or exchange in
combination on the basis of the predominant characteristics of the overall
credit facility (e.g., amounts are fully drawn and an increase in the interest
rate of one component is compensated by a decrease in the interest rate of the
other component). An entity should allocate the fees and costs incurred to amend
a credit facility to the different components of the facility by using a
reasonable and systematic approach that is consistently applied (e.g., relative
fair value).
If a credit facility involves multiple lenders, and an individual creditor no
longer participates in the credit facility, any term loan with that creditor is
accounted for as an extinguishment unless the replacement of an original
creditor with a new creditor, in substance, represents a transfer of the
existing debt to a new debt holder (see Section 10.2.8). Any deferred costs related to a line-of-credit
or revolving-debt arrangement or delayed-draw term loan commitment with a
creditor that no longer participates in the credit facility would be written off
through current-period earnings. If a new creditor is added to the credit
facility, any term loan with that creditor is recognized as a new term loan and
any costs attributable to a line-of-credit or revolving-debt arrangement or
delayed-draw term loan commitment with that creditor is deferred as an asset, if
appropriate.
The table below summarizes the above considerations.
|
Individual Creditors
|
Original Credit Facility
|
Amended Credit Facility
|
Accounting
|
|---|---|---|---|
|
Continuing creditor
|
Term debt
|
Term debt
|
Perform the 10 percent cash flow test
and apply the guidance on conversion features (see
Section 10.3) to determine whether the
original term debt should be treated as modified or
extinguished (see Section 10.4)
|
|
Line of credit or revolver
|
Line of credit or revolver
|
Perform the borrowing-capacity test (see
Section 10.6.2) to determine the
accounting for any deferred costs
| |
|
Term debt
|
Line of credit or revolver
|
Perform the 10 percent cash flow test on
the basis of the amount drawn and apply the guidance on
conversion features (see Section 10.3) to
determine whether the original term debt should be
treated as modified or extinguished (see Section
10.4)
| |
|
Line of credit or revolver
|
Term debt
|
Perform the borrowing-capacity test (see
Section 10.6.2) to determine the
accounting for any deferred costs
| |
|
No longer creditor
|
Term debt
|
N/A
|
Apply debt extinguishment accounting
(see Section 9.3) to the related term
loan
|
|
Line of credit or revolver
|
N/A
|
Expense the related deferred financing
costs
| |
|
New creditor
|
N/A
|
Term debt
|
Recognize as a new term loan (see
Chapters 4 and 5)
|
|
N/A
|
Line of credit or revolver
|
Recognize an asset for the related
deferred financing costs (see Section 5.4)
|
Chapter 11 — Troubled Debt Restructurings
Chapter 11 — Troubled Debt Restructurings
11.1 Background
ASC 470-60
05-1 This Subtopic addresses
measurement, derecognition, disclosure, and implementation
guidance issues concerning troubled debt restructurings
focused on the debtor’s records. . . .
If a creditor anticipates that a debtor might be unable to pay its outstanding debt
obligations as they become due, the creditor may be willing to grant the debtor a
concession. For example, the creditor might agree to reduced or extended payment
terms or a settlement of some or all of the obligation through the transfer of
assets or equity shares (see Section 11.2). By
granting a concession, the creditor hopes to improve its prospects of recovering as
much as possible of its investment and avoiding a costly legal process (e.g.,
foreclosure, bankruptcy proceedings, or other adverse consequences of an event of
default).
Under ASC 470-60, a debt restructuring qualifies as a TDR if both of the following
two criteria are met: (1) the debtor is experiencing financial difficulties and (2)
the creditor for economic or legal reasons related to such difficulties has granted
the debtor a concession that it would not otherwise consider (see Section 11.3). ASC 470-60 discusses special
accounting, presentation, and disclosure requirements related to TDRs (see Sections 11.4 and 11.5).
11.2 Scope
11.2.1 General
ASC 470-60
15-1 The guidance in this
Subtopic applies to all debtors.
15-2 The guidance in this
Subtopic applies to all troubled debt restructurings by
debtors.
15-4 . . . Payables that may
be involved in troubled debt restructurings commonly
result from borrowing of cash, or purchasing goods or
services on credit. Examples are accounts payable,
notes, debentures and bonds (whether those payables are
secured or unsecured and whether they are convertible or
nonconvertible), and related accrued interest, if any. .
. .
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.
15-9 A troubled debt
restructuring may include, but is not necessarily
limited to, one or a combination of the following:
- Transfer from the debtor to the creditor of receivables from third parties, real estate, or other assets to satisfy fully or partially a debt (including a transfer resulting from foreclosure or repossession)
- Issuance or other granting of an equity interest to the creditor by the debtor to satisfy fully or partially a debt unless the equity interest is granted pursuant to existing terms for converting the debt into an equity interest
- Modification of terms of a debt, such as one or
a combination of any of the following:
- Reduction (absolute or contingent) of the stated interest rate for the remaining original life of the debt
- Extension of the maturity date or dates at a stated interest rate lower than the current market rate for new debt with similar risk
- Reduction (absolute or contingent) of the face amount or maturity amount of the debt as stated in the instrument or other agreement
- Reduction (absolute or contingent) of accrued interest.
15-11 For purposes of this
Subtopic, none of the following are considered troubled
debt restructurings:
- Lease modifications (for guidance, see Topic 842)
- Changes in employment-related agreements, for example, pension plans and deferred compensation contracts
- Unless they involve an
agreement between debtor and creditor to
restructure, neither of the following:
- Debtors’ failures to pay trade accounts according to their terms
- Creditors’ delays in taking legal action to collect overdue amounts of interest and principal.
15-13 For further guidance
on determining whether a modification or exchange is a
troubled debt restructuring, see paragraphs 470-60-55-4
through 55-7. If a debtor concludes that the
modification or exchange is not within the scope of this
Subtopic, the debtor would apply the provisions of
Subtopic 470-50.
If a debtor undertakes any of the following transactions involving its
outstanding debt, it should evaluate whether the transaction qualifies as a TDR
under ASC 470-60 (see Section 11.3):
- A modification of terms — The creditor might agree to extend the terms by deferring the timing of the contractual interest or principal payments due. Alternatively, the creditor might agree to reduce the amounts due by (1) decreasing the contractual interest rate to a below-market interest rate or (2) forgiving a portion of the principal amount or previously accrued interest. Further, the modification might make payment terms contingent on, for example, the debtor’s revenue.
- An exchange of debt instruments — The debtor and creditor might agree to exchange the outstanding debt instrument for a new debt instrument with terms that are more favorable to the debtor.
- Transfer of assets in full or partial satisfaction of the debt — The debtor might transfer cash, trade receivables, real estate, or other assets to the creditor to fully or partially satisfy the debt.
- Grant of equity interest in full or partial satisfaction of the debt — The debtor might transfer an equity interest (such as shares of common or preferred stock or warrants on such shares) to the creditor to satisfy fully or partially the obligation even though the debt was not convertible into such an equity interest under the debt’s original contractual terms.
A restructuring that extends the debt’s maturity date might
qualify as a TDR under ASC 470-60 even if the principal balance and the stated
interest rate remain unchanged. ASC 470-60-15-9(c) states, in part, that a TDR
may include “[e]xtension of the maturity date or dates at a stated interest rate
lower than the current market rate for new debt with similar risk.” If the
stated interest rate on the restructured loan is lower than the current market
rate for a new loan with similar risk that a creditor would be willing to make,
the restructuring might be deemed a concession (see Section 11.3.3).
Further, a debt restructuring might represent a TDR even if the debt is settled
in full. For example, a debtor is required to disclose specific information
about TDRs that have occurred during the period for which financial statements
are presented (see Section 11.5.2).
Unless a modification has been made to the debt terms, the
debtor’s failure to pay amounts when due or the creditor’s delay in taking
action to enforce the payment terms is not within the scope of ASC 470-60.
However, the settlement of debt through a foreclosure or repossession or the
transfer of assets or equity securities should be evaluated under ASC 470-60
even if the contractual terms are not modified (see the next section). Special
considerations are necessary for bankruptcy proceedings and
quasi-reorganizations (see Section 11.2.3).
The following transactions are exempt from the scope of ASC 470-60:
- Lease modifications.
- Changes in employment-related contracts (e.g., pensions or deferred compensation arrangements).
ASC 470-60 does not apply to the creditor’s accounting.
11.2.2 Foreclosures and Repossessions
ASC 470-60
15-6 . . . Although troubled
debt that is fully satisfied by foreclosure,
repossession, or other transfer of assets or by grant of
equity securities by the debtor is, in a technical
sense, not restructured, that kind of event is included
in the term troubled debt restructuring in this
Subtopic.
35-9 A troubled debt
restructuring that is in substance a repossession or
foreclosure by the creditor or other transfer of assets
to the creditor shall be accounted for according to the
provisions of the preceding paragraph and paragraphs
470-60-35-2 through 35-3.
Debt that is satisfied through foreclosure, repossession, other
transfer of the debtor’s assets is not exempt from the scope of ASC 470-60 if it
otherwise meets the criteria for a TDR (see Section 11.3). Further, we understand that
the FASB and SEC believe that ASC 470-60 applies to foreclosures or
repossessions of specified collateral (e.g., mortgaged property) if the creditor
has no recourse to the debtor’s other assets. For example, assume that on
January 1, 20X1, an entity borrows, on a nonrecourse basis, $1 million to
purchase real property that has a fair value of $1.2 million. Since the
borrowing is nonrecourse, the lender only has recourse to the real property
being financed and cannot look to any other assets of the borrower to satisfy
the loan. Further assume that on December 1, 20X3, the property has a fair value
of $700,000 and the amount due on the loan is still $1 million. If the borrower
transfers the real property to the lender in full satisfaction of the loan
(i.e., title to the property reverts to the lender and the borrower has no
further obligation), the settlement of the loan is a TDR. Therefore, the
borrower would recognize a loss on the real property of $500,000. The borrower
would also recognize a gain on the debt restructuring of $300,000, which
represents the excess of the loan balance over the fair value of the property.
(For simplicity, it is assumed that the borrower had not previously treated the
real property as impaired even though such treatment may have been required
earlier.)
11.2.3 Bankruptcy Proceedings and Quasi-Reorganizations
ASC 470-60
15-10 The guidance in this
Subtopic shall be applied to all troubled debt
restructurings including those consummated under
reorganization, arrangement, or other provisions of the
Federal Bankruptcy Act or other federal statutes related
thereto. This Subtopic does not apply, however, if under
provisions of those federal statutes or in a
quasi-reorganization or corporate readjustment (see
Topic 852) with which a troubled debt restructuring
coincides, the debtor restates its liabilities
generally, that is, if such restructurings or
modifications accomplished under purview of the
bankruptcy court encompass most of the amount of the
debtor’s liabilities.
55-1 Entities involved with
Chapter 11 bankruptcy proceedings frequently reduce all
or most of their indebtedness with the approval of their
creditors and the court in order to provide an
opportunity for the entity to have a fresh start. Such
reductions are usually by a stated percentage so that,
for example, the debtor owes only 60 cents on the
dollar. Because the debtor would be restating its
liabilities generally, this Subtopic would not apply to
the debtor’s accounting for such reduction of
liabilities.
55-2 On
the other hand, this Subtopic would apply to an isolated
troubled debt restructuring by a debtor involved in
bankruptcy proceedings if such restructuring did not
result in a general restatement of the debtor’s
liabilities.
ASC 470-60 does not apply to debt restructurings in which a debtor makes a
general restatement of its liabilities in a reorganization under federal
bankruptcy law or in conjunction with a quasi-reorganization. A
quasi-reorganization is an accounting procedure by which an entity revalues its
assets and liabilities on a “fresh-start” basis to their current fair value
without undergoing a legal reorganization (see ASC 852). As noted in ASC
852-20-25-5, the “effective date of the readjustment . . . shall be as near as
practicable to the date on which formal consent of the stockholders [to the
reorganization] is given.” For example, a debt restructuring may be considered
to have occurred in conjunction with a quasi-reorganization if each occurs
within 30 days of the other.
If a debtor undergoing Chapter 11 bankruptcy proceedings obtains creditor and
bankruptcy court approval for a reduction of substantially all of its
liabilities, such a debt restructuring would be considered a general restatement
of its liabilities and consequently excluded from the scope of ASC 470-60.
However, ASC 470-60 applies if a company negotiates debt restructurings on only
some if its liabilities and does not generally restate its liabilities.
11.3 Determining Whether a Transaction Qualifies as a TDR
11.3.1 General
ASC Master Glossary
Troubled Debt Restructuring
A restructuring of a debt constitutes a troubled debt
restructuring if the creditor for economic or legal
reasons related to the debtor’s financial difficulties
grants a concession to the debtor that it would not
otherwise consider.
In accordance with the definition of a TDR, (1) the debtor must be experiencing
financial difficulties and (2) the creditor must grant the debtor a concession
that it would not have considered in the absence of “economic or legal reasons
related to the debtor’s financial difficulties.” In a TDR, a creditor accepts
terms that it normally would not consider because it no longer expects to earn
the rate of return anticipated at the time of initial investment. In other
words, in the absence of the restructuring, the creditor would be paid a higher
effective interest rate for the same receivable currently. For a TDR to exist,
the debtor’s creditworthiness must have deteriorated after the original issuance
of the debt instrument and such deterioration must have compelled the creditor
to accept terms that it would not otherwise consider.
ASC 470-60
55-4 No single
characteristic or factor, taken alone, is determinative
of whether a modification or exchange is a troubled debt
restructuring under this Subtopic. That is, the fact
that a single characteristic is present in a transaction
(such as that described in paragraph 470-60-15-9(c)(3)
or 470-60-15-12(d)) should not be considered sufficient
to overcome the preponderance of contrary evidence.
Determining whether a transaction is within the scope of
this Subtopic requires the exercise of judgment. The
guidance that follows is not limited to marketable debt
instruments.
55-5 The following model
should be applied by a debtor when determining whether a
modification or an exchange of debt instruments is
within the scope of this Subtopic.
ASC 470-60-15-9 (see Section 11.2.1) identifies characteristics
or factors that may be present in a TDR, whereas ASC 470-60-15-8 and ASC
470-60-15-12 identify characteristics and factors that, if present, indicate
that a debt restructuring is not necessarily a TDR even if the debtor is
experiencing financial difficulties (see Section 11.3.2.2). No single
characteristic or factor should be considered determinative of whether a debt
restructuring is a TDR. The model described in ASC 470-60-55-5 through 55-14
must be applied to determine whether a debt modification or exchange is a TDR
(see also Section
11.3.3.4). A debt modification or exchange that does not qualify
as a TDR should be evaluated under ASC 470-50 (see Chapter 10).
11.3.2 Criterion 1 — The Debtor Is Experiencing Financial Difficulties
11.3.2.1 Indicators of Financial Difficulties
ASC 470-60
55-7 If the debtor’s
creditworthiness (for example, based on its credit
rating or equivalent, the effects of the original
collateral or credit enhancements in the debt, or
its sector risk) has deteriorated since the debt was
originally issued, the debtor should evaluate
whether it is experiencing financial difficulties.
Changes in an investment-grade credit rating are not
considered a deterioration in the debtor’s
creditworthiness for purposes of this guidance.
Conversely, a decline in credit rating from
investment grade to noninvestment grade is
considered a deterioration in the debtor’s
creditworthiness for purposes of this guidance.
55-8 All of the following
factors are indicators that the debtor is
experiencing financial difficulties:
-
The debtor is currently in default on any of its debt.
-
The debtor has declared or is in the process of declaring bankruptcy.
-
There is significant doubt as to whether the debtor will continue to be a going concern.
-
Currently, the debtor has securities that have been delisted, are in the process of being delisted, or are under threat of being delisted from an exchange.
-
Based on estimates and projections that only encompass the current business capabilities, the debtor forecasts that its entity-specific cash flows will be insufficient to service the debt (both interest and principal) in accordance with the contractual terms of the existing agreement through maturity.
-
Absent the current modification, the debtor cannot obtain funds from sources other than the existing creditors at an effective interest rate equal to the current market interest rate for similar debt for a nontroubled debtor.
One of the two conditions in ASC 470-60 for TDR accounting is that the debtor
must be experiencing financial difficulties. A debtor is required to
evaluate whether it is experiencing financial difficulties if its
creditworthiness has deteriorated since the debt was originally issued
(i.e., the likelihood that it is unable to meet its debt obligations has
increased). ASC 470-60 specifies that a change in credit rating from
investment grade to noninvestment grade should be considered a deterioration
in creditworthiness. However, a credit rating downgrade is not considered a
deterioration in creditworthiness if the new credit rating is investment
grade (e.g., the new credit rating is BBB or higher if issued by Standard
and Poor’s or Baa or higher if issued by Moody’s). Other factors that may
suggest that the debtor’s creditworthiness has deteriorated include:
-
A decline in the debtor’s financial performance (e.g., recurring losses).
-
A decline in the value of any collateral.
-
Adverse changes in business, financial, or economic conditions (e.g., in the debtor’s industry).
-
Adverse changes in market indicators of the issuer’s creditworthiness (e.g., credit spreads, credit default swap prices, or observable transactions in the debtor’s securities).
The debtor should use judgment in determining whether, on
the basis of the preponderance of the evidence, it is experiencing financial
difficulties. The following factors are strong indicators that the debtor is
experiencing financial difficulties:
-
The debtor is experiencing current liquidity issues (i.e., insufficient cash flows to service its debt).
-
The debtor forecasts that it will not have sufficient cash flows to pay the contractual principal and interest payments during the debt’s remaining term.
-
The debtor is generally unable to pay its debts when due.
-
The debtor is unable to obtain new debt at terms applicable to nontroubled debtors from sources other than the current creditor.
-
There is significant doubt related to whether the debtor will continue as a going concern.
-
The debtor has declared or is it in the process of declaring bankruptcy.
-
The debtor’s securities cease to meet exchange listing requirements because of financial issues.
Example 11-1
Debtor That Is Experiencing Financial
Difficulties
Company A has defaulted on some its debt and there is
doubt related to whether it will be able to meet its
debt obligations as they become due over the next 12
months. Company A concludes that it is experiencing
financial difficulties.
If the debtor concludes that it is not experiencing financial difficulties, a
debt restructuring is not a TDR. If the debtor is experiencing financial
difficulties, it should evaluate whether it has received a concession before
deciding whether the debt restructuring is a TDR (see Section 11.3.3).
11.3.2.2 Access to Alternative Funding
ASC 470-60
15-8 In general, a debtor
that can obtain funds from sources other than the
existing creditor at market interest rates at or
near those for nontroubled debt is not involved in a
troubled debt restructuring. A debtor in a troubled
debt restructuring can obtain funds from sources
other than the existing creditor in the troubled
debt restructuring, if at all, only at effective
interest rates (based on market prices) so high that
it cannot afford to pay them.
15-12 A debt restructuring is not
necessarily a troubled debt restructuring for
purposes of this Subtopic even if the debtor is
experiencing some financial difficulties. For
example, a troubled debt restructuring is not
involved if any of the following circumstances
exist: . . .
c. The creditor reduces the effective
interest rate on the debt primarily to reflect a
decrease in market interest rates in general or a
decrease in the risk so as to maintain a
relationship with a debtor that can readily obtain
funds from other sources at the current market
interest rate.
d. The debtor issues in exchange for its debt
new marketable debt having an effective interest
rate based on its market price that is at or near
the current market interest rates of debt with
similar maturity dates and stated interest rates
issued by nontroubled debtors.
55-9 Notwithstanding the
above, the following factors, if both are present,
provide determinative evidence that the debtor is
not experiencing financial difficulties, and, thus,
the modification or exchange is not within the scope
of this Subtopic (the presence of either factor
individually would be an indicator, but not
determinative, that the debtor is not experiencing
financial difficulty):
- The debtor is currently servicing the old debt and can obtain funds to repay the old prepayable debt from sources other than the existing creditors (without regard to the current modification) at an effective interest rate equal to the current market interest rate for a nontroubled debtor.
- The creditors agree to restructure the old debt solely to reflect a decrease in current market interest rates for the debtor or positive changes in the creditworthiness of the debtor since the debt was originally issued.
A debtor that has access to alternative sources of funding from other
creditors at a rate that is at or near the rates for nontroubled debt would
not necessarily be experiencing financial difficulties even if its
creditworthiness has deteriorated. Under ASC 470-60-55-9, a debtor is deemed
not to be experiencing financial difficulties if the following two factors
are present:
- “The debtor is [both (1)] currently servicing the old debt and [(2) able to] obtain funds to repay the old prepayable debt from sources other than the existing creditors (without regard to the current modification) at an effective interest rate equal to the current market interest rate for a nontroubled debtor.” In evaluating whether this condition is met, the debtor ignores any third-party debt that it was able to issue as a consequence of the debt restructuring. The debtor only considers debt that it would have been able to issue at a nontroubled borrowing rate in the absence of a debt restructuring.
- “The creditors agree to restructure the old debt solely to reflect [either (1)] a decrease in current market interest rates for the debtor or [(2)] positive changes in the creditworthiness of the debtor since the debt was originally issued.”
ASC 470-60-15-8 and ASC 470-60-15-12 should be applied in a manner consistent
with ASC 470-60-55-5 through 55-14. For example, as noted in ASC
470-60-55-4, the transaction described in ASC 470-60-15-12(d) might be a TDR
even if it involves the issuance of debt with an effective interest rate
that is at or near the current market rates for nontroubled debt. The debtor
should consider the factors in ASC 470-60-55-9 when evaluating such a
transaction.
The January 4, 2002, meeting materials for the interpretive guidance in EITF Issue 02-4 (Issue Summary No. 1), which was subsequently codified in ASC
470-60, included two nonauthoritative examples, reproduced below, which
illustrate the above guidance. The first example shows that a debt
restructuring that involves a reduction in the effective borrowing rate (see
Section 11.3.3.4.1) might not be a TDR in a scenario in
which the debtor’s creditworthiness has not deteriorated and the debtor has
access to alternative sources of funding from external sources at a rate
that is at or near the rates for nontroubled debt even if the debtor
anticipates some difficulties in meeting future principal and interest
payments on the original debt. The second example shows that a debt
restructuring that involves a reduction in the effective borrowing rate
would be a TDR even if the restructured debt’s effective borrowing rate is
based on a market price that is at or near the rates for nontroubled debt in
a scenario in which the debtor is experiencing financial difficulties and
does not have access to alternative sources of funding at a rate that is at
or near the rates for nontroubled debt.
Nonauthoritative EITF Meeting Materials
EITF Issue 02-4, Issue Summary 1 (January 4,
2002)
Example 1
Company A has publicly traded debt
(old debt) outstanding. Company A is experiencing
financial difficulties caused, in part, by the fact
that its sales margins are decreasing while fixed
costs have remained level. Based on current
forecasts, Company A believes that it will have
sufficient cash flows to service the old debt in
accordance with its terms over the next six months,
but may have difficulty making scheduled
principal and interest payments beyond that point.
The stated rate on the old debt is significantly
higher than current market rates. To reduce costs,
Company A renegotiated the terms of the old debt
with its creditors and replaced it with new
marketable debt (new debt).
Company A considered the following specific facts and
circumstances:
-
Company A initiated the restructuring to reduce the interest rate on its outstanding debt to a level more consistent with current market rates. At the reduced interest rate, Company A forecasts that its cash flows will be more than sufficient to service the debt in accordance with the revised terms, over both the near and longer term.
-
The old debt’s market price had increased since the date the debt was issued solely as a result of a decrease in general interest rates.
-
Company A’s credit rating has remained the same since the date it issued the old debt. That is, Company A concluded that the increase in the old debt’s effective market rate was not due to a perceived increase in risk to the creditor.
-
The new debt has the same payment dates, collateral requirements and covenant requirements as the old debt.
-
The new debt has a lower principal amount and stated interest rate than the old debt. However, on the date of exchange, the new marketable debt has an effective interest rate based on its market price that is at or near the current market interest rates of debt with similar maturity dates and stated interest rates issued by nontroubled debtors.
-
Company A was able to and considered borrowing funds from other sources at a lower interest rate than the old debt but decided that its best economic alternative was to renegotiate the debt with its current debt holders provided they agree to restructure the debt in ways more favorable to Company A.
-
When Company A exchanged the new debt for the old debt with existing creditors, Company A issued an additional 20 percent of the par amount of the new debt at the same terms of the new debt to new investors. However, Company A could not have obtained those additional funds if the existing creditors did not agree to the terms of the restructuring.
Based on the above, even though there was a principal
reduction in the old debt, Company A appropriately
concluded sufficient persuasive evidence exists to
support its assertion that economic and legal
considerations related to its financial difficulty
were not the primary reasons that compelled the
creditors to restructure the marketable debt in ways
more favorable to Company A. That is, the
restructuring was not within the scope of [ASC
470-60].
While the following factors were also present,
Company A did not consider them relevant to its conclusion:
-
The market value of the old debt prior to the announcement of the terms of the restructuring was greater than the market value of the new debt.
-
Eighty percent of the existing creditors at the date of the restructuring purchased the old debt within the past week, 10 percent purchased the old debt within the past month, while the remaining 10 percent were the original purchasers of the old debt.
Example 2
Company B has publicly traded debt (old debt)
outstanding. Company B is experiencing financial
difficulties caused, in part, by the fact that its
sales margins are decreasing while fixed costs have
remained level. Based on current forecasts, Company
B believes that it will not have sufficient cash
flows to service the old debt in accordance with its
terms in the near or long term. The stated rate on
the old debt is significantly higher than current
market rates. To reduce future cash flows, Company B
renegotiated the terms of the old debt with its
creditors and replaced it with new marketable debt
(new debt).
Company B considered the following specific facts and circumstances:
-
Company B’s financial difficulties, which render it unable to service the debt over the near and long term, were the primary reason for its decision to renegotiate the terms of its debt in a manner that reduces both principal and interest.
-
The old debt’s market price had decreased since the date the debt was issued even though there was a decrease in general interest rates.
-
Company B’s credit rating has fallen below investment grade since the date it issued the old debt. That is, Company B concluded that the decrease in the old debt’s market price was primarily due to a perceived increase in risk to the creditor.
-
The new debt has the same payment dates, collateral requirements, and covenant requirements as the old debt.
-
The new debt has a lower principal amount and stated interest rate than the old debt; however, on the date of exchange, the new marketable debt has an effective interest rate based on its market price that is at or near the current market interest rates of debt with similar maturity dates and stated interest rates issued by nontroubled debtors.
-
Company B was not able to borrow funds from other sources at an effective interest rate that it could afford to pay. That is, Company B must rely on the current creditors to agree to restructure the old debt in ways more favorable to Company B in order for Company B to sustain operations.
-
When Company B exchanged the new debt for the old debt with existing creditors, Company B issued an additional 20 percent of the par amount of the new debt at the same terms of the new debt to new investors. However, Company B could not have obtained those additional funds if the existing creditors did not agree to the terms of the restructuring.
Based on the above, even though the new debt has an
effective interest rate based on its market price
that is at or near the current market interest rates
of debt with similar maturity dates and stated
interest rates issued by nontroubled debtors,
Company B appropriately concluded sufficient
persuasive evidence exists to support its assertion
that economic and legal considerations related to
its financial difficulty were the primary reasons
that compelled the creditors to restructure the
marketable debt in ways more favorable to Company B.
That is, the restructuring was within the scope of
[ASC 470-60].
While the following factors were also present,
Company B did not consider them relevant to its conclusion:
-
The market value of the old debt prior to the announcement of the restructuring was equal to the market value of the new debt. That is, theoretically, Company B could have purchased the old debt from the existing creditors in the marketplace for an amount equal to the market value of the new debt.
-
Eighty percent of the existing creditors at the date of the restructuring purchased the old debt within the past week, 10 percent purchased the old debt within the past month, while the remaining 10 percent were the original purchasers of the old debt.
11.3.3 Criterion 2 — The Creditor Has Granted a Concession
11.3.3.1 General
ASC 470-60
15-5 A restructuring of a
debt constitutes a troubled debt restructuring for
purposes of this Subtopic if the creditor for
economic or legal reasons related to the debtor’s
financial difficulties grants a concession to the
debtor that it would not otherwise consider.
15-6 That concession is
granted by the creditor in an attempt to protect as
much of its investment as possible. That concession
either stems from an agreement between the creditor
and the debtor or is imposed by law or a court; for
example, either of the following circumstances might
occur:
- A creditor may restructure the terms of a debt to alleviate the burden of the debtor’s near-term cash requirements, and many troubled debt restructurings involve modifying terms to reduce or defer cash payments required of the debtor in the near future to help the debtor attempt to improve its financial condition and eventually be able to pay the creditor.
- The creditor may accept cash, other assets, or an equity interest in the debtor in satisfaction of the debt though the value received is less than the amount of the debt because the creditor concludes that step will maximize recovery of its investment. . . .
15-7 Whatever the form of
concession granted by the creditor to the debtor in
a troubled debt restructuring, the creditor’s
objective is to make the best of a difficult
situation. That is, the creditor expects to obtain
more cash or other value from the debtor, or to
increase the probability of receipt, by granting the
concession than by not granting it.
The second of the two conditions in ASC 470-60 for TDR accounting is that the
creditor must have granted a concession. Such a concession might involve a
reduction of the interest rate, forgiveness of principal or accrued
interest, or a payment delay or deferral, and it could result from an
agreement between the debtor and the creditor or be imposed by law or a
court.
Although a concession involves making terms more favorable
to the debtor, a creditor may have an economic incentive to grant a
concession when a debtor is experiencing financial difficulties. For
example, a concession may be in the creditor’s economic best interest if it
enables the debtor to avoid bankruptcy or other consequences of a default
that could (1) have an adverse impact on the creditor’s prospects of
recovering amounts due from the debtor or (2) result in additional costs to
the creditor (e.g., the legal costs of a foreclosure or bankruptcy
proceeding). A creditor grants a concession when it no longer believes that
its investment in the receivable will earn the rate of return expected at
the time of the investment because of anticipated credit losses in the
absence of a restructuring.
While the definition of a TDR suggests that the creditor must have granted a
concession that it would not have considered if not for the debtor’s
financial difficulties, a debtor is not required to specifically evaluate
whether the debtor’s financial difficulties were the reason for the
concession or whether the creditor would have granted the concession even if
the debtor had not experienced financial difficulties.
11.3.3.2 Level of Aggregation
If a debtor has outstanding debt with multiple creditors, it should
separately determine for each creditor whether a concession has been
granted. If a debt arrangement involving multiple lenders is structured as a
loan participation, the debtor has only one creditor (see Section 10.3.2.4).
If one creditor (or multiple creditors within a consolidated
group or otherwise under common control) holds multiple debt instruments
issued by the same debtor, the debtor should consider its total relationship
with the creditor in determining whether a concession has been granted. For
example, in assessing whether the effective borrowing rate on the
restructured debt is below the effective borrowing rate immediately before
the restructuring (see Section 11.3.3.4), the debtor would calculate and use a
composite effective interest rate for any debt instruments that are
evaluated on an aggregated basis.
11.3.3.3 Transfers of Assets or Issuances of Equity Interests
ASC 470-60
15-12 A debt restructuring
is not necessarily a troubled debt restructuring for
purposes of this Subtopic even if the debtor is
experiencing some financial difficulties. For
example, a troubled debt restructuring is not
involved if any of the following circumstances
exist: . . .
b. The fair value of cash, other assets, or
an equity interest transferred by a debtor to a
creditor in full settlement of its payable at
least equals the debtor’s carrying amount of the
payable. . . .
If a debt restructuring involves a transfer of assets or the issuance of an
equity interest in full satisfaction of a debt obligation, the debtor should
consider whether the fair value of those assets or equity interests equals
or exceeds the debt’s net carrying amount. The debtor has not received a
concession if the fair value of those assets or equity interests equals or
exceeds the debt’s net carrying amount. Conversely, the debtor has received
a concession if the debt’s net carrying amount exceeds the fair value of
such assets or equity interests.
The transferred assets’ carrying amount before the debt
restructuring is not relevant in the determination of whether a concession
has been granted. If a debtor transfers an asset that has a carrying amount
of $100 to settle debt with a net carrying amount of $100, the creditor
would be viewed as having granted a concession if the asset’s fair value at
the time of the debt restructuring is less than $100 (see also Section 11.4.2).
ASC 470-60 contains special accounting guidance for TDRs that involve a
transfer of assets (see Section 11.4.2), a grant of equity interests (see Section 11.4.3), and a combination of the characteristics in
ASC 470-60-15-9(a)–(c) (see Section 11.4.5).
11.3.3.4 Debt Modifications and Exchanges
11.3.3.4.1 Effective Borrowing Rate Test
ASC 470-60
55-10 A creditor is deemed
to have granted a concession if the debtor’s
effective borrowing rate on the restructured debt
is less than the effective borrowing rate of the
old debt immediately before the restructuring. The
effective borrowing rate of the restructured debt
(after giving effect to all the terms of the
restructured debt including any new or revised
options or warrants, any new or revised guarantees
or letters of credit, and so forth) should be
calculated by projecting all the cash flows under
the new terms and solving for the discount rate
that equates the present value of the cash flows
under the new terms to the debtor’s current
carrying amount of the old debt.
55-11 The carrying amount
for purposes of this test would not include any
hedging effects (including basis adjustments to
the old debt) but would include any unamortized
premium, discount, issuance costs, accrued
interest payable, and so forth.
55-12 When determining the
effect of any new or revised sweeteners (options,
warrants, guarantees, letters of credit, and so
forth), the current fair value of the new
sweetener or change in fair value of the revised
sweetener would be included in day-one cash flows.
If such sweeteners are not exercisable for a
period of time, that delay is typically considered
within the estimation of the initial fair value as
of the debt’s modification date.
If existing debt is modified or exchanged for new debt, the debtor is
deemed to have received a concession if the effective borrowing rate on
the restructured debt is less than the effective borrowing rate
immediately before the restructuring. However, a reduction in the
effective borrowing rate is not considered a concession if there is
persuasive evidence that it is due solely to a factor that is not
reflected in the calculation of the effective borrowing rate (see
Section 11.3.3.4.2).
A debtor calculates the effective borrowing rate on the
modified debt by solving for the discount rate that equates the future
cash flows of the modified debt to the current net carrying amount of
the original debt. In this calculation, the net carrying amount excludes
any hedge accounting adjustments (e.g., if the debt was designated as a
hedged item in a fair value hedge under ASC 815; see Section 14.2.1.2)
but reflects any remaining unamortized premium or discount (see
Chapter
6) as well as any accrued interest payable.
All terms of the restructured debt must be considered in the
determination of the cash flows of the restructured debt. If the debt
restructuring includes any new “sweetener” (e.g., warrant, option,
guarantee, or letter of credit) issued by the debtor, its fair value is
treated as an immediate cash outflow as of the time of the debt
restructuring (i.e., as a “day 1 cash outflow”). Similarly, the change
in fair value of any amended sweeteners as a result of the modification
(i.e., the fair value of the sweetener immediately before the debt
restructuring compared with its fair value immediately after the
modification) is treated as a day 1 cash flow. However, in evaluating
whether a concession has been made, the debtor does not compare the fair
value of the restructured debt with the fair value of the original debt
at the time of the debt restructuring.
ASC 470-60-15-9 contains special accounting guidance for TDRs that
involve a debt modification or exchange (see Section 11.4.4) or a combination of the characteristics
specified in that guidance (see Section 11.4.5).
Example 11-2
Increase in Interest Rate Does Not Involve a
Concession
Company P is in violation of its debt covenants.
Although P’s revolver has been amended several
times in the past year, resulting in an increase
of 100 basis points in the interest rate, the
amendments have not provided for either a
reduction or forgiveness of the outstanding
obligation (principal and interest). The
amendments include “stand-still” agreements, which
generally state that the banks will not force P
into bankruptcy as long as it makes monthly
interest payments and periodic principal payments
despite its failure to meet the debt covenants. In
the absence of the stand-still agreements, the
debt would have become currently due.
The amendments to P’s debt do not constitute a
TDR but rather an increase in interest rates, and
they have not resulted in a reduced principal or
accrued interest balance. In addition, P has not
granted an equity interest to its creditors nor
has it transferred title to any of its assets to
its creditors in satisfaction of any of the
outstanding debt. Therefore, the creditor has not
granted P a concession, and the amendments to P’s
debt do not result in a TDR.
Example 11-3
Amendment to Debt Covenant Ratio Does Not
Involve a Concession
Company S has been experiencing financial
difficulties and announced that it would be unable
to make the required interest payment to Lender H
for the month of December. The terms of the debt
agreement provide for a 30-day grace period for
paying the interest. In December, S amended its
credit agreement with H and reduced the
fixed-charge coverage ratio requirement from 1.25
to 1.05 for its fourth-quarter debt covenant
calculation. Company S paid $1.3 million to H to
obtain this waiver. In January, S was able to
refinance the debt with a different creditor on
substantially similar terms and made the required
interest payments within the 30-day grace period.
In these circumstances, the amendment to the debt
covenant ratio does not represent a concession on
the part of H. As a result of the cash payment
required on the date of the fixed-charge ratio
waiver, H has increased its effective interest
rate. In addition, S was able to obtain new
financing after year-end on substantially similar
terms. ASC 470-50-40-18 addresses the treatment of
fees paid to third parties in the event of a
modification or exchange of a debt instrument in a
nontroubled debt situation.
Example 11-4
Change in Effective Rate on Debt — Concession
Has Been Granted
On December 31, 20X0, Entity D issues five-year
debt for net proceeds of $245,000. The face amount
is $250,000. The stated interest rate is 5 percent
per annum payable annually in arrears. The
effective interest rate is 5.47 percent per annum.
The original amortization schedule is shown
below.
On December 31, 20X1, D is experiencing financial
difficulties and negotiates a debt restructuring
with its creditor. The new stated interest rate is
7 percent per annum (i.e., the stated rate has
increased), and the new face amount is $210,000
(i.e., the creditor has forgiven $40,000 of
principal). In addition, D issues a warrant with a
fair value of $10,000 to the creditor.
To determine whether the creditor has granted a
concession, D computes the new effective borrowing
rate. It treats the fair value of the warrants
issued as an immediate cash outflow to pay down a
portion of the outstanding balance (i.e., as an
immediate reduction in the net carrying amount).
Because the new effective borrowing rate (3.63
percent per annum) is lower than the original
effective borrowing rate, D is deemed to have
received a concession and applies TDR accounting
to the debt restructuring.
Example 11-5
Change in
Effective Borrowing Rate — Concession Has Been
Granted
On December 31, 20X0, Entity T issues a five-year
debt security for net proceeds of $97,000. The
principal amount is $100,000, and the stated
coupon rate is 8 percent payable annually in
arrears. Because the debt security was issued at a
discount, its stated interest rate differs from
its effective interest rate. By solving for the
rate that equates the initial net proceeds to the
future contractual interest and principal cash
flows, T determines that the annual effective
interest rate equals 8.77 percent. The original
discount amortization schedule is shown below.
In late 20X2, T is experiencing
financial difficulties and negotiates a debt
restructuring with the lender. On January 1, 20X3,
the lender agrees to forgive $4,000 of principal
and reduces the stated coupon rate to 4 percent
per annum. In addition, T delivers warrants with a
fair value of $5,000 to the holder.
In evaluating whether there is a
concession, T should calculate the effective
borrowing rate of the restructured debt. Entity T
solves for the discount rate that equates the
contractual cash flows of the modified debt
(including the fair value of the warrant) to the
current net carrying amount of the original debt
($98,051.38). It treats the fair value of the
warrants as an immediate cash outflow. Entity T
determines that the revised annual effective
borrowing rate is 5.13 percent. Because the
original effective borrowing rate exceeds the
revised effective borrowing rate, the lender has
granted a concession. Since T is experiencing
financial difficulties, the debt restructuring is
a TDR.
11.3.3.4.2 Decrease in Effective Borrowing Rate Due to Other Factors
ASC 470-60
55-13 Although considered
rare, if there is persuasive evidence that the
decrease in the effective borrowing rate is due
solely to a factor that is not captured in the
mathematical calculation (for example, additional
collateral), the creditor may not have granted a
concession and the modification or exchange should
be evaluated based on the substance of the
modification.
While a decrease in the debt’s effective borrowing rate generally
represents a concession under ASC 470-60 (see Section 11.3.3.4.1), ASC 470-60-55-13 provides an
exception for scenarios in which persuasive evidence exists that the
reduction is due solely to a factor that is not reflected in the
calculation of the effective borrowing rate. For example, a reduction in
the effective borrowing rate that results from the posting of additional
collateral that justifies the reduction in rate is not treated as a
concession. However, ASC 470-60-55-13 notes that it would be rare to
conclude that a reduction in the effective borrowing rate is not a
concession.
ASC 470-60-15-12 specifies that TDR accounting does not apply when the
interest rate on the debt is reduced to reflect a general decrease in
market interest rates or an improvement in the debtor’s creditworthiness
as long as the debtor is currently servicing the original debt and can
obtain funds from other sources at rates at or near those for
nontroubled debt (see Section 11.3.2.2). The fact that the debtor can readily
obtain funds from other sources at or near the current market interest
rates for nontroubled debtors suggests that the debtor should not be
viewed as experiencing financial difficulties.
11.3.3.4.3 Consecutive Restructurings
ASC 470-60
55-14 Notwithstanding the
guidance in this Section, if an entity has
recently restructured the debt and is currently
restructuring that debt again, the effective
borrowing rate of the restructured debt (after
giving effect to all the terms of the restructured
debt including any new or revised options or
warrants, any new or revised guarantees or letters
of credit, and so forth) should be calculated by
projecting all the cash flows under the new terms
and solving for the discount rate that equates the
present value of the cash flows under the new
terms to the debtor’s previous carrying amount of
the debt immediately preceding the earlier
restructuring. In addition, the effective
borrowing rate of the restructured debt should be
compared with the effective borrowing rate of the
debt immediately preceding the earlier
restructuring for purposes of determining whether
the creditor granted a concession (that is,
whether the effective borrowing rate decreased).
If a debtor restructures the same debt multiple times in a short period,
those debt restructurings are evaluated on a cumulative basis. That is,
the debtor calculates the effective borrowing rate of the restructured
debt (see Section 11.3.3.4.1) on the basis of (1) the net carrying
amount before the first recent modification (rather than the net
carrying amount after the most recent modification) and (2) the modified
cash flows after the most recent modification. In determining whether
the creditor has granted a concession, the debtor compares the effective
borrowing rate of the debt before the first recent modification with the
effective borrowing rate of the restructured debt. ASC 470-60 does not
specifically address what would be considered a “recent” modification.
Unless the facts and circumstances suggest that a different time frame
should apply, a debtor may analogize to the one-year time frame that
applies to debt modifications under ASC 470-50 (see Section 10.3.3.4).
11.3.4 Factors That Do Not Affect the Evaluation
ASC 470-60
55-6 The following factors
have no relevance in the determination of whether a
modification or an exchange is within the scope of this
Subtopic:
- The amount invested in the old debt by the current creditors
- The fair value of the old debt immediately before the modification or exchange compared to the fair value of the new debt at issuance
- Transactions among debt holders.
In addition, the length of time the current creditors
have held the investment in the old debt is not relevant
in the determination of whether a modification or
exchange is within the scope of this Subtopic unless all
the current creditors recently acquired the debt from
the previous debt holders to effect what is in substance
a planned refinancing.
In accordance with ASC 470-60, the following factors are not relevant in the
evaluation of whether a debt restructuring is a TDR:
-
The amount that current creditors have invested in the debt. For example, the fact that an investor may have purchased the debt from another investor at a discount to par does not affect the analysis of whether that investor has granted a concession or the debtor is experiencing financial difficulties.
-
The fair value of the restructured debt relative to the fair value of the original debt at the time of the debt restructuring. Note, however, that the fair value of any consideration transferred (such as assets or equity interests) in full or partial satisfaction of the debt is relevant to the analysis (see Section 11.3.3.3).
-
Transactions among debt holders to which the debtor is not a party (see Section 10.2.8). For example, the fact that the debt may be purchased at a deep discount to par in market transactions between third parties does not affect whether TDR accounting applies.
-
The length of time during which creditors have held the debt (unless they acquired it recently for a planned refinancing).
Although transactions among debt holders do not trigger TDR
accounting, any debt modification or exchange that involves the debtor or its
agent should be evaluated in the determination of whether TDR accounting applies
even if the modification is made in connection with a transfer to a new holder
(see Section 10.2.8
for analogous guidance).
Example 11-6
Modification After a Creditor’s Sale of Debt
Company T is experiencing financial difficulties and
expects to renegotiate its outstanding loan with Bank A.
Bank A would like to end its relationship with T;
therefore, A sells its loan receivable to Bank B.
Shortly after this sale, T modifies the terms of the
loan with B by reducing the principal amount owed. In
this example, the debtor is experiencing financial
difficulties and a concession has been granted.
Therefore, the modification is within the scope of ASC
470-60 even though the modification involves a new
creditor.
If the debtor has involved an intermediary (e.g., a bank) to transact with its
debt holders, the debtor should evaluate whether the intermediary acts as a
principal in its own capacity or as the debtor’s agent (see Section 10.5). Transactions made by an intermediary as the
debtor’s agent are treated as transactions made by the debtor itself.
11.3.5 Relationship to Creditor’s Assessment
The creditor’s accounting for restructured debt has no impact on
the debtor’s accounting because the accounting requirements for debtors and
creditors differ.
11.4 Accounting for a TDR
11.4.1 General
11.4.1.1 Background
ASC 470-60
10-1 The accounting for
restructured debt is based on the substance of the
modifications — the effect on cash flows — not on
the labels chosen to describe those cash flows. The
substance of all modifications of a debt in a
troubled debt restructuring is essentially the same
whether they involve modifications of any of the
following:
- Timing
- Amounts designated as interest
- Amounts designated as face amounts.
10-2 All of those kinds of
modifications affect future cash receipts or
payments and therefore affect both of the following:
- The creditor’s total return on the receivable, its effective interest rate, or both
- The debtor’s total cost on the payable, its effective interest rate, or both.
35-1 A debtor shall
account for a troubled debt restructuring according
to the type of the restructuring as prescribed in
this Section.
The accounting for a TDR depends on whether it involves a transfer of assets,
the grant of an equity interest, a modification of the debt terms, or a
combination thereof:
-
Transfer of assets (see Sections 11.4.2 and 11.4.5) — The debtor transfers trade receivables, real estate, or other assets to the creditor to fully or partially satisfy outstanding debt.
-
Grant of equity interest (see Sections 11.4.3 and 11.4.5) — The debtor issues an equity interest (e.g., the issuer’s common or preferred stock) to the creditor to fully or partially satisfy outstanding debt.
-
Modification of the debt terms (see Section 11.4.4) — For example:
-
A reduction of the stated interest rate.
-
A reduction of the principal amount of the debt.
-
An extension of maturity dates.
-
A forgiveness or reduction of the amount of accrued interest due.
-
A payment deferral.
-
If a TDR involves a transfer of assets, any difference
between the fair value (under ASC 820) and carrying amount of the
transferred assets at the time of the restructuring is reflected as a gain
or loss in the same manner as if the assets were sold for cash. If a TDR
involves a grant of an equity interest, the equity securities are initially
recognized at fair value in accordance with ASC 820 at the time of the
restructuring. However, if a TDR involves a modification of debt terms, it
is accounted for only prospectively unless the carrying amount exceeds the
undiscounted total amount of future cash payments.
11.4.1.2 Unit of Account
ASC 470-60
15-4 The substance rather
than the form of the payable shall govern. . . .
Typically, each payable is negotiated separately,
but sometimes two or more payables are negotiated
together. For example, a debtor may negotiate with a
group of creditors but sign separate debt
instruments with each creditor. For purposes of this
Subtopic, restructuring of each payable, including
those negotiated and restructured jointly, shall be
accounted for individually.
55-3 To a debtor, a bond
constitutes one payable even though there are many
bondholders.
If an entity determines that a debt restructuring should be
accounted for as a TDR, it applies the TDR accounting requirements in ASC
470-60 separately to each unit of account (see Section 3.3). This means that the TDR
must be accounted for on a creditor-by-creditor basis. However, if one
creditor (or multiple creditors with a consolidated group or otherwise under
common control) holds multiple debt instruments before or after the
restructuring, the debtor should determine whether a restructuring gain may
be recognized by considering the aggregate relationship with such creditor.
If, as a result of the relationship with the individual creditor, one debt
instrument is restructured into multiple debt instruments, or multiple debt
instruments are restructured into one debt instrument, the debtor will need
to allocate the existing net carrying amount of the original debt instrument
(or aggregate net carrying amount of the original debt instruments) to the
restructured debt instrument or instruments. Performing this allocation may
require judgment. Subsequently, each debt instrument that meets the
definition of a freestanding financial instrument should be accounted for as
a separate unit of account.
Example 11-7
Debt Owned by Multiple Creditors
Company R has subordinated debentures that are held
by a significant shareholder, a major insurance
company, and other parties. Company R is
experiencing financial difficulties and has
negotiated with the shareholder and the major
insurance company to redeem the debentures for
senior indebtedness and a combination of preferred
and common stock of R. In addition, R has offered
the other parties a package of preferred stock and
cash in exchange for their subordinated debentures.
The TDR accounting requirements of ASC 470-60 should
be applied to each individual transaction (or group
of creditors) rather than in the aggregate because
each group separately negotiated its restructuring.
In substance, there are three creditor groups. If a
company presents a restructuring plan to holders of
debt securities and a portion of the debt holders
accept the plan, the company should account for the
bonds as TDRs to the extent of the participation in
the exchange offer. Accordingly, the TDR accounting
requirements of ASC 470-60 should be applied only to
the portion of the bonds that are actually
restructured. The accounting for the bonds owned by
bondholders that do not participate in the
restructuring is not affected.
11.4.1.3 Time of Restructuring
ASC Master Glossary
Time of Restructuring
Troubled debt restructurings may occur before, at, or
after the stated maturity of debt, and time may
elapse between the agreement, court order, and so
forth, and the transfer of assets or equity
interest, the effective date of new terms, or the
occurrence of another event that constitutes
consummation of the restructuring. The date of
consummation is the time of the restructuring.
A TDR should be recognized in the period in which it occurs (i.e., at the
time of the debt restructuring). The time of the restructuring is the date
of its consummation (e.g., the date on which any assets or equity interests
are transferred in settlement of the debt, or new debt terms become legally
binding). A debtor should not recognize a gain on restructuring before
consummation of the restructuring.
If an entity restructures debt after its balance sheet date but before
issuing its financial statements, that restructuring is a nonrecognized
subsequent event under ASC 855. However, the debtor is required to consider
whether the restructuring is of such a nature that it must be disclosed to
keep the financial statements from being misleading (see ASC 855-10-50-2).
Example 11-8
Debt Modification That Is Consummated After the
Balance Sheet Date
Entity C has $120 million of notes outstanding. On
October 31, 20X1, C defaulted on an interest payment
due under the debt and entered into negotiations
with the noteholders to restructure the debt. On
December 1, 20X1, the noteholders agreed to exchange
their existing notes for new notes through an
exchange offer to be completed before February 28,
20X2. The noteholders had a choice of receiving new
notes or a combination of new notes and cash. The
agreement stipulated certain steps that C was to
take before the exchange offer could take place
(e.g., renewal of a line of credit, sale of a
division for cash). On December 31, 20X1, no legal
documentation had been finalized for the
restructuring; the agreement was therefore not
binding. On February 8, 20X2, the choices of all
noteholders had been received and the exchange offer
document was finalized.
Because the actual debt restructuring occurred after
December 31, 20X1, and was not legally binding on
December 31, 20X1, the transaction should be treated
as a nonrecognized subsequent event and recognized
in the first quarter of 20X2. Accordingly, interest
should be accrued as of December 31, 20X1, on the
basis of the terms of the original debt
agreements.
11.4.1.4 Costs and Fees
ASC 470-60
35-12 Legal fees and other
direct costs that a debtor incurs in granting an
equity interest to a creditor in a troubled debt
restructuring shall reduce the amount otherwise
recorded for that equity interest according to
paragraphs 470-60-35-4 and 470-60-35-8. All other
direct costs that a debtor incurs to effect a
troubled debt restructuring shall be deducted in
measuring gain on restructuring of payables or shall
be included in expense for the period if no gain on
restructuring is recognized.
The accounting for any costs and fees incurred in connection with a TDR
depends on whether they are attributable to an equity interest granted.
Legal fees and other direct costs of issuing an equity interest (e.g.,
common or preferred stock) reduce the initial carrying amount of the equity
interest issued. Other costs incurred in a TDR (e.g., a TDR that involves
the transfer of assets or a debt modification or exchange) reduce any
restructuring gain recognized (see Section
11.4.4) or, if there is no gain, are expensed in the period
incurred. If the TDR represents a combination of the characteristics in ASC
470-60-15-9(a)–(c), a debtor should use a reasonable method to allocate fees
and costs between equity interests granted and the restructuring gain or
expenses (e.g., by specifically identifying such costs). Costs incurred
related to a potential restructuring that has not been completed as of the
balance sheet date may not be deferred and recognized as an asset.
ASC 470-60-35-12 does not apply to any remaining unamortized debt issuance
costs at the time of the restructuring; such costs are part of the debt’s
net carrying amount immediately before the restructuring. Accordingly, if
the total amount of future undiscounted cash flows of the restructured debt
exceeds the net carrying amount, such costs continue to be amortized after
the TDR (see Section 11.4.4.2).
Alternatively, if the TDR involves the recognition of a restructuring gain,
any remaining unamortized debt issuance costs reduce the amount of the gain
that would otherwise have been recognized (see Section 11.4.4.3).
11.4.1.5 Related-Party Transactions
ASC 470-60 applies to all debt restructurings (i.e., there
is no scope exception for transactions with related parties). However, if
the creditor is a related party (e.g., a significant shareholder), any
restructuring gain would be recognized in equity in accordance with ASC
470-50-40-2 (see Section
9.3.7.2). Since the evaluation of whether the creditor is a
related party of the debtor under ASC 850 is performed immediately before
the restructuring, any equity interests granted as part of the restructuring
would not affect the determination of whether a restructuring gain should be
recognized as a capital contribution.
Example 11-9
TDR Involving a Related Party
To meet future needs for debt service, operations
support, and capital outlay, Company N negotiated a
restructuring with its preferred stockholders,
subordinated debt holders, and bank debt holders. As
part of the restructuring, the aggregated
outstanding principal amount of the subordinated
debt was converted into shares of common stock. The
value provided to the debt holders in the form of
the common stock was substantially less than the
carrying amount of the subordinated debt before the
exchange. The subordinated debt holders also had
significant investments in preferred stock of N.
By analogy to ASC 470-50-40-2 (see Section 9.3.7.2),
forgiveness of the amounts owed to a significant
shareholder should be accounted for as a capital
contribution to the debtor to the extent that the
carrying amount of the payable on the date of the
restructuring exceeds either (1) the total future
cash payments that will be made to the shareholder
under the new terms or (2) the fair value of the
assets transferred or the equity interest granted.
Accordingly, N should recognize the “restructuring
gain” realized from the forgiveness of amounts owed
as an equity capital contribution.
11.4.2 Accounting for Transfer of Assets in Full Settlement of Troubled Debt
ASC 470-60
35-2 A debtor that transfers
its receivables from third parties, real estate, or
other assets to a creditor to settle fully a payable
shall recognize a gain on restructuring of payables. The
gain shall be measured by the excess of the carrying
amount of the payable over the fair value of the assets
transferred to the creditor. However, while the guidance
in this Subtopic indicates that the fair value of assets
transferred or the fair value of an equity interest
granted shall be used in accounting for a settlement of
a payable in a troubled debt restructuring, that
guidance is not intended to preclude using the fair
value of the payable settled if more clearly evident
than the fair value of the assets transferred or of the
equity interest granted in a full settlement of a
payable. However, in a partial settlement of a payable,
the fair value of the assets transferred or of the
equity interest granted shall be used in all cases to
avoid the need to allocate the fair value of the payable
between the part settled and the part still outstanding.
35-3 A difference between
the fair value and the carrying amount of assets
transferred to a creditor to settle a payable is a gain
or loss on transfer of assets. The carrying amount of a
receivable encompasses not only unamortized premium,
discount, acquisition costs, and the like but also an
allowance for uncollectible amounts and other valuation
accounts, if any. The debtor shall include that gain or
loss in measuring net income for the period of transfer,
reported as provided in Topic 220. A loss on
transferring receivables to creditors may therefore have
been wholly or partially recognized in measuring net
income before the transfer and be wholly or partly a
reduction of a valuation account rather than a gain or
loss in measuring net income for the period of the
transfer.
If a debtor pays cash to settle troubled debt in full, it recognizes a
restructuring gain to the extent that the net carrying amount exceeds the amount
of cash paid. ASC 470-60 requires a debtor to apply a “two-step” approach in
accounting for a TDR involving a transfer of noncash assets (including a
repossession or foreclosure of assets; see Section
11.2.2). That is, when a debtor transfers a noncash asset in full
settlement of a debt, any resulting gain or loss consists of two separate
components:
- The difference, if any, between the fair value and carrying amount of the asset transferred is recognized as a gain or loss upon derecognition of the asset transferred. (If an issuer transfers assets in full settlement of a payable, ASC 470-60-35-2 does not preclude the debtor from calculating this gain or loss on the basis of the fair value of the payable settled instead of the fair value of the assets transferred if the fair value of the payable settled is more clearly evident.)
- The difference, if any, between that fair value and the carrying amount of the debt is recognized as a restructuring gain on the debt that is settled.
A “one-step” approach is not appropriate. Under such a method, a restructuring
gain or loss would be recognized for the net difference between the carrying
amount of the asset transferred and the carrying amount of the payable
settled.
For TDRs that occurred during a reporting period, ASC 470-60-50-1 requires
separate disclosure, either on the face of the financial statements or in the
accompanying notes, of (1) the aggregate net gain or loss on asset transfers
recognized during the period and (2) the aggregate gain on restructuring of
payables (see Section 11.5.2).
Example 11-10
Accounting for a Transfer of Financial Assets in Full
Settlement of a Payable
Company A is experiencing financial difficulties and
agrees to settle its $125 million of debt to Creditor C
in full by transferring fixed-rate loan receivables that
have a net carrying amount of $130 million. Company A
estimates the current fair value of the receivables to
be $110 million.
Even though the net carrying amount of the assets
transferred exceeds the net carrying amount of the debt
settled, A would recognize a restructuring gain of $15
million to reflect the difference between the fair value
of the assets transferred to settle the debt and the net
carrying amount of the debt settled. Further, it would
recognize a loss on the asset transfer of $20
million.
Example 11-11
Accounting for a Transfer of Nonfinancial Assets in
Full Settlement of a Payable
Company S is experiencing financial difficulties and will
not be able to make the scheduled payments on its
outstanding note to Company T. Company S has reached an
agreement with T under which S will transfer land to T
to fully settle the outstanding obligation. The land has
a book value of $90,000 and a fair value of $100,000.
The outstanding note has a principal balance of $100,000
and related accrued interest of $5,000. Company S would
record the following entry related to the settlement:
Example 11-12
Accounting for a Foreclosure of Collateral in Full
Settlement of a Payable
Company T, whose fiscal year ends on December 31, owns a
mall that is subject to nonrecourse debt. The fair value
of the mall is significantly less than the amount of
related debt (due November 1, 20X4) and the carrying
amount of the mall. Although T is currently negotiating
with the lender, T believes that it will most likely
allow the bank to foreclose on the property, in which
case it will realize a gain on extinguishment of debt.
Consequently, T believes that it will not be able to
recover the carrying amount of the asset and that it
should therefore recognize a loss on impairment. Company
T would prefer not to record an impairment loss on the
property in its third quarter but rather recognize a
gain on extinguishment of debt in its fourth
quarter.
Company T cannot defer recognition of the impairment loss
until its fourth quarter and net the loss with the
anticipated gain on the extinguishment of debt. ASC
360-10-35-15 through 35-49 require an entity to measure
an impairment loss for a long-lived asset, including an
asset that is subject to nonrecourse debt, as the amount
by which the carrying amount of the asset (asset group)
exceeds its fair value. The recognition of an impairment
loss and the recognition of a gain on the extinguishment
of debt are separate events, and each event should be
recognized in the period in which it occurs. The
recognition of an impairment loss should be based on the
measurement of the asset at its fair value; the
existence of nonrecourse debt should not influence that
measurement.
11.4.3 Accounting for Grant of Equity Interest in Full Settlement of Troubled Debt
ASC 470-60
35-4 A debtor that issues
or otherwise grants an equity interest to a creditor to
settle fully a payable shall account for the equity
interest at its fair value. The difference between the
fair value of the equity interest granted and the
carrying amount of the payable settled shall be
recognized as a gain on restructuring of payables.
35-12 Legal fees and other
direct costs that a debtor incurs in granting an equity
interest to a creditor in a troubled debt restructuring
shall reduce the amount otherwise recorded for that
equity interest according to paragraphs 470-60-35-4 and
470-60-35-8. . . .
When a debtor grants an equity interest (e.g., common or preferred stock or
warrants that qualify for classification in equity) in full settlement of debt
in a TDR, multiple financial statement accounts are affected:
-
The debtor recognizes an increase in shareholders’ equity for the fair value of the equity interests issued less legal fees and other direct issuance costs (see Section 11.4.1.4). (If an issuer grants equity interests in full settlement of a payable, it is permitted to elect to measure the equity interests issued on the basis of the fair value of the payable settled instead of the fair value of the equity interests issued if the fair value of the payable settled is more clearly evident; see ASC 470-60-35-2.)
-
The difference, if any, between that fair value and the carrying amount of the debt is recognized as a restructuring gain on the debt that is settled.
The FASB has rejected approaches that would have involved including the
restructuring gain in equity or increasing equity for the carrying amount of the
payable settled with no gain recognized.
Example 11-13
Accounting for a Transfer of Equity Shares in Full
Settlement of a Payable
Entity E is experiencing financial difficulties. It
agrees with creditors to settle outstanding
nonconvertible debt with a net carrying amount of $45
million in full by issuing 10 million shares of common
stock, which have an aggregate fair value of $25 million
at the time of the restructuring (i.e., $2.50 per
share). Accordingly, E recognizes a restructuring gain
of $20 million.
If a debtor issues a mandatorily redeemable financial instrument
in the form of a share that must be classified as a liability under ASC
480-10-25-4, the issuer should not account for it as a grant of an equity
interest under ASC 470-60 but as a troubled debt modification or exchange (see
Section
11.4.4).
Example 11-14
Accounting for a Transfer of Liability-Classified
Shares in Full Settlement of a Payable
Company G has restructured its debt because of its
inability to service its existing debt load. As part of
the restructuring, Creditor P exchanged its debt for a
new note and shares of mandatorily redeemable preferred
stock classified as a liability under ASC 480-10-25-4.
The issuance of liability-classified mandatorily
redeemable preferred stock should not be viewed as the
granting of an equity interest under ASC 470-60-35-4 or
ASC 470-60-35-8. The substance of the exchange of
liability-classified mandatorily redeemable equity
securities for debt represents a continuation of
monetary payments under new terms. Therefore, such a
transaction should be accounted for as a modification of
the debt terms in accordance with ASC 470-60-35-5
through 35-7. A gain would be recognized only to the
extent that the carrying amount of the existing debt
exceeds all future payments (including dividends and
contingent dividends) to be made on the new note and
redeemable equity securities.
By contrast, if G had issued a new note and redeemable
preferred stock that qualified for equity classification
under ASC 480 (e.g., mandatorily redeemable preferred
stock that is convertible into common stock or
nonmandatorily redeemable preferred stock), the
transaction would be accounted for as a partial
settlement in accordance with paragraph ASC
470-60-35-8.
11.4.4 Accounting for a Troubled Debt Modification or Exchange
11.4.4.1 Background
If a modification of debt terms qualifies as a TDR, the debtor accounts for
the effect of the modification to the debt terms prospectively as an
adjustment to the effective interest rate except that the rate cannot be
reduced below zero. Although a TDR involves a concession, the debtor does
not recognize a restructuring gain (or corresponding adjustment to the net
carrying amount) unless the net carrying amount exceeds the total
undiscounted future principal and interest payments of the restructured
debt.
Accordingly, as of the time of the restructuring, the debtor should compare
the total amount of undiscounted future cash payments required by the
modified terms (excluding contingently payable amounts) with the debt’s net
carrying amount. Different considerations are necessary if the future cash
payments exceed the debt’s carrying amount (see Section 11.4.4.2) or if the debt’s carrying amount exceeds
the future cash payments (see Section 11.4.4.3). Other special considerations are
necessary related to restructured debt with contingent payments (see
Section 11.4.4.4); put, call, or prepayment features (see
Section 11.4.4.5); and variable-rate debt (see Section 11.4.4.6). Section 11.4.4.7 compares the accounting for a troubled
debt modification or exchange with that for a nontroubled debt modification
or exchange.
Since a TDR involves a concession made by the creditor, a TDR typically
cannot result in the recognition of a restructuring loss by the debtor.
11.4.4.2 Future Cash Payments Exceed Carrying Amount
ASC 470-60
35-5 A debtor in a
troubled debt restructuring involving only
modification of terms of a payable — that is, not
involving a transfer of assets or grant of an equity
interest — shall account for the effects of the
restructuring prospectively from the time of
restructuring, and shall not change the carrying
amount of the payable at the time of the
restructuring unless the carrying amount exceeds the
total future cash payments specified by the new
terms. Total future cash payments includes related
accrued interest, if any, at the time of the
restructuring that continues to be payable under the
new terms. That is, the effects of changes in the
amounts or timing (or both) of future cash payments
designated as either interest or face amount shall
be reflected in future periods. Interest expense
shall be computed in a way such that a constant
effective interest rate is applied to the carrying
amount of the payable at the beginning of each
period between restructuring and maturity (in
substance the interest method prescribed by
paragraphs 835-30-35-2 and 835-30-35-4 through
35-5). The new effective interest rate shall be the
discount rate that equates the present value of the
future cash payments specified by the new terms
(excluding amounts contingently payable) with the
carrying amount of the payable.
If the total amount of future undiscounted cash payments required by the
modified terms (excluding contingently payable amounts) exceeds the debt’s
net carrying amount, a restructuring gain is not recognized and the
effective interest rate is adjusted to reflect the modified terms. The
adjusted effective interest rate is the discount rate that equates the
future cash payments required by the modified agreement, excluding amounts
contingently payable, with the debt’s net carrying amount at the time of the
restructuring. After the TDR, interest expense is recognized by using the
adjusted effective interest rate.
Example 11-15
Accounting for an Extension of the Maturity Date
of a Payable
Company F has an outstanding note payable that will
yield total interest of $4 million. The note matures
on September 30, 20X3, on which date the creditor
becomes fully entitled to payment of all principal
and interest. Company F is experiencing financial
difficulties and will be unable to make the
scheduled principal and interest payments on the
original due date.
On September 1, 20X3, F negotiated an extension of
the maturity date to December 31, 20X3. The
extension has not changed the amount of principal or
interest to be paid by F. The creditor agreed to
extend the maturity date to increase its ability to
recover its investment. As of September 1, 20X3,
$3.5 million had been accrued by F as interest
expense.
The extension of the maturity date represents a TDR
(see ASC 470-60-15-9(c)(2)). Since the creditor did
not obtain any additional entitlement to principal
or interest in exchange for the extension, F
effectively extended the maturity of its debt at a
zero percent interest rate. Company F’s remaining
unrecognized interest expense ($500,000) on
September 1, 20X3, should be accrued by F over the
remaining maturity in accordance with ASC
470-60-35-5 (i.e., constant effective interest rate)
so that the full amount of interest expense of $4
million will be recognized by December 31, 20X3.
Example 11-16
Accounting for a Reduction in the Interest Rate on
a Payable
As of January 1, 20X1, Company B has a note payable
to Company S with a principal balance of $95,000,
accrued interest of $5,000, an interest rate of 5
percent, and a remaining life of five years.
Interest is payable on December 31 each year.
Because of B’s financial difficulties, S has agreed
to forgive all of the accrued interest and lower the
stated interest rate to 4 percent.
In this example, the future cash payments exceed the
carrying value of the liability (see calculation
below). Therefore, in accordance with ASC
470-60-35-5, the net carrying amount of the note is
not adjusted.
The effects of changes in the amount and timing of
future cash payments should be accounted for
prospectively. A new effective interest rate should
be calculated so that the present value of the
future payments equals the carrying amount of the
liability ($100,000).
Interest Amortization Schedule
The following entries would be recorded by the debtor
to reflect the terms of the modified agreement (note
that no entry is required on January 1, 20X1 — the
date of the modification):
Example 11-17
Accounting for a Reduction in the Interest Rate on
a Payable
On December 31, 20X0, Entity B issues five-year debt
for net proceeds of $260,000. The principal amount
is $250,000, and the stated interest rate is 5.50
percent payable annually in arrears. Because the
debt was issued at net premium, its stated interest
rate differs from its effective interest rate. By
solving for the rate that equates the initial net
proceeds to the future contractual interest and
principal cash flows, B determines that the annual
effective interest rate is 4.59 percent (see
Section 6.2). The full discount
amortization schedule is shown below.
Entity B is experiencing financial difficulties and
negotiates a debt restructuring with the debt
holder. On January 1, 20X3, the holder agrees to
reduce the stated coupon rate to 2 percent.
In evaluating whether the holder has granted a
concession, B calculates the effective borrowing
rate of the restructured debt (see Section 11.3.3.4.1). Entity A solves
for the discount rate that equates the future cash
flows of the modified debt to the current net
carrying amount of the original debt ($256,266.79)
and determines that the revised annual effective
borrowing rate is 1.15 percent. Because the original
effective borrowing rate exceeds the revised
effective borrowing rate, the holder has granted a
concession. Since B is experiencing financial
difficulties, the debt restructuring qualifies as a
TDR.
The sum of the undiscounted future contractual
interest and principal cash flows ($265,000) exceeds
the current net carrying amount of the debt
($256,266.79). Therefore, B does not recognize a
restructuring gain; instead, it adjusts the
effective interest rate to reflect the modified cash
flows.
The revised amortization schedule is
shown below.
11.4.4.3 Net Carrying Amount Exceeds Future Cash Payments
ASC 470-60
35-6 If, however, the
total future cash payments specified by the new
terms of a payable, including both payments
designated as interest and those designated as face
amount, are less than the carrying amount of the
payable, the debtor shall reduce the carrying amount
to an amount equal to the total future cash payments
specified by the new terms and shall recognize a
gain on restructuring of payables equal to the
amount of the reduction. If the carrying amount of
the payable comprises several accounts (for example,
face amount, accrued interest, and unamortized
premium, discount, finance charges, and issue costs)
that are to be continued after the restructuring,
some possibly being combined, the reduction in
carrying amount may need to be allocated among the
remaining accounts in proportion to the previous
balances. Thereafter, all cash payments under the
terms of the payable shall be accounted for as
reductions of the carrying amount of the payable,
and no interest expense shall be recognized on the
payable for any period between the restructuring and
maturity of the payable. The only exception is to
recognize interest expense according to paragraph
470-60-35-10. However, the debtor may choose to
carry the amount designated as face amount by the
new terms in a separate account and adjust another
account accordingly.
If the debt’s net carrying amount exceeds the total amount of future
undiscounted cash payments required by the modified terms (excluding
contingently payable amounts), the effective interest rate is reset to zero.
Thereafter, the debtor accounts for any cash paid (including amounts
designated as interest) as a reduction of the net carrying amount and no
interest expense is recognized. As of the time of the restructuring, the
debtor should also evaluate whether the modified terms specify any
contingently payable or otherwise currently indeterminate amounts (e.g.,
additional amounts become payable if the debtor’s financial situation
improves or the stated interest rate is indexed to a market interest
rate).
If the modified terms do not specify any contingently payable or otherwise
currently indeterminate amounts, the debtor recognizes a debt restructuring
gain at the time of the restructuring equal to the excess of the debt’s net
carrying amount over the total amount of undiscounted future cash payments.
However, if the modified terms do specify such amounts, the debtor
recognizes a debt restructuring gain only if the debt’s net carrying amount
exceeds the maximum potential amount of total undiscounted future cash
payments that the debtor might be required to pay (irrespective of the
likelihood that the debtor would be required to pay them; see Section 11.4.4.4).
Example 11-18
Calculation of Gain on Modification Involving
Forgiveness of Principal and Accrued Interest and
a Reduction of the Interest Rate on a Payable
As of January 1, 20X1, Company B has a note payable
to Company S with a principal balance of $100,000,
accrued interest of $10,000, an interest rate of 5
percent, and a remaining life of five years. Because
of B’s financial difficulties, S agrees to modify
the note by reducing the principal amount to
$80,000, lowering the stated interest rate to 4
percent, and forgiving all accrued interest.
Interest is payable on December 31 each year.
In this example, the future cash payments are less
than the carrying value of the liability (see
calculation below). Therefore, in accordance with
ASC 470-60-35-6, the carrying value of the note
should be adjusted. Furthermore, all future cash
payments under the terms of the modified agreement
should reduce the carrying amount of the note. No
interest expense should be recognized on the note
payable between the restructuring and the maturity
of the note.
The calculation of the debtor’s gain on restructuring
is as follows:
Example 11-19
Calculation of Gain on Modification Involving a
Forgiveness of Principal and a Reduction of the
Interest Rate on a Payable
On December 31, 20X0, Entity A
issues five-year debt for net proceeds of $120,000.
The principal amount is $125,000, and the stated
interest rate is 6 percent payable annually in
arrears. Because the debt was issued at a net
discount, its stated interest rate differs from its
effective interest rate. By solving for the rate
that equates the initial net proceeds to the future
contractual interest and principal cash flows, A
determines that the annual effective interest rate
is 6.97 percent (see Section 6.2). The full discount
amortization schedule is shown below.
Entity A is experiencing financial difficulties and
negotiates a debt restructuring with the debt
holder. On January 1, 20X3, the holder agrees to
forgive $15 million of principal and to reduce the
stated interest rate to 2 percent. There are no
contingently payable or otherwise currently
indeterminate amounts payable on the restructured
debt.
In evaluating whether the holder has granted a
concession, A calculates the effective borrowing
rate of the restructured debt (see Section 11.3.3.4.1). Entity A solves
for the discount rate that equates the future cash
flows of the modified debt to the current net
carrying amount of the original debt ($121,800.45)
and determines that the revised annual effective
borrowing rate is negative. Because the original
effective borrowing rate exceeds the revised
effective borrowing rate, the holder is deemed to
have granted a concession. Since A is experiencing
financial difficulties, the debt restructuring
qualifies as a TDR.
The sum of the undiscounted future contractual
interest and principal cash flows ($116,600) is less
than the current net carrying amount of the debt
($121,800.45). Further, there are no contingently
payable or otherwise indeterminate amounts.
Therefore, A recognizes a restructuring gain for the
amount by which the current net carrying amount
exceeds the total amount of undiscounted future cash
payments; that is, it recognizes a gain of
$5,200.45. Further, it adjusts the effective
interest rate to zero. The revised amortization
schedule is shown below.
11.4.4.4 Contingent Payment Terms
11.4.4.4.1 Limit on the Recognition of Restructuring Gains
ASC 470-60
35-7 A debtor shall not
recognize a gain on a restructured payable
involving indeterminate future cash payments as
long as the maximum total future cash payments may
exceed the carrying amount of the payable. Amounts
designated either as interest or as face amount by
the new terms may be payable contingent on a
specified event or circumstance (for example, the
debtor may be required to pay specified amounts if
its financial condition improves to a specified
degree within a specified period). To determine
whether the debtor shall recognize a gain
according to the provisions of the preceding two
paragraphs, those contingent amounts shall be
included in the total future cash payments
specified by the new terms to the extent necessary
to prevent recognizing a gain at the time of
restructuring that may be offset by future
interest expense. Thus, the debtor shall apply
paragraphs 450-30-25-1 and 450-30-50-1 in which
probability of occurrence of a gain contingency is
not a factor, and shall assume that contingent
future payments will have to be paid. The same
principle applies to amounts of future cash
payments that must sometimes be estimated to apply
the provisions of the preceding two paragraphs.
For example, if the number of future interest
payments is flexible because the face amount and
accrued interest is payable on demand or becomes
payable on demand, estimates of total future cash
payments shall be based on the maximum number of
periods possible under the restructured terms.
Sometimes, the terms of restructured debt specify contingently payable
amounts. For example, the debtor might be required to pay additional
amounts of principal or interest if its financial condition or financial
performance improves. To prevent offsetting by future interest expense,
ASC 470-60 precludes the recognition of a restructuring gain if the
restructured debt specifies contingent payments and the maximum total
possible amount of contingent and noncontingent payments equals or
exceeds the net carrying amount of the debt. The likelihood that
contingent payments might need to be paid is not a factor. In
determining the amount of any restructuring gain, the debtor must assume
that it will have to pay the maximum amount possible under any
contingent payment terms. Therefore, the debtor should reduce the amount
of any restructuring gain that would otherwise have been recognized up
to the maximum total undiscounted amount of any contingent payments.
As noted above, the purpose of the guidance is to prevent the debtor from
recognizing a restructuring gain that might be offset by future losses
under contingent payment terms. This means that the debtor should first
compare (1) the debt’s net carrying amount immediately before the
modification with (2) the total amount of undiscounted future cash
payments required by the modified debt terms (excluding
contingently payable amounts):
-
If the total amount of undiscounted future cash payments (excluding contingently payable amounts) exceeds the net carrying amount immediately before the debt restructuring, the debtor adjusts the effective interest rate prospectively to reflect the modified cash flows (see Section 11.4.4.2). In this circumstance, there is no restructuring gain, the net carrying amount is not adjusted, and no portion of the net carrying amount is attributable to contingently payable amounts at the time of the restructuring.
-
If the net carrying amount immediately before the debt restructuring exceeds the amount of undiscounted future cash payments (excluding contingently payable amounts), the effective interest rate is reset to zero (see Section 11.4.4.3). Further, in this circumstance, the debtor should compare the net carrying amount immediately before the modification with the total amount of undiscounted future cash payments required by the modified terms (including contingently payable amounts):
-
If the net carrying amount immediately before the debt restructuring exceeds the total amount of undiscounted future cash payments required by the modified terms (including contingently payable amounts), the debtor recognizes a debt restructuring gain and a corresponding decrease in the net carrying amount for the difference at the time of the restructuring. In this circumstance, any or all contingently payable amounts are included in the net carrying amount as if they were not contingent.
-
If the total amount of undiscounted future cash payments required by the modified terms (including contingently payable amounts) exceeds the net carrying amount immediately before the debt restructuring, there is no restructuring gain and the net carrying amount is not adjusted. In this circumstance, a portion of contingently payable amounts are included in the net carrying amount at the time of the restructuring but only to the extent that they offset the contingent gain that would otherwise have been recognized.
-
Contingently payable amounts include cash as well as
other contingently payable amounts (e.g., equity shares).
Example 11-20
Accounting for a Modification Involving
Contingently Payable Amounts
Entity A has outstanding debt with a net carrying
amount of $1.5 million, an effective interest rate
of 10 percent per annum, and a remaining term of
eight years. On January 1, 20X1, A is experiencing
financial difficulties and negotiates a debt
restructuring with its creditor. Under the terms
of the restructured debt, the creditor reduces the
principal amount to $750,000 (i.e., it forgives
$750,000). The stated rate of the restructured
debt is 10 percent per annum payable annually in
arrears. The maturity date is not modified. In
conjunction with the modification, A agrees that
if it is acquired by a third party at any time
before the final maturity of the debt, it will
make an additional payment to the creditor in an
amount equal to the forgiven principal amount.
On the basis of the net carrying
amount and the modified cash flows, excluding the
contingent payment that will be made if A is
acquired, A determines that the undiscounted
future cash flows of $1,350,000, or $750,000 +
($750,000 × .10 × 8) are less than the existing
carrying amount of the debt (i.e., $1,500,000).
Because A is experiencing financial difficulties
and a concession has been granted, TDR accounting
applies. The maximum total possible amount of
principal and interest payments is $2.1 million.
Consequently, there should be no change to the net
carrying amount of the debt and no interest
expense recognized prospectively provided that an
acquisition of A is not expected. Any remaining
carrying amount of the debt at maturity would be
recognized by A as a gain as long as an
acquisition of A did not occur.
11.4.4.4.2 Subsequent Accounting
ASC 470-60
35-10 If a troubled debt
restructuring involves amounts contingently
payable, those contingent amounts shall be
recognized as a payable and as interest expense in
future periods in accordance with paragraph
450-20-25-2. Thus, in general, interest expense
for contingent payments shall be recognized in
each period in which both of the following
conditions exist:
- It is probable that a liability has been incurred.
- The amount of that liability can be reasonably estimated.
Before recognizing a payable and interest expense
for amounts contingently payable, however, accrual
or payment of those amounts shall be deducted from
the carrying amount of the restructured payable to
the extent that contingent payments included in
total future cash payments specified by the new
terms prevented recognition of a gain at the time
of restructuring (see paragraph 470-60-35-7).
The accounting for probable and actual losses under contingent payment
terms after the debt restructuring depends on whether those losses were
included in the net carrying amount at the time of the restructuring. To
the extent that potential losses under contingent payment terms
prevented the recognition of a restructuring gain at the time of the
restructuring (i.e., they are included in the debt’s net carrying
amount), the realization of such losses after the debt restructuring are
accounted for as a direct reduction of the debt’s net carrying amount
(e.g., as debit to debt and a credit to cash). When the debt’s net
carrying amount includes an accrual for such losses at the time of the
restructuring, it would be inappropriate to recognize an additional
payable for the losses without a corresponding reduction in the net
carrying amount (i.e., the same losses would be counted twice).
The terms of restructured debt might specify that a contingent payment
obligation expires if a specified event does not occur by a stated date
before the debt matures. If the contingent payment obligation precluded
the recognition of a restructuring gain on the date of the debt
restructuring and the amount of the contingent payment obligation was
therefore included in the net carrying amount of the restructured debt,
the expiration of the contingent payment obligation is accounted for as
a partial extinguishment of the restructured debt (see Section 9.3). Special considerations
apply to variable-rate debt (see Section
11.4.4.6).
Unless the contingent payment feature is bifurcated as a derivative
instrument under ASC 815-15, the debtor should apply a loss contingency
approach in a manner similar to that in ASC 450-20 to accrue for any
estimated losses under contingent payment terms that exceed the amount
of contingently payable amounts that were included in the net carrying
amount at the time of the restructuring. That is, the debtor would
recognize interest expense with a corresponding increase to the net
carrying amount of the debt (or a separate payable) if such incremental
losses are probable and can be reasonably estimated.
A debtor is required to disclose the extent to which inclusion of
contingent future cash payments prevented the recognition of a
restructuring gain under ASC 470-60-35-7 (see Section 11.5.2).
Connecting the Dots
Although interest payments that vary on the
basis of a variable interest rate are similar to contingent
payments in that their amount is uncertain at the time of the
restructuring, they are accounted for differently from
contingent payments (see Section 11.4.4.6).
11.4.4.5 Put, Call, or Prepayment Features
Sometimes, restructured debt includes put, call, or prepayment features. For
example, the debt might be repayable on demand so that the total amount of
undiscounted future cash payments that the debtor might have to pay depends
on whether and, if so, when the creditor demands repayment of the debt. In
determining whether to recognize a restructuring gain, the debtor analyzes a
call, put, or prepayment feature that could accelerate the repayment of the
restructured debt in a manner similar to how it analyzes a contingent
payment term. That is, the debtor assumes that it will be required to make
the maximum potential amount of principal and interest payments (i.e., the
debt will be outstanding for the maximum number of periods possible).
A debtor should disregard the possibility that the net carrying amount of the
debt could exceed the total amount of principal and interest payments that
the debtor may pay over the life of the debt in determining whether to
bifurcate the put, call, or prepayment feature as a derivative instrument
under ASC 815-15. Because ASC 470-60 requires the debtor to assume that it
will need to pay the maximum amount possible to prevent the recognition of a
gain that may not be realized, it is reasonable for the debtor to assume
that the debt cannot be prepaid at an amount less than the net carrying
amount. However, to the extent that the debt could be prepaid at an amount
in excess of the net carrying amount, it would be appropriate to analyze the
put, call, or prepayment feature as an embedded feature that may need to be
bifurcated under ASC 815-15.
11.4.4.6 Variable-Rate Debt
ASC 470-60
35-11 If amounts of future
cash payments must be estimated to apply the
provisions of paragraphs 470-60-35-5 through 35-7
because future interest payments are expected to
fluctuate — for example, the restructured terms may
specify the stated interest rate to be the prime
interest rate increased by a specified amount or
proportion — estimates of maximum total future
payments shall be based on the interest rate in
effect at the time of the restructuring.
Fluctuations in the effective interest rate after
the restructuring from changes in the prime rate or
other causes shall be accounted for as changes in
estimates in the periods in which the changes occur.
However, the accounting for those fluctuations shall
not result in recognizing a gain on restructuring
that may be offset by future cash payments (see the
preceding paragraph and paragraph 470-60-35-7).
Rather, the carrying amount of the restructured
payable shall remain unchanged, and future cash
payments shall reduce the carrying amount until the
time that any gain recognized cannot be offset by
future cash payments.
If interest payments on restructured debt are variable (e.g., indexed to the
prime rate or LIBOR), the debtor must estimate the total amount of
undiscounted future variable interest payments. To estimate that amount, the
debtor uses the current variable interest rate in effect at the time of the
restructuring (or the “TDR rate”). For example, if the restructured debt’s
interest payments are indexed to the prime rate, the debtor estimates future
interest payments on the basis of the assumption that the prime rate will
not change in future periods.
The debtor determines whether it should recognize a restructuring gain at the
time of the restructuring as follows:
-
If the net carrying amount exceeds the total amount of estimated future undiscounted cash payments (including variable cash payments estimated at the TDR rate and the maximum possible amount of other contingently payable amounts), the debtor recognizes a restructuring gain and a corresponding adjustment to the net carrying amount at the time of the restructuring. Unlike the accounting for other contingently payable amounts discussed in Section 11.4.4.4.1, a restructuring gain may be recognized at the time of the debt restructuring even if it is possible that it will be offset by future interest expense should actual payments exceed estimated payments because of an increase in variable interest rates.
-
If the total amount of estimated future undiscounted cash payments (including variable cash payments estimated at the TDR rate and the maximum possible amount of other contingently payable amounts) exceeds the debt’s net carrying amount at the time of the restructuring, the debtor does not recognize a restructuring gain.
After the TDR, the debtor would recognize interest expense on variable-rate
debt in three circumstances:
-
If the variable rate exceeds the TDR rate (i.e., interest rates have increased), the debtor accrues interest expense for such excess since those amounts were not included in the net carrying amount at the time of the restructuring. The amount of additional interest expense equals the product of the net carrying amount and the difference between the current rate and the TDR rate. When the variable rate exceeds the TDR rate in a specific financial reporting period, an entity may calculate the amount of interest expense to accrue in that period either on a period-by-period basis or a cumulative basis. Under a period-by-period approach, additional interest is accrued in each period in which the variable rate exceeds the TDR rate irrespective of whether the TDR rate exceeded the variable rate in a prior period. Under a cumulative approach, additional interest is accrued if the cumulative amount of interest accrued at the actual variable rates in effect for each period since the TDR exceeds the cumulative amount of interest accrued at the TDR rate in each period since the TDR.
-
If the total amount of estimated future undiscounted cash payments (including variable interest payments estimated at the TDR rate but excluding contingently payable amounts) exceeds the debt’s net carrying amount at the time of the restructuring (i.e., there was no restructuring gain; see Section 11.4.4.2), the debtor should accrue interest expense over the life of the restructured debt for the difference between the net carrying amount and the total amount of undiscounted future principal and estimated interest payments estimated at the TDR rate, since such amounts were not included in the debt’s net carrying amount at the time of the restructuring.
-
The debtor should expense any estimated losses under contingent payment terms that exceed the amount included in the net carrying amount at the time of the restructuring (see Section 11.4.4.4.2).
Other than in the above three circumstances, the debtor would recognize no
interest expense on variable-rate debt after the TDR since amounts payable
as interest directly reduce the debt’s net carrying amount.
In situations in which the TDR rate exceeds the variable rate in a subsequent
period (i.e., interest rates have decreased), ASC 470-60 precludes the
debtor from recognizing a gain for the difference between actual and
estimated payments before the debt’s extinguishment (see Section 9.2) since such a gain might be offset by future
cash payments if the variable rate increases again before the debt is
settled. The debtor recognizes the gain only when no obligations remain
(i.e., when the debt is extinguished).
Example 11-21
Accounting for a Modification of a Payable —
Interest Rate Changed From Fixed Rate to Variable
Rate
Debtor D has a fixed-rate loan with a net carrying
amount of $100,000 and a remaining term of five
years. The stated interest rate is 12 percent per
annum payable in arrears. The loan was originated at
no discount or premium, and the debt issuance costs
were negligible. Because of D’s financial
difficulties, on January 1, 20X1, its lender agrees
to forgive $25,000 of principal and change the
interest rate to the prime rate plus 1 percent per
annum (i.e., the interest rate on the restructured
debt is variable). At the time of the restructuring,
the prime rate is 4.5 percent.
Debtor D estimates the future
principal and interest cash flows on the
restructured debt on the basis of the prime rate in
effect at the time of the restructuring (i.e., the
TDR rate). On the basis of the net carrying amount
($100,000) and the future cash flows of the
restructured debt estimated at the TDR rate (5.50
percent), which is $95,625, D determines that the
effective borrowing rate on the restructured debt is
negative (see Section
11.3.3.4.1). Because the principal
amount of the original debt was equal to its net
carrying amount, the effective borrowing rate on the
original debt was equal to its stated interest rate
of 12 percent per annum.
Since the effective borrowing rate of the modified
loan is lower than that of the original debt, the
lender has granted a concession. Because D is
experiencing financial difficulties, TDR accounting
applies.
The net carrying amount ($100,000) exceeds the total
amount of undiscounted principal and interest cash
flows estimated at the TDR rate ($95,625).
Therefore, D recognizes a restructuring gain
($4,375) at the time of the restructuring with a
corresponding reduction in the debt’s net carrying
amount. Subsequent variable interest payments are
recognized as a reduction in the debt’s net carrying
amount except to the extent that variable interest
payments exceed the amount estimated at the TDR
rate. Because the total amount that D estimated it
would pay as interest at the TDR rate exceeds its
actual interest payments over the debt’s life, it
also recognizes a gain for the difference when the
debt matures.
11.4.4.7 Comparison of ASC 470-50 and ASC 470-60
A debt modification or exchange that qualifies as a TDR
should be accounted for as a modification of the debt terms under ASC 470-60
irrespective of whether the original and new terms are substantially
different. This is unlike the analysis of a debt modification or exchange
that does not qualify as a TDR under ASC 470-50, which should be accounted
for as a debt modification or an extinguishment depending on whether the
terms are substantially different (see Chapter 10). The table below depicts
key differences between the accounting for a debt modification or exchange
depending on whether the transaction qualifies as a TDR.
|
TDR (ASC 470-60)
|
Not a TDR (ASC 470-50)
| ||
|---|---|---|---|
|
Future Undiscounted Cash Flows Exceed Original Net
Carrying Amount
|
Original Net Carrying Amount Exceeds Future
Undiscounted Cash Flows
| ||
|
Terms substantially different
|
|
|
|
|
Terms not substantially different
|
|
|
|
The example below discusses a debt modification that
qualifies as a TDR.
Example 11-22
Debtor’s Analysis of a Debt Modification That
Qualifies as a TDR
Entity D issues debt on which it must make interest
payments of $100 at the end of each year for five
more years and repay the $1,000 face amount at the
end of those five years. The stated interest rate is
10 percent, compounded annually. The debt’s initial
and current net carrying amount is $1,000, and the
annual effective interest rate implicit in the debt
is also 10 percent. If all contractual amounts are
paid, the debtor’s total interest expense will be
$500 — the difference between the total amount to be
paid ($1,500) and the debt’s net carrying amount
($1,000). The effective interest rate on the $1,000
net carrying amount will be 10 percent.
Entity D and the creditor are considering whether to
modify the debt in one of the following four
ways:
-
Timing of interest only — Terms modified to defer payment of interest until the debt matures (a single collection of $500 at the end of five years is substituted for five annual collections at $100).
-
Amount of interest only — Terms modified to leave unchanged the timing of interest and the timing and amount of principal payment but to reduce the annual interest from $100 to $60.
-
Amount of principal only — Terms modified to leave unchanged the amounts and timing of interest but to reduce the principal amount to $800 due at the end of five years.
-
Both timing of interest and principal amount — Terms modified to defer collection of interest until the debt matures and to reduce the principal amount to $800 (modifications 1 and 3 combined).
The contractual cash payments before the modification
and in the above four modification scenarios are as
follows:
If D and the creditor modified the debt terms in
accordance with one of the above four scenarios and
the modification qualifies as a TDR under ASC
470-60, D would reduce the effective interest rate
used to calculate interest expense on the debt
prospectively in each of the four modification
scenarios above in accordance with ASC 470-60-35-5
(see Section 11.4.4.2). The revised
effective interest rate would be the discount rate
that equates the future cash payments specified by
the new terms with the debt’s net carrying amount
(see row (d) in the table below). Because the
modified remaining cash payments would exceed the
net carrying amount, the carrying amount would not
be adjusted, and there would be no restructuring
gain in any scenario in accordance with ASC 470-60.
The following table illustrates the analysis under
ASC 470-60 of each of these scenarios:
If the debt modification was not a TDR, the
accounting analysis for the same set of facts would
be different. Because the present value of the
modified cash payments discounted at the original
effective interest rate would be more than 10
percent different from the net carrying amount
(i.e., the present value of the original cash
payments discounted at the original effective
interest rate) in scenarios 2, 3, and 4, the
original debt would be accounted for as an
extinguishment under ASC 470-50 (see Section 10.4.2). Therefore, the new
debt would be recognized at its fair value as of the
modification date, an extinguishment gain or loss
would be recognized for the difference between the
net carrying amount and the current fair value, and
a new effective interest rate would be calculated on
the basis of the initial net carrying amount of the
modified debt.
In scenario 1, the present value of
the modified cash payments discounted at the
original effective interest rate is less than 10
percent different from the net carrying amount.
Therefore, the debt would not qualify for
extinguishment accounting under ASC 470-50 (see
Section
10.4.3). Instead, D would calculate a
revised effective interest rate in accordance with
ASC 470-50-40-14 (see row (l) below). The table
below illustrates the analysis under ASC 470-50 of
each of the above modification scenarios in
situations in which the modification does not
qualify as a TDR. It is assumed in the scenarios
that the applicable current market interest rate for
the debt is 5.5 percent.
11.4.5 Accounting for a Combination of TDR Characteristics
ASC 470-60
35-8 A troubled debt
restructuring may involve partial settlement of a
payable by the debtor’s transferring assets or granting
an equity interest (or both) to the creditor and
modification of terms of the remaining payable. Even if
the stated terms of the remaining payable, for example,
the stated interest rate and the maturity date or dates,
are not changed in connection with the transfer of
assets or grant of an equity interest, the restructuring
shall be accounted for as prescribed by this guidance. A
debtor shall account for a troubled debt restructuring
involving a partial settlement and a modification of
terms as prescribed in paragraphs 470-60-35-5 through
35-7 except that, first, assets transferred or an equity
interest granted in that partial settlement shall be
measured as prescribed in paragraphs 470-60-35-2 and
470-60-35-4, respectively, and the carrying amount of
the payable shall be reduced by the total fair value of
those assets or equity interest. If cash is paid in a
partial settlement of a payable in a troubled debt
restructuring, the carrying amount of the payable shall
be reduced by the amount of cash paid. A difference
between the fair value and the carrying amount of assets
transferred to the creditor shall be recognized as a
gain or loss on transfer of assets. No gain on
restructuring of payables shall be recognized unless the
remaining carrying amount of the payable exceeds the
total future cash payments (including amounts
contingently payable) specified by the terms of the debt
remaining unsettled after the restructuring. Future
interest expense, if any, shall be determined according
to the provisions of paragraphs 470-60-35-5 through
35-7.
Some TDRs involve a partial settlement of the debt through a transfer of cash or
other assets or the issuance of equity instruments. The terms of the remaining
debt might also be modified. When a TDR involves a combination of the
characteristics in ASC 470-60-15-9(a)–(c), the accounting is as follows:
-
The debt’s net carrying amount is reduced by the amount of any cash paid to the creditor.
-
The debtor recognizes a gain or loss on any noncash assets transferred that is equal to the difference between their carrying amount and fair value and reduces the debt’s net carrying amount by that fair value.
-
The debtor recognizes the issuance of any equity instruments at fair value and reduces the net carrying amount of the debt by that fair value.
-
Once the net carrying amount has been reduced for the amount of cash and the fair value of any assets transferred or equity interests granted, the debtor applies the accounting requirements for troubled debt modifications and exchanges (see Section 11.4.4) to the remaining debt on the basis of the reduced net carrying amount.
The guidance in ASC 470-60-35-8 applies to a TDR with a combination of the
characteristics specified in ASC 470-60-15-9(a)–(c) even if such TDR does not
involve a partial settlement of the debt (e.g., an asset transfer and debt
modification that does not involve a reduction of the debt’s principal amount).
Also, note that the fair value of the assets transferred or equity instruments
issued may be different from any reduction in the debt’s net carrying amount
agreed to by the debtor and creditor.
Example 11-23
Accounting for a Modification Involving a Reduction of
Interest Rate on a Payable in Exchange for an
Issuance of Common Stock
A company issues common stock to
fixed-rate debt holders in exchange for delaying
interest payments on the outstanding debt. The
transaction qualifies as a TDR. Although none of the
debt has been settled as a result of this transaction,
this arrangement is analogous to a TDR with a
combination of the characteristics described in ASC
470-60-15-6(a)–(c).
The company should reduce the carrying amount of the debt
by the fair value of the common stock issued, and it
would not record a gain because the adjusted carrying
amount of the debt does not exceed the total future cash
payments required by the new terms (only the timing of
the payments was affected). The reduction of the
carrying amount effectively creates a discount on the
debt, which will result in increased interest expense
prospectively over the remaining term of the debt, as
described in ASC 470-60-35-5 through 35-7.
11.5 Presentation and Disclosure
11.5.1 Current Versus Noncurrent Classification
ASC 470-60
45-1 All or a portion of the
carrying amount of the payable at the time of the
restructuring may need to be reclassified in the balance
sheet because of changes in the terms, for example, a
change in the amount of the payable due within one year
after the date of the debtor’s balance sheet.
45-2 A troubled debt
restructuring of a short-term obligation after the date
of a debtor’s balance sheet but before that balance
sheet is issued or is available to be issued (as
discussed in Section 855-10-25) may affect the
classification of that obligation in accordance with
Subtopic 470-10.
Like a credit-related covenant violation that takes place after
the balance sheet date, a TDR that occurs after the balance sheet date may
affect the classification of the related debt as current or noncurrent (see
Section 13.5).
11.5.2 Disclosure
ASC 470-60
50-1 A debtor shall
disclose, either in the body of the financial statements
or in the accompanying notes, all of the following
information about troubled debt restructurings that have
occurred during a period for which financial statements
are presented:
- For each restructuring, a description of the principal changes in terms, the major features of settlement, or both; separate restructurings within a fiscal period for the same category of payables (for example, accounts payable or subordinated debentures) may be grouped for disclosure purposes
- Aggregate gain on restructuring of payables
- Aggregate net gain or loss on transfers of assets recognized during the period (see paragraphs 470-60-35-3 and 470-60-35-8)
- Per-share amount of the aggregate gain on restructuring of payables.
50-2 A debtor shall disclose
in financial statements for periods after a troubled
debt restructuring the extent to which amounts
contingently payable are included in the carrying amount
of restructured payables pursuant to the provisions of
paragraph 470-60-35-7. If required by paragraphs
450-20-50-1 through 50-6 and 450-20-50-9 through 50-10,
a debtor shall also disclose in those financial
statements total amounts that are contingently payable
on restructured payables and the conditions under which
those amounts would become payable or would be
forgiven.
ASC 470-60-50-1 and 50-2 specify the disclosure requirements for a TDR that has
occurred during a financial reporting period. Such disclosures are required even
if the debt is no longer outstanding.
Chapter 12 — Debt Conversions
Chapter 12 — Debt Conversions
12.1 Background
This chapter describes the accounting for a conversion of debt into
the debtor’s equity shares.
12.2 Scope
ASC 470-20 addresses the issuer’s accounting for a conversion of
debt into the issuer’s equity shares in accordance with the debt’s original
conversion terms (see Section
12.3.2) or under an induced conversion (see Section 12.3.4). The guidance
in ASC 470-20 does not apply to any of the following:
-
A conversion that occurs upon the issuer’s exercise of a call option if the instrument did not contain a substantive conversion feature as of its issuance date. This type of transaction must be accounted for as a debt extinguishment even if the instrument was converted in accordance with its original conversion privileges. See Sections 9.3.5 and 12.3.3 for further discussion.
-
A conversion that occurs in accordance with changed conversion privileges and does not meet the criteria for induced conversion accounting. This type of transaction must be accounted for as a debt extinguishment. See Sections 9.3.5 and 12.3.4 for further discussion.
-
A modification or exchange of debt, including convertible debt. This type of transaction must be evaluated under ASC 470-50. See Sections 9.3.5 and 10.2.12 for further discussion.
-
A conversion of debt, including convertible debt, into a variable number of shares in accordance with a share-settled redemption feature (e.g., it is determined that the number of shares delivered has a fair value equal to the redemption amount). This type of transaction must be accounted for as a debt extinguishment. See Sections 8.4.7.2.5 and 9.3.5 for further discussion.
-
The repayment of debt, including convertible debt, by the delivery of the debtor’s equity shares if the debtor is using its own shares as a means of currency to settle the debt obligation’s value (e.g., the number of shares delivered is determined to have a value equal to the monetary amount of the debt obligation). This type of transaction must be accounted for as a debt extinguishment. See Sections 9.2.3.2 and 9.3.5 for further discussion.
-
The repayment of debt, including convertible debt, by the delivery of the debtor’s equity shares if the settlement is a TDR. This type of transaction must be accounted for as a TDR. See Chapter 11 for further discussion.
-
A conversion of debt into equity shares of a third party. This type of transaction must be accounted for as a debt extinguishment.
In certain circumstances, the tendering of debt upon the exercise of
a detachable warrant is accounted for as a debt conversion and not as a debt
extinguishment (see Section
9.3.6). Further, it may be appropriate to apply extinguishment
accounting to conversions of convertible debt for which the conversion feature was
separated as a derivative instrument under ASC 815-15 (see Section 12.4).
12.3 Convertible Debt With No Equity Component
12.3.1 Background
If convertible debt that does not contain a bifurcated embedded conversion
feature under ASC 815-15 or a separately recognized equity component is
converted into the issuer’s equity shares under the instrument’s original
conversion terms, (1) the net carrying amount of the debt is derecognized and
cash, equity, or both are credited to reflect the consideration issued and (2)
no gain or loss is recognized (see Section 12.3.2). In practice, this is
often referred to “conversion accounting.”1 If the conversion qualifies as an “induced conversion” under ASC
470-20-40-16, the issuer first recognizes “an expense equal to the fair value of
all securities and other consideration transferred in the transaction in excess
of the fair value of securities issuable [under] the original conversion terms”
and then applies conversion accounting (see Section 12.3.4).
12.3.2 Conversion in Accordance With the Original Conversion Terms
ASC 470-20
35-11 If the terms of
conversion of a convertible debt instrument provide that
any accrued but unpaid interest at the date of
conversion is forfeited by the former debt holder, that
interest should be accrued or imputed to the date of
conversion of the debt instrument.
Contractual Conversion
40-4 If a convertible debt
instrument accounted for in its entirety as a liability
under paragraph 470-20-25-12 is converted into shares,
cash (or other assets), or any combination of shares and
cash (or other assets), in accordance with the
conversion privileges provided in the terms of the
instrument, upon conversion the carrying amount of the
convertible debt instrument, including any unamortized
premium, discount, or issuance costs, shall be reduced
by, if any, the cash (or other assets) transferred and
then shall be recognized in the capital accounts to
reflect the shares issued and no gain or loss is
recognized.
Interest
Forfeiture
40-11 If the terms of
conversion of a convertible debt instrument provide that
any accrued but unpaid interest at the date of
conversion is forfeited by the former debt holder,
accrued interest from the last interest payment date, if
applicable, to the date of conversion, net of related
income tax effects, if any, shall be charged to interest
expense and credited to capital as part of the cost of
securities issued. Thus, the accrued interest is
accounted for in the same way as the principal amount of
the debt converted and any unamortized premium,
discount, or issuance costs; the net carrying amount of
the debt, including any unamortized premium, discount,
or issuance costs and the related accrual for interest
to the date of conversion, net of any related income tax
effects, is a credit to the entity’s capital.
ASC 470-20-40-4 specifies the accounting for a conversion of a
convertible debt instrument that (1) does not contain a bifurcated embedded
conversion feature under ASC 815-15 and (2) is not addressed by other guidance
(i.e., conversions of convertible debt that contain a separately recorded equity
component as well as induced conversions). Under this guidance, no gain or loss
is recognized upon the conversion of debt into shares, cash, or other assets in
accordance with the debt’s original conversion terms. Conversion accounting does
not apply if the minimum number of shares that were required to be issued under
the original conversion terms have not been issued.
If the conversion feature is settled entirely in shares, the debt’s net carrying
amount is credited to equity upon conversion to reflect the equity shares
issued. For example, the issuer may make the following accounting entry:
Convertible debt
Equity — common stock/APIC
If the conversion feature is settled (1) entirely in cash upon
conversion or (2) in a combination of cash and shares, the journal entry would
differ because it would reflect the payment of cash in lieu of equity shares,
but the issuer still would recognize no gain or loss on the conversion date.
The net carrying amount of the debt reflects any remaining
unamortized discount or premium as of the date of conversion as well as any
remaining unamortized debt issuance costs as of that date, in accordance with
the definition of “net carrying amount of debt” in ASC 470-50 (see Section 9.3.1.3). The
issuer should amortize any premium or discount and debt issuance costs up to the
date on which the instrument is converted. As indicated in ASC 470-20-40-11, the
carrying amount also includes any “accrued interest from the last interest
payment date, if applicable, to the date of conversion, net of related income
tax effects, if any,” irrespective of whether accrued unpaid interest is
forfeited upon conversion. If convertible debt does not contain a bifurcated
embedded conversion feature under ASC 815-15 (see Section 12.4) or a separately recognized
equity component (see Section
12.5), the accrued interest cost, net of any related income tax
effects, is credited to equity as part of the cost of any equity shares
issued.
See Section 12.3.4 for a
discussion of the accounting for induced conversions. See Section 12.4 for a
discussion of the accounting for a conversion of a convertible debt instrument
for which the embedded conversion option has been separated as an embedded
derivative liability. Such accounting applies if the embedded conversion option
has been separated from the host debt instrument upon or after issuance but
before conversion. See Section 12.5 for a
discussion of the application of conversion accounting to a convertible debt
instrument with a separated equity component.
Connecting the Dots
For certain convertible debt instruments, the issuer may
elect to settle a conversion partially or fully in cash. In such cases,
the issuer must elect to settle the conversion value in cash on a date
before the settlement occurs (e.g., 30 days before the cash settlement
occurs). Consequently, if the election is irrevocable and the issuer
elects to settle all or a portion of the conversion value in cash, the
embedded conversion feature will no longer meet the own-equity exception
in ASC 815-10-15-74(a). Therefore, the issuer will have to bifurcate the
embedded conversion feature as a derivative instrument under ASC 815-15.
This bifurcated derivative will generally represent a nonoption embedded
derivative that the issuer must initially recognize at zero in
accordance with ASC 815-15-55-160 through 55-164. However, the issuer
must recognize in earnings the change in fair value of the bifurcated
embedded derivative. The issuer would do so from the date of the
irrevocable notice to settle a portion of the conversion in cash until
the settlement date (i.e., a derivative balance will exist after initial
bifurcation). Depending on variations in the issuer’s share price, the
change in fair value could represent an asset or a liability.
Conversion accounting is still appropriate in these circumstances because
the separation of the conversion feature is incidental to the settlement
of the debt instrument in accordance with its original conversion terms.
In the application of conversion accounting, the net carrying amount of
the convertible debt will include the fair value of the bifurcated
embedded derivative. Therefore, no gain or loss will be recognized on
the conversion date (i.e., the settlement date). Nevertheless, the gain
or loss on the bifurcated embedded derivative should not be reversed
(i.e., it will remain recognized in earnings). Thus, while the
conversion of the instrument does give rise to a gain or loss that is
reported in earnings (i.e., for the period between the date on which the
issuer elects cash settlement and the settlement date), it does not
invalidate the application of conversion accounting as of the settlement
date. That is, extinguishment accounting is not required. The
alternative views discussed in Section
12.4 are not relevant to these types of settlements.
12.3.3 Conversion Upon the Issuer’s Exercise of a Call Option
12.3.3.1 General
ASC 470-20
05-11 An entity may issue
equity securities to settle a debt instrument that
was not otherwise currently convertible but became
convertible upon the issuer’s exercise of a call
option when the issuance of equity securities is
pursuant to the instrument’s original conversion
terms. This Subtopic provides related guidance.
40-5 The following
guidance addresses accounting for the issuance of
equity securities to settle a debt instrument
(pursuant to the instrument’s original conversion
terms) that became convertible upon the issuer’s
exercise of a call option:
- Substantive conversion feature. If the debt instrument contained a substantive conversion feature as of time of issuance, the issuance of equity securities shall be accounted for as a contractual conversion. That is, no gain or loss shall be recognized related to the equity securities issued to settle the instrument.
- No substantive conversion feature. If the debt instrument did not contain a substantive conversion feature as of time of issuance, the issuance of equity securities shall be accounted for as a debt extinguishment. That is, the fair value of the equity securities issued should be considered a component of the reacquisition price of the debt.
Sometimes, the terms of a convertible debt instrument include both (1) an
option for the issuer to call the instrument and (2) a right for the holder
to exercise the conversion feature if the issuer calls the instrument. In
this circumstance, the accounting for the conversion of the instrument into
the issuer’s equity shares in accordance with the original terms of the debt
depends on whether the conversion feature was (1) otherwise currently
convertible and (2) substantive as of the instrument’s issuance date (see
Section 12.3.3.2).
If the conversion option is nonsubstantive at issuance and the instrument
becomes convertible upon the issuer’s exercise of the call option, the
conversion of the instrument into equity shares is accounted for as a debt
extinguishment (see Section 9.3). As long as the conversion feature is
nonsubstantive at issuance, and provided that the holder does not currently
have the ability to convert the instrument unless the issuer exercises its
call option, extinguishment accounting applies even if the instrument would
have become convertible upon the passage of time (e.g., a conversion option
that becomes exercisable on the instrument’s maturity date or on specified
prior dates).
The conversion of an instrument into the issuer’s equity shares is accounted
for as a conversion (see Section 12.3.2) as long as it otherwise qualifies for such
accounting if either (1) the conversion feature is substantive at issuance
or (2) the holder has the ability to exercise the conversion feature
irrespective of the issuer’s exercise of its call option.
|
Convertibility of Debt Instrument
|
Conversion Feature Substantive at Inception
|
Conversion Feature Not Substantive at Inception
|
|---|---|---|
|
Convertible only upon the issuer’s exercise of a call
option
|
N/A. (By definition, such a conversion option is not
substantive as of the issuance date.)
|
Accounted for as an extinguishment.
|
|
Convertible upon the issuer’s exercise of a call
option and could otherwise become convertible in the
future
|
Accounted for as a conversion.
|
Accounted for as an extinguishment.
|
|
Currently convertible even if the issuer has not
exercised its call option
|
Accounted for as a conversion. Because the instrument
is convertible without the issuer’s exercise of a
call option, the accounting does not depend on
whether the conversion option was substantive on the
issuance date.
| |
This guidance does not apply to transactions that would not
otherwise qualify for conversion accounting (see Section 12.2) or to induced conversions. See Section 12.4 for a
discussion of the accounting for a conversion of a convertible debt
instrument for which the embedded conversion option has been separated as an
embedded derivative liability. Such accounting applies if the embedded
conversion option has been separated from the host debt instrument upon or
after issuance but before conversion.
12.3.3.2 Determining Whether a Conversion Feature Is Substantive
ASC Master Glossary
Substantive Conversion Feature
A conversion feature that is at least reasonably
possible of being exercisable in the future absent
the issuer’s exercise of a call option.
ASC 470-20
40-6 The assessment of
whether the conversion feature is substantive may be
performed after time of issuance but shall be based
only on assumptions, considerations, and marketplace
information available as of time of issuance.
40-7 By definition, a
substantive conversion feature is at least
reasonably possible of being exercised in the
future. If the conversion price of an instrument at
issuance is extremely high so that conversion of the
instrument is not deemed at least reasonably
possible as of time of issuance, then the conversion
feature would not be considered substantive.
40-8 For purposes of
determining whether a conversion feature is
reasonably possible of being exercised, the
assessment of the holder’s intent is not necessary.
Therefore, even if such an instrument included a
conversion feature that provided for conversion due
solely to the passage of time (for example, the
instrument will become convertible at a date before
its maturity date), it would be inappropriate to
conclude that the conversion feature is substantive.
Also, an instrument that became convertible only
upon the issuer’s exercise of its call option does
not possess a substantive conversion feature.
40-9 Methods that may be
helpful in assessing whether a conversion feature is
substantive include the following:
- The fair value of the conversion feature relative to the fair value of the debt instrument. Comparing the fair value of a conversion feature to the fair value of the debt instrument (that is, the complete instrument as issued) may provide evidence that the conversion feature is substantive.
- The effective annual interest rate per the terms of the debt instrument relative to the estimated effective annual rate of a nonconvertible debt instrument with an equivalent expected term and credit risk. Comparing the effective annual interest rate of the debt instrument to the effective annual rate the issuer estimates it could obtain on a similar nonconvertible instrument may provide evidence that a conversion feature is substantive.
- The fair value of the debt instrument relative to an instrument that is identical except for which the conversion option is not contingent. Comparing the fair value of the debt instrument to the fair value of an identical instrument for which conversion is not contingent isolates the effect of the contingencies and may provide evidence about the substance of a conversion feature. If the fair value of the debt instrument is similar to the fair value of an identical convertible debt instrument for which conversion is not contingent, then it may indicate that the conversion feature is substantive. However, this approach may not be appropriate unless it is clear that the conversion feature, not considering the contingencies, is substantive.
- Qualitative evaluation of the conversion provisions. The nature of the conditions under which the instrument may become convertible may provide evidence that the conversion feature is substantive. For example, if an instrument may become convertible upon the occurrence of a specified contingent event, the likelihood that the contingent event will occur before the instrument’s maturity date may indicate that the conversion feature is substantive. However, this approach may not be appropriate unless it is clear that the conversion feature, not considering the contingencies, is substantive.
40-10 The guidance in paragraphs
470-20-40-7 through 40-9 does not address the
treatment of an instrument for purposes of applying
Subtopic 260-10.
In evaluating whether a conversion option is substantive as of the debt’s
issuance date, an issuer considers the assumptions that were made and the
marketplace information that was available as of that date even if the
assessment is performed subsequently. A conversion option may be deemed
substantive if — as of the instrument’s issuance date — there is at least a
reasonable possibility that it will become exercisable by the holder upon
(1) the passage of time or (2) the occurrence or nonoccurrence of a
specified event (other than the issuer’s exercise of the call option) that
is likely to occur. However, in accordance with ASC 470-20-40-7, a
conversion option that currently has a reasonable possibility of becoming
exercisable would not be considered substantive if, as of the instrument’s
issuance date, its exercise was not reasonably possible (e.g., because the
conversion option is deeply out-of-the-money).
Under ASC 470-20, a conversion feature would not be considered substantive as
of the instrument’s issuance date in any of the following circumstances:
-
The holder has no ability to exercise the conversion feature (i.e., it is not exercisable) unless the issuer exercises its call option.
-
It is not reasonably possible for the holder to obtain the ability to exercise the conversion feature (i.e., it is not reasonably possible that the feature will become exercisable) unless the issuer exercises its call option. For example, this would be the case if the only circumstance in which the holder can obtain a right to convert the instrument (other than the issuer’s exercise of the call option) is a specified event that does not have a reasonable possibility of occurring.
-
It is not reasonably possible that the holder will exercise the conversion feature (e.g., the conversion price is extremely high relative to the current share price as of the issuance date).
In evaluating whether a conversion option is substantive as of the issuance
date in accordance with ASC 470-20-40-9 (e.g., when determining whether it
is reasonably possible that the holder will exercise the conversion
feature), an issuer should consider the following:
-
The smaller the fair value of the conversion feature relative to the fair value of the debt instrument, the more likely it is that the conversion option is not substantive.
-
The smaller the difference between the convertible debt’s effective interest rate and the effective interest rate on a hypothetical nonconvertible debt instrument with the same terms except for the conversion feature, the more likely it is that the conversion option is not substantive.
-
The greater the difference between the fair value of the convertible debt and the fair value of a hypothetical convertible debt instrument with the same terms (except that the conversion feature is not contingent), the more likely it is that the conversion option is not substantive.
-
The smaller the likelihood of a contingent event that would make the conversion feature exercisable, the more likely it is that the conversion option is not substantive.
12.3.3.3 Illustration
ASC 470-20
Example 9: Illustration of a Conversion of an
Instrument That Becomes Convertible Upon the
Issuer’s Exercise of a Call Option
55-67 This Example
illustrates an instrument subject to the guidance in
paragraphs 470-20-40-5 through 40-9.
55-68 An entity issues a
contingently convertible instrument on January 1,
2006, with a market price trigger, a $1,000 par
amount, and a maturity date of December 31, 2020.
The debt instrument is convertible at the option of
the holder if the share price of the issuer exceeds
a specified amount. The issuer can call the debt at
any time between 2009 and the maturity date of the
debt. If the issuer calls the debt, the holder has
the option to receive cash for the call amount or a
fixed number of shares as specified in the terms of
the instrument upon issuance, regardless of whether
the market price trigger has been met. In 2010, the
issuer calls the debt before the market price
trigger being met and the holder elects to receive a
fixed number of shares (as specified in the terms of
the instrument).
Example 9 in ASC 470-20-55 describes a contingently
convertible debt instrument (the “CoCo”). Since the holder does not have the
ability to convert the CoCo debt before the issuer calls it (because the
market price trigger is not met), the transaction is evaluated on the basis
of the guidance in ASC 470-20-40-5 on conversions that occur upon the
issuer’s exercise of a call option. If the feature had been substantive at
issuance, the conversion would have been accounted for as a conversion (see
Section
12.3.2). If the feature had been nonsubstantive at issuance,
the conversion would have been accounted for as an extinguishment (see
Section
9.3).
If the facts were altered so that the market-price trigger had been met when
the issuer exercised its call option, the guidance in ASC 470-20-40-5 on
conversions that occur upon the issuer’s exercise of a call option would not
have applied because the holder already had an unconditional right to elect
to convert the debt when the issuer chose to call it. In those
circumstances, the conversion would have been accounted for as a conversion
irrespective of whether the conversion feature was substantive at
issuance.
12.3.4 Induced Conversions
12.3.4.1 Scope
ASC 470-20
05-10 Some convertible
debt instruments include provisions allowing the
debtor to alter terms of the debt to the benefit of
debt holders. In some circumstances, conversion
privileges for a convertible debt instrument are
changed or additional consideration is paid to debt
holders for the purpose of inducing prompt
conversion of the debt to equity securities
(sometimes referred to as a convertible debt
sweetener). Such provisions may be general in
nature, permitting the debtor or trustee to take
actions to protect the interests of the debt
holders, or they may be specific, for example,
specifically authorizing the debtor to temporarily
reduce the conversion price for the purpose of
inducing conversion.
40-13 The guidance in
paragraph 470-20-40-16 applies to conversions of
convertible debt to equity securities pursuant to
terms that reflect changes made by the debtor to the
conversion privileges provided in the terms of the
debt at issuance (including changes that involve the
payment of consideration) for the purpose of
inducing conversion. That guidance applies only to
conversions that both:
- Occur pursuant to changed conversion privileges that are exercisable only for a limited period of time (inducements offered without a restrictive time limit on their exercisability are not, by their structure, changes made to induce prompt conversion)
- Include the issuance of all of the equity securities issuable pursuant to conversion privileges included in the terms of the debt at issuance for each debt instrument that is converted, regardless of the party that initiates the offer or whether the offer relates to all debt holders.
40-14 A conversion
includes an exchange of a convertible debt
instrument for equity securities or a combination of
equity securities and other consideration, whether
or not the exchange involves legal exercise of the
contractual conversion privileges included in terms
of the debt. The preceding paragraph also includes
conversions pursuant to amended or altered
conversion privileges on such instruments, even
though they are literally provided in the terms of
the debt at issuance.
40-15 The changed terms
may involve any of the following:
- A reduction of the original conversion price thereby resulting in the issuance of additional shares of stock
- An issuance of warrants or other securities not provided for in the original conversion terms
- A payment of cash or other consideration to those debt holders that convert during the specified time period.
The guidance in the following paragraph does not
apply to conversions pursuant to other changes in
conversion privileges or to changes in terms of
convertible debt instruments that are different from
those described in this paragraph.
For various reasons, such as to reduce interest costs or improve debt-equity
ratios, an issuer may seek to induce debt holders to promptly convert
convertible debt into equity shares under changed conversion terms that are
effective for a limited period and involve additional consideration. That
is, the issuer may make an “inducement offer.” The additional consideration
offered can take any form (e.g., reduced conversion price, issuance of
warrants or other securities, issuance of other noncash assets, payment of
cash).
If convertible debt is converted in accordance with an inducement offer that
meets the conditions described above, neither conversion only accounting (as
described in Section 12.3.2) nor extinguishment accounting (as described
in Section 9.3) applies; instead, the issuer must recognize an
inducement expense upon the conversion. Such accounting applies to
conversions that have all of the following characteristics:
-
The debt’s original terms contained conversion privileges (i.e., the debt was convertible into the issuer’s equity shares).
-
Either the debtor or the holder offered revised conversion terms that gave the holder an economic incentive to convert. For example, a debtor might offer each holder that elects to accept the inducement offer a reduced conversion price, additional instruments (e.g., warrants), or cash or other consideration in addition to the shares that would have been issued under the original conversion terms (“sweeteners”).
-
To induce prompt conversion, the inducement offer contained an exercisability period that was limited. An offer that does not include a limited exercisability period is not a change that is made to induce prompt conversion. Although ASC 470-20-40-13(a) does not address the length of such period, the examples in ASC 470-20-55 imply that 30 or 60 days could qualify as “a limited period of time.” When the conversion terms are altered for the remaining term of the convertible debt instrument, a modification of the convertible debt instrument has occurred (see Chapter 10).
-
The convertible debt was converted under the revised conversion terms.
-
For each converted instrument, all equity securities that were issuable in accordance with the instrument’s original conversion terms were in fact issued (i.e., the conversion can result in the issuance of additional equity shares but cannot result in the issuance of fewer equity shares than the number required to be issued in accordance with the original conversion privileges). (Note that some convertible debt instruments may be settled entirely in cash in accordance with the original conversion privileges [i.e., Instrument X]. For these convertible debt instruments, inducement accounting may be applied even if no shares are issued upon settlement. For other convertible debt instruments under which all or a portion of any conversion must be settled in shares, inducement accounting applies only if all of the equity shares that are required to be issued under the original conversion terms are issued.)
Therefore, induced conversion accounting does not apply in any of the
following circumstances:
-
The original debt instrument did not contain a conversion feature.
-
The instrument was converted under the original conversion terms (see Section 12.3.2).
-
The terms were adjusted for some purpose other than to induce conversion (e.g., to settle a legal dispute about the correct interpretation of the conversion terms).
-
The offer was not for a limited period (i.e., the changed conversion privileges have no stated expiration date or are available for the remaining term of the convertible debt).
-
The inducement offer involves the issuance of fewer equity securities than the original conversion terms required.
-
The inducement offer involves the issuance of different equity securities than those that were issuable under the original conversion terms (e.g., preferred stock instead of common stock).
-
The fair value of the consideration transferred is equal to or less than the fair value of the securities issuable under the original conversion terms.
In the evaluation of whether inducement accounting applies, it does not
matter whether:
-
The inducement offer is initiated by the debtor or the holder.
-
The inducement offer is provided to all holders, some holders, or only one holder of the debt.
-
Some holders accept the offer and others do not (i.e., inducement accounting applies only to a holder or holders that accept the offer).
-
The inducement transaction involves the legal exercise of contractual conversion privileges (i.e., the legal form of the inducement transaction does not matter). For example, a repurchase of convertible bonds in the open market may be accounted for as an induced conversion if it involves the issuance of all of the equity securities that were required to be issued under the original conversion terms and the other requirements for inducement accounting are met (e.g., the convertible instrument allowed the issuer to elect to settle a conversion entirely in cash).
-
The ability to modify the conversion terms to induce conversion was contemplated in the original terms of the debt instrument (i.e., the original terms of the instrument explicitly permit contractual revisions for the purpose of inducing conversion).
-
The inducement offer involves the issuance of equity securities only or a combination of equity securities and cash or other consideration (as long as the inducement offer does not reduce the number of equity shares issuable under the original conversion terms).
-
The conversion option is out-of-the-money, at-the-money, or in-the-money.
-
The holder’s carrying amount of the convertible debt differs from the principal amount.
An entity applies extinguishment accounting (see Section 9.3) to any
settlement of convertible debt whose terms are different from the original
conversion terms or is otherwise outside the scope of the accounting
requirements for induced conversions. Induced conversion accounting can
never be applied if the settlement would not have been treated as a
conversion, aside from the incremental consideration the issuer provides to
the holders. Accordingly, induced conversion accounting would not apply to a
convertible debt instrument for which the principal amount must be settled
in cash and the excess conversion spread must be settled in equity shares if
(1) the principal amount is settled partially or fully in equity shares or
(2) the excess conversion spread is settled partially or fully in cash.
Changing Lanes
In December 2023, the FASB issued a proposed ASU that would clarify whether induced
conversion accounting can be applied when:
-
The conversion includes the incorporation, elimination, or modification of a volume-weighted average price formula that affects the amount of cash or number of shares to be delivered to the counterparty upon conversion of a convertible debt instrument that the issuer may settle partially or fully in cash.
-
The convertible debt instrument is not currently convertible in the absence of an induced conversion offer.
Until the proposal is finalized, there may be diversity in practice.
Entities should consider disclosing their accounting for any such
conversions that could be affected by this guidance.
12.3.4.2 Recognition and Measurement
ASC 470-20
40-16 If a convertible debt
instrument is converted to equity securities of the
debtor pursuant to an inducement offer (see
paragraph 470-20-40-13), the debtor shall recognize
an expense equal to the fair value of all securities
and other consideration transferred in the
transaction in excess of the fair value of
securities issuable pursuant to the original
conversion terms. The fair value of the securities
or other consideration shall be measured as of the
date the inducement offer is accepted by the
convertible debt holder. That date normally will be
the date the debt holder converts the convertible
debt into equity securities or enters into a binding
agreement to do so. Until the debt holder accepts
the offer, no exchange has been made between the
debtor and the debt holder. Example 1 (see paragraph
470-20-55-1B) illustrates the application of this
guidance.
40-17 The guidance in the
preceding paragraph does not require recognition of
gain or loss with respect to the shares issuable
pursuant to the original conversion privileges of
the convertible debt when additional securities or
assets are transferred to a debt holder to induce
prompt conversion of the debt to equity securities.
In a conversion pursuant to original conversion
terms, debt is extinguished in exchange for equity
pursuant to a preexisting contract that is already
recognized in the financial statements, and no gain
or loss is recognized upon conversion.
Under ASC 470-20, when a conversion must be accounted for as
an induced conversion, the issuer should recognize an inducement expense
equal to the fair value of the consideration transferred (including the fair
value of the additional securities issued and that of any other sweetener,
such as cash, warrants, or other securities issued) in excess of the fair
value of the securities issuable under the original conversion terms. No
gain or loss is recognized for the securities that were issuable under the
original conversion terms (i.e., conversion accounting applies). Thus, in an
induced conversion that involves only the issuance of additional shares, for
example, the issuer may make the following accounting entry:
Convertible debt
Debt conversion expense (inducement loss)
Equity — common stock
Although conversions in accordance with changed conversion
terms are otherwise accounted for as debt extinguishments, it would be
inappropriate to record a debt extinguishment gain or loss related to the
shares issuable under the original conversion terms in an induced conversion
subject to ASC 470-20-40-13.
The inducement expense is recognized as of the date the
inducement offer is accepted by the convertible debt holder (i.e., generally
the earlier of (1) the conversion date and (2) the date the holder enters
into a binding agreement to convert), not as of the date the inducement
offer is made.
Similarly, in the calculation of the inducement cost, the
fair value of the securities or other consideration transferred as part of
the inducement transaction is measured as of the date the inducement offer
is accepted by the holder, not as of the date the inducement offer is made.
If different holders accept the same offer on different dates, there may be
multiple measurement dates.
Because the inducement expense recognized must equal the
fair value of the additional securities issued upon conversion regardless of
the convertible debt’s net carrying amount and the total fair value of the
consideration paid on conversion, some accounting outcomes may be
economically counterintuitive. For example, an offer that is settled
entirely in cash might result in the recognition of a debt extinguishment
gain, whereas an offer of equal economical value that is settled in shares
might result in the recognition of an inducement loss. Further, the amount
credited to equity to reflect the shares issued may exceed their fair value.
Example 12-1
Recognition of Inducement Loss
Issuer A has outstanding convertible
bonds that it accounts for as convertible debt under
ASC 470-20-25-12 (i.e., entirely as a liability).
Their net carrying amount is $1 million. The
original conversion price was $20 (i.e., the issuer
would deliver 50,000 shares upon conversion). To
induce prompt conversion, A reduces the conversion
price to $16 for a limited period (i.e., 62,500
shares), and the holders accept the offer. The
current stock price is $15. Accordingly, the fair
value of the securities issuable under the original
conversion terms was $750,000 (50,000 × $15) and the
fair value of the securities issuable under the
revised conversion terms is $937,500 (62,500 × $15).
Because the consideration issuable under the changed
conversion privileges exceeds the consideration
under the original terms, A recognizes an inducement
loss under ASC 470-20 equal to the fair value of the
additional shares, $187,500 (12,500 × $15). However,
if A had repurchased the shares for a cash payment
of $937,500 instead of issuing shares worth
$937,500, it would have recognized a debt
extinguishment gain of $62,500 ($1,000,000 –
$937,500).
12.3.4.3 Illustrations
ASC 470-20
Example 1: Induced Conversions of Convertible
Securities
55-1B The
following Cases illustrate application of the
guidance in paragraph 470-20-40-16 to induced
conversions of convertible securities:
- Reduced conversion price for conversion before determination date, increase in bond fair value (Case A)
- Reduced conversion price for conversion before determination date, decrease in bond fair value (Case B).
55-2 For simplicity, the
face amount of each security is assumed to be equal
to its carrying amount in the financial statements
(that is, no original issue premium or discount
exists).
Case A: Reduced Conversion Price for Conversion
Before Determination Date — Bond Fair Value
Increased
55-3 On January 1, 19X4,
Entity A issues a $1,000 face amount 10 percent
convertible bond maturing December 31, 20X3. The
carrying amount of the bond in the financial
statements of Entity A is $1,000, and it is
convertible into common shares of Entity A at a
conversion price of $25 per share. On January 1,
19X6, the convertible bond has a fair value of
$1,700. To induce convertible bondholders to convert
their bonds promptly, Entity A reduces the
conversion price to $20 for bondholders that convert
before February 29, 19X6 (within 60 days).
55-4 Assuming the market
price of Entity A’s common stock on the date of
conversion is $40 per share, the fair value of the
incremental consideration paid by Entity A upon
conversion is calculated as follows for each $1,000
bond that is converted before February 29, 19X6.
55-5 Therefore, Entity A
records debt conversion expense equal to the fair
value of the incremental consideration paid as
follows.
Case B: Reduced Conversion Price for Conversion
Before Determination Date — Bond Fair Value
Decreased
55-6 On January 1, 19X1,
Entity B issues a $1,000 face amount 4 percent
convertible bond maturing December 31, 20X0. The
carrying amount of the bond in the financial
statements of Entity B is $1,000, and it is
convertible into common shares of Entity B at a
conversion price of $25. On June 1, 19X4, the
convertible bond has a fair value of $500. To induce
convertible bondholders to convert their bonds
promptly, Entity B reduces the conversion price to
$20 for bondholders that convert before July 1, 19X4
(within 30 days).
55-7 Assuming the market
price of Entity B’s common stock on the date of
conversion is $12 per share, the fair value of the
incremental consideration paid by Entity B upon
conversion is calculated as follows for each $1,000
bond that is converted before July 1, 19X4.
55-8 Therefore, Entity B
records debt conversion expense equal to the fair
value of the incremental consideration paid as
follows.
55-9 The same accounting would
apply if, instead of reducing the conversion price,
Entity B issued shares pursuant to a tender offer of
50 shares of its common stock for each $1,000 bond
surrendered to the entity before July 1, 19X4. See
paragraph 470-20-40-14.
Footnotes
1
As noted in Section 12.2, conversion
accounting does not apply in certain circumstances in which a debt
instrument is settled for the issuer’s equity shares in accordance with
the original conversion privileges.
12.4 Convertible Debt With a Bifurcated Embedded Conversion Feature
The guidance in U.S. GAAP does not clearly address whether
conversion or extinguishment accounting applies to a conversion in situations in
which the conversion feature has been bifurcated as a derivative instrument under
ASC 815-15. Therefore, as discussed in the example below, it may be acceptable to
apply either type of accounting. Similarly, since there is no clear guidance in U.S.
GAAP on whether inducement accounting applies to such a conversion, it may be
acceptable to use either inducement accounting (because of the lack of an explicit
scope exception; see Section
12.3.4) or extinguishment accounting. The example is not, however,
intended to address situations in which the conversion feature is bifurcated solely
as a result of an issuer’s election to cash settle all or a portion of the
conversion when that election precedes the settlement date of the conversion by a
short period and is made in accordance with the original terms of the instrument
(i.e., the bifurcation is incidental to the settlement of the instrument). As
discussed in Section
12.3.2, conversion accounting would apply in these circumstances.
Example 12-2
Accounting for Convertible Debt With a Bifurcated
Conversion Option That Is Converted in Accordance With
Its Stated Conversion Terms
On January 1, 20X7, Company A issued a convertible debt
instrument with a stated interest rate of 5 percent and a
principal amount of $1,000. At the option of the holder, the
debt could be converted into 100 shares of A’s common stock
at any time. If the debt is not converted before January 1,
20X9, A would be required to repay the principal amount of
the debt in cash. The fair value of A’s common stock on
January 1, 20X7, was $10 per share.
Company A separately accounted for the embedded conversion
option as a derivative liability under ASC 815-15 because of
assumed net-cash settlement requirements upon the occurrence
of certain events outside of A’s control. However, the
stated terms of the convertible debt instrument require
physical share settlement upon conversion. The following
additional facts are related to the convertible debt instrument:
-
On January 1, 20X7, the fair value of the embedded conversion option was $200.
-
On June 1, 20X8, the fair value of the embedded conversion option was $400 ($300 of intrinsic value plus $100 in time value). The carrying amount of the host contract was $950. There was no accrued or unpaid interest.
-
On June 1, 20X8, the holder converted the instrument in accordance with its original conversion terms and received 100 shares of A’s common stock, which had a fair value of $1,300 ($13 per share × 100 shares).
In addition, assume the following:
-
The embedded conversion option was bifurcated from the host debt contract on the issuance date of the convertible debt instrument.
-
It was deemed reasonably possible that the embedded conversion option could be exercised on the instrument’s issuance date.
-
According to the terms of the convertible debt instrument, (1) the issuer does not have the option to partially settle a conversion in cash (e.g., the issuer cannot settle the principal amount in cash and the excess conversion value in common shares) and (2) accrued and unpaid interest is not forfeited upon conversion.
Alternative views on the accounting for such a conversion are
discussed below.
View 1 — Extinguishment Accounting
Equity should be increased by the
settlement-date fair value of the common shares issued and a
gain or loss should be recognized in earnings for the
difference between (1) the fair value of those shares and
(2) the sum of the carrying amounts of the debt host and the
bifurcated conversion option liability.
Accordingly, A would record the following journal entry upon
conversion:
This view is based on the premise that once
the embedded conversion option has been separated from the
debt host contract under ASC 815-15, the debt instrument no
longer has an equity conversion feature (i.e., the financial
instruments are considered separate for accounting
purposes). ASC 470-50-40-3 indicates that both of the
separated liabilities are subject to extinguishment
accounting and that the guidance on early extinguishments of
debt in ASC 470-50-40-2 (which requires a gain or loss to be
recognized on the basis of the difference between the
reacquisition price and the net carrying amount of the
extinguished debt) applies to extinguishments that are
effected by the issuance of common stock. Under ASC
470-50-40-3, the reacquisition price of extinguished debt is
determined on the basis of the value of either the common
stock issued or the debt — whichever is more clearly
determinable.
View 2 — Conversion Accounting
Equity should be increased by the sum of the
carrying amounts of the debt host and bifurcated conversion
option liability, with no gain or loss recognized in
earnings.
Accordingly, A would recognize the following journal entry
upon conversion:
This view is based on the premise that ASC
470-20-40-4, which requires conversion accounting (i.e., no
gain or loss is recorded), applies to the conversion of the
debt instrument in accordance with its original terms. Thus,
ASC 470-20-40-4 would apply in this scenario since the debt
host and bifurcated conversion option liability were settled
in accordance with the original conversion privileges. Under
ASC 470-50-40-5, conversion accounting applies if a debt
instrument is tendered to exercise detachable warrants that
were originally issued with the debt, provided that the debt
is permitted to be tendered toward the warrants’ exercise
price under the terms of the securities at issuance. That
guidance, which does not specify that it applies only to
warrants classified in equity, supports the conclusion that
regardless of whether the debt host and the embedded
conversion option are considered to be separate for
accounting purposes, extinguishment accounting does not
apply (i.e., conversion accounting applies) if the
settlement of those instruments occurs in accordance with
the conversion privileges provided in the terms of the debt
at issuance. Consequently, the instrument’s form and that of
the conversion terms, rather than the accounting
classification, determines the appropriate accounting for
the conversion.
View 3 — Conversion Accounting With Immediate Expense
of Unamortized Discount
The remaining unamortized discount on the
debt host should be immediately recognized in earnings, and
then equity should be increased by the sum of the carrying
amounts of the debt host and the bifurcated conversion
option liability, with no additional gain or loss recognized
in earnings.
Accordingly, A would recognize the following journal entries
upon conversion:
This view is based on an analogy to the
guidance in (1) ASC 815-15-40-1 on the accounting for a
conversion of a debt instrument with a previously bifurcated
embedded conversion option in accordance with its original
conversion terms and (2) ASC 815-40-40-2 on the accounting
for a reclassification of a bifurcated derivative liability
to equity. Under ASC 815-40-40-2, any unamortized discount
on the debt host is immediately recorded to income, and then
the carrying amount of the liability is reclassified to
equity. Because the issuer meets the conditions for
classification of the embedded conversion option immediately
before settlement of the conversion, ASC 815-15-40-1 applies
to the settlement of the debt host and bifurcated conversion
option liability and ASC 815-40-40-2 specifies the treatment
of the reclassification of the embedded conversion option
liability. Therefore, the issuer reclassifies the bifurcated
conversion option liability to equity immediately before
accounting for the conversion as specified by ASC
815-15-40-1.
On the basis of our understanding of the views of the staff of the SEC’s OCA, we
believe that the SEC staff would not object to any of the three alternative views
discussed in the above example because (1) the guidance in GAAP does not
specifically address the issue and (2) each alternative view emanates from a
reasonable interpretation of analogous guidance. However, an entity should disclose
which view it applied and how that view affected its statement of financial
performance and results of operations.
Note that the analysis in the above example does not apply to a convertible debt
instrument with a bifurcated embedded conversion option that is converted into
common shares in accordance with its original conversion terms on the instrument’s
maturity date. On that date, there is no remaining unamortized discount on the debt
host, and the sum of the debt host and embedded conversion option would be expected
to equal the intrinsic value, if any, of the conversion right in the instrument.
12.5 Convertible Debt With a Separated Equity Component
ASC 815-15
40-1 If a
holder exercises a conversion option for which the carrying
amount has previously been reclassified to shareholders’
equity pursuant to paragraph 815-15-35-4, the issuer shall
recognize any unamortized discount remaining at the date of
conversion immediately as interest expense.
An equity component is recognized upon the issuance of a convertible debt instrument
at a substantial premium. In these situations, the liability for the convertible
debt instrument recognized at issuance would generally equal or closely approximate
the principal amount of the debt instrument. It is therefore appropriate to account
for the conversion of such an instrument in accordance with its original conversion
terms, as discussed in Section 12.3.2.
Even if a convertible debt instrument does not contain a separately
recognized equity component on the issuance date (i.e., a substantial premium does
not exist), an equity component may be recognized after issuance if the issuer (1)
reclassifies to equity an embedded conversion feature that was previously classified
as an embedded derivative liability or (2) modifies or exchanges the convertible
debt instrument in a transaction that does not result in extinguishment but in which
the fair value of the embedded conversion option is increased (see Section 10.4.3.3.1).
ASC 815-15-40-1 addresses the accounting for scenarios in which a convertible debt
instrument with a separate equity component that resulted from a previous
reclassification of the embedded conversion option from a liability to equity is
converted in accordance with the instrument’s original terms. Under that guidance,
any remaining unamortized discount upon conversion is immediately recognized as
interest expense.
A convertible debt instrument may contain an equity component that
resulted from a previous modification or exchange that increased the conversion
option’s fair value. The Codification does not specifically address the accounting
for any unamortized discount that remains on the conversion date if such an
instrument is converted into common stock in accordance with the instrument’s
original conversion terms. However, given its similarity to a separately recognized
equity component that resulted from a previous reclassification of the embedded
conversion option from a liability to equity, an entity should immediately amortize
any unamortized discount on the debt that remains on the instrument’s conversion
date in accordance with its original conversion terms and recognize such amount as
an expense.
Chapter 13 — Balance Sheet Classification
Chapter 13 — Balance Sheet Classification
13.1 Background
Many entities prepare a classified balance sheet in which assets and liabilities are
grouped on the basis of whether they are current or noncurrent. ASC 470-10 contains
guidance related to such classification, whereas ASC 210-10 contains more broadly
applicable requirements related to an entity’s classification of assets and
liabilities as either current or noncurrent.
13.2 Scope
13.2.1 Entities
ASC 210-10
05-4 . . .
The balance sheets of most entities show separate
classifications of current assets and current
liabilities (commonly referred to as classified balance
sheets) permitting ready determination of working
capital.
15-3 The
guidance in this Subtopic that relates to separate
classification of current assets and current liabilities
(that is, a classified balance sheet) applies only when
an entity is preparing a classified balance sheet for
financial accounting and reporting purposes.
The guidance in ASC 470-10 on the balance sheet classification of debt applies to
debtors that present a classified balance sheet, which (as indicated in ASC
210-10-05-4) includes most debtors. Further, Regulation S-X, Rule 5-02
(reproduced in ASC 210-10-S99-1), requires SEC registrants within the scope of
that rule (i.e., commercial and industrial companies) to present a classified
balance sheet when filing financial statements with the SEC. However, that
requirement does not apply to registered investment companies, employee stock
purchase, savings and similar plans, insurance companies, bank holding companies
and banks, brokers and dealers, and real estate entities.
13.2.2 Instruments
ASC 210-10 contains broadly applicable guidance on the classification of assets
and liabilities as current or noncurrent. Further, ASC 470-10 requires entities
to classify the following types of obligations as current or noncurrent on a
classified balance sheet:
-
Debt repayable on demand (see Section 13.4).
-
Long-term debt that includes covenants that, if violated, make the debt repayable (see Section 13.5).
-
Long-term obligations that contain a subjective acceleration clause (SAC) (see Section 13.6).
-
Short-term obligations expected to be refinanced on a long-term basis (see Section 13.7)
-
Revolving-credit arrangements, including those with lockbox arrangements (see Section 13.8).
-
Increasing-rate debt (see Section 13.9).
For discussion of the application of the classification guidance to convertible
debt, see Section 13.10.
13.3 General
13.3.1 Background
To determine whether debt should be classified as current or
noncurrent, an entity must apply the guidance in ASC 470-10 and ASC 210-10.
13.3.2 Debt Classification Guidance in ASC 470-10
ASC 470-10 does not establish a uniform principle for classifying debt as current
or noncurrent; 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.
Accordingly, the following types of debt must be classified as current
liabilities unless (1) their settlement will not require the use of current
assets or the creation of other current liabilities (see Section
13.3.3.4) or (2) a specific exception applies:
-
Debt that is contractually scheduled to mature within one year (or the operating cycle, if longer) after the balance sheet date (see Section 13.3.4.2).
-
Any portion of long-term debt that is contractually scheduled to mature within one year (or the operating cycle, if longer) after the balance sheet date, such as the current portion of an amortizing loan for which the principal is paid down over the loan’s life (see Section 13.3.3.4).
- Debt that contractually is due on demand as of the balance sheet date or that will become payable on demand within one year (or the operating cycle, if longer) after the balance sheet date, including puttable debt (see Section 13.4) and debt that has become payable on demand because of a covenant violation (see Section 13.5).
However, short-term obligations are classified as noncurrent liabilities if:
-
A debtor has violated an objectively verifiable debt covenant as of the balance sheet date that makes an otherwise long-term obligation due on demand or payable on demand within one year of the balance sheet date and the creditor grants a waiver before the financial statements are issued (or available to be issued) or a grace period applies (see Section 13.5.3).
-
A debtor has the intent and ability to refinance a short-term obligation on a long-term basis (see Section 13.7).
In some scenarios, a debtor is required to consider expectations about whether
the creditor will accelerate a debt’s due date. If long-term debt contains a SAC
and is not payable on demand or within one year (or the operating cycle, if
longer) after the balance sheet date, the debtor must evaluate whether the SAC
is likely to be invoked to determine whether the debt is classified as current
or noncurrent (see Section 13.6). Further,
special guidance applies to revolving debt with a lockbox arrangement (see
Section 13.8) and to increasing-rate
debt (see Section 13.9), and there are
some unique issues associated with the treatment of convertible debt (see
Section 13.10). For a discussion of
the classification of long-term obligations that are repaid or that the debtor
intends to repay after the balance sheet date, see Section 13.11.
Debt that is contractually scheduled to mature beyond one year after the balance
sheet date is presented as noncurrent unless any of the following exceptions
apply:
-
The debt is due on demand or will become due on demand within one year of the balance sheet date (see Section 13.4) unless the debtor has the intent and ability to refinance the debt on a long-term basis (see Section 13.7).
-
A covenant violation has occurred that causes the debt to become repayable within one year of the balance sheet date (see Sections 13.3.4.5 and 13.5) unless (1) the creditor grants a waiver before the financial statements are issued (or available to be issued), (2) a grace period applies (see Section 13.5.3), or (3) the debtor has the intent and ability to refinance the debt on a long-term basis (see Section 13.7).
-
The debt contains a subjective acceleration clause that is likely to be triggered (see Sections 13.3.4.6 and 13.6) unless the debtor has the intent and ability to refinance the debt on a long-term basis (see Section 13.7).
-
Other facts and circumstances suggest that the debt should be classified as current (see Section 13.5.2.2).
The table below provides an
overview of the classification of different types of debt as current or
noncurrent under ASC 210-10 and ASC 470-10. Note, however, that the appropriate
classification depends on the application of GAAP to the specific facts and
circumstances.
|
Noncurrent
|
Current1
|
|---|---|
|
|
13.3.3 Classification Guidance in ASC 210-10
13.3.3.1 Background
ASC 210-10
05-4 The Overall Subtopic
provides general guidance on the classification of
current assets and current liabilities and discusses
the determination of working capital. The balance
sheets of most entities show separate
classifications of current assets and current
liabilities (commonly referred to as classified
balance sheets) permitting ready determination of
working capital.
The sections below briefly summarize the various definitions
and guidance in ASC 210-10 that could be relevant to the classification of
debt as current or noncurrent.
13.3.3.2 Working Capital
ASC Master Glossary
Working Capital
Working capital (also called net working capital) is
represented by the excess of current assets over
current liabilities and identifies the relatively
liquid portion of total entity capital that
constitutes a margin or buffer for meeting
obligations within the ordinary operating cycle of
the entity.
ASC 210-10
05-5 Financial position,
as it is reflected by the records and accounts from
which the statement is prepared, is revealed in a
presentation of the assets and liabilities of the
entity. In the statements of manufacturing, trading,
and service entities, these assets and liabilities
are generally classified and segregated; if they are
classified logically, summations or totals of the
current or circulating or working assets (referred
to as current assets) and of obligations currently
payable (designated as current liabilities) will
permit the ready determination of working
capital.
The classification of assets and liabilities as current is intended to permit
a financial statement user to readily determine an entity’s working capital.
In practice, metrics and ratios that are computed on the basis of balance
sheet measures of working capital or components thereof are often used in
financial statement analysis and referenced in debt covenants.
13.3.3.3 Operating Cycle
ASC Master Glossary
Operating Cycle
The average time intervening between the acquisition
of materials or services and the final cash
realization constitutes an operating cycle.
ASC 210-10
05-6 The ordinary
operations of an entity involve a circulation of
capital within the current asset group. Cash is
expended for materials, finished parts, operating
supplies, labor, and other factory services, and
such expenditures are accumulated as inventory cost.
Inventory costs, upon sale of the products to which
such costs attach, are converted into trade
receivables and ultimately into cash again.
45-3 A one-year time
period shall be used as a basis for the segregation
of current assets in cases where there are several
operating cycles occurring within a year. However,
if the period of the operating cycle is more than 12
months, as in, for instance, the tobacco,
distillery, and lumber businesses, the longer period
shall be used. If a particular entity has no clearly
defined operating cycle, the one-year rule shall
govern.
Most entities use a one-year period as the basis for distinguishing between
current and noncurrent items. Under ASC 210-10-45-3, an entity that has no
clearly defined operating cycle or more than one operating cycle within a
year must use the one-year time frame. However, if the entity’s operating
cycle is greater than one year, it should base the distinction on the
operating cycle. ASC 210-10-45-3 suggests that a period longer than a year
may be appropriate, for example, in the tobacco, distillery, and lumber
businesses. The operating cycle is the average amount of time it takes an
entity to acquire materials or services, convert those items into finished
goods or services, and collect cash from the sale of those goods or
services.
13.3.3.4 Current Assets and Current Liabilities
ASC Master Glossary
Current Assets
Current assets is used to designate cash and other
assets or resources commonly identified as those
that are reasonably expected to be realized in cash
or sold or consumed during the normal operating
cycle of the business. See paragraphs 210-10-45-1
through 45-4.
Current Liabilities
Current liabilities is used principally to designate
obligations whose liquidation is reasonably expected
to require the use of existing resources properly
classifiable as current assets, or the creation of
other current liabilities. See paragraphs
210-10-45-5 through 45-12.
ASC 210-10
Obligations in the Operating Cycle
45-8 As a balance sheet
category, the classification of current liabilities
generally includes obligations for items that have
entered into the operating cycle, such as the
following:
-
Payables incurred in the acquisition of materials and supplies to be used in the production of goods or in providing services to be offered for sale.
-
Collections received in advance of the delivery of goods or performance of services. Examples of such current liabilities are obligations resulting from advance collections on ticket sales, which will normally be liquidated in the ordinary course of business by the delivery of services. On the contrary, obligations representing long-term deferments of the delivery of goods or services would not be shown as current liabilities. Examples of the latter are the issuance of a long-term warranty or the advance receipt by a lessor of rental for the final period of a 10 year lease as a condition to execution of the lease agreement.
-
Debts that arise from operations directly related to the operating cycle, such as accruals for wages, salaries, commissions, rentals, royalties, and income and other taxes.
Other Liabilities
45-9 Other liabilities
whose regular and ordinary liquidation is expected
to occur within a relatively short period of time,
usually 12 months, are also generally included, such
as the following:
-
Short-term debts arising from the acquisition of capital assets
-
Serial maturities of long-term obligations
-
Amounts required to be expended within one year under sinking fund provisions
-
Agency obligations arising from the collection or acceptance of cash or other assets for the account of third persons. Loans accompanied by pledge of life insurance policies would be classified as current liabilities if, by their terms or by intent, they are to be repaid within 12 months. The pledging of life insurance policies does not affect the classification of the asset any more than does the pledging of receivables, inventories, real estate, or other assets as collateral for a short-term loan. However, when a loan on a life insurance policy is obtained from the insurance entity with the intent that it will not be paid but will be liquidated by deduction from the proceeds of the policy upon maturity or cancellation, the obligation shall be excluded from current liabilities.
Because the definition of working capital (see Section 13.3.3.2) refers to an entity’s operating cycle (see
Section 13.3.3.3), current assets
are limited to those assets that are “reasonably expected to be realized in
cash or sold or consumed during the normal operating cycle of the business.”
Similarly, current liabilities are limited to those obligations “that have
entered into the operating cycle,” such as payables for goods or services
that are used in the entity’s production process (see ASC 210-10-45-8), or
“whose regular and ordinary liquidation is expected to occur within a
relatively short period of time,” such as short-term debt and the current
portion of long-term obligations (see ASC 210-10-45-9).
In the application of this guidance to debt obligations, a debtor must comply
with the more specific requirements in ASC 470-10. As discussed in Section 13.3.2, debt that is 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 is
generally classified as a current liability under ASC 470-10 even if it is
not expected to be settled within a relatively short period.
Current liabilities are limited to obligations whose settlement is
“reasonably expected to require the use of existing resources properly
classifiable as current assets, or the creation of other current
liabilities.” Accordingly, short-term obligations that must be settled in
the debtor’s nonredeemable equity shares (e.g., certain mandatorily
convertible shares) do not meet the definition of current liabilities.
13.3.3.5 Funds Set Aside for the Liquidation of Long-Term Debt
ASC 210-10
45-4 The concept of the
nature of current assets contemplates the exclusion
from that classification of such resources as the
following:
- Cash and claims to cash that are restricted as to withdrawal or use for other than current operations, are designated for expenditure in the acquisition or construction of noncurrent assets, or are segregated for the liquidation of long-term debts. Even though not actually set aside in special accounts, funds that are clearly to be used in the near future for the liquidation of long-term debts, payments to sinking funds, or for similar purposes shall also, under this concept, be excluded from current assets. However, if such funds are considered to offset maturing debt that has properly been set up as a current liability, they may be included within the current asset classification. . . .
45-12 The current
liability classification is not intended to include
debts to be liquidated by funds that have been
accumulated in accounts of a type not properly
classified as current assets, or long-term
obligations incurred to provide increased amounts of
working capital for long periods.
If a debtor segregates funds for the purpose of settling long-term debt, those funds should be classified as noncurrent assets in accordance with ASC 470-10-45-4(a). Footnote 1 of FASB Statement 6 (not codified) indicates that
“funds obtained on a long-term basis prior to the balance sheet date would
be excluded from current assets if the obligation to be liquidated is
excluded from current liabilities.” However, funds that are set aside to pay
a current liability would be classified as current assets.
13.3.4 Other Key Terms
13.3.4.1 Background
This section discusses key terms in ASC 470-10 that are used to determine the
appropriate classification of debt as current or noncurrent.
13.3.4.2 Short-Term Obligations
ASC Master Glossary
Short-Term Obligations
Short-term obligations are those that are scheduled
to mature within one year after the date of an
entity’s balance sheet or, for those entities that
use the operating cycle concept of working capital
described in paragraphs 210-10-45-3 and 210-10-45-7,
within an entity’s operating cycle that is longer
than one year.
A short-term obligation is one that is “scheduled to mature within one year”
(or the operating cycle, if longer) after the balance sheet date. It also
includes any portion of long-term debt that is contractually scheduled to
mature within one year (or the operating cycle, if longer) after the balance
sheet date, such as the current portion of an amortizing loan for which the
principal is paid down over the loan’s life (see Section 13.3.3.4). Under ASC 470-10-45-14, an obligation
that is repayable on demand or within one year (or the operating cycle, if
longer) after the balance sheet date would also be a short-term obligation
(see Section 13.4). Similarly, an
obligation that has become repayable on demand or within one year (or the
operating cycle, if longer) after the balance sheet date because of a
covenant violation would be a short-term obligation under that guidance (see
Section 13.5). The term
“short-term obligation” does not have the same meaning as “current
liability” because some short-term obligations qualify as noncurrent
liabilities in accordance with the guidance on refinancing arrangements and
covenant waivers.
13.3.4.3 Long-Term Obligations
ASC Master Glossary
Long-Term Obligations
Long-term obligations are those scheduled to mature
beyond one year (or the operating cycle, if
applicable) from the date of an entity’s balance
sheet.
Under ASC 470-10, a long-term obligation is one that is “scheduled to mature
beyond one year” (or the operating cycle, if longer) after the balance sheet
date. It excludes any portion of long-term debt that is contractually
scheduled to mature within one year (or the operating cycle, if longer)
after the balance sheet date, such as the current portion of an amortizing
loan for which the principal is paid down over the loan’s life (see
Section 13.3.3.4). Under ASC
470-10-45-2, an obligation that is repayable on demand or within one year
(or the operating cycle, if longer) after the balance sheet date would not
be considered a long-term obligation (see Section
13.4). Similarly, an obligation that has become repayable on
demand or within one year of the balance sheet date (or the operating cycle,
if longer) because of a covenant violation would not be considered a
long-term obligation (see Section
13.5). The term “long-term obligation” does not have the same
meaning as “noncurrent liability” because some long-term obligations must be
classified as current liabilities (see Section
13.6).
13.3.4.4 Callable Obligations
ASC Master Glossary
Callable Obligation
An obligation is callable at a given date if the
creditor has the right at that date to demand, or to
give notice of its intention to demand, repayment of
the obligation owed to it by the debtor.
ASC 470-10 describes an obligation as “callable” if “the creditor has the
right at that date to demand, or to give notice of its intention to demand,
repayment.” In practice, such debt is often described as debt with an
embedded put option or a demand or acceleration feature. Further, ASC 815
describes such a feature as a put option, not as a call option (see, for
example, ASC 815-15-55-26 through 55-53). Under ASC 815, an embedded call
option is an option held by the debtor, not the creditor (see, for example,
ASC 815-15-25-37 and 25-38, and ASC 815-15-25-43). To reduce the potential
for confusion related to the terminological inconsistency between ASC 470-10
and ASC 815-15, this Roadmap generally refers to debt that is described as
callable under ASC 470-10 as debt with a demand or put feature (see also
Section 13.4.2).
13.3.4.5 Violation of a Provision
ASC Master Glossary
Violation of a Provision
The failure to meet a condition in a debt agreement
or a breach of a provision in the agreement for
which compliance is objectively determinable,
whether or not a grace period is allowed or the
creditor is required to give notice of its intention
to demand repayment.
ASC 470-10
45-12 Drawing a
distinction between significant violations of
critical conditions and technical violations is not
practicable. A violation that a debtor considers to
be technical may be considered critical by the
creditor. Furthermore, a creditor may choose to use
a technical violation as a means to withdraw from
its lending relationship with the debtor. If the
violation is considered insignificant by the
creditor, then the debtor should be able to obtain a
waiver as discussed in the preceding paragraph.
ASC 470-10-45-11 provides two exceptions to the requirements related to
current classification (see Section 13.5.3). The
reference in that guidance to a debtor’s “violation of a provision” includes
any objectively determinable provision that accelerates the debt’s maturity
date or otherwise makes the debt payable on demand (or will make the debt
payable on demand unless cured within a specified grace period) to protect
the creditor from an adverse issuer-specific credit event. In practice, the
contractual terms of debt arrangements often describe such covenant
violations as events of default. Examples of debt covenants that, if
violated, may cause debt to be repayable on demand include those related to:
-
Working capital requirements.
-
Minimum current ratios.
-
Maximum debt-to-equity ratios.
-
The issuance of an unqualified audit opinion (e.g., within 90 days of year-end).
-
Bankruptcy prohibitions.
Whether a credit deterioration occurs in connection with a
specific provision that was violated is not relevant. For example, an event
of default may not actually be related to a deterioration in the debtor’s
credit. That is, to apply the exceptions in ASC 470-10-45-11, a debtor does
not have to establish that an event that results in the debt’s becoming
payable on demand is associated with a decline in the debtor’s credit
standing. However, the provision that was violated must be related to
credit. For example, the exceptions in ASC 470-10-45-11 would not apply to
provisions under which (1) debt becomes callable solely on the basis of
passage of time or (2) cash-settleable convertible debt becomes convertible
if a stock price target is triggered because both provisions are unrelated
to the borrower’s credit risk. In those situations, debt that is payable on
demand on the balance sheet date would be classified as a current liability
regardless of whether the redemption provision lapses before the financial
statements are issued or available to be issued unless the debtor meets the
exception for certain refinancing arrangements (see Section 13.7).
ASC 470-10-45-11 does not distinguish between significant
covenant violations and minor technical violations that can be easily
corrected. In accordance with ASC 470-10-45-12, distinguishing between those
two types of violations is not practicable.
Example 13-1
Debt Callable as a Result of a Change in
Control
On December 15, 20X2, Company ABC issued a 10-year
debt instrument that contains a change-in-control
provision. Under the terms of the debt instrument,
the lender has the ability to demand repayment of
the debt upon the occurrence of a change-in-control
event. However, the lender’s ability to demand
repayment of the debt expires 45 days from the date
of the change-in-control event. The debt agreement
does not define a change-in-control event as an
event of default.
On December 16, 20X4, Company XYZ acquires ABC,
triggering a change-in-control event. As a result,
on that date and as of ABC’s December 31, 20X4,
balance sheet date, the debt was repayable on
demand. However, as of February 1, 20X5 (46 days
later), the lender had not requested repayment of
the debt, and the demand feature therefore expired
unexercised. In addition, as of February 1, 20X5,
ABC’s financial statements as of and for the year
ended December 31, 20X4, were not yet issued (or
available to be issued, as discussed in ASC
855-10).
Company ABC has determined that the purpose of the
change-in-control feature was to protect the lender
from potential adverse credit-related events that
could result from a change of control. Therefore,
ABC concludes that ASC 470-10-45-11 applies to the
change-in-control provision.
As long as ABC is able to objectively and
unconditionally determine that the lender’s ability
to demand repayment of the debt has lapsed as of or
before the date the 20X4 financial statements are
issued (or available to be issued), ABC would
classify the debt as noncurrent on its balance
sheet.
Example 13-2
Debt Repayable on Lender’s Demand
On December 15, 20X2, Company SCP issued a 10-year
debt instrument that allows the lender to demand
repayment of the debt three years after the original
issuance date. However, the lender’s ability to
demand repayment of the debt expires 60 days from
the third anniversary of the debt instrument’s
issuance date.
On December 15, 20X5 (the third anniversary of the
debt’s issuance date), and as of SCP’s December 31,
20X5, balance sheet date, the debt instrument was
payable on demand. On February 14, 20X6, the
lender’s right to demand repayment of the debt
expired unexercised. In addition, as of February 14,
20X6, the financial statements of SCP as of and for
the year ended December 31, 20X5, were not yet
issued (or available to be issued, as discussed in
ASC 855-10).
Company SCP has determined that the purpose for
including the feature in the debt instrument is
unrelated to potential adverse credit-related
events, and it therefore concludes that applying ASC
470-10-45-11 to the feature is not appropriate.
Accordingly, because SCP’s debt is repayable on
demand as of the balance sheet date, it would be
classified as a current liability under ASC
470-10-45-10 even though the lender ultimately did
not exercise its right (see Section 13.4).
The guidance in ASC 470-10-45-11 related to objectively determinable covenant
violations differs from that for SACs. Whereas the likelihood that the
creditor will demand repayment is a factor in the evaluation of whether a
SAC that has not been invoked triggers current classification of a long-term
obligation, such likelihood usually does not affect the analysis of an
objectively determinable covenant that has not been violated (see
Section 13.5.2.2).
Nevertheless, the likelihood of a repayment demand is a factor in an entity’s
evaluation of whether it can apply one of the exceptions to current
classification for an objectively determinable covenant that has been
violated. That is, before it can apply the covenant waiver exception, a
debtor must assess whether it will comply with the covenant as of
measurement dates that are within the next 12 months (see Section
13.5.3.3). Likewise, before it can apply the grace period
exception, a debtor must assess whether it is probable that it will cure the
violation within the grace period (see Section
13.5.3.4).
13.3.4.6 Subjective Acceleration Clauses
ASC Master Glossary
Subjective Acceleration Clause
A subjective acceleration clause is a provision in a
debt agreement that states that the creditor may
accelerate the scheduled maturities of the
obligation under conditions that are not objectively
determinable (for example, if the debtor fails to
maintain satisfactory operations or if a material
adverse change occurs).
The contractual terms of debt obligations often include some debt covenants
that are objectively determinable (e.g., nonpayment of a debt obligation)
and others that require a subjective evaluation (e.g., failure to maintain
satisfactory operations or a material adverse change). A SAC is a
contractual term in a debt agreement that permits the creditor to accelerate
the repayment of the debt under conditions that are not objectively
determinable. A subjective cancellation clause (which is also considered a
SAC and referred to as such herein) is a contractual term in a financing
agreement that permits the potential creditor or investor to terminate the
financing agreement on terms that are not objectively determinable.
A subjective condition is one that may be evaluated differently by the
parties to the agreement. Examples of subjective conditions include the following:
-
At all times, the debtor’s financial condition and results of operations must be satisfactory to the creditor.
-
There will be an event of default if there is a material impairment of the collateral on a debt obligation (and “material” is not objectively defined).
-
The creditor must have reasonably determined that any event that materially adversely affects a debt instrument’s collectibility has not occurred (i.e., a material adverse change clause).
-
A deterioration has taken place in the quality of the servicing of receivables used as collateral on a debt instrument that the creditor, in its sole discretion, determines to be material.
An objectively determinable condition is one that would not
be evaluated differently by the parties to the agreement. Examples include
but are not limited to specified financial ratios, a change-of-control
provision based on a specified percentage change in capital ownership of the
debtor, and the occurrence of particular events (bankruptcy, restatements,
going-concern audit opinions, etc.). If a debt contract defines an adverse
change in an objectively determinable manner (e.g., a maximum decrease in
reported earnings), it would be considered an objectively determinable
condition.
Some debt and financing agreements (e.g., revolving-debt agreements) contain
a material adverse change clause that applies only upon the initial
execution of the agreement. For example, a creditor might require a debtor
to represent that no material adverse change has occurred in the period
between the most recent financial statements and the initial execution of
the agreement as a precondition for entering into the agreement. However,
the agreement might not give the creditor a right to demand repayment or
cancel the agreement if the debtor experiences a material adverse change
after the agreement’s initial execution. In this case, the agreement does
not contain a subjective acceleration or cancellation provision since it
does not permit the creditor to demand repayment or cancel the agreement
unless it can demonstrate that the debtor’s initial representation was
false. Conversely, an agreement is considered to contain a subjective
acceleration or cancellation clause if the creditor is able to demand
repayment or reject a funding request if it determines that a material
adverse change has occurred after the initial execution of the agreement.
For example, a financing agreement would be considered to contain a
subjective cancellation provision if it requires the debtor to represent
that no material adverse change has occurred each time it borrows under the
agreement.
An acceleration or cancellation clause in a debt or financing agreement may
include both objectively determinable and subjective conditions that must be
met before the creditor is permitted to demand repayment or cancel the
agreement. For example, a financing agreement might require the debtor to
represent that it has not, without the creditor’s prior written consent,
amended, restated, or otherwise modified any contracts that serve as
collateral under the agreement in a manner that would reasonably be expected
to have a material adverse effect. Such a clause should be evaluated as an
objectively determinable condition under ASC 470-10 since the creditor
cannot demand repayment or cancel the agreement unless the objectively
determinable condition is met (i.e., the debtor has amended, restated, or
otherwise modified such contracts without the creditor’s prior written
consent).
13.3.4.7 “Traditional” Lockbox Arrangement
ASC Master Glossary
Lock-Box Arrangement
An arrangement with a lender whereby the borrower’s
customers are required to remit payments directly to
the lender and amounts received are applied to
reduce the debt outstanding. A lock-box arrangement
refers to any situation in which the borrower does
not have the ability to avoid using working capital
to repay the amounts outstanding. That is, the
contractual provisions of a loan arrangement require
that, in the ordinary course of business and without
another event occurring, the cash receipts of a
debtor are used to repay the existing
obligation.
ASC 470-10
45-5A The term lock-box
arrangement as used in this guidance refers to
any situation in which the borrower does not have
the ability to avoid using working capital to repay
the amounts outstanding. That is, if the contractual
provisions of a loan arrangement require that, in
the ordinary course of business and without another
event occurring, the cash receipts of a debtor be
used to repay the existing obligation, the credit
agreement shall be considered a short-term
obligation.
The terms of some debt obligations contain a “lockbox” arrangement under
which the debtor’s customers submit payments for goods or services directly
to a special collection account maintained by the creditor. In a
“traditional” lockbox arrangement, payments to the lockbox are automatically
applied to reduce the outstanding debt. Therefore, a debt arrangement that
incorporates a traditional lockbox arrangement is considered a short-term
obligation under ASC 470-10 even if the final maturity of the debt is not
within one year (or the operating cycle, if longer) after the balance sheet
date (see Section 13.8.3.1). In a revolving-debt
arrangement, the contractual terms usually permit the debtor to request
additional borrowings so that the outstanding balance due under the
arrangement remains unchanged (i.e., the debtor draws an amount equal to the
daily cash receipts). To determine the appropriate classification of such
debt, the debtor must evaluate the right to request additional borrowings
under the guidance on refinancing arrangements (see Sections
13.7.4 and 13.8.3.3).
Connecting the Dots
A contractual provision might meet the definition of a lockbox
arrangement even if the terms of the debt do not explicitly refer to
it as a lockbox. For example, a contract might refer to a lockbox as
a blocked collection account or a deposit account control
agreement.
13.3.4.8 Springing Lockbox Arrangement
ASC Master Glossary
Springing Lock-Box Arrangement
Some borrowings outstanding under a revolving credit
agreement include both a subjective acceleration
clause and a requirement to maintain a springing
lock-box arrangement, whereby remittances from the
borrower’s customers are forwarded to the debtor’s
general bank account and do not reduce the debt
outstanding until and unless the lender exercises
the subjective acceleration clause.
In a springing lockbox arrangement, the debtor has full access to amounts
collected from its customers. The creditor is not entitled to the payments,
although such amounts may be subject to a security interest in the
creditor’s favor. If a triggering event occurs (e.g., the debtor does not
pay its debts on time or the creditor exercises a SAC), the arrangement
becomes a traditional lockbox under which the payments received from
customers are automatically applied to reduce the debtor’s outstanding debt.
A springing lockbox arrangement does not prevent a debt instrument from
being treated as a long-term obligation (see Section
13.8.3.2).
13.3.4.9 Financial Statements Are Issued (or Available to Be Issued)
ASC Master Glossary
Financial Statements Are Available to Be
Issued
Financial statements are considered available to be
issued when they are complete in a form and format
that complies with GAAP and all approvals necessary
for issuance have been obtained, for example, from
management, the board of directors, and/or
significant shareholders. The process involved in
creating and distributing the financial statements
will vary depending on an entity’s management and
corporate governance structure as well as statutory
and regulatory requirements.
Financial Statements Are Issued
Financial statements are considered issued when they
are widely distributed to shareholders and other
financial statement users for general use and
reliance in a form and format that complies with
GAAP. (U.S. Securities and Exchange Commission [SEC]
registrants also are required to consider the
guidance in paragraph 855-10-S99-2.)
ASC 855-10 — SEC Materials — SEC
Staff Guidance
Announcements
Made by SEC Staff at Emerging Issues Task Force
(EITF) Meetings
SEC Staff Announcement: Issuance of
Financial Statements
S99-2 The following is the
text of SEC Staff Announcement: Issuance of
Financial Statements.
In considering
when financial statements have been issued, the SEC
staff observed that Rules 10b-5 and 12b-20 under the
Securities Exchange Act of 1934 and General
Instruction C(3) to Form 10-K specify that financial
statements must not be misleading as of the date
they are filed with the Commission. For example,
assume that a registrant widely distributes its
financial statements but, before filing them with
the Commission, the registrant or its auditor
becomes aware of an event or transaction that
existed at the date of the financial statements that
causes those financial statements to be materially
misleading. If a registrant does not amend those
financial statements so that they are free of
material misstatement or omissions when they are
filed with the Commission, the registrant will be
knowingly filing a false and misleading document. In
addition, registrants are reminded of their
responsibility to, at a minimum, disclose subsequent
events,FN1 while independent auditors
are reminded of their responsibility to assess
subsequent eventsFN2 and evaluate the
impact of the events or transactions on their audit
report.FN3
A registrant
and its independent auditor have responsibilities
with regard to post-balance-sheet-date subsequent
events, as well as the application of authoritative
literature applicable to such events. See Topic 855
and AU 560, Subsequent Events, paragraph 3.
Generally, the
staff believes that financial statements are
“issued” as of the date they are distributed for
general use and reliance in a form and format that
complies with generally accepted accounting
principles (GAAP) and, in the case of annual
financial statements, that contain an audit report
that indicates that the auditors have complied with
generally accepted auditing standards (GAAS) in
completing their audit. Issuance of financial
statements then would generally be the earlier of
when the annual or quarterly financial statements
are widely distributed to all shareholders and other
financial statement usersFN4 or filed
with the Commission. Furthermore, the issuance of an
earnings release does not constitute issuance of
financial statements because the earnings release
would not be in a form and format that complies with
GAAP and GAAS.
_____________________
FN1 See AU Section 560,
Subsequent Events, paragraphs 5 and 8 and Section
855-10-50.
FN2 See AU 560 and AU
Section 561, Subsequent Discovery of Facts Existing
at Date of the Auditor’s Report.
FN3 See AU Section 530,
Dating of the Independent Auditor’s Report, and AU
560, paragraph 9.
FN4 Posting financial
statements to a registrant’s web site would be
considered wide distribution to all shareholders and
other financial statement users if the registrant
uses its web site to disclose information to the
public in a manner consistent with the requirements
of Regulation FD. See the Commission’s interpretive
guidance in Exchange Act Release No. 58288 (Aug. 7,
2008).
Some of the guidance in ASC 470-10 refers to the date on which the financial
statements are “issued” or “available to be issued” (e.g., the guidance on
refinancing arrangements in ASC 470-10-45-14 discussed in Section 13.7), as those terms are defined in
ASC 855-10. Financial statements are considered available to be issued when
they have been completed in a form and format that complies with GAAP and
all necessary approvals for issuance have been obtained. Generally,
financial statements are considered issued when they are widely distributed
for general use in a form and format that complies with GAAP. For an SEC
registrant, financial statements are generally considered issued on the
earlier of the date on which they are (1) widely distributed to all
shareholders and other financial statement users or (2) filed with the
SEC.
Footnotes
1
Unless an item must be classified as noncurrent
because the refinancing exception discussed in
Section 13.7
applies.
13.4 Debt With Early Settlement Feature
13.4.1 Background
This section discusses the classification of debt with early settlement features
(such as put and call options), including debt with provisions that (1) permit
the creditor to demand early repayment (see the next section), (2) contingently
accelerate the maturity date or contingently permit the debtor to demand early
repayment (see Section
13.4.3), or (3) permit the debtor to prepay the amount
outstanding (see Section
13.4.4). For a discussion of credit-related early settlement
features with contingencies, see Section 13.5.
13.4.2 Provisions That Permit the Creditor to Demand Early Repayment
ASC 470-10
45-9 Loan agreements may
specify the debtor’s repayment terms but also enable the
creditor, at his discretion, to demand payment at any
time. Those loan arrangements may have wording such as
either of the following:
-
“The term note shall mature in monthly installments as set forth therein or on demand, whichever is earlier.”
-
“Principal and interest shall be due on demand, or if no demand is made, in quarterly installments beginning on. . . .”
45-10 The current liability
classification shall include obligations that, by their
terms, are due on demand or will be due on demand within
one year (or operating cycle, if longer) from the
balance sheet date, even though liquidation may not be
expected within that period. The demand provision is not
a subjective acceleration clause as discussed in
paragraph 470-10-45-2.
Except for certain obligations that are expected to be
refinanced on a long-term basis (see Section 13.7), debt that is due on demand
or that will become payable on demand within one year after the balance sheet
date (or the operating cycle, if longer) should be classified as current even if
it is not expected to be repaid within that period. For example, an obligation
that is scheduled to mature more than one year after the balance sheet date may
contain an embedded put option that permits the investor to put the debt to the
issuer at any time or on one or more dates within the next 12 months in exchange
for the repayment of the principal and interest amounts owed. Such debt would be
classified as current under ASC 470-10-45-10 unless it meets the conditions for
debt that is expected to be refinanced on a long-term basis (see Section 13.7). An entity
should generally treat debt that is repayable upon the occurrence or
nonoccurrence of an event that is within the creditor’s control as debt that is
due on demand.
13.4.3 Provisions That Require or Permit the Creditor to Demand Early Payment Upon a Non-Credit-Related Contingent Event
Some debt obligations become immediately due and payable, or
payable within one year (or the operating cycle, if longer) after the balance
sheet date, upon the occurrence or nonoccurrence of a specified event that is
beyond the control of the creditor. For example, debt may contain a put option
or redemption feature that is activated upon the occurrence or nonoccurrence of
a specified event (e.g., a fundamental change, a change of control, a ratings
downgrade, delisting, or the loss of a business license or permit) or on the
basis of quantitative criteria (e.g., related to the debtor’s stock price,
debt-to-equity ratio, working capital, or other financial ratios).
If the contingency that causes the debt to become repayable is met as of the
balance sheet date and is not credit-related, such debt obligations are analyzed
as debt that is due on demand or within one year (or the operating cycle, if
longer) after the balance sheet date (see the previous section). If, as a result
of a discrete event that occurred after the balance sheet date, the contingency
is not credit-related and is not met as of the balance sheet date but is met
before the financial statements are issued (or available to be issued), it is
acceptable to treat the debt as a long-term obligation. For example, noncurrent
classification would be appropriate if the triggering event was within the
debtor’s control (e.g., the entity’s decision to sell certain assets after the
balance sheet date). In that scenario, the debtor should disclose an
acceleration of the debt’s due date as a nonrecognized subsequent event under
ASC 855-10.
If the contingency is credit-related, the debtor should apply
the guidance in ASC 470-10-45-11 on covenant violations that cause the debt to
become repayable (see Section
13.5) regardless of whether the covenant violation occurred (1)
as of the balance sheet date or (2) after the balance sheet date but before the
financial statements were issued (or available to be issued).
13.4.4 Provisions That Permit the Debtor to Pay Early
Some debt obligations contain call or prepayment options that permit the debtor
to prepay the obligation before its maturity date (e.g., at any time, on
specified dates, or upon the occurrence or nonoccurrence of a specified event).
Generally, such options do not affect the classification of debt as current or
noncurrent before it is exercised since the debtor has discretion over whether
to exercise the options and could not be contractually forced to repay the debt
early because of them. However, if the debtor irrevocably exercises a call or
prepayment option before or as of the balance sheet date, the related debt
should be classified as current if the debt’s repayment will occur within one
year (or the operating cycle, if longer) after the balance sheet date. If the
debtor exercises a call or prepayment option after the balance sheet date, it
should disclose that fact as a nonrecognized subsequent event.
13.5 Credit-Related Covenant Violations That Cause Debt to Become Repayable
13.5.1 General
ASC 470-10
45-11 Current liabilities
shall include long-term obligations that are or will be
callable by the creditor either because the debtor’s
violation of a provision of the debt agreement at the
balance sheet date makes the obligation callable or
because the violation, if not cured within a specified
grace period, will make the obligation callable. . .
.
If an entity violates an objectively determinable covenant on a long-term debt
arrangement, the contractual terms might accelerate the debt’s due date or give
the creditor the right to accelerate the debt’s due date. Long-term debt that
has become payable on demand or within one year (or the operating cycle, if
longer) after the balance sheet date because of a covenant violation that has
occurred as of the balance sheet date or, in the case of credit-related
covenants, after the balance sheet date but before the financial statements are
issued (or available to be issued) (see Section 13.5.2.2)
generally must be classified as current. This is the case even if the creditor
has not demanded repayment and there is no indication that it will do so.
However, a credit-related covenant violation in a long-term obligation does not
trigger current classification if one of the following exceptions in ASC 470-10 applies:
-
Covenant waiver — The debtor obtains a covenant waiver that meets the requirements in ASC 470-10-45-1 and ASC 470-10-45-11(a) before the financial statements are issued or are available to be issued (see Sections 13.5.3.2 and 13.5.3.3).
-
Grace period — The debt contains a grace period and it is probable that the violation will be cured within such period (see ASC 470-10-45-11(b) and Section 13.5.3.4).
-
Refinancing arrangement — The debtor has the intent and ability to refinance the obligation on a long-term basis (see Section 13.7).
To apply the exceptions in ASC 470-10-45-11 that address
covenant waivers and grace periods, an entity must ensure that the violated
provision is related to credit (see Section
13.3.4.5). The exception for refinancing arrangements applies
irrespective of whether the event is associated with credit. For a discussion of
the analysis of covenant violations that are not credit-related, see Section 13.4.3.
13.5.2 Scope
13.5.2.1 Background
This section discusses credit-related covenant violations
that occur after the balance sheet date but before the financial statements
are issued or available to be issued (see the next section), debt
modifications that are made to avoid a covenant violation (see Section 13.5.2.3),
and credit-related covenant violations that are cured before the financial
statements are issued or available to be issued (see Section
13.5.2.4).
13.5.2.2 Covenant Violation After the Balance Sheet Date
The classification implications of credit-related debt covenant violations
that occur after the balance sheet date but before the financial statements
are issued or available to be issued are generally consistent with the
requirements triggered by a violation as of the balance sheet date (see
Section 13.5.1). A debt covenant
violation that occurs after the balance sheet date but before the financial
statements are issued or available to be issued would generally be an
example of other “facts and circumstances,” as discussed in ASC 470-10-45-1
(see Section 13.5.3.3), under which current
classification of the debt would be required unless one of the exceptions
described in Section 13.5.3 applies. We have confirmed
this position through informal discussions with the SEC staff.
Such scenarios primarily involve credit-related debt covenants, including
those associated with quantitative financial metrics or ratios and those
regarding going-concern matters. In some circumstances, the violation may be
unrelated to credit or may be the result of a discrete event after year-end
(e.g., a debt covenant that is triggered upon a sale of specified assets
that occurred after year-end). We encourage entities to consult their
advisers in these situations to determine the appropriate classification
guidelines to apply.
Sometimes, a debtor might expect that it will violate a credit-related debt
covenant only after the financial statements have been issued or are
available to be issued. Unless the debtor is virtually certain that it will
violate the covenant after such time, it should not classify the debt as a
current liability on the basis of such anticipated covenant violation.
Example 13-3
Debt That Becomes Due on Demand as a Result of a
Going-Concern Audit Opinion
Company ABC has a long-term loan
that requires it to (1) comply with quantitative
ratios, including liquidity ratios (e.g., current
ratio, quick ratio) and financial leverage ratios
(e.g., debt ratio, debt-to-equity ratio), and (2)
obtain an audit opinion on its annual financial
statements that is not subject to any qualifications
or exceptions with respect to the scope of the audit
or that contains a going-concern emphasis. If ABC
does not comply with each of these covenant
requirements, the lender has the ability to require
repayment of the debt immediately. As of December
31, 20X1, ABC is in compliance with all of the
quantitative ratios; however, the audit opinion
issued for December 31, 20X1, will contain a
going-concern emphasis. Company ABC does not obtain
a waiver from the lender.
Because of the going-concern emphasis in the audit
opinion, ABC should classify the loan as a current
obligation in its December 31, 20X1, balance sheet.
Although the audit opinion is issued after the
balance sheet date, under ASC 470-10-45-1, such a
known violation as of the date financial statements
are issued or available to be issued would be
considered an example of other “facts and
circumstances” under which current classification of
the debt would be required as of December 31,
20X1.
Example 13-4
Debt That Becomes Due on Demand Because of Failure
to Satisfy Quantitative Covenants
Company ABC has a long-term loan that requires it to
comply with quantitative ratios, including liquidity
ratios (e.g., current ratio, quick ratio) and
financial leverage ratios (e.g., debt ratio,
debt-to-equity ratio). If ABC does not comply with
each of these covenant requirements, the lender has
the ability to require repayment of the debt
immediately. Assume that ABC violated one of the
quantitative ratio covenants as of a measurement
date after the balance sheet date but before
issuance of the financial statements. Assume also
that ABC has obtained a waiver related to the
specific violation before issuance of the financial
statements for the year ended December 31, 20X1, and
that ABC believes that it is probable that it will
fail to meet the same covenant requirement again as
of measurement dates occurring within the 12 months
after December 31, 20X1.
In this situation, the covenant violation after the
balance sheet date but before financial statement
issuance should be viewed in the same way as a
violation as of the balance sheet date (i.e., the
violation constitutes evidence of “other facts and
circumstances” as discussed in ASC 470-10-45-1).
Since it is probable that ABC will not be able to
comply with the same covenant as of compliance dates
within 12 months of the balance sheet date, the debt
should be classified as current as of December 31,
20X1.
13.5.2.3 Covenant Violation Would Have Occurred in the Absence of Debt Modification
ASC 470-10-55-4(d) and ASC 470-10-55-6 (see Section
13.5.3.3) indicate that a modification of the contractual
terms of a debt obligation before the balance sheet date should be analyzed
as a covenant violation as of the balance sheet date if all of the following
conditions are met:
-
The modification removes or adjusts the covenant so that the debtor will comply as of the balance sheet date.
-
In the absence of the modification, the debtor would have violated the covenant as of the balance sheet date.
-
The same or a more restrictive covenant must be met as of the compliance dates after the balance sheet date.
A debt modification that meets the above conditions is treated as a covenant
waiver under ASC 470-10, even though no covenant violation exists as of the
balance sheet date, because a covenant violation would have occurred
notwithstanding the modification (i.e., in substance, the modification
represents a waiver).
13.5.2.4 Covenant Violation Cured Before the Financial Statements Are Issued or Available to Be Issued
If a debtor cures a credit-related covenant violation before the financial
statements are issued or available to be issued or before the creditor
otherwise loses its right to demand repayment for more than one year (or the
operating cycle, if longer) after the balance sheet date, the debt is
classified as noncurrent (see ASC 470-10-45-11(a) and Section
13.5.3.2). For example, if a long-term debt obligation
contains a put option that may be exercised by the creditor because of a
covenant violation, but such option is only exercisable for 30 days after
the balance sheet date, noncurrent classification is appropriate since the
put option expired before the issuance of the financial statements.
13.5.3 Exceptions to the Current-Classification Requirements
13.5.3.1 Background
Violation of a covenant in a long-term obligation that makes the debt
repayable on demand does not cause the debt to be classified as current if
an exception in ASC 470-10 related to one or more of the following applies:
-
Covenant waivers and cures (see Section 13.5.3.2).
-
Grace periods (see Section 13.5.3.4).
-
Refinancing arrangements (see Section 13.7).
13.5.3.2 Covenant Waivers and Cures
ASC 470-10
45-11 Current liabilities
shall include long-term obligations that are or will
be callable by the creditor either because the
debtor’s violation of a provision of the debt
agreement at the balance sheet date makes the
obligation callable or because the violation, if not
cured within a specified grace period, will make the
obligation callable. Accordingly, such callable
obligations shall be classified as current
liabilities unless either of the following
conditions is met:
- The creditor has waived or subsequently lost (for example, the debtor has cured the violation after the balance sheet date and the obligation is not callable at the time the financial statements are issued or are available to be issued [as discussed in Section 855-10-25]) the right to demand repayment for more than one year (or operating cycle, if longer) from the balance sheet date. If the obligation is callable because of violations of certain provisions of the debt agreement, the creditor needs to waive its right with regard only to those violations. . . .
Long-term obligations that become payable on demand or
within one year (or the operating cycle, if longer) after the balance sheet
date because of a covenant violation are classified as current liabilities
unless the debtor obtains a covenant waiver that meets the requirements in
ASC 470-10-45-1 and ASC 470-10-45-11(a) before the financial statements are
issued or are available to be issued. Such debt would qualify as noncurrent
if the creditor either waives its right to demand repayment under the
specific covenant that was violated or otherwise loses its right to demand
repayment (e.g., because the debtor cures the violation) for a period of
more than one year after the balance sheet date. However, noncurrent
classification would not be permitted if the creditor retains its right to
demand repayment with respect to future covenant violations and it is
probable that the debtor will violate the same or a more restrictive
covenant as of measurement dates that are within 12 months of the balance
sheet date (see Section
13.5.3.3). To apply the exception in ASC 470-10-45-11(a) for
covenant waivers, an entity must ensure that the violated provision is
related to credit (see Section
13.3.4.5). For a discussion of the analysis of covenant
violations that are not credit-related, see Section 13.4.3.
Debt cannot be classified as noncurrent unless a waiver is binding and
eliminates the creditor’s right to demand repayment of the debt within one
year (or the operating cycle, if longer) after the balance sheet date as a
result of the covenant violation. If the creditor has a right to revoke the
waiver at its sole discretion, the waiver would not meet this condition.
Further, a creditor’s statement that it does not intend or expect to demand
repayment in the event of a covenant violation does not represent a waiver.
A debtor is not permitted to consider the likelihood that a creditor will
grant a waiver in the future even if the creditor has historically issued a
waiver for the same type of violation or other covenant violations.
Lenders often request something in exchange for a covenant waiver. For
example, the parties might agree to an up-front fee, an increase to the
interest rate, a principal modification, the addition of a cross-default
provision, or additional collateral. Since such changes represent
modifications to the contractual terms of the original debt instrument, the
debtor should consider whether the modifications are TDRs under ASC 470-60
(see Chapter 11) and, if not, whether
to account for them as an extinguishment or modification of the original
debt under ASC 470-50 (see Chapter
10). Unless it performs the necessary calculations, an entity
cannot assume that the payment of a fee to obtain a debt covenant waiver
does not pass the 10 percent cash flow test under ASC 470-50 (see Section 10.3.3).
13.5.3.3 Recurring Covenant Tests
ASC 470-10
45-1 Some long-term loans
require compliance with certain covenants that must
be met on a quarterly or semiannual basis. If a
covenant violation occurs that would otherwise give
the lender the right to call the debt, a lender may
waive its call right arising from the current
violation for a period greater than one year while
retaining future covenant requirements. Unless facts
and circumstances indicate otherwise, the borrower
shall classify the obligation as noncurrent, unless
both of the following conditions exist:
-
A covenant violation that gives the lender the right to call the debt has occurred at the balance sheet date or would have occurred absent a loan modification.
-
It is probable that the borrower will not be able to cure the default (comply with the covenant) at measurement dates that are within the next 12 months.
See Example 1 (paragraph 470-10-55-2) for an
illustration of this classification guidance.
The contractual terms of long-term debt obligations often contain covenants
that must be met on certain dates and that render the debt repayable on
demand if they are not met on those dates. If such a covenant has been
violated as of the balance sheet date or before the date on which the
financial statements are issued or available to be issued, the debt must be
classified as current unless one of the exceptions in ASC 470-10-45-11 or
ASC 470-10-45-14 applies (see Section
13.5.3.1).
ASC 470-10-45-1 addresses the application of ASC 470-10-45-11 to covenant
waivers (see Section 13.5.3.2) in
situations in which the creditor has waived the specific covenant that was
violated as of the balance sheet date but retains its right to demand debt
repayment if the debtor violates the same or a more restrictive covenant on
subsequent compliance dates within one year (or the operating cycle, if
longer) after the balance sheet date. This guidance applies when a debtor
would have violated a covenant as of the balance sheet date in the absence
of a modification to the debt terms (i.e., a debt modification before the
balance sheet date is treated as a waiver of a debt covenant under this
guidance; see Section 13.5.2.3).
Example 13-5
Recurring Minimum Working Capital
Requirement
The terms of a debt obligation require the debtor to
maintain a minimum amount of working capital in each
fiscal quarter. If the working capital requirement
is not met, the creditor obtains the right to
immediately accelerate the due date of the debt’s
outstanding amount. The debtor violates the covenant
as of December 31, 20X1. Further, the creditor
waives its right to accelerate the due date of the
debt as a result of the debtor’s violation of the
covenant as of December 31, 20X1. However, the
debtor retains its right to accelerate the debt’s
due date if the covenant is not met as of March 31,
20X2. In this scenario, the debtor must consider the
guidance in ASC 470-10-45-1.
Generally, a long-term obligation should be classified as noncurrent if the
creditor has waived the specific covenant violation unless it is probable
that the debtor will be unable to cure the violation on the compliance dates
within the next 12 months (or the operating cycle, if longer) after the
balance sheet date. If it is reasonably possible that the debtor will meet
the same and more restrictive covenants on the subsequent compliance dates
within the next 12 months (or the operating cycle, if longer) after the
balance sheet date, the debt should be classified as noncurrent. However,
the obligation should be classified as current if it is probable that debtor
will be unable to meet the covenant on any of the subsequent
compliance dates within the next 12 months (or the operating cycle, if
longer) after the balance sheet date. In other words, the obligation should
be classified as current if there is a remote likelihood that the debtor
will meet the covenant on all subsequent compliance dates within the
next 12 months (or the operating cycle, if longer) after the balance sheet
date.
Note that the guidance on recurring covenant tests includes a different
likelihood threshold for curing the covenant violation than the guidance on
grace periods. For a debtor to justify noncurrent classification under the
guidance on grace periods, curing the default must be probable (see
Section 13.5.3.4), whereas it must
merely not be probable that the debtor will be unable to cure the default
under the guidance on recurring covenant tests.
ASC 470-10
Example 1: Classification of Long-Term Debt
That Includes Covenants
55-2 This Example
illustrates the guidance in paragraph 470-10-45-1
for the classification of long-term debt when a debt
covenant violation is waived by a lender for a
period greater than a year.
55-3 A borrower has a
long-term loan that requires compliance with certain
covenants, such as maintenance of a minimum current
ratio, minimum debt-to-equity ratio, or minimum
level of shareholders’ equity. The borrower must
meet the covenants on a quarterly or semiannual
basis. At one of the compliance dates, the borrower
violates a covenant. That violation gives the lender
the right to call the debt. The lender waives that
right for a period greater than one year but retains
the future covenant requirements.
55-4 The issue is whether
the waiver of the lender’s rights resulting from the
violation of the covenant with the retention of the
periodic covenant tests represents, in substance, a
grace period. If viewed as a grace period, the
borrower would classify the debt as current (see
paragraph 470-10-45-11) unless it is probable that
the borrower can cure the violation (comply with the
covenant) within the grace period. Specifically, the
balance sheet classification of an obligation is
considered in the following situations:
-
The debt covenants are applicable only after the balance sheet date, and it is probable that the borrower will fail to meet the covenant requirement at the compliance date three months after the balance sheet date.
-
The borrower meets the current covenant requirement at the balance sheet date, and it is probable that the borrower will fail to meet the same covenant requirement at the compliance date in three months.
-
The borrower meets the current covenant requirement, and it is probable that the borrower will fail to meet a more restrictive covenant requirement applicable at the compliance date in three months.
-
The borrower has met the covenant requirement in the prior quarter but before the balance sheet date negotiates a modification of the loan agreement that eliminates the covenant requirement at the balance sheet date or modifies the requirement so that the borrower will comply. Absent the modification, the borrower would have been in violation of the covenant at the balance sheet date. The same or a more restrictive covenant must be met at the compliance date in three months, and it is probable that the borrower will fail to meet that requirement at that subsequent date.
-
The borrower is in violation of the current covenant requirement at the balance sheet date and, after the balance sheet date but before the financial statements are issued or are available to be issued (as discussed in Section 855-10-25), obtains a waiver. The same or a more restrictive covenant must be met at the compliance date in three months, and it is probable that the borrower will fail to meet that requirement at that subsequent date.
55-5 In the situations
described in (a) through (c) of the preceding
paragraph, the debt would be classified as
noncurrent, in which case the borrower would be
required to disclose the adverse consequences of its
probable failure to satisfy future covenants.
55-6 In the situations
described in paragraph 470-10-55-4(d) through (e),
the debt would be classified as current. However, if
the debt is expected to be refinanced on a long-term
basis and the borrower meets the provisions of
paragraphs 470-10-45-13 through 45-20, the debt
would be classified as noncurrent.
13.5.3.4 Grace Periods
ASC 470-10
45-11 Current liabilities
shall include long-term obligations that are or will
be callable by the creditor either because the
debtor’s violation of a provision of the debt
agreement at the balance sheet date makes the
obligation callable or because the violation, if not
cured within a specified grace period, will make the
obligation callable. Accordingly, such callable
obligations shall be classified as current
liabilities unless either of the following
conditions is met: . . .
b. For long-term obligations containing a
grace period within which the debtor may cure the
violation, it is probable that the violation will
be cured within that period, thus preventing the
obligation from becoming callable.
Generally, long-term debt that has become payable on demand
or within one year (or the operating cycle, if longer) after the balance
sheet date because of a covenant violation is classified as current (see
Section
13.5.1). However, if the debt agreement contains a grace
period during which the debtor may cure the violation, the debtor classifies
the debt as noncurrent if it is probable that the violation will be cured
within the established grace period. To apply the exception in ASC
470-10-45-11(b) for grace periods, an entity must ensure that the violated
provision is related to credit (see Section
13.3.4.5). For a discussion of the analysis of covenant
violations that are not credit-related, see Section 13.4.3.
In determining whether it is probable that the violation will be cured within
the contractual grace period, a debtor must use judgment and consider all
relevant facts and circumstances. In the absence of persuasive evidence that
it is probable that the debtor will be able to cure the violation before the
end of the grace period, the obligation should be classified as current
unless the debtor has obtained a covenant waiver that meets the requirements
in ASC 470-10-45-11(a) (see Section
13.5.3.2) or the debtor has the intent and ability to
refinance the obligation on a long-term basis (see Section 13.7). If a more than remote
likelihood exists that the debtor will be unable to remedy the violation,
the debt should be classified as current even if the debtor expects that the
creditor will not demand repayment.
ASC 470-10-50-2 requires a debtor to disclose the circumstances in which it
is in violation of a debt covenant but classifies the related debt as
noncurrent because it is probable that the violation will be cured within a
specified grace period (see Section 13.5.4).
13.5.3.5 Comparison of Guidance on Covenant Waivers and Grace Periods
When a lender issues a covenant waiver, the related debt is classified as
noncurrent unless it is probable that the debtor will violate the same or a
more restrictive covenant again as of a measurement date that is within 12
months of the balance sheet date (see Section
13.5.3.3). By contrast, when a loan agreement contains a
grace period, the related debt is classified as current unless it is
probable that the debtor will cure the violation within the specified grace
period, thus preventing the obligation from becoming repayable on demand
(see Section 13.5.3.4). The decision
tree below summarizes the guidance on classification of debt upon the
violation of a covenant as of the balance sheet date.
Example 13-6
Failure to Satisfy Debt Covenant — No Grace Period
Provided in Debt Agreement
Company A has a long-term loan that requires it to
comply with certain covenants, including quarterly
minimum quantitative ratios (e.g., a debt-to-equity
ratio) and issuance of annual audited financial
statements with an audit opinion that is not subject
to any qualifications or exceptions with respect to
the scope of the audit or any going-concern
emphasis. Company A failed to meet the minimum
quantitative ratio as of December 31, 20X1. Thus,
the lender has the right to demand repayment of the
debt immediately. The loan agreement does not
specify a grace period for curing covenant
violations.
Company A must classify the debt as current as of
December 31, 20X1. When a loan agreement does not
contain a grace period, long-term debt should be
classified as current when a debtor is in violation
of a loan covenant as of the balance sheet date
since the obligation is repayable on demand by the
lender.
Example 13-7
Failure to Satisfy Debt Covenant — Grace Period
Provided in Debt Agreement
Assume the same facts as in the
example above, except that the loan agreement
contains a grace period during which the debtor can
cure the violation. Company A would need to assess
the probability of curing the covenant violation.
Unless A determines that it is probable that the
covenant violation will be cured within the
specified grace period, current classification of
the loan would be required.
Example 13-8
Failure to Satisfy Debt Covenant — Waiver Obtained
by Debtor
Assume the same facts as in
Example 13-6
except that the lender has waived its right to
demand repayment of the loan related to the specific
covenant violation for a period of more than 12
months after the balance sheet date. Company A would
classify the debt as a current liability only if it
is probable that it will violate the same or a more
restrictive covenant again as of measurement dates
that are within 12 months of the balance sheet date
(see Section
13.5.3.3).
13.5.4 Disclosure
ASC 470-10
50-2 If an obligation
under paragraph 470-10-45-11(b) is classified as a
long-term liability (or, in the case of an unclassified
balance sheet, is included as a long-term liability in
the disclosure of debt maturities), the circumstances
shall be disclosed.
SEC Regulation S-X, Rule 4-08
§210.4-08 General Notes to Financial Statements
[Reproduced in ASC 235-10-S99-1]
If applicable to the person for which the financial
statements are filed, the following shall be set forth
on the face of the appropriate statement or in
appropriately captioned notes. The information [required
by paragraph (c)] shall be provided as of the most
recent audited balance sheet being filed . . . . When
specific statements are presented separately, the
pertinent notes shall accompany such statements unless
cross-referencing is appropriate. . . .
(c) Defaults. The
facts and amounts concerning any default in principal,
interest, sinking fund, or redemption provisions with
respect to any issue of securities or credit agreements,
or any breach of covenant of a related indenture or
agreement, which default or breach existed at the date
of the most recent balance sheet being filed and which
has not been subsequently cured, shall be stated in the
notes to the financial statements. If a default or
breach exists but acceleration of the obligation has
been waived for a stated period of time beyond the date
of the most recent balance sheet being filed, state the
amount of the obligation and the period of the waiver. .
. .
Nonauthoritative AICPA Guidance
Technical Q&As Section 3200, “Long-Term
Debt”
.17 Disclosure of Covenant Violation and Subsequent
Bank Waiver
Inquiry — At the balance-sheet
date, an entity was in violation of certain provisions
of the loan covenant associated with its long-term debt.
Under the terms of the loan agreement, the obligation is
now callable by the creditor. Subsequent to the
balance-sheet date, the bank waived its right to demand
repayment for more than one year from the balance-sheet
date. Therefore, the loan remained classified as
long-term, per Financial Accounting Standards Board
(FASB) Accounting Standards Codification (ASC)
470-10-45-12. Does the covenant violation and subsequent
bank waiver need to be disclosed in the financial
statements?
Reply — The authoritative literature applicable to
nonpublic entities does not address disclosure of debt
covenant violations existing at the balance-sheet date
that have been waived by the creditor for a stated
period of time. Nevertheless, disclosure of the existing
violation(s) and the waiver period should be considered
for reasons of adequate disclosure. If the covenant
violation resulted from nonpayment of principal or
interest on the debt, inability to maintain required
financial ratios, or other such financial covenants,
that information may be vital to users of the financial
statements even though the debt is not callable. If the
lender has waived the right for greater than one year
but retained the future covenant requirements (i.e.,
covenant requirements will have to be met at interim
dates during the next 12 months), the accounting and
disclosure provisions of FASB ASC 470, Debt,
apply.
For SEC registrants, Regulations S-X,
Article 4, Section 210-4-08(c), requires disclosure of
the amount of the obligation and the period of waiver
whenever a creditor has waived its right to call the
debt for a stated period of time.
ASC 470-10-50-2 requires a debtor to disclose the circumstances in which it is in
violation of a debt covenant but classifies the related debt as noncurrent
because it is probable that the violation will be cured with a specified grace
period that extends beyond the date on which the financial statements are to be
issued (see Section 13.5.3.4). For example, it might be appropriate to
disclose a description of the nature of the violation, the actions taken by the
debtor to cure the violation, and a statement that it is probable that the
violation will be cured before the end of the grace period. In addition, debtors
that do not present a classified balance sheet and describe the obligation as a
long-term liability must disclose this description in their discussion of debt
maturities.
Further, SEC Regulation S-X, Rule 4-08, requires SEC registrants to disclose
information about (1) the facts and amounts associated with any defaults or
other covenant violations that existed as of the balance sheet date and that
have not been subsequently cured and (2) the amount and the period of the waiver
if a waiver of a default or covenant violation was given for a period beyond the
balance sheet date. As discussed in AICPA Technical Q&As Section 3200.17,
disclosure of covenant waivers and the waiver period “may be vital” also for
users of financial statements of nonpublic entities.
13.6 SACs in Long-Term Obligations
ASC 470-10
45-2
In some situations, the circumstances (for example,
recurring losses or liquidity problems) would indicate that
long-term debt subject to a subjective acceleration clause
should be classified as a current liability. Other
situations would indicate only disclosure of the existence
of such clauses. Neither reclassification nor disclosure
would be required if the likelihood of the acceleration of
the due date were remote, such as if the lender historically
has not accelerated due dates of loans containing similar
clauses and the financial condition of the borrower is
strong and its prospects are bright.
50-3
As indicated in paragraph 470-10-45-2, in some situations
long-term debt subject to a subjective acceleration clause
shall be reclassified. That paragraph explains that other
situations would indicate only disclosure of the existence
of such clauses. That paragraph states further that neither
reclassification nor disclosure is required if the
likelihood of the acceleration of the due date is remote,
such as when the lender historically has not accelerated due
dates of loans containing similar clauses and the financial
condition of the borrower is strong and its prospects are
bright.
If a long-term debt obligation contains a SAC, the debtor should assess the
likelihood that the creditor will accelerate the debt’s due date. If exercise of the
SAC is probable, the long-term obligation must be classified as a current liability
and the SAC disclosed. If the debtor has experienced recurring losses or liquidity
problems, the obligation should be classified as current unless the exception for
refinancing arrangements applies (see Section
13.7). If the likelihood that the creditor will accelerate the debt’s
due date is reasonably possible, the existence of the SAC should be disclosed. If
the likelihood that the debt’s due date will be accelerated is remote, neither
disclosure nor reclassification is required. If a creditor has accelerated the
debt’s due date under a SAC, the debt is considered due on demand (see Section 13.4) and is classified as current unless
the exception for refinancing arrangement is met.
ASC 470-10 contains guidance on the impact of SACs on the classification of
revolving-debt arrangements that require a lockbox arrangement (see Section 13.8).
13.7 Refinancing Arrangements
13.7.1 Background
Under ASC 470-10-45-14, short-term obligations are classified as noncurrent if
the debtor has the intent and ability to refinance the obligation on a long-term
basis. To demonstrate that it has such an intent and ability, a debtor must (1)
refinance the obligation on a long-term basis (see Section
13.7.3) after the balance sheet date, but before the financial
statements are issued or available to be issued, or (2) have a financing
agreement that clearly permits it to refinance the obligation on a long-term
basis (see Section 13.7.4) before the financial statements
are issued or available to be issued.
13.7.2 Scope
13.7.2.1 Background
ASC 470-10-45-14 applies to certain short-term obligations
(see Section
13.3.4.2) of a debtor that has the intent and ability to
refinance on a long-term basis (see the next section). It does not apply to
certain short-term obligations incurred as part of an entity’s operating
cycle (see Section
13.7.2.3). Further, the post-balance-sheet-date refinancing
or financing agreement must be in place before the financial statements are
issued or available to be issued (see Section 13.3.4.9).
13.7.2.2 Refinancing a Short-Term Obligation on a Long-Term Basis
ASC 470-10
45-12A Some short-term
obligations are expected to be refinanced on a
long-term basis and, therefore, are not expected to
require the use of working capital during the
ensuing fiscal year. Examples include commercial
paper, construction loans, and the currently
maturing portion of long-term debt.
45-12B Refinancing a
short-term obligation on a long-term basis means
either replacing it with a long-term obligation or
with equity securities or renewing, extending, or
replacing it with short-term obligations for an
uninterrupted period extending beyond one year (or
the operating cycle, if applicable) from the date of
an entity’s balance sheet.
45-13 . . . A short-term
obligation shall be excluded from current
liabilities only if the conditions in the following
paragraph are met. Funds obtained on a long-term
basis before the balance sheet date would be
excluded from current assets if the obligation to be
liquidated is excluded from current liabilities.
45-14 A short-term
obligation shall be excluded from current
liabilities if the entity intends to refinance the
obligation on a long-term basis (see paragraph
470-10-45-12B) and the intent to refinance the
short-term obligation on a long-term basis is
supported by an ability to consummate the
refinancing demonstrated in either of the following
ways:
-
Post-balance-sheet-date issuance of a long-term obligation or equity securities. . . .
-
Financing agreement. . . .
45-21 Replacement of a
short-term obligation with another short-term
obligation after the date of the balance sheet but
before the balance sheet is issued or is available
to be issued (as discussed in Section 855-10-25) is
not, by itself, sufficient to demonstrate an
entity’s ability to refinance the short-term
obligation on a long-term basis. If, for example,
the replacement is made under the terms of a
revolving credit agreement that provides for renewal
or extension of the short-term obligation for an
uninterrupted period extending beyond one year (or
operating cycle) from the date of the balance sheet,
the revolving credit agreement must meet the
conditions in paragraph 470-10-45-14(b) to justify
excluding the short-term obligation from current
liabilities. Similarly, if the replacement is a
rollover of commercial paper accompanied by a
standby credit agreement, the standby agreement must
meet the conditions in that paragraph to justify
excluding the short-term obligation from current
liabilities.
As discussed in Section 13.7.1, ASC
470-10-45-14 applies when a debtor has the intent and ability to refinance a
short-term obligation on a long-term basis. ASC 470-10-45-12B clarifies that
refinancing a short-term obligation on a long-term basis includes:
-
Issuing a long-term obligation that replaces the short-term obligation.
-
Issuing equity securities that replace the short-term obligation.
-
Renewing or extending a short-term obligation for a period of more than one year (or the operating cycle, if longer) after the balance sheet date. (Note that provisions that permit the successive renewal or extension of short-term obligations generally should be evaluated under the guidance on financing agreements [see Section 13.7.4] and not under the requirements for post-balance-sheet-date issuance of long-term obligations or equity securities [see Section 13.7.3] since they do not represent long-term obligations.)
A debtor does not have the intent and ability to refinance a short-term
obligation on a long-term basis if:
-
It issues another short-term obligation that matures within one year (or the operating cycle, if longer) after the balance sheet date.
-
It extends or renews a short-term obligation for a period of less than one year (or the operating cycle, if longer) after the balance sheet date.
-
The short-term financing agreement expires within one year (or the operating cycle, if longer) after the balance sheet date.
13.7.2.3 Short-Term Obligations Related to the Operating Cycle
ASC 470-10
45-13 Short-term
obligations arising from transactions in the normal
course of business that are due in customary terms
shall be classified as current liabilities. . .
.
ASC 470-10-45-14 does not apply to short-term obligations that are classified
as current liabilities under ASC 210-10-45-8 and the first sentence of ASC
470-10-45-13 (see Section 13.3.3.4).
That is, “[s]hort-term obligations arising from transactions in the normal
course of business that are due in customary terms,” such as payables for
goods and services and accruals for wages, salaries, commissions, rentals,
and royalties, cannot be classified as noncurrent on the basis of the
guidance on refinancing arrangements. However, as noted in paragraph 20 of the Basis for Conclusions of FASB Statement 6, the guidance does apply to
short-term obligations “arising from the acquisition or construction of
noncurrent assets” or “not directly related to the operating cycle,” such as
a “note given to a supplier to replace an account payable that originally
arose in the normal course of business and had been due in customary
terms.”
13.7.3 Post-Balance-Sheet-Date Issuance of Long-Term Debt or Equity
13.7.3.1 General
ASC 470-10
45-14 A short-term
obligation shall be excluded from current
liabilities if the entity intends to refinance the
obligation on a long-term basis (see paragraph
470-10-45-12B) and the intent to refinance the
short-term obligation on a long-term basis is
supported by an ability to consummate the
refinancing demonstrated in either of the following
ways:
-
Post-balance-sheet-date issuance of a long-term obligation or equity securities. After the date of an entity’s balance sheet but before that balance sheet is issued or is available to be issued (as discussed in Section 855-10-25), a long-term obligation or equity securities have been issued for the purpose of refinancing the short-term obligation on a long-term basis. If equity securities have been issued, the short-term obligation, although excluded from current liabilities, shall not be included in owners’ equity. . . .
45-16 If an entity’s
ability to consummate an intended refinancing of a
short-term obligation on a long-term basis is
demonstrated by post-balance-sheet-date issuance of
a long-term obligation or equity securities (see
paragraph 470-10-45-14(a)), the amount of the
short-term obligation to be excluded from current
liabilities shall not exceed the proceeds of the new
long-term obligation or the equity securities
issued.
One way a debtor can demonstrate its intent and ability to refinance a
short-term obligation on a long-term basis is to repay the short-term
obligation by using the proceeds from the issuance of a long-term obligation
or equity securities. Such refinancing must occur before the financial
statements are issued or available to be issued (see Section 13.3.4.9). The amount of the
short-term obligation that is classified as noncurrent cannot exceed the
amount of the proceeds received from issuing the new long-term obligation or
equity securities and that are used to repay the short-term obligation.
The issuance of a new debt instrument or equity security that contains a put
option or other provision that permits the holder to demand repayment within
one year (or the operating cycle, if longer) after the balance sheet date
does not demonstrate the debtor’s ability to refinance on a long-term basis
(see Section 13.4.2). A debtor that
has violated a credit-related covenant in the new debt obligation before the
financial statements are issued or available to be issued should consider
the guidance on covenant violations (see Section
13.5). If a new long-term debt obligation contains a SAC, the
debtor should assess the likelihood that the holder will accelerate the
debt’s due date under that clause since it can affect whether noncurrent
classification is appropriate (see Section
13.6).
ASC 470-10-55-15 through 55-24 contain an example of a
post-balance-sheet-date refinancing that would be evaluated under ASC
470-10-45-14(a) (see Section 13.7.6.3).
13.7.3.2 Repayment of Short-Term Obligation Before Long-Term Refinancing
ASC 470-10
45-15 Repayment of a
short-term obligation before funds are obtained
through a long-term refinancing requires the use of
current assets. Therefore, if a short-term
obligation is repaid after the balance sheet date
and subsequently a long-term obligation or equity
securities are issued whose proceeds are used to
replenish current assets before the balance sheet is
issued or is available to be issued (as discussed in
Section 855-10-25), the short-term obligation shall
not be excluded from current liabilities at the
balance sheet date. See Example 5 (paragraph
470-10-55-33) for an illustration of this
guidance.
If a debtor repays a short-term obligation after the balance sheet date by
using current assets (e.g., excess cash), that obligation must be classified
as current as of the balance sheet date even if the debtor subsequently
issues a new long-term obligation or equity securities before the financial
statements are issued or available to be issued. This is because the
repayment of the short-term obligation required the use of current assets.
ASC 470-10-55-33 through 55-36 contain an example of a short-term obligation
that is repaid after the balance sheet date and subsequently replaced by
long-term debt before the balance sheet is issued (see Section
13.7.6.3).
13.7.4 Financing Agreement
13.7.4.1 Background
A debtor can demonstrate that it is able to refinance a
short-term obligation on a long-term basis by having a financing agreement
(e.g., a term loan commitment, a line of credit, a revolving-debt
arrangement, an equity facility, or a forward sale of debt or equity
securities) that permits such refinancing and meets certain criteria (see
the next section). Further, the guidance on financing agreements applies to
scenarios in which the debtor renews or extends the short-term obligation
(see ASC 470-10-45-12B).
ASC 470-10 limits the amount of the short-term obligation that can be
classified as noncurrent (see Section 13.7.4.3).
Generally, a debtor is not precluded from using a stand-by financing
agreement, although its terms cannot be unreasonable (see Section
13.7.4.4). However, a best-efforts agreement cannot be used
to demonstrate an ability to refinance a short-term obligation on a
long-term basis (see Section 13.7.4.5). In certain
circumstances, a subsidiary might be able to use a parent’s financing
agreement to demonstrate such ability (see Section
13.7.4.6).
13.7.4.2 Financing Agreement Criteria
ASC 470-10
45-14 A short-term
obligation shall be excluded from current
liabilities if the entity intends to refinance the
obligation on a long-term basis (see paragraph
470-10-45-12B) and the intent to refinance the
short-term obligation on a long-term basis is
supported by an ability to consummate the
refinancing demonstrated in either of the following
ways: . . .
b. Financing agreement. Before the balance
sheet is issued or is available to be issued (as
discussed in Section 855-10-25), the entity has
entered into a financing agreement that clearly
permits the entity to refinance the short-term
obligation on a long-term basis on terms that are
readily determinable, and all of the following
conditions are met:
1. The agreement does
not expire within one year (or operating cycle)
from the date of the entity’s balance sheet and
during that period the agreement is not cancelable
by the lender or the prospective lender or
investor (and obligations incurred under the
agreement are not callable during that period)
except for violation of a provision with which
compliance is objectively determinable or
measurable. For purposes of this Subtopic,
violation of a provision means failure to meet a
condition set forth in the agreement or breach or
violation of a provision such as a restrictive
covenant, representation, or warranty, whether or
not a grace period is allowed or the lender is
required to give notice. Financing agreements
cancelable for violation of a provision that can
be evaluated differently by the parties to the
agreement (such as a material adverse change or
failure to maintain satisfactory operations) do
not comply with this condition.
2. No violation of any
provision in the financing agreement exists at the
balance sheet date and no available information
indicates that a violation has occurred thereafter
but before the balance sheet is issued or is
available to be issued (as discussed in Section
855-10-25), or, if one exists at the balance sheet
date or has occurred thereafter, a waiver has been
obtained.
3. The lender or the
prospective lender or investor with which the
entity has entered into the financing agreement is
expected to be financially capable of honoring the
agreement.
55-1 Under paragraph
470-10-45-2, the lender has already loaned money on
a long-term basis. To continue long-term
classification requires a judgment about the
likelihood of acceleration of the due date.
Paragraphs 470-10-45-13 through 45-20 cover
circumstances in which the obligation is by its
terms short-term. For such an obligation to be
excluded from current liabilities, the lender must
advance new funds or refinance the short-term
obligation on a long-term basis based on conditions
existing on the date of the new loan or refinancing.
Therefore, to classify an obligation as long-term,
paragraphs 470-10-45-13 through 45-20 require a
higher standard for a financing agreement that
permits an entity to refinance a short-term
obligation on a long-term basis than paragraph
470-10-50-2 requires for an existing long-term loan
for which early repayment might be requested.
For debt to be classified as noncurrent on the basis of a financing
agreement, all of the following conditions must be met:
-
The financing agreement must clearly permit the debtor to refinance the short-term obligation on a long-term basis on terms that are readily determinable.The terms of the financing commitment must be unambiguous about whether the debtor is able to refinance the short-term obligation on a long-term basis. For example, the agreement might state that “[b]orrowings are available at [the debtor’s] request for such purposes as it deems appropriate and will mature three years from the date of borrowing” (see ASC 470-10-55-16(a) and ASC 470-10-55-17 in Section 13.7.6.4). Further, the debtor cannot be subject to any legal or contractual restrictions that prevent it from accessing funds that otherwise would be available under the financing agreement (e.g., transfer restrictions) (see Section 13.7.4.3). If the amount available under the financing agreement fluctuates, only the minimum amount that is expected to be available can be used to support a conclusion that noncurrent classification is appropriate for a short-term obligation. If the amount available under the financing agreement fluctuates and no reasonable estimate of the minimum amount that is expected to be available can be made, the financing agreement does not allow the debtor to refinance a short-term obligation on a long-term basis (see Section 13.7.4.3).In addition, the agreement must bind the potential creditor or investor to extend credit on a long-term basis or purchase the debtor’s equity securities. If the potential creditor or investor has a right to cancel the agreement in its sole discretion without any penalty or damages, the agreement would not meet this condition. For example, a letter of intent or memorandum of understanding would generally not be sufficient to meet this condition even if the potential investor or creditor is expected to honor its stated intent. Further, ASC 470-10-55-8 implies that the existence of a best-efforts remarketing agreement is not sufficient to demonstrate an intent and ability to refinance a short-term obligation on a long-term basis under ASC 470-10-45-14(b) (see Section 13.7.4.5). However, there is no requirement that the financing agreement be contractually linked to the short-term obligation.The fact that a debtor is considering other more advantageous sources of financing does not necessarily preclude it from asserting an intent to use a financing agreement to refinance a short-term obligation on a long-term basis under ASC 470-10-45-14(b) (see Section 13.7.4.4). However, the debtor must intend to use the financing agreement if no other source of financing becomes available (see ASC 470-10-45-20).
-
The financing agreement must be in place as of the date the financial statements are issued or available to be issued.There is no requirement that the debtor enter into the financing agreement as of the balance sheet date. ASC 470-10-45-14(b) requires the financing agreement to have been executed by the time the financial statements are issued or available to be issued.
-
The financing agreement cannot expire within one year (or the debtor’s operating cycle, if longer) after the balance sheet date except for the violation of an objective covenant.ASC 470-10-45-14(b)(1) requires the potential creditor’s or investor’s commitment under the financing agreement to be for at least one year (or the operating cycle, if longer) after the balance sheet date. During that period, the potential creditor or investor cannot have a right to cancel the agreement unless the debtor violates a provision (e.g., a restrictive covenant, representation, or warranty) with which compliance is objectively determinable or measurable (see item 5 below and Section 13.3.4.6).
-
The obligations or equity securities that would be issued under the financing agreement cannot be repayable on demand or within one year (or the operating cycle, if longer) after the balance sheet date.ASC 470-10-45-14(b)(1) indicates that any obligation incurred or equity securities issued under the financing agreement cannot be repayable on demand or within one year (or the debtor’s operating cycle, if longer) after the balance sheet date. Obligations that are repayable on demand or within one year (or the debtor’s operating cycle, if longer) after the balance sheet date are considered short-term obligations (see Section 13.4). Similarly, the renewal or extension of a short-term obligation for a period of more than one year would not meet this condition if the obligation contains a put option or other provision that permits the holder to demand repayment within one year after the balance sheet date.
-
The financing agreement and any obligations that would be issued under the financing agreement cannot contain a SAC.ASC 470-10-45-14(b)(1) indicates that the financing agreement cannot contain a SAC (see Section 13.3.4.6). For example, a liquidity facility with a material adverse change clause that permits the potential creditor or investor to terminate the facility would not qualify under this condition.Note that a long-term financing arrangement might not meet the conditions in ASC 470-10-45-14(b) for classification of a short-term obligation as noncurrent even if the debt that would be issued under the financing agreement would qualify as noncurrent once issued (see ASC 470-10-55-1). Long-term obligations with SACs often qualify as noncurrent under ASC 470-10-45-2 (see Section 13.6). However, a financing agreement can only be used as the basis for excluding a short-term obligation from current liabilities if the financing cannot be canceled by the lender on the basis of a SAC. The FASB believes that the circumstances addressed in the guidance on refinancing agreements in ASC 470-10-45-13 through 45-20 are different from those addressed in the guidance on SACs in long-term obligations in ASC 470-10-45-2. That is, the guidance on SACs in long-term obligations requires an entity to use judgment in determining the likelihood of acceleration of the due date of the long-term obligation, whereas the guidance on refinancing arrangements in ASC 470-10-45-14 requires the creditor to advance new funds or refinance the short-term obligation on a long-term basis.
-
If the debtor has violated a provision in the financing agreement, it has obtained a waiver.Under ASC 470-10-45-14(b)(2), the debtor must not be in violation of any provision in the financing agreement on the balance sheet date or when the financial statements are issued or available to be issued or, if a violation has occurred, the other party must have granted a waiver. Waivers should be evaluated under the guidance in ASC 470-10 on waivers (see Sections 13.5.3.2 and 13.5.3.3).
-
The potential creditor or investor must be expected to be financially capable of honoring the agreement.Under ASC 470-10-45-14(b)(3), the potential creditor or investor must be “expected to be financially capable of honoring the [financing] agreement.” If substantial doubt exists about the potential creditor’s or investor’s capacity to honor its commitment, this condition is not met.
-
The terms of the financing agreement cannot be unreasonable to the debtor.If the terms of a financing agreement are unreasonable to the debtor (e.g., with respect to interest rates or collateral requirements), the debtor would not be able to assert an intent to refinance the short-term obligation on a long-term basis under that agreement. Although a debtor is permitted to seek alternative sources of financing (see Section 13.7.4.4), it must intend to use the existing financing agreement if another source of financing does not become available.
13.7.4.3 Limit on the Amount That Can Be Classified as Noncurrent
ASC 470-10
45-17 If ability to
refinance is demonstrated by the existence of a
financing agreement (see paragraph 470-10-45-14(b)),
the amount of the short-term obligation to be
excluded from current liabilities shall be reduced
to the amount available for refinancing under the
agreement if the amount available is less than the
amount of the short-term obligation.
45-18 The amount to be
excluded shall be reduced further if information
(such as restrictions in other agreements or
restrictions as to transferability of funds)
indicates that funds obtainable under the agreement
will not be available to liquidate the short-term
obligation.
45-19 Further, if amounts
that could be obtained under the financing agreement
fluctuate (for example, in relation to the entity’s
needs, in proportion to the value of collateral, or
in accordance with other terms of the agreement),
the amount to be excluded from current liabilities
shall be limited to a reasonable estimate of the
minimum amount expected to be available at any date
from the scheduled maturity of the short-term
obligation to the end of the fiscal year (or
operating cycle). If no reasonable estimate can be
made, the entire outstanding short-term obligation
shall be included in current liabilities.
The amount of a short-term obligation that can be classified as noncurrent
cannot exceed the amount that the debtor is able to access under the
financing agreement and should take into account any limitations on the
debtor’s ability to access the amount committed under the financing
agreement. For example, the debtor may be subject to legal or contractual
restrictions that prevent it from using some or all of the amount committed
under the financing agreement to repay its short-term obligation. ASC
470-10-55-20 and 55-21 (see Section 13.7.6.4) include
an example of a scenario in which the transfer of funds between a parent and
subsidiary is legally restricted so that the parent is unable to access
funds that are available under the subsidiary’s financing agreement.
If the amount obtainable under a financing agreement fluctuates (e.g., on the
basis of collateral value of the debtor’s trade receivables), the debtor
should make a reasonable estimate of the minimum amount expected to be
available on any date during the period from the scheduled maturity of the
short-term obligation to the end of the fiscal year (or the entity’s
operating cycle, if longer). If a reasonable estimate cannot be made, the
financing agreement cannot be used to support a decision to exclude the
short-term obligation from current liabilities. ASC 470-10-55-27 through
55-29 (see Section 13.7.6.4) contain an example of a
financing agreement that meets the conditions in ASC 470-10-45-14(b) and
limits the amount that the debtor can borrow under the agreement to the
amount of its inventory.
13.7.4.4 Standby Financing Agreement
ASC 470-10
45-20 The entity may
intend to seek an alternative source of financing
rather than to exercise its rights under the
existing agreement when the short-term obligation
becomes due. The entity must intend to exercise its
rights under the existing agreement, however, if
that other source does not become available. The
intent to exercise may not be present if the terms
of the agreement contain conditions or permit the
prospective lender or investor to establish
conditions, such as interest rates or collateral
requirements, that are unreasonable to the
entity.
A financing agreement can qualify under ASC 470-10-45-14(b) even if a debtor
is seeking an alternative source of financing (e.g., one that is more
advantageous). Although a debtor is required to demonstrate an intent to
refinance the short-term obligation on a long-term basis, such an intent can
be present even if the financing agreement serves as a fallback or standby
source of financing. It is sufficient that the debtor intends to use the
financing agreement to refinance the short-term obligation on a long-term
basis if it does not find another source of financing. However, the debtor
should evaluate whether the terms of the financing agreement are reasonable.
If the terms are unreasonable to the debtor (e.g., the interest rate is in
excess of what the debtor is ready and willing to pay), it would be unable
to assert an intent to use that financing agreement if another source of
financing is not available.
Example 13-9
Lack of Intent to Refinance Short-Term Obligation
on a Long-Term Basis
A debtor is evaluating whether it can classify a
short-term obligation as a noncurrent liability
under ASC 470-10-45-14(b). It has a long-term line
of credit that clearly permits it to refinance the
short-term obligation on a long-term basis at 15
percent per annum. Because that interest rate is
significantly in excess of the interest rate the
debtor expects it would have to pay if it were to
enter into a similar line of credit arrangement that
reflects current market interest rates, it is
exploring whether to renegotiate the line of credit.
However, if it is unable to obtain a reduction in
the interest rate on the line of credit, the debtor
expects to pay off the short-term obligation by
using excess cash. In this scenario, the debtor
would not be able to assert an intent to refinance
the short-term obligation on a long-term basis under
the line of credit because it expects to use current
assets rather than the existing financing agreement
to repay the short-term obligation if it is unable
to renegotiate the financing agreement’s terms.
13.7.4.5 Best-Efforts Remarketing Agreements
ASC 470-10
Example 2: Classification by
the Issuer of Redeemable Instruments That Are
Subject to Remarketing Agreements
55-7 This Example
illustrates the guidance for the appropriate
classification by the issuer of debt if all of the
following conditions exist:
-
The debt has a long-term maturity (for example, 30 to 40 years).
-
The debt holder may redeem or put the bond on short notice (7 to 30 days).
-
The issuer has a remarketing agreement that states that the agent will make its best effort to remarket the bond when redeemed.
-
The debt is secured by a short-term letter of credit that provides protection to the debt holder in the event that the redeemed debt cannot be remarketed. (Amounts drawn against the letter of credit are payable back to the issuer of the letter of credit by the issuer of the redeemable debt instrument on the same day that the drawdown occurs.)
55-8 Debt agreements that
allow a debt holder to redeem (or put) a debt
instrument on demand (or within one year) should be
classified as short-term liabilities despite the
existence of a best-efforts remarketing agreement.
That is, unless the issuer of the redeemable debt
instrument has the ability and intent to refinance
the debt on a long-term basis as provided for in
paragraph 470-10-45-14, the debt should be
classified as a current liability.
55-9 In this Example, the
obligation would be classified by the issuer as
noncurrent only if the letter-of-credit arrangement
meets the requirements of paragraph
470-10-45-14(b).
ASC 470-10-55-7 through 55-9 include guidance on the classification of a
puttable debt obligation (such as a variable rate demand obligation) that is
subject to a best-efforts remarketing agreement and short-term letter of
credit. ASC 470-10-55-8 indicates that since a best-efforts remarketing
agreement is not binding, its existence is not sufficient evidence of a
debtor’s intent and ability to refinance a short-term obligation on a
long-term basis under ASC 470-10-45-14(b) (see Section 13.7.4.2).
13.7.4.6 Subsidiary’s Ability to Rely on Parent’s Financing Agreement
Rather than have multiple subsidiaries enter into individual long-term
financing agreements, a parent may enter into a single external arrangement
that allows it to provide intercompany financing to its subsidiaries for all
their short-term obligations to be refinanced on a long-term basis. Although
there may be no formal written agreement between the parent and its
individual subsidiaries that describes the terms of such a financing
arrangement, the parent’s intent and ability to provide long-term financing
to the subsidiary (through either an intercompany loan or an infusion of
capital) would enable the subsidiary to refinance its short-term obligations
on a long-term basis. The parent may provide such financing to the
subsidiary by either (1) using its own working capital or (2) drawing down
on the external financing agreement.
To exclude short-term obligations from current liabilities in its stand-alone
financial statements, a subsidiary may use an intercompany financing
arrangement with its parent to demonstrate its ability to refinance a
short-term obligation on a long-term basis if the criteria in ASC
470-15-45-14 are met (see Section
13.7.4.2). For the subsidiary to meet the criteria in ASC
470-15-45-14, there must be evidence that its parent has committed a portion
of its liquidity resources to servicing the subsidiary’s short-term
obligation on a long-term basis. That evidence should be documented in a
written intercompany financing agreement or in a confirmation of the details
of the arrangement with the parent. In either case, the evidence should
explicitly cover the criteria in ASC 470-10-45-14:
-
The parent must be committed to providing financing to the subsidiary on terms that would allow the subsidiary to refinance the short-term obligation on a long-term basis.
-
The parent must be committed to not canceling the agreement within one year (or the operating cycle) after the subsidiary’s balance sheet date for any reason that is not objectively determinable. To the extent that objectively determinable events may give rise to cancellation of the agreement, such events should be detailed in the confirmation obtained from the parent.
-
The parent must be financially capable of honoring the intercompany financing agreement after taking into account all of its other obligations, including the obligation to provide financing to other subsidiaries under similar agreements.
Although the parent is not required to have an external financing agreement
that meets the conditions in ASC 470-10-45-14 to demonstrate its financial
capabilities, in some circumstances establishing the parent’s ability to
refinance may be difficult in the absence of such agreement. In the
consolidated financial statements, a subsidiary’s obligations represent
obligations of the consolidated entity; therefore, the absence of an
external financing agreement (or post-balance-sheet issuance of a long-term
obligation or equity securities) that meets the conditions in ASC
470-10-45-14 would preclude a noncurrent classification of the subsidiary’s
short-term obligations on the parent’s consolidated balance sheet.
13.7.5 Disclosure
ASC 470-10
Short-Term Obligations Expected to Be
Refinanced
50-4 If a short-term
obligation is excluded from current liabilities pursuant
to the provisions of this Subtopic, the notes to
financial statements shall include a general description
of the financing agreement and the terms of any new
obligation incurred or expected to be incurred or equity
securities issued or expected to be issued as a result
of a refinancing.
When a debtor classifies a short-term obligation as a noncurrent liability under
ASC 470-10-45-14, it must include a general description of the
post-balance-sheet-date refinancing (see Section
13.7.3) or the financing agreement (see Section 13.7.4), as applicable.
13.7.6 Examples
13.7.6.1 Background
ASC 470-10
Example 4: Current Maturity of Long-Term Debt
and Notes Payable to Be Refinanced
55-13 The following Cases
illustrate various scenarios for refinancing the
current portion of long-term debt and notes payable
as discussed in paragraphs 470-10-45-13 through
45-20:
-
Entity refinances on long-term basis the current maturity of long-term debt and notes payable (Case A).
-
Laws prohibit the transfer of funds (Case B).
-
Entity issues debentures to liquidate the debt (Case C).
-
Entity negotiates a revolving credit agreement (Case D).
-
Entity negotiates a revolving credit agreement with borrowing limits (Case E).
-
Entity refinances commercial paper (Case F).
-
Case illustrates balance sheet presentation (Case G).
ASC 470-10-55 includes multiple cases illustrating whether
short-term obligations should be classified as current or noncurrent under
ASC 470-10-45-14 in various refinancing scenarios. The assumptions in most
of the cases are similar (see the next section). The cases address the
application of the guidance to:
-
Two post-balance-sheet-date refinancing scenarios (Case C of Example 4, and Example 5); see Section 13.7.6.3.
-
Various financing agreements (Cases A, B, D, and E of Example 4); see Section 13.7.6.4.
-
A financing agreement related to a long-term construction project (Case F of Example 4); see Section 13.7.6.5. (SAB Topic 6.H.2 also addresses this scenario.)
In addition, Case G in Example 4 illustrates balance sheet
presentation; see Section
13.7.6.6.
13.7.6.2 Shared Assumptions
ASC 470-10
Example 4: Current Maturity of Long-Term Debt
and Notes Payable to Be Refinanced
55-14 The Cases in this
Example do not comprehend all possible circumstances
and do not include all the disclosures that would
typically be made regarding long-term debt or
current liabilities.
55-15 Cases A through G
share all of the following assumptions:
-
Entity A’s fiscal year-end is December 31, 19X5.
-
The date of issuance of the December 31, 19X5, financial statements is March 31, 19X6; the Entity’s practice is to issue a classified balance sheet.
-
At December 31, 19X5, short-term obligations include $5,000,000 representing the portion of 6 percent long-term debt maturing in February 19X6 and $3,000,000 of 9 percent notes payable issued in November 19X5 and maturing in July 19X6.
-
The Entity intends to refinance on a long-term basis both the current maturity of long-term debt and the 9 percent notes payable.
-
Accounts other than the long-term debt maturing in February 19X6 and the notes payable maturing in July 19X6 are as follows.
-
Unless otherwise indicated, the Cases also assume that the lender or prospective lender is expected to be capable of honoring the agreement, that there is no evidence of a violation of any provision, and that the terms of borrowings available under the agreement are readily determinable.
ASC 470-10-55-14 and 55-15 contain assumptions that apply to
Cases A through G in Example 4 in ASC 470-10-55-16 through 55-32 (see the
next section and Section
13.7.6.4).
13.7.6.3 Post-Balance-Sheet-Date Refinancing
ASC 470-10
Example 4: Current Maturity of Long-Term Debt
and Notes Payable to Be Refinanced
Case C: Entity Issues Debentures to Liquidate the
Debt
55-21 In this Case, the
Entity issues $8,000,000 of 10-year debentures to
the public in January 19X6. The Entity intends to
use the proceeds to liquidate the $5,000,000 debt
maturing February 19X6 and the $3,000,000 of 9
percent notes payable maturing July 19X6. In
addition, assume the debt maturing February 19X6 is
paid before the issuance of the balance sheet, and
the remaining proceeds from the sale of debentures
are invested in a U.S. Treasury note maturing the
same day as the 9 percent notes payable.
55-22 Because the Entity
refinanced the long-term debt maturing in February
19X6 in a manner that meets the conditions set forth
in paragraph 470-10-45-14, that obligation would be
excluded from current liabilities. In addition, the
9 percent notes payable maturing in July 19X6 would
also be excluded because the Entity has obtained
funds expressly intended to be used to liquidate
those notes and not intended to be used in current
operations. In balance sheets after the date of sale
of the debentures and before the maturity date of
the notes payable, the Entity would exclude the
notes payable from current liabilities if the U.S.
Treasury note is excluded from current assets (see
paragraph 210-10-45-4).
55-23 If the debentures
had been sold before January 1, 19X6, the $8,000,000
of obligations to be paid would be excluded from
current liabilities in the balance sheet at that
date if the $8,000,000 in funds were excluded from
current assets.
55-24 If, instead of
issuing the 10-year debentures, the Entity had
issued $8,000,000 of equity securities and all other
facts in this Case remained unchanged, both the 6
percent debt due February 19X6 and the 9 percent
notes payable due July 19X6 would be classified as
liabilities other than current liabilities, such as
Indebtedness Due in 19X6 Refinanced in January
19X6.
Example 5: Classification of a Short-Term
Obligation Repaid Before Being Replaced by a
Long-Term Security
55-33
This Example illustrates the guidance in paragraph
470-10-45-15.
55-34 This Example has the
following assumptions:
-
An Entity has issued $3,000,000 of short-term commercial paper during the year to finance construction of a plant.
-
At June 30, 1976, the Entity’s fiscal year end, the Entity intends to refinance the commercial paper by issuing long-term debt. However, because the Entity temporarily has excess cash, in July 1976 it liquidates $1,000,000 of the commercial paper as the paper matures.
-
In August 1976, the Entity completes a $6,000,000 long-term debt offering.
-
Later during the month of August, it issues its June 30, 1976, financial statements.
-
The proceeds of the long-term debt offering are to be used to do all of the following:
-
Replenish $1,000,000 in working capital
-
Pay $2,000,000 of commercial paper as it matures in September 1976
-
Pay $3,000,000 of construction costs expected to be incurred later that year to complete the plant.
-
55-35 The $1,000,000 of
commercial paper liquidated in July would be
classified as a current liability in the Entity’s
balance sheet at June 30, 1976. The $2,000,000 of
commercial paper liquidated in September 1976 but
refinanced by the long-term debt offering in August
1976 would be excluded from current liabilities in
balance sheets at the end of June 1976, July 1976,
and August 1976. It should be noted that the
existence of a financing agreement at the date the
financial statements are issued or are available to
be issued (as discussed in Section 855-10-25) rather
than a completed financing at that date would not
change these classifications.
55-36 At the end of August
1976, $2,000,000 of cash would be excluded from
current assets or, if included in current assets, a
like amount of debt would be classified as a current
liability.
Case C in Example 4 in ASC 470-10-55-21 through 55-24 illustrates the
application of the guidance on post-balance-sheet-date refinancings in ASC
470-10-25-14(a) (see Section
13.7.3.1). Example 5 in ASC 470-10-55-33 through 55-36
illustrates the application of that guidance in a scenario in which the
short-term obligation is repaid before the post-balance-sheet-date
refinancing (see Section 13.7.3.2).
The assumptions in ASC 470-10-55-14 and 55-15 apply to Case C (see Section 13.7.6.2).
13.7.6.4 Financing Agreements
ASC 470-10
Example 4: Current Maturity of Long-Term Debt
and Notes Payable to Be Refinanced
Case A: Entity Refinances on Long-Term Basis the
Current Maturity of Long-Term Debt and Notes
Payable
55-16 The Entity
negotiates a financing agreement with a commercial
bank in December 19X5 for a maximum borrowing of
$8,000,000 at any time through 19X7 with the
following terms:
-
Borrowings are available at Entity A’s request for such purposes as it deems appropriate and will mature three years from the date of borrowing.
-
Amounts borrowed will bear interest at the bank’s prime rate.
-
An annual commitment fee of 1/2 of 1 percent is payable on the difference between the amount borrowed and $8,000,000.
-
The agreement is cancelable by the lender only if any of the following occur:
-
The Entity’s working capital, excluding borrowings under the agreement, falls below $10,000,000.
-
The Entity becomes obligated under lease agreements to pay an annual rental in excess of $1,000,000.
-
Treasury stock is acquired without the prior approval of the prospective lender.
-
The Entity guarantees indebtedness of unaffiliated persons in excess of $500,000.
-
55-17 The Entity’s
intention to refinance meets the condition specified
by paragraph 470-10-45-14. Compliance with the
provisions listed in (d) of the preceding paragraph
is objectively determinable or measurable;
therefore, the condition specified by paragraph
470-10-45-14(b)(1) is met. The proceeds of
borrowings under the agreement are clearly available
for the liquidation of the 9 percent notes payable
and the long-term debt maturing in February 19X6.
Both obligations, therefore, would be classified as
other than current liabilities.
55-18 Following are the
liability section of Entity A’s balance sheet at
December 31, 19X5, and the related note disclosures
required by this Subtopic, based on the information
in paragraphs 470-10-55-15 through 55-16. Because
the balance sheet is issued subsequent to the
February 19X6 maturity of the long-term debt, the
note describes the refinancing of that
obligation.
Note A
The Entity has entered into a financing agreement
with a commercial bank that permits the Entity to
borrow at any time through 19X7 up to $8,000,000 at
the bank’s prime rate of interest. The Entity must
pay an annual commitment fee of 1/2 of 1 percent of
the unused portion of the commitment. Borrowings
under the financing agreement mature three years
after the date of the loan. Among other things, the
agreement prohibits the acquisition of treasury
stock without prior approval by the bank, requires
maintenance of working capital of $10,000,000
exclusive of borrowings under the agreement, and
limits the annual rental under lease agreements to
$1,000,000. In February 19X6, the Entity borrowed
$5,000,000 at 8 percent and liquidated the 6 percent
long-term debt, and it intends to borrow additional
funds available under the agreement to refinance the
9 percent notes payable maturing in July 19X6.
Case B: Laws Prohibit the Transfer of Funds
55-19 A foreign subsidiary
of the Entity negotiates a financing agreement with
its local bank in December 19X5. Funds are available
to the subsidiary for its unrestricted use,
including loans to affiliated entities; other terms
are identical to those cited in Case A. Local laws
prohibit the transfer of funds outside the
country.
55-20 The requirement of
paragraph 470-10-45-14(b)(1) is met because
compliance with the provisions of the agreement is
objectively determinable or measurable. Because of
the laws prohibiting the transfer of funds, however,
the proceeds from borrowings under the agreement are
not available for liquidation of the debt maturing
in February and July 19X6. Accordingly, both the 6
percent debt maturing in February 19X6 and the 9
percent notes payable maturing in July 19X6 would be
classified as current liabilities.
Case D: Revolving Credit Agreement
55-25 In December 19X5 the
Entity negotiates a revolving credit agreement
providing for unrestricted borrowings up to
$10,000,000. Borrowings will bear interest at 1
percent over the prevailing prime rate of the bank
with which the agreement is arranged but in any
event not less than 8 percent, will have stated
maturities of 90 days, and will be continuously
renewable for 90-day periods at the Entity’s option
for 3 years provided there is compliance with the
terms of the agreement. Provisions of the agreement
are similar to those cited in paragraph
470-10-55-16(d). Further, the Entity intends to
renew obligations incurred under the agreement for a
period extending beyond one year from the balance
sheet date. There are no outstanding borrowings
under the agreement at December 31, 19X5.
55-26 In this instance,
the long-term debt maturing in February 19X6 and the
9 percent notes payable maturing in July 19X6 would
be excluded from current liabilities because the
Entity consummated a financing agreement meeting the
conditions set forth in paragraph 470-10-45-14(b)
before the issuance of the balance sheet.
Case E: Revolving Credit Agreement
With Borrowing Limits
55-27 Assume that the
agreement cited in Case D included an additional
provision limiting the amount to be borrowed by the
Entity to the amount of its inventory, which is
pledged as collateral and is expected to range
between a high of $8,000,000 during the second
quarter of 19X6 and a low of $4,000,000 during the
fourth quarter of 19X6.
55-28 The terms of the
agreement comply with the conditions required by
this Subtopic; however, because the minimum amount
expected to be available from February to December
19X6 is $4,000,000, only that amount of short-term
obligations can be excluded from current liabilities
(see paragraphs 470-10-45-16 through 45-19). Whether
the obligation to be excluded is a portion of the
currently maturing long-term debt or some portions
of both it and the 9 percent notes payable depends
on the intended timing of the borrowing.
55-29 If the Entity
intended to refinance only the 9 percent notes
payable due July 19X6 and the amount of its
inventory is expected to reach a low of
approximately $2,000,000 during the second quarter
of 19X6 but be at least $3,000,000 in July 19X6 and
thereafter during 19X6, the $3,000,000 9 percent
notes payable would be excluded from current
liabilities at December 31, 19X5 (see paragraphs
470-10-45-16 through 45-19).
Cases A, B, D, and E in Example 4 in ASC 470-10-55-16 through 55-20 and ASC
470-10-55-25 through 55-29 illustrate the application of the guidance on
financing agreements in ASC 470-10-25-14(b) (see Section 13.7.4). The assumptions in ASC 470-10-55-14 and
55-15 (see Section 13.7.6.2) apply to these cases. Further, Cases B and
E illustrate the application of the guidance on the limits on the amount
that can be classified as noncurrent when the amount available under the
financing agreement is subject to transfer restrictions or fluctuates (see
Section 13.7.4.3).
13.7.6.5 Financing Agreements Related to Long-Term Construction Projects
ASC 470-10
Example 4: Current Maturity of Long-Term Debt
and Notes Payable to Be Refinanced
Case F: Commercial Paper Refinancing
55-30 In lieu of the facts
given in paragraph 470-10-55-15(c) through (d),
assume that during 19X5 the Entity entered into a
contract to have a warehouse built. The warehouse is
expected to be financed by issuance of the Entity’s
commercial paper. In addition, the Entity negotiated
a standby agreement with a commercial bank that
provides for maximum borrowings equal to the
expected cost of the warehouse, which will be
pledged as collateral. The agreement also requires
that the proceeds from the sale of commercial paper
be used to pay construction costs. Borrowings may be
made under the agreement only if the Entity is
unable to issue new commercial paper. The proceeds
of borrowings must be used to retire outstanding
commercial paper and to liquidate additional
liabilities incurred in the construction of the
warehouse. At December 31, 19X5, the Entity has
$7,000,000 of commercial paper outstanding and
$1,000,000 of unpaid construction costs resulting
from a progress billing through December 31.
55-31 Because the
commercial paper will be refinanced on a long-term
basis, either by uninterrupted renewal or, failing
that, by a borrowing under the agreement, the
commercial paper would be excluded from current
liabilities. The $1,000,000 liability for the unpaid
progress billing results from the construction of a
noncurrent asset and will be refinanced on the same
basis as the commercial paper and, therefore, it
would also be excluded from current liabilities (see
paragraph 470-10-45-13).
SEC Staff Accounting Bulletins
SAB Topic 6.H.2, Classification of
Short-Term Obligations — Debt Related to Long-Term
Projects
[Reproduced in ASC
470-10-S99-3]
Facts: Companies engaging in
significant long-term construction programs
frequently arrange for revolving cover loans which
extend until the completion of long-term
construction projects. Such revolving cover loans
are typically arranged with substantial financial
institutions and typically have the following
characteristics:
-
A firm long-term mortgage commitment is obtained for each project.
-
Interest rates and terms are in line with the company’s normal borrowing arrangements.
-
Amounts are equal to the expected full mortgage amount of all projects.
-
The company may draw down funds at its option up to the maximum amount of the agreement.
-
The company uses short-term interim construction financing (commercial paper, bank loans, etc.) against the revolving cover loan. Such indebtedness is rolled over or drawn down on the revolving cover loan at the company’s option. The company typically has regular bank lines of credit, but these generally are not legally enforceable.
Question: Under FASB ASC
Subtopic 470-10, Debt — Overall, will the
classification of loans such as described above as
long-term be acceptable?
Interpretive Response: Where
such conditions exist providing for a firm
commitment throughout the construction program as
well as a firm commitment for permanent mortgage
financing, and where there are no contingencies
other than the completion of construction, the
guideline criteria are met and the borrowing under
such a program should be classified as long-term
with appropriate disclosure.
Case F in Example 4 in ASC 470-10-55-30 and 55-31 and SAB Topic 6.H.2
illustrate the application of the guidance on financing agreements in ASC
470-10-25-14(b) (see Section 13.7.4)
to scenarios that involve short-term interim financing to fund long-term
construction projects. The assumptions in ASC 470-10-55-14 and 55-15 (see
Section 13.7.6.2) apply to Case F
except as specified in ASC 470-10-55-30.
This guidance illustrates that a short-term interim financing (e.g.,
commercial paper, bank loans) can be classified as noncurrent if a financing
agreement (e.g., a firm, revolving long-term mortgage commitment for the
construction project) meets the conditions in ASC 470-10-45-14(b). The fact
that the financing agreement is contingent on the completion of construction
is not relevant.
13.7.6.6 Balance Sheet Presentation
ASC 470-10
Example 4: Current Maturity of Long-Term Debt
and Notes Payable to Be Refinanced
Case G: Balance Sheet Presentation
55-32 The following are
two methods of presenting liabilities in Entity A’s
balance sheet at December 31, 19X5, assuming the
Entity intends to refinance the 6 percent debt
maturing in February 19X6 and the 9 percent notes
payable maturing in July 19X6 but has not met the
conditions required by this Subtopic to exclude
those obligations from current liabilities.
Alternative 1
Alternative 2
Case G in Example 4 in ASC 470-10-55-32 illustrates the appropriate balance
sheet presentation based on the assumptions in ASC 470-10-55-14 and 55-15
(see Section 13.7.6.2).
13.8 Revolving Debt
13.8.1 Background
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).
A revolving-debt arrangement is an agreement under which
borrowed amounts that are repaid can be reborrowed. That is, the potential
debtor can make multiple borrowings up to a specified maximum amount, repay
borrowed amounts, and reborrow. Some, but not all, revolving-debt arrangements
contain a lockbox feature with which remittances made by the debtor’s customers
are used to repay the debtor’s outstanding debt obligation (see Sections 13.3.4.7 and
13.3.4.8). The
next section discusses the classification of a revolving-debt arrangement
without a lockbox feature, and Section 13.8.3 addresses revolving-debt arrangements with a
lockbox feature.
13.8.2 Revolving Debt Without Lockbox Feature
ASC 470-10
45-4 Borrowings outstanding
under certain revolving credit agreements are considered
long-term debt because the borrowings are due at the end
of a specified period (for example, 3 years) rather than
when short-term notes roll over (for example, every 90
days). Borrowings may be collateralized, but the only
note is the overall note signed at the agreement’s
inception. . . .
Nonauthoritative AICPA Guidance
Technical Q&As Section 3200, “Long-Term
Debt”
.12 Balance Sheet Classification of Revolving Line
of Credit
Inquiry — A company has a revolving line of credit
with a bank. The company is only required to make
monthly interest payments. No principal payments are
required. In the event the credit line is terminated,
the principal is due 12 months after the date of
termination.
Should the principal amount be classified as current or
long-term in a classified balance sheet?
Reply — Financial Accounting Standards Board
(FASB) Accounting Standards Codification (ASC)
210-10-45-9 states that liabilities whose regular and
ordinary liquidation is expected to occur within a
relatively short period of time, usually 12 months, are
intended for inclusion in the current liability
classification. If the line of credit has not been
terminated at the balance sheet date, the principal
amount should be classified as long-term, unless the
company intends to repay the outstanding debt within 12
months.
[Revised, June 2009, to reflect conforming changes
necessary due to the issuance of FASB ASC.]
Borrowings under a revolving-debt agreement without a lockbox feature are
classified as current or noncurrent in the same manner as nonrevolving-debt
obligations. Generally, such borrowings are classified as current liabilities if
(1) they are scheduled to mature within one year (or the operating cycle, if
longer), (2) the creditor could demand earlier repayment (see Sections 13.4 and 13.5), or (3) it is probable that a SAC will be exercised (see
Section 13.6). However, a
revolving-debt agreement would qualify as a noncurrent liability if the debtor
can demonstrate its intent and ability to refinance the obligation on a
long-term basis (see Section 13.7) or, in
the case of a long-term revolving-debt agreement for which a covenant violation
has occurred, either of the exceptions for covenant waivers and grace periods
applies (see Section 13.5.3). ASC
470-10-55-25 and 55-26 illustrate a scenario in which a long-term
revolving-credit agreement is used to demonstrate an intent and ability to
refinance a short-term obligation on a long-term basis (see Section 13.7.6.4).
13.8.3 Revolving Debt With Lockbox Feature
Some debt agreements require the debtor to establish a lockbox with the creditor.
ASC 470-10-45-5 and 45-6 draw a distinction between traditional and springing
lockbox features.
13.8.3.1 Traditional Lockbox Arrangements
As discussed in Section
13.8.3.3, a revolving-debt obligation that contains a
traditional lockbox arrangement is considered a short-term obligation.
Therefore, it can be classified as a noncurrent liability only if the debtor
has the intent and ability to refinance the obligation on a long-term basis.
This depends on the circumstances, including whether the debt agreement has
a SAC and whether repayments made through the lockbox arrangement can be
considered refinanced on a long-term basis in accordance with ASC
470-10-45-13 through 45-21 (see Section 13.7.4).
13.8.3.2 Springing Lockbox Arrangements
Because customer remittances paid to a lockbox in a revolving-credit
arrangement that incorporates a springing lockbox feature (see Section 13.3.4.8) are not used to pay down
the debtor’s obligation unless the springing lockbox is triggered, a
revolving-credit arrangement that is not repayable within one year (or the
operating cycle, if longer) generally is considered a long-term obligation
under ASC 470-10 even if it contains a springing lockbox feature (see ASC
470-10-45-6).
Springing lockbox arrangements usually include a SAC (see Section 13.3.4.6) that, if exercised, allows
the creditor to cause the cash in the lockbox at that moment, as well as all
subsequent customer lockbox remittances, to be applied against the debtor’s
outstanding debt balance. That is, once the creditor exercises the SAC, in
addition to acceleration of the debt, the springing lockbox arrangement will
function like a traditional lockbox agreement (see Section 13.3.4.7). Therefore, the debtor
must consider the guidance on SACs in long-term obligations (see Section 13.6).
Borrowings under revolving-debt arrangements with a springing lockbox feature
are classified as noncurrent liabilities if they are scheduled to mature one
year (or the operating cycle, if applicable) after the balance sheet date
unless (1) the creditor could demand earlier repayment (see Sections 13.4 and 13.5) or (2) it is probable that a SAC will be exercised
(see Section 13.6). If a covenant
violation has occurred that makes the debt repayable within one year (or the
operating cycle, if longer) after the balance sheet date, the debtor should
also consider whether the debt can be classified as noncurrent under the
guidance on waiver exceptions and grace periods (see Section 13.5.3).
Borrowings under revolving-debt arrangements with a
springing lockbox feature are classified as current liabilities if (1) they
are scheduled to mature within one year (or the operating cycle, if longer),
(2) the creditor could demand earlier repayment (see Sections 13.4 and
13.5), or
(3) it is probable that a SAC will be exercised (see Section 13.6).
However, such borrowings qualify as noncurrent liabilities if the debtor can
demonstrate its intent and ability to refinance the obligation on a
long-term basis (see Section 13.7) or, in the case of a covenant violation,
either of the exceptions for covenant waivers and grace periods applies (see
Section
13.5.3).
13.8.3.3 Revolving Debt With Lockbox Feature and SAC
ASC 470-10
45-3 This guidance does
not apply to lock-box arrangements that are
maintained at the discretion of the borrower.
45-4 . . . Some agreements
require that the borrower maintain a lock-box
arrangement. If borrowings outstanding under the
agreement are considered long-term obligations, the
effect of a subjective acceleration clause on
balance sheet classification is determined based on
the criteria in paragraph 470-10-45-2. If borrowings
outstanding are considered short-term obligations,
and the borrower intends to refinance the obligation
on a long-term basis, paragraph 470-10-45-13 applies
and the debt shall be classified as a current
liability because of the existence of the subjective
acceleration clause.
45-5 Borrowings
outstanding under a revolving credit agreement that
includes both a subjective acceleration clause and a
requirement to maintain a lock-box arrangement shall
be considered short-term obligations. Accordingly,
because of the subjective acceleration clause, the
debt shall be classified as a current liability
unless the conditions in paragraph 470-10-45-14 are
met based on an agreement, other than the revolving
credit agreement, to refinance the obligation after
the balance sheet date on a long-term basis.
45-6 Borrowings
outstanding under a revolving credit agreement that
includes both a subjective acceleration clause and a
requirement to maintain a springing lock-box
arrangement shall be considered long-term
obligations since the remittances do not
automatically reduce the debt outstanding without
another event occurring. The effect of the
agreement’s subjective acceleration clause shall be
determined based on the provisions of paragraph
470-10-45-2.
45-21 Replacement of a
short-term obligation with another short-term
obligation after the date of the balance sheet but
before the balance sheet is issued or is available
to be issued (as discussed in Section 855-10-25) is
not, by itself, sufficient to demonstrate an
entity’s ability to refinance the short-term
obligation on a long-term basis. If, for example,
the replacement is made under the terms of a
revolving credit agreement that provides for renewal
or extension of the short-term obligation for an
uninterrupted period extending beyond one year (or
operating cycle) from the date of the balance sheet,
the revolving credit agreement must meet the
conditions in paragraph 470-10-45-14(b) to justify
excluding the short-term obligation from current
liabilities. . . .
A revolving-credit arrangement with a traditional lockbox
feature (see Section
13.3.4.7) is considered a short-term obligation. Under ASC
470-10-45-14, short-term obligations are classified as noncurrent
liabilities if the borrower has the intent and ability to refinance such
obligations on a long-term basis (see Section 13.7). However, the existence
of a SAC within a revolving-debt arrangement disqualifies the entity from
using the revolving-debt arrangement as the means to refinance the
obligation on a long-term basis even if the revolving-debt arrangement does
not expire within one year (or the operating cycle, if longer) after the
balance sheet date. Accordingly, a revolving-credit agreement that
incorporates both a traditional lockbox feature and a SAC must be classified
as a current liability unless the conditions in ASC 470-10-45-14 are met on
the basis of an agreement other than the revolving-debt arrangement (see
Section
13.7). (As discussed in Section 13.7.4, a long-term
revolving-debt agreement with a traditional lockbox feature that does not
have a SAC may meet the conditions in ASC 470-10-45-14(b).)
If a long-term
revolving-debt arrangement incorporates a springing lockbox feature (see
Section
13.3.4.8) and a SAC (see Section 13.3.4.6), the classification
of the related borrowings depends on the likelihood that the SAC will be
exercised. If exercise of the SAC is probable, the revolving-debt
arrangement must be classified as a current liability unless the conditions
in ASC 470-10-45-14 are met on the basis of an agreement other than the
revolving-debt arrangement (see Section 13.7). The impact of lockbox
features and SACs on the classification of a revolving-credit agreement is
summarized in the following decision tree:
2
Remittances from the borrower’s customers are
forwarded to the debtor’s general bank account and not used to
reduce the outstanding debt unless or until the lender exercises
the SAC (ASC 470-10-45-6).
3
Classify the borrowing as a current liability
unless the ability to refinance the liability for a long-term
period comes from an agreement other than the revolving-credit
agreement.
13.9 Increasing-Rate Debt
ASC 470-10
45-7
Classification of increasing-rate debt as current or
noncurrent would reflect the borrower’s anticipated source
of repayment that is, current assets or a new short-term
debt borrowing versus a long-term refinancing agreement that
meets the requirements of this Subtopic and need not be
consistent with the time frame used to determine periodic
interest cost.
The manner in which increasing-rate extendable debt is classified as current or
noncurrent is not necessarily consistent with how periodic interest cost is
determined under ASC 470-10-35-1 and 35-2 (see Section
6.2.4.5). Rather, increasing-rate extendable debt should be
classified as current or noncurrent on the basis of the same general guidance in ASC
470-10 that applies to all other debt instruments. The debtor may therefore need to
consider whether a refinancing arrangement meets the requirements in ASC
470-10-45-14 (see Section 13.7).
13.10 Convertible Debt
ASC 470-20
45-1B The guidance on
convertible debt instruments in this Subtopic does not
affect an issuer’s determination of whether the instruments
should be classified as a current liability or a long-term
liability. For purposes of applying other applicable U.S.
generally accepted accounting principles (GAAP) to make that
determination, all terms of the convertible debt instrument
shall be considered.
Nonauthoritative AICPA Guidance
Technical Q&As Section 1100, “Statement of Financial
Position”
.14 Classification of Convertible Debt
Inquiry — A company has debt that is convertible into
common stock of the company at the option of the company.
The debt by its terms is considered long-term debt in the
classified balance sheet. The company intends to call the
debt and issue the common stock within one year of the
balance sheet date. Should this debt be classified as a
current liability?
Reply — No. The expected call of the debt securities
will not consume current assets or increase current
liabilities, and accordingly should continue to be
classified as a long-term obligation.
The general principle underlying the classification of debt
in a debtor’s principal balance sheet should be based on
facts existing at the date of the balance sheet rather than
on expectations. According to FASB Accounting Standards
Codification (ASC) glossary, the term current
liabilities “is used principally to designate
obligations whose liquidation is reasonably expected to
require the use of existing resources properly classifiable
as current assets, or the creation of other current
liabilities.” . . .
The classification of convertible debt as current or noncurrent depends on the terms
of the debt. Current liabilities generally include convertible debt obligations for
which payment of cash or other current assets or the creation of current liabilities
could be required within one year (or the operating cycle, if longer) after the
balance sheet date. Unless debt has met the requirements related to short-term
obligations expected to be refinanced on a long-term basis (see Section 13.7), current classification is necessary for:
-
Convertible debt that is scheduled to mature within one year (or the operating cycle, if longer) after the balance sheet date (see Section 13.3).
-
Any portion of long-term convertible debt that is scheduled to mature within one year (or the operating cycle, if longer) after the balance sheet date (e.g., the current portion of an amortizing long-term debt obligation for which the principal amount is paid down over the obligation’s life; see Section 13.3).
-
Convertible debt that is repayable on demand or puttable by the holder within one year (or the operating cycle, if longer) after the balance sheet date (see Section 13.4), including convertible debt that is contingently puttable if the contingency has been met.
-
Long-term convertible debt that became repayable on demand or within one year (or the operating cycle, if longer) after the balance sheet date because of a covenant violation that occurred as of the balance sheet date or before the financial statements were issued or available to be issued (see Section 13.5). Note that the issuer should consider whether either of the exceptions for covenant waivers and grace periods is applicable (see Section 13.5.3).
-
The cash-settled portion of debt that is convertible at any time or within one year (or the operating cycle, if longer) after the balance sheet date if the issuer is or could be required to settle all or part of the conversion value in cash upon conversion (e.g., Instrument A and Instrument C; see Section 2.3.2.2). Such debt is treated as debt that is repayable on demand (see Section 13.4) even if the conversion option is out-of-the-money.
Generally, the holder’s conversion option does not affect the classification of
convertible debt as current or noncurrent if it must be settled by the delivery of
the issuer’s equity shares (see Section
13.3.3.4).
13.11 Long-Term Obligations That Debtor Repays or Intends to Repay After the Balance Sheet Date
ASC 470-10 does not require an entity to classify a long-term debt
obligation as a current liability on the basis that the entity expects to settle the
debt within one year (or the operating cycle, if longer) after the balance sheet
date (e.g., the debtor expects to exercise an early repayment option such as an
embedded call option in the debt). While ASC 210-10-45-9 states that liabilities
whose “ordinary liquidation is expected to occur within a relatively short period of
time, usually 12 months,” are intended for inclusion in the current liability
classification, noncurrent classification is appropriate when a debt obligation
meets the conditions for long-term classification even if the debtor intends to
repay it within one year (or the operating cycle, if longer) after the balance sheet
date. That is, if the debtor controls the ability to not repay the debt obligation
within one year (or the operating cycle, if longer) after the balance sheet date,
the debt represents a noncurrent liability notwithstanding the debtor’s intent to
repay it within one year (or the debtor’s actual repayment of the liability after
the balance sheet date and before the financial statements are issued or available
to be issued). This is consistent with the general principle in U.S. GAAP that a
debtor should classify debt on the basis of facts known on the balance sheet date
rather than on its expectations. Therefore, a debt repayment that occurs after the
balance sheet date but before the financial statements are issued or available to be
issued represents a nonrecognized subsequent event under ASC 855-10-25-3.
However, on the basis of observed diversity in practice, it would be acceptable for a
debtor to classify a debt obligation as current that otherwise meets the conditions
for noncurrent classification when both of the following conditions are met:
-
The debtor either (1) has the ability and intent to repay the obligation within one year (or the operating cycle, if longer) after the balance sheet date or (2) repays the obligation after the balance sheet date but before the financial statements were issued or available to be issued.
-
The repayment of the debt is made with assets that were classified as current as of the balance sheet date (e.g., the debtor did not repay the debt by refinancing it with the issuance of replacement long-term debt).
This alternative view would be considered acceptable and consistent with the
nonauthoritative guidance in AICPA Technical Q&As Section 3200.12, which refers
to classification of a long-term debt obligation as current on the basis of an
intent to repay it within 12 months after the balance sheet date. However, if an
entity applies this alternative, it should appropriately disclose the rationale for
the classification of the debt as a current liability as of the balance sheet
date.
13.12 Presentation
13.12.1 Balance Sheet Presentation
ASC 210-10
45-5 A total of current
liabilities shall be presented in classified balance
sheets.
In a classified balance sheet, current liabilities are presented separately from
noncurrent liabilities, with a summation of each total. SEC Regulation S-X, Rule
5-02 (reproduced in ASC 210-10-S99-1), requires SEC registrants within the scope
of that rule (i.e., commercial and industrial companies) to present long-term
debt separately from current liabilities when filing financial statements with
the SEC. Case G in Example 4 in ASC 470-10-55-32 illustrates the appropriate
balance sheet presentation based on the assumptions in ASC 470-10-55-14 and
55-15 (see Section 13.7.6.6).
13.12.2 Subsidiary’s and Parent’s Fiscal Years Differ
ASC 470-10 — SEC Materials — SEC Staff Guidance
Comments Made by SEC Observer at Emerging Issues
Task Force (EITF) Meetings
SEC Observer Comment: Classification of
Subsidiary’s Loan Payable in Consolidated Balance Sheet
When Subsidiary’s and Parent’s Fiscal Years Differ
S99-4 The following is the text
of SEC Observer Comment: Classification of Subsidiary’s
Loan Payable in Consolidated Balance Sheet When
Subsidiary’s and Parent’s Fiscal Years Differ.
Issues periodically occur related to
classification of a subsidiary’s loan payable in a
consolidated balance sheet when the subsidiary’s
and parent’s fiscal years differ. For example,
assume that a consolidated balance sheet prepared
as of February 29, 1988, comprised of the parent
company’s balance sheet as of that date and the
subsidiary’s balance sheet as of December 31,
1987. The subsidiary’s balance sheet included a
material loan payable to a bank due January 31,
1989. The SEC staff would expect the debt in this
case to be classified as current because to do
otherwise would result in a material
misclassification.
A subsidiary’s fiscal year may end before that of its parent. As a result, a
subsidiary may have debt that becomes due more than one year (or the operating
cycle, if longer) after the subsidiary’s balance sheet date but less than one
year (or the operating cycle, if longer) after the parent’s balance sheet date.
ASC 470-10-S99-4 includes the SEC staff’s views about the classification in this
situation. If a debt obligation matures less than one year (or the operating
cycle, if longer) after the parent’s balance sheet date, the debt should be
classified as a current liability in the parent’s consolidated balance
sheet.
13.12.3 Comparative Financial Statements
Nonauthoritative AICPA Guidance
Technical Q&As Section 3200, “Long-Term
Debt”
.13 Uncertainty Arising From Violation of Debt
Agreement
Inquiry — At the end of 20X1, a company was in
violation of its long-term debt covenant and was unable
to obtain a waiver from the bank. It therefore
reclassified its debt to current and appropriate
footnote disclosures were made. During 20X2, the
violation was cured. What is the proper classification
of the debt in the company’s 20X2 comparative financial
statements?
Reply — . . . Since the violation was cured in
20X2, the debt should be classified as long-term in the
20X2 financial statements. The debt should not be
reclassified to long term in the 20X1 financial
statements because it was a current liability based on
the facts existing at the 20X1 balance sheet date. . .
.
AICPA Technical Q&As Section 3200.13 clarifies that when an entity presents
comparative financial statements, it should not retrospectively reclassify debt
as noncurrent if the debt was appropriately classified as current when those
financial statements were first issued. The specific situation addressed in
Technical Q&As Section 3200.13 is one in which the debtor (1) violated a
covenant, which caused the debt to become repayable as of the 20X1 balance sheet
date (see Section 13.5), and (2) did not
obtain a waiver from the creditor before the 20X1 financial statements were
issued (see Section 13.5.3). Accordingly,
the debt was classified as current in the 20X1 financial statements. The debtor
cured the violation in 20X2 so that the debt qualified for noncurrent
classification in the 20X2 financial statements. Nevertheless, the debtor could
not reclassify the debt as noncurrent in its 20X2 comparative financial
statements for 20X1.
Chapter 14 — Presentation, Disclosure, and Other Considerations
Chapter 14 — Presentation, Disclosure, and Other Considerations
14.1 Background
This chapter briefly discusses accounting, presentation, and disclosure matters that
are not addressed elsewhere in the Roadmap.
14.2 Accounting
14.2.1 Hedge Accounting
14.2.1.1 General
This section discusses how the accounting for debt might be affected by the
application of hedge accounting.
14.2.1.2 Debt Designated as Hedged Item in Fair Value Hedge
When the qualifying criteria for hedge accounting are met,
ASC 815-20-25-12 permits an entity to designate debt (such as fixed-rate
debt) as a hedged item in a fair value hedge. Under ASC 815-20-25-12(f), the
debtor is permitted to designate the hedged risk as the risk of changes in
(1) the debt’s fair value in its entirety or (2) the portion of the debt’s
fair value attributable to changes in (a) a designated benchmark interest
rate (interest rate risk), (b) foreign currency exchange rates (foreign
exchange risk), or (c) changes in credit risk (such as the credit spread
over the benchmark interest rate). Under ASC 815-20-25-12(b), a debtor is
permitted to designate a portfolio of similar liabilities, a percentage of
an entire liability, or the contractual cash flows of one or more liability
as the hedged item (e.g., a partial-term interest rate risk hedge of the
first 5 years of 10-year debt by using an assumed term for the debt that
matches the hedged payments; see ASC 815-25-35-13B). Further, a debtor is
permitted to designate a benchmark rate component of the contractual cash
flows determined at hedge inception as the hedged item in an interest rate
risk hedge of debt (ASC 815-25-35-13). However, a debtor cannot designate a
fair value hedge related to a risk of changes in the debt’s fair value that
is recognized in earnings, such as interest rate risk related to debt for
which the fair value option in ASC 815-15 or ASC 825-10 has been elected or
foreign exchange risk related to foreign-denominated debt that is remeasured
at spot rates under ASC 830-20 (ASC 815-20-25-43(c)(3)).
When fair value hedge accounting is applied, the change in the debt’s fair
value attributable to the hedged risk is recognized as an adjustment to the
debt’s carrying amount, with an offsetting entry to earnings (ASC
815-25-35-1(b)). Except for excluded components, which are amortized to
earnings, gains and losses on the hedging instrument are recognized
immediately in earnings (ASC 815-25-35-1(a)). All amounts recognized in
earnings are presented in the same line item as the earnings effect of the
hedged item (e.g., interest expense). An adjustment to the debt’s carrying
amount is amortized to interest expense and must begin no later than the
debt ceases to be adjusted for changes in its fair value attributable to the
hedged risk (ASC 815-25-35-9). When a debtor uses a pay-variable,
receive-fixed interest rate swap to hedge debt and the conditions for the
shortcut method are met (see ASC 815-20-25-104 and 25-105), the change in
fair value of the hedged debt attributable to the risk being hedged does not
need to be directly measured. Instead, the change in the fair value of the
derivative hedging instrument adjusts the carrying amount of the hedged
debt, and interest expense is recognized on the basis of the variable rate
of the swap, adjusted for any difference between the fixed rate on the swap
and that on the hedged debt (ASC 815-25-55-43).
Fair value hedge accounting must be discontinued prospectively if the hedging
relationship no longer meets the criteria for fair value hedge accounting
(e.g., the hedge is no longer expected to be highly effective), the debtor
dedesignates the hedge, or the derivative expires or is sold, terminated
(except for certain novations), or exercised (ASC 815-25-40-1).
14.2.1.3 Debt Designated as Hedged Item in Cash Flow Hedge
When the qualifying criteria for hedge accounting are met,
an entity is permitted to designate probable variable cash flows associated
with existing debt (such as variable-rate debt or foreign-denominated
fixed-rate debt) or a probable forecasted purchase or issuance of debt (or
probable interest payments on such debt) as a hedged item in a cash flow
hedge. ASC 815-20-25-15(j) permits the debtor to designate the hedged risk
as the risk of changes in (1) overall changes in the hedged cash flows, (2)
forecasted variable-rate interest payments associated with existing debt and
attributable to changes in a contractually specified interest rate (interest
rate risk), (3) forecasted cash flows associated with the forecasted
issuance of debt (or the forecasted interest payments) and attributable to
changes in a benchmark interest rate or an expected contractually specified
interest rate, (4) the functional-currency-equivalent cash flows
attributable to changes in the related foreign currency exchange rate
(foreign exchange risk), or (5) the risk of changes in cash flows
attributable to credit risk (e.g., changes in the credit spread over the
contractually specified interest rate or the benchmark interest rate).
However, a debtor cannot designate a cash flow hedge related to existing
debt or the forecasted issuance of debt if the debt is remeasured, with
changes in fair value attributable to the hedged risk recognized in
earnings, such as foreign exchange risk related to foreign-denominated debt
that is remeasured at spot rates under ASC 830-20.
When cash flow hedge accounting is applied, the accounting
for the hedged item is not altered. Instead, gains and losses on the hedging
instrument related to the hedged risk are recognized in OCI and reclassified
to earnings in the same period or periods during which the hedged forecasted
transaction affects earnings. That reclassification and the amount
recognized in earnings for any excluded components are presented in the same
income statement line item as the earnings effect of the hedged item (e.g.,
interest expense).
Cash flow hedge accounting must be discontinued
prospectively if the hedging relationship no longer meets the criteria for
cash flow hedge accounting (e.g., the hedge is no longer expected to be
highly effective), the debtor dedesignates the hedge, or the derivative
expires or is sold, terminated (except for certain novations), or exercised
(ASC 815-30-40-1). However, in accordance with ASC 815-30-40-4, the amount
in AOCI related to a discontinued hedge is not reclassified to earnings
unless both (1) “it is probable that the forecasted transaction will not
occur by the end of the originally specified time period (as documented at
the inception of the hedging relationship) or within an additional two-month
period of time thereafter” and (2) no rare, “extenuating circumstances that
are related to the nature of the forecasted transaction and are outside the
control or influence of the reporting entity . . . cause the forecasted
transaction to be probable of occurring on a date that is beyond the
additional two-month period of time.” Further, under ASC 815-30-40-5, “[a]
pattern of determining that hedged forecasted transactions are probable of
not occurring would call into question both an entity’s ability to
accurately predict forecasted transactions and the propriety of using hedge
accounting in the future for similar forecasted transactions.”
14.2.1.4 Debt Designated as Hedging Instrument in Foreign Currency Fair Value Hedge of a Firm Commitment
When the qualifying criteria for hedge accounting are met,
ASC 815-20-25-58 permits an entity to designate foreign-denominated debt as
a hedging instrument in a foreign currency fair value hedge of an
unrecognized firm commitment or a portion thereof (e.g., a firm commitment
to purchase or sell a nonfinancial item). ASC 815-20 does not address how to
account for such debt. Instead, an entity applies ASC 830-20, which requires
foreign-denominated debt to be remeasured at spot rates (see Section 14.2.3).
Certain foreign-denominated intra-entity loans for which an offsetting
third-party loan is in place can also be designated as a hedging instrument
in a foreign currency fair value hedge of an unrecognized firm commitment or
a portion thereof (see ASC 815-20-25-60).
14.2.1.5 Debt Designated as Hedging Instrument in Net Investment Hedge
When the qualifying criteria for hedge accounting are met,
ASC 815-20-25-66 permits an entity to designate foreign-denominated debt as
a hedging instrument in a foreign currency hedge of a net investment in a
foreign operation. However, such designation cannot be applied if the debt
is accounted for at fair value through earnings. When net investment hedge
accounting is applied, the foreign currency transaction gain or loss on the
debt (i.e., the remeasurement of the debt at spot rates) under ASC 835-30
(see Section
14.2.3) is recognized in OCI in a manner similar to a
translation adjustment associated with the hedged net investment. The
cumulative translation adjustment is recognized in earnings in accordance
with ASC 830-30-40 (see Section 5.4 of Deloitte’s Roadmap Foreign Currency Matters).
14.2.2 Fair Value Measurements
Sometimes, the accounting for debt involves fair value
measurements (e.g., the initial measurement of debt that is initially measured
by using present value techniques under ASC 835-30, debt accounted for at fair
value by using the fair value option in ASC 815-15 or ASC 825-10, the
measurement of bifurcated embedded derivatives under ASC 815-15, debt that is
designated as a hedged item in a fair value hedge under ASC 815-20 and ASC
815-25, and initial measurements in transactions that include multiple units of
accounts). In determining fair value, an entity should apply the guidance in ASC
820. In the absence of a specific exception, ASC 820 applies whenever fair value
measurements or disclosures are permitted or required under GAAP.
For a detailed discussion of the guidance in ASC 820, see
Deloitte’s Roadmap Fair
Value Measurements and Disclosures (Including the Fair Value
Option). That Roadmap addresses fair value measurement
considerations specific to notes payable (Section 2.3.1), hedged items in fair value
hedges (Section
2.3.11), liabilities and instruments classified in equity
(Section
10.2.7), fair value disclosures (Chapter 11), and the application of the
fair value option (Chapter
12).
14.2.3 Foreign Currency Matters
ASC 830-20
35-1 A change
in exchange rates between the functional currency and
the currency in which a transaction is denominated
increases or decreases the expected amount of functional
currency cash flows upon settlement of the transaction.
That increase or decrease in expected functional
currency cash flows is a foreign currency transaction
gain or loss that generally shall be included in
determining net income for the period in which the
exchange rate changes.
35-2 At each
balance sheet date, recorded balances that are
denominated in a currency other than the functional
currency of the recording entity shall be adjusted to
reflect the current exchange rate. At a subsequent
balance sheet date, the current rate is that rate at
which the related receivable or payable could be settled
at that date. Paragraphs 830-20-30-2 through 30-3
provide more information about exchange rates.
Under ASC 830-20, a debtor is required to remeasure the carrying
amount of debt that is denominated in a currency other than its functional
currency as of each reporting date by using the current exchange rate. Because
debt issuance costs are presented as a reduction of the debt’s carrying amount,
the remeasurement should be based on the carrying amount after deduction of any
remaining unamortized debt issuance costs. Accordingly, the debt’s carrying
amount will change each reporting date (until the debt is extinguished) as a
result of changes in exchange rates. Generally, the changes in the net carrying
amount are recognized in earnings as transaction gains or losses. For additional
discussion of the application of ASC 830, see Deloitte’s Roadmap Foreign Currency
Matters.
14.2.4 Capitalization of Interest
ASC 835-20
15-5 Interest
shall be capitalized for the following types of assets
(qualifying assets):
- Assets that are constructed or otherwise produced for an entity’s own use, including assets constructed or produced for the entity by others for which deposits or progress payments have been made.
- Assets intended for sale or lease that are constructed or otherwise produced as discrete projects (for example, ships or real estate developments).
- Investments (equity, loans, and advances) accounted for by the equity method while the investee has activities in progress necessary to commence its planned principal operations provided that the investee’s activities include the use of funds to acquire qualifying assets for its operations. The investor’s investment in the investee, not the individual assets or projects of the investee, is the qualifying asset for purposes of interest capitalization.
30-3 The
amount capitalized in an accounting period shall be
determined by applying the capitalization rate to the
average amount of accumulated expenditures for the asset
during the period. The capitalization rates used in an
accounting period shall be based on the rates applicable
to borrowings outstanding during the period. If an
entity’s financing plans associate a specific new
borrowing with a qualifying asset, the entity may use
the rate on that borrowing as the capitalization rate to
be applied to that portion of the average accumulated
expenditures for the asset that does not exceed the
amount of that borrowing. If average accumulated
expenditures for the asset exceed the amounts of
specific new borrowings associated with the asset, the
capitalization rate to be applied to such excess shall
be a weighted average of the rates applicable to other
borrowings of the entity.
ASC 835-20 requires debtors to capitalize certain interest costs as part of the
cost of “qualifying assets.” Generally, capitalization of interest is required
during the period that an entity is getting a qualifying asset ready for its
intended use. Qualifying assets include assets that are (1) constructed or
produced either for the entity’s own use or, as discrete projects, for lease or
sale (e.g., ships or real estate) or (2) accounted for under the equity method
“while the investee has activities in progress necessary to commence its planned
principal operations.” Capitalization is not permitted for assets that are in
use, substantially complete and ready for their intended use, or not in use
unless they are undergoing activities necessary to get them ready for use.
Further, capitalization is not permitted for inventories that are produced in
large quantities on a repetitive basis.
An entity determines the amount to be capitalized by applying a
capitalization rate to the average amount of accumulated expenditure it has
incurred on a qualifying asset during a period. To the extent that the average
accumulated expenditures do not exceed the amount of specific new borrowings
related to a qualifying asset, the entity is permitted to use the rate on those
borrowings as the capitalization rate. Otherwise the entity uses a weighted
average rate applicable to borrowings outstanding during the period. In
determining an appropriate capitalization rate, the entity should also consider
the amortization of any fair value hedge adjustments on its outstanding
borrowings (see ASC 815-25-35-14 and ASC 815-25-55-52).
14.2.5 Reference Rate Reform
14.2.5.1 Background
ASC 848 permits entities to elect optional expedients and
exceptions related to the application of certain accounting requirements for
contracts, hedging relationships, and other transactions that refer to a
reference rate that is expected to be discontinued as a result of the
transition away from the use of interbank offered rates (e.g., LIBOR) to
alternative reference rates.1 An entity can elect to apply the optional expedients and exceptions to
certain contract modifications and hedging relationships from the beginning
of the interim period that includes March 20, 2020, through December 31,
2024. While a comprehensive discussion of ASC 848 is beyond the scope of
this Roadmap, this section briefly discusses the guidance in ASC 848-20 on
contract modifications (see Section 14.2.5.2) and summarizes the
relief available to debtors under ASC 470-50 and ASC 815-15 for such
modifications (see Sections 14.2.5.3 and 14.2.5.4, respectively).
14.2.5.2 Scope
ASC 848-20
General
15-1 This
Subtopic provides guidance on optional expedients
for accounting for contract modifications when one
or more terms are modified because of reference rate
reform.
Modifications of Terms
15-2 The guidance in this
Subtopic, if elected, shall apply to contracts that
meet the scope of paragraph 848-10-15-3 if either or
both of the following occur:
- The terms that are modified directly replace, or have the potential to replace, a reference rate within the scope of paragraph 848-10-15-3 with another interest rate index. If other terms are contemporaneously modified in a manner that changes, or has the potential to change, the amount or timing of contractual cash flows, the guidance in this Subtopic shall apply only if those modifications are related to the replacement of a reference rate. For example, the addition of contractual fallback terms or the amendment of existing contractual fallback terms related to the replacement of a reference rate that are contingent on one or more events occurring has the potential to change the amount or timing of contractual cash flows and the entity potentially would be eligible to apply the guidance in this Subtopic.
- The interest rate used for margining, discounting, or contract price alignment is modified as a result of reference rate reform.
15-3 Other than a
modification of the interest rate used for
margining, discounting, or contract price alignment
in accordance with paragraph 848-20-15-2(b), for
contracts that meet the scope of paragraph
848-10-15-3, the guidance in this Subtopic shall not
apply if a contract modification is made to a term
that changes, or has the potential to change, the
amount or timing of contractual cash flows and is
unrelated to the replacement of a reference rate.
That is, this Subtopic shall not apply if contract
modifications are made contemporaneously to terms
that are unrelated to the replacement of a reference
rate.
15-4 Contemporaneous
modifications of contract terms that do not change,
or do not have the potential to change, the amount
or timing of contractual cash flows shall not
preclude application of the guidance in this
Subtopic, regardless of whether those
contemporaneous contract modifications are related
or unrelated to the replacement of a reference rate
or the modification of the interest rate used for
margining, discounting, or contract price alignment
as a result of reference rate reform.
Identifying
Changes to Terms Related and Unrelated to the
Replacement of the Reference Rate
15-5 Changes
to terms that are related to the replacement of the
reference rate are those that are made to effect the
transition for reference rate reform and are not the
result of a business decision that is separate from
or in addition to changes to the terms of a contract
to effect that transition. . . .
ASC 848-20 permits an entity to elect certain expedients (such as those
described in Sections 14.2.5.3 and
14.2.5.4) related to the modification of contract
terms that will directly replace, or have the potential to replace, an
affected rate with another interest rate index, as well as certain
contemporaneous modifications of other contract terms related to the
replacement of an affected rate. When contemporaneous modifications are
made, an entity’s eligibility to use the optional expedients depends on
whether the contemporaneous modifications to the other terms (1) could
affect the amount or timing of contractual cash flows and (2) are related to
reference rate reform. If a contemporaneous contract modification could
affect the amount or timing of contractual cash flows, the optional
expedients are not available if that modification is unrelated to the
replacement of a reference rate. Changes in contract terms are considered
unrelated to the replacement of a reference rate if they are “the result of
a business decision that is separate from or in addition to changes to the
terms of a contract to effect that transition.” If it is not possible for a
contemporaneous contract modification to affect the amount or timing of
contractual cash flows, an entity is not precluded from applying the
optional expedients even if that modification is unrelated to the
replacement of a reference rate.
The table below provides
examples of possible types of modifications and indicates whether they
generally would be considered related to the replacement of a reference
rate.
|
Related
|
Unrelated
|
|---|---|
|
Changes to:
|
Changes to:
|
|
The addition of:
|
The addition of:
|
|
The addition of or changes to:
|
The addition or removal of:
|
|
A concession granted to a debtor experiencing
financial difficulty
|
Further, ASC 848-20 permits an entity to disregard circumstances in which
modified fallback terms include or have the potential to include a term
unrelated to reference rate reform if, when the fallback terms are added or
amended, the entity “determines that activation of the term unrelated to
reference rate reform is not probable of occurring if the fallback terms are
triggered.”
14.2.5.3 Evaluation of Debt Modifications Under ASC 470-50
ASC 848-20
35-8 If an entity elects the
optional expedient in this paragraph, the entity
shall account for a modification of a contract
within the scope of Topic 470 that meets the scope
of paragraphs 848-20-15-2 through 15-3 in accordance
with paragraphs 470-50-40-14, 470-50-40-17(b), and
470-50-40-18(b) as if the modification was not
substantial. That is, the original contract and the
new contract shall be accounted for as if they were
not substantially different from one another, and
the modification shall not be accounted for in the
same manner as a debt extinguishment in accordance
with paragraph 470-50-40-13.
35-9 If the
optional expedient in paragraph 848-20-35-8 is
elected, it shall be applied to all contracts under
Topic 470 as described in paragraph 848-20-35-1.
35-10 If the
optional expedient in paragraph 848-20-35-8 is
elected, an entity that applies the 10 percent cash
flow test described in paragraph 470-50-40-10 for
any subsequent contract modification within a year
shall consider only terms and provisions that were
in effect immediately following the election of the
optional expedient for the particular contract.
If a debt modification is within the scope of the elective relief (see
Section 14.2.5.2), the debtor can choose to account
for the modification as if it was not substantial under ASC 470-50 even if
the modification would have been considered an extinguishment under ASC
470-50 (see Section 10.3). When elected, the optional
expedient must be applied consistently for all eligible contracts within the
scope of ASC 470. In performing the 10 percent cash flow test (see
Section 10.3.3) in ASC 470-50-40-10 for any
subsequent contract modifications made within a year, the debtor should
consider only terms and provisions that were in effect immediately following
the election of the optional expedient, which is an exception to the
guidance in ASC 470-10-25-12(f) (see Section
10.3.3.4).
14.2.5.4 Reassessment of Embedded Derivatives Under ASC 815-15
ASC 848-20
35-14 If the
optional expedient in this paragraph is elected,
modification of a contract that meets the scope of
paragraphs 848-20-15-2 through 15-3 (including the
addition of an interest rate floor or cap that is
out of the money in paragraph 848-20-15-5(e)) shall
not require an entity to reassess its original
conclusion about whether that contract contains an
embedded derivative that is clearly and closely
related to the economic characteristics and risks of
the host contract for the purposes of paragraph
815-15-25-1(a).
35-15 If the
optional expedient in paragraph 848-20-35-14 is
elected, it shall be applied to all contracts under
Subtopic 815-15 as described in paragraph
848-20-35-1.
If a debt modification is within the scope of ASC 848 (see Section
14.2.5.2), the debtor can elect not to reassess its
conclusion about whether the debt contains an embedded derivative that is
clearly and closely related to the economic characteristics and risks of the
host contract under ASC 815-15 (see Section 8.5.4).
When elected, the optional expedient must be applied consistently for all
eligible contracts within the scope of ASC 815-15.
Footnotes
1
ASC 848 applies to derivatives that are affected by
reference rate reform as a result of the discounting transition even
if such derivatives do not refer to a rate that is expected to be
discontinued.
14.3 Presentation
14.3.1 Balance Sheet
14.3.1.1 Balance Sheet Offsetting
ASC 210-20
45-1 A right
of setoff exists when all of the following
conditions are met:
- Each of two parties owes the other determinable amounts.
- The reporting party has the right to set off the amount owed with the amount owed by the other party.
- The reporting party intends to set off.
- The right of setoff is enforceable at law.
45-2 A debtor
having a valid right of setoff may offset the
related asset and liability and report the net
amount.
When certain conditions are met, ASC 210-20 permits but does not require an
entity to offset the carrying amounts of assets and liabilities and present
only a net amount on the balance sheet (i.e., only a net asset or a net
liability is presented related to the amounts that have been offset).
Offsetting does not affect the application of the accounting requirements
that apply to the recognition, measurement, and derecognition of assets and
liabilities (e.g., it does not affect when gain or loss recognition is
appropriate or how it should be measured); it only affects the display of
assets and liabilities on the balance sheet.
Under ASC 210-20-45-1, four conditions must be met for an
entity to offset assets and liabilities:
- “Each of two parties owes the other determinable
amounts.”That is, (1) an entity cannot offset receivables and payables with different counterparties, (2) the amounts must be determinable (i.e., contingent or estimated amounts cannot be offset), and (3) an entity is not precluded from offsetting amounts that are denominated in different currencies or have different stated interest rates (see ASC 210-20-45-3).
- “The reporting party has the right to set off the
amount owed with the amount owed by the other party.”In the absence of a right to set off, an entity cannot present amounts net even if it expects that such amounts will be net settled. If the maturities of a payable and receivable with the same counterparty differ, only the party with the nearer maturity can offset the related amounts (see ASC 210-20-45-3). Balances without an explicit settlement date cannot be set off. For example, payables cannot be offset against cash on deposit at a financial institution (see ASC 210-20-55-18A).
- “The reporting party intends to set off.”An entity should document its intention to set off, and that intention should be consistent with its past practice of setting off in similar situations, if applicable (see ASC 210-20-45-5). If an entity’s right to set off is contingent on the entity’s or the counterparty’s default, the related amounts cannot be presented net. The right to set off must be exercisable in the normal course of business. If an entity does not expect to set off amounts, those amounts do not qualify for net presentation on the balance sheet.There are two exceptions to this condition. They apply to amounts recognized under certain (1) repurchase agreements and reverse repurchase agreements accounted for as collateral borrowings under ASC 860 (see ASC 210-20-45-11 through 45-17) and (2) derivatives and cash collateral balances subject to a master netting agreement (see ASC 815-10-45-5). However, these exceptions do not apply to debt that is within the scope of the guidance in this Roadmap (see Section 2.3.2).
- “The right of setoff is enforceable at law.”A legal analysis may be necessary in the determination of whether an enforceable right of setoff exists. In accordance with ASC 210-20-45-9, all available evidence must be considered and must provide “reasonable assurance that the right of setoff would be upheld in bankruptcy.” An entity cannot necessarily assume that it has a right to set off even if a contract states so, since state laws differ and the U.S. bankruptcy code limits the ability to assert a right of set off in certain circumstances (see ASC 210-20-45-8).An entity should apply a consistent policy for offsetting amounts that qualify for such treatment.
14.3.1.2 Legal-Form Debt Cannot Be Presented in Equity
SEC Staff Accounting Bulletins
SAB Topic 4.A,
Subordinated Debt [Reproduced in ASC
470-10-S99-2]
Facts: Company E proposes to
include in its registration statement a balance
sheet showing its subordinate debt as a portion of
stockholders’ equity.
Question: Is this
presentation appropriate?
Interpretive Response:
Subordinated debt may not be included in the
stockholders’ equity section of the balance sheet.
Any presentation describing such debt as a component
of stockholders’ equity must be eliminated.
Furthermore, any caption representing the
combination of stockholders’ equity and only
subordinated debts must be deleted.
An instrument that represents a legal-form debt obligation should be
presented as a liability even if it has certain economic characteristics
that are similar to those of an equity instrument. For example, debt that
has a stated maturity, a stated coupon right, and creditor rights (e.g., an
ability to seek recourse in a bankruptcy court) is presented as a liability
on the basis of its legal form even if it is mandatorily convertible into
the debtor’s equity shares. As noted in SAB Topic 4.A, a debtor is not
permitted to present debt as a component of equity even if it is
subordinated to other debt or presented in a balance sheet caption that
includes both subordinated debt and equity.
An instrument that represents a legal-form debt obligation in the
jurisdiction in which it is issued and carries creditor rights should be
presented as a liability even if the issuer only has 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) or no stated
maturity, (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 the entity
legally represents debt or equity, the entity may need to seek an opinion
from legal counsel.
A debtor is precluded from presenting debt as equity even if
it is converted into the debtors’ equity shares or repaid from the proceeds
of the issuance of equity-classified shares shortly after the balance sheet
date. Such an event represents a nonrecognized subsequent event under ASC
855. Further, ASC 470-10-45-14(a) states, in part, that if “equity
securities have been issued for the purpose of refinancing [a] short-term
obligation on a long-term basis . . . , the short-term obligation, although
excluded from current liabilities, shall not be included in owners’ equity”
(see Section
13.7.3).
14.3.1.3 Structured Trade Payable Arrangements
14.3.1.3.1 Financial Statement Presentation
SEC Rules, Regulations, and
Interpretations
Regulation
S-X, Rule 5-02, Balance Sheets [Reproduced in ASC
210-10-S99-1]
19. Accounts and notes
payable.
(a) State
separately amounts payable to
(1) banks for borrowings;
(2) factors or other financial institutions
for borrowings;
(3) holders of commercial paper;
(4) trade creditors;
(5) related parties (see §
210.4-08(k));
(6) underwriters, promoters, and employees
(other than related parties); and
(7) others.
Amounts applicable to (1), (2) and (3) may be
stated separately in the balance sheet or in a
note thereto. . . .
When an entity purchases goods or services on credit
from a supplier (vendor), a trade payable arises for the invoice amount
owed to the supplier. Sometimes entities with trade payables enter into
arrangements with a bank or other intermediary under which the
intermediary offers to purchase receivables held by the entity’s
suppliers. Such arrangements are known by various names, such as
“structured payable arrangements,” “vendor payable programs,” “open
account structured vendor payable programs,” “reverse factoring,”
“supplier finance,” or “supplier-chain finance.”
Examples of structured payable arrangements include (1)
open account platforms that permit an entity’s suppliers to elect to
sell trade receivables to one or more participating intermediaries, (2)
an entity’s use of charge cards issued by a financial institution to
settle invoices, and (3) an entity’s issuance of negotiable instruments
(e.g., bills of exchange) to settle invoices.
Typically, open account platforms give participating
suppliers the option to settle trade receivables by obtaining a payment
from an intermediary either (1) before the invoice date at a discounted
amount or (2) on the invoice due date for its full amount. Although the
supplier may receive payment early, the purchasing entity is not
required to settle its trade payable with the intermediary until the
original invoice date.
Depending on its terms, a structured trade payable
arrangement offers the parties various potential benefits, such as the
following:
- Suppliers can monetize trade receivables and reduce the associated credit exposure — By selling their trade receivables to an intermediary, suppliers can receive payment before the invoice due date and reduce their credit exposure.
- Purchasers can obtain extended payment terms — Suppliers may be more willing to agree to extended payment terms with purchasers if they can obtain early payment from intermediaries. Further, intermediaries may offer purchasers extended payment terms.
- Intermediaries can benefit from early payment discounts, rebates, and transaction fees and charges — Intermediaries earn a spread on the basis of the relationship between their funding costs and the amount of early payment discounts, rebates, and other fees and charges received from suppliers.
- Operational benefits — Because of an intermediary’s involvement, the arrangement may enhance the processing, administration, and control of the associated payments for purchasers and suppliers.
- Extended early-payment discount period — If an intermediary pays a supplier within the period during which the supplier offers an early payment discount (e.g., a 2 percent discount for payment within 30 days or 2/10 net 30), for instance, the intermediary may offer the entity a discount on the amount due for an extended period (e.g., 1/10 net 60).
- Reduction in the amount due or other similar rebate — The intermediary may offer the entity a reduction of the amount due or a reimbursement of part of the amount paid on the basis of net amounts paid to suppliers. (A supplier may agree to pay the intermediary a fee or reduce the amount due because of benefits it receives from the arrangement, such as a lowered credit risk exposure on the amount due or earlier payment of such amount.)
If an entity has a trade payable arrangement involving
an intermediary, it should consider how to appropriately present and
disclose the amount payable. Regulation S-X, Rule 5-02(19)(a), requires
SEC registrants to present amounts payable to trade creditors separately
from borrowings on the face of the balance sheet. Accordingly, a
purchasing entity that participates in a trade payable program involving
an intermediary should consider whether the intermediary’s involvement
changes the appropriate presentation of the payable from a trade payable
to a borrowing from the intermediary (e.g., bank debt). Entities often
seek to achieve trade payable classification because trade payables tend
to be treated more favorably than short-term indebtedness in the
calculation of financial ratios (e.g., balance sheet leverage measures)
and in the determination of whether financial covenants are met.
Further, the determination of whether the payable should be presented as
an amount owed to trade creditors or an amount borrowed from the
intermediary may affect the appropriate cash flow statement
classification (see below for further discussion).
Generally, a supplier’s decision to factor a trade
receivable to a bank or other financial institution does not affect the
purchaser’s presentation of the associated trade payable if the
factoring terms are negotiated and agreed to independently by the
supplier and the institution without any involvement of the purchaser,
which may not even be aware of the factoring transaction. Similarly, an
entity’s decision to outsource its supplier processing payments to an
intermediary does not necessarily cause a reclassification of associated
trade payables if the terms of the payables remain unaffected and the
entity is not involved in, or does not benefit from, transactions
between the suppliers and the intermediary. In other words, if the
intermediary’s involvement does not change the nature, amount, and
timing of the entity’s payables and does not provide the entity with any
direct economic benefit, continued trade payable classification may be
appropriate. However, reclassification may be required if such changes
or benefits result from the intermediary’s involvement (e.g., because
fees or rebate payments were received from the intermediary).
In speeches at the 2003 and 2004 AICPA Conferences on
Current SEC and PCAOB Developments, then Professional Accounting Fellow
Robert Comerford discussed the SEC staff’s views about the presentation
of certain trade payable arrangements involving an intermediary as trade
payables or short-term borrowings. At the 2004 event, he stated the following:
As a general rule, the OCA Staff does not believe
that it is possible to determine the appropriate accounting for
structured transactions simply via reference to checklists and
templates. Rather, . . . an entity must perform a thorough analysis
of all the facts and circumstances specific to the individual
transaction in order to ensure that the entity’s accounting for the
transaction serves investors well. . . . [T]his necessitates meeting
not just the letter, but the spirit of the accounting
literature.
Mr. Comerford identified a number of points (summarized
below) that the SEC staff encourages preparers and auditors to consider
in determining whether amounts due in trade payable arrangements
involving an intermediary should be classified as trade payables or
borrowings. He also noted that a registrant may wish to preclear its
proposed classification with the OCA if there is a risk that its
position could be subject to challenge. Given the subjective nature of
the evaluation and the lack of prescriptive guidance, alternative views
may be acceptable in some circumstances.
|
SEC Staff Consideration
Point
|
Related SEC Staff
Observations
|
Deloitte Observations
|
|---|---|---|
|
What are “the roles,
responsibilities and relationships of each party”
to the arrangement? What is “the totality of the
arrangement”?
|
By analogy to a supplier’s
factoring of accounts receivables, the definition
of factoring “does not make any mention of the
[purchaser] actively or passively participating in
the process.”
|
It can be helpful to consider
whether the intermediary’s role in the arrangement
is primarily that of (1) a factor of supplier
receivables, (2) a finance provider to the entity,
or (3) the entity’s paying agent. If the
intermediary’s involvement does not change the
nature, amount, and timing of the entity’s
payments and does not provide the entity with any
direct economic benefit, continued trade payable
classification may be appropriate. See below for
further discussion.
|
|
“Does the financial institution
make any sort of referral or rebate payments” to
the purchaser?
|
By analogy to a supplier’s
factoring of accounts receivables, the definition
of factoring “does not make any mention of [the
supplier’s] customer receiving . . . any referral
fees or rebates.”
|
If the entity receives no fees,
rebates, payments, or other direct economic
benefits from transactions between suppliers and
the intermediary, continued trade payable
classification may be appropriate. An entity’s
receipt of referral or rebate payments from the
intermediary (e.g., on the basis of fees, early
settlement discounts collected by the
intermediary, or a dollar-volume-based rebate)
suggests that continued classification of a
payable as an amount owed to trade creditors may
no longer be appropriate. In practice, classifying
payables as trade payables has been considered
unacceptable when the purchaser shares in early
settlement discounts collected by the intermediary
from the supplier (e.g., the intermediary provides
a rebate to the purchaser that is equivalent to
half of a 2 percent early settlement discount
received from the supplier).
|
|
“Has the financial institution
reduced the amount due . . . , such that the
amount due is less than the amount the [entity]
would have had to pay to the vendor on the
original payable due date?”
|
By analogy to a supplier’s
factoring of accounts receivables, the definition
of factoring does not “make any mention of the
[supplier’s] customer receiving any reductions in
the amount of its obligation.”
|
If the entity’s original invoice
terms remain the same, continued trade payable
classification may be appropriate. An
intermediary’s reduction of the amount due from
the entity may suggest that continued
classification of a payable as an amount owed to
trade creditors is no longer appropriate.
|
|
“Has the financial institution
extended beyond the payable’s original due date,
the date on which payment is due”?
|
By analogy to a supplier’s
factoring of accounts receivables, the definition
of factoring does not “make any mention of the
[supplier’s] customer receiving . . . any
extension of its trade payable maturity dates
beyond that which were customary prior to the
inception of the arrangement [e.g.,] 2/10 net
30.”
|
Payment terms and amounts that
remain consistent with those of the entity’s other
vendor payables and industry practice may suggest
that continued classification as a trade payable
may be appropriate. However, if the intermediary
is not merely facilitating the payment of the
entity’s invoice but extending the entity’s due
date to a date after the original invoice due date
and the date the intermediary pays suppliers, the
entity’s arrangement may, in substance, be a
borrowing from the intermediary.
|
|
The literal definition of the
term “trade creditor.”
|
“The OCA Staff believes that a
trade creditor is a supplier that has provided an
entity with goods and services in advance of
payment.”
|
Generally, third-party factoring
arrangements involving an entity’s payables do not
preclude trade payable classification if the
entity has no involvement and is not a party to
contracts entered into between the supplier and
the factor. If the creditor at origination is a
supplier, therefore, the supplier’s subsequent
sale of its receivable to a factor does not
necessarily change the nature of that trade
payable so that reclassification is required.
|
As noted above, one of the consideration points is
related to the roles, responsibilities, and relationships among the
parties and the totality of the arrangement, such as whether the
intermediary’s primary role in the arrangement is that of a factor of
supplier receivables, a finance provider to the purchaser, or a paying
agent of the purchaser. In some arrangements, the intermediary may serve
both as a paying agent and a factor or finance provider (e.g., if the
intermediary gives suppliers the option to either receive payment on the
original invoice due date or to transfer trade receivables to the
intermediary before the due date at a discounted amount).
|
Primary Role of Intermediary
|
Description
|
Implication
|
|---|---|---|
|
Factor of trade receivables
|
The intermediary purchases trade
receivables from the entity’s suppliers, with no
active involvement of the entity. The arrangement
does not significantly affect the nature, amount,
and timing of the entity’s payments to settle
trade payables.
|
Trade payable classification may
be appropriate.
|
|
Finance provider to purchasing
entity
|
The entity’s purpose is to
obtain financing from the intermediary. The
arrangement affects the nature, amount, or timing
of the entity’s payments to settle trade payables,
and there may be a direct economic benefit to the
entity.
|
Trade payable classification is
likely to be inappropriate.
|
|
Paying agent of purchasing
entity
|
The intermediary acts as the
purchasing entity’s paying agent in settling trade
payables with suppliers on behalf of the
entity.
|
Although trade payable
classification may be appropriate initially, the
purchasing entity should assess whether
extinguishment accounting is required under ASC
405-20 when the intermediary pays the
supplier.
|
In practice, additional
factors that an entity may consider in its evaluation of whether amounts
due in trade payable arrangements involving an intermediary should be
classified as trade payables or borrowings include:
|
Consideration Point
|
Observations
|
|---|---|
|
How significant is the entity’s
involvement in the contractual relationship
between suppliers and the intermediary?
|
The purchaser’s involvement in
the initial set-up of the process (e.g., by
requiring vendors to sign up with the
intermediary) and submitting invoices for payment
to the financial institution (e.g., in an
electronic payable processing system) would not
necessarily preclude a conclusion that the payable
is still an amount due to trade creditors. More
direct involvement by the purchasing entity may
suggest that trade payable classification is
inappropriate, particularly if the entity has a
direct economic interest in the terms agreed to
between the suppliers and the intermediary (e.g.,
through the sharing of fees or discounts received
by the intermediary from suppliers).
|
|
Have any of the terms of the
payable changed as a result of the intermediary’s
involvement in the arrangement?
|
If the terms of the payable have
not changed as a result of the intermediary’s
involvement in the arrangement, continued trade
payable classification may be appropriate. If the
intermediary has rights that go beyond that of a
holder of the original trade receivable (e.g., a
priority claim in the entity’s liquidation),
reclassification may be required.
|
|
Does the supplier maintain
recourse against the entity?
|
The supplier’s maintenance of
recourse against the entity for nonpayment, and
the intermediary’s recourse against the supplier
if the entity does not pay, may help support a
conclusion that the payable should be presented as
a trade payable.
|
|
Does the entity still have the
right to negotiate returns of damaged goods and
refunds and other adjustments to the invoice terms
with the supplier?
|
If the entity does not retain
the right to negotiate returns of damaged goods
and refunds and other adjustments to the invoice
terms with the supplier (e.g., in case of
commercial disputes), reclassification may be
required.
|
|
Is supplier participation
voluntary?
|
Although a requirement for an
entity’s suppliers to participate in a trade
payable arrangement with an intermediary is not
determinative, it may support a conclusion that
trade payable classification is inappropriate.
|
|
Is the arrangement offered to a
broad range of suppliers?
|
If the arrangement is offered
only to one or a small, limited group of
suppliers, a conclusion that trade payable
classification is inappropriate may be
supported.
|
|
Are the payment terms consistent
with those of trade payables in the entity’s
industry?
|
If the payment terms are
atypical of those of trade payables in the
entity’s industry (e.g., due dates) because of the
intermediary’s involvement in the arrangement,
trade payable classification may be
inappropriate.
|
|
Is the entity informed of
transactions between suppliers and the
intermediary?
|
The entity’s lack of direct
knowledge of transactions between suppliers and
the intermediary (e.g., early settlements at a
discount) may help support a conclusion that the
payable should be presented as a trade payable.
However, the entity’s right to obtain such
information does not necessarily preclude trade
payable classification.
|
|
Does interest accrue before the
due date?
|
The fact that the payable
accrues interest before the due date may suggest
that trade payable classification is
inappropriate.
|
|
What is the legal form of the
entity’s obligation?
|
An instrument whose legal form
under the U.S. Uniform Commercial Code is more
like a negotiable instrument (such as a promissory
note) than an account payable may suggest that
trade payable classification is inappropriate.
(The intermediary may prefer the legal form to be
that of a negotiable instrument to facilitate
transfers of the receivable.)
|
|
Does the intermediary require
the entity to post collateral, maintain credit
facilities, or arrange third-party guarantees?
|
The fact that the entity is
required to post collateral, maintain credit
facilities, or arrange third-party guarantees for
the benefit of the intermediary suggests that
trade payable classification may be
inappropriate.
|
|
Is the priority of the
intermediary’s claim on the entity more senior
than that of the original trade payable?
|
If the priority of the
intermediary’s claim on the entity is more senior
than that of the original trade payable, trade
payable classification may be inappropriate.
|
In his 2003 speech, Mr. Comerford provided two examples of arrangements involving
trade payable transactions with an intermediary that an entity should
not, according to the SEC staff, present as amounts payable to trade
creditors but rather as borrowings from financial institutions:
- “[A]n intermediary, typically a financial institution or one of its affiliates, pays trade payables on behalf of the purchaser in order to take advantage of discounts for early payment that the purchaser would not otherwise avail itself of. The purchaser then pays the lender either the full amount of the trade payable at a future date beyond the payable’s normal terms, or an amount less than the full amount of the trade payable but on the trade payable’s normal due date. Thus, the arrangement between the lender and the purchaser often results in the purchaser securing financing at lower cost of funds than is inherent in the vendor’s invoice. In this transaction, the vendor is often not aware of the arrangement between the purchaser and the lender.”
- “[T]he vendor [is] a willing participant in a tri-party arrangement between the manufacturer, the vendor and the intermediary. Specifically, the intermediary accepts an IOU from the purchaser and presents a separate IOU to the vendor. The lender provides the purchaser with incentives similar to those provided in the first transaction and provides the vendor with the ability to present its IOU to the lender for accelerated payment at an appropriately discounted amount.”
In both examples, the purchasing entity benefits by
either (1) obtaining a repayment date from the financial institution
beyond the due date of the original payable or (2) sharing in a portion
of the trade discount received by the financial institution via the
accelerated payment to the vendor. Further, the payments made by the
intermediary to the vendor “were made within the time period necessary
to secure a trade discount.” Mr. Comerford noted that the OCA objects to
trade payable classification in these circumstances. Instead, the staff
believes as follows:
[T]he substance of both of
these transactions equates to the purchaser obtaining financing from
a lender in order to pay amounts due to its vendors. . . . [T]he
manufacturer’s original liability to the vendor is extinguished on
the date the lender remits cash or a lender IOU to the vendor.
Pursuant to the provisions of Article 5, the purchaser should
derecognize its trade account payable and record a new liability
classified on its balance sheet as a borrowing from the lender.
Consistent with this classification, the purchaser should then
accrete the difference between the initial carrying amount of the
borrowing (i.e. the discounted amount of the vendor invoice) and the
repayment amount (i.e. the amount owed to the lender) through
interest expense using the effective yield method.
In his 2004 speech, Mr. Comerford warned registrants and
auditors not to mistake the SEC staff’s 2003 discussion of the two trade
payable arrangements for a set of rules to use for determining when
short-term borrowings should be classified as trade payables. Rather, as
noted above, an entity must consider all the facts and circumstances and
comply with both the letter and the spirit of the accounting
requirements.
We are not aware that the SEC staff has addressed an
entity’s use of p-cards (i.e., purchase cards), other types of charge
cards, or credit cards to pay invoices. If these arrangements are only
used as the original mechanism to incur an expenditure with a vendor, it
may be acceptable to consider such amounts owed as trade payables in
certain situations. For example, if one of these types of bank-issued
cards is used only as a matter of convenience to incur an expenditure
(i.e., pay the vendor immediately), the amounts owed are paid during the
customary period in which trade payables are due, and interest costs are
not incurred, classification of such amounts owed as trade payables is
generally acceptable.
P-cards and other charge cards are sometimes used by
entities to extend payment terms. When a p-card or other charge card is
used to pay an invoice owed to a vendor, the entity has extinguished its
liability to the vendor and incurred an obligation with a bank.
Therefore, continued classification as a trade payable is not
appropriate. For example, an entity might extend the payment terms on a
trade payable with an invoice due date of April 1, 20X0, by using a
charge card that has a monthly settlement date of April 30, 20X0, for
which full payment of all charges incurred in April 20X0 are due on May
31, 20X0. In this scenario, the entity has extended the payment terms by
60 days. Continued classification as a trade payable after the vendor
has been paid is inappropriate; therefore, such classification could
only be accepted on the basis of a materiality argument in this type of
arrangement.
It is difficult to distinguish between (1) an entity’s
use of a credit card to make payments to vendors and (2) its use of a
traditional revolving line of credit to make such payments (i.e., in
both arrangements, interest costs accrue). Therefore, any time a credit
card is used to pay trade payables, the entity should reclassify such
payables as liabilities owed to a bank. In no situation in which an
entity (1) uses any type of bank-issued card to pay invoices and (2)
incurs interest on such card can the entity continue to classify as
trade payables amounts paid to vendors as a result of having incurred
those charges.
Example 14-1
Structured
Vendor Payable Program
A structured vendor payable
program (SVPP) that is established as follows
might not change the characteristics of trade
payables (i.e., it might not require
reclassification to short-term debt):
- The entity enters into an agreement for buyer payment services in which the intermediary is acting as the entity’s paying agent for the entity’s suppliers.
- The intermediary offers participating suppliers the opportunity to voluntarily factor their receivables from the entity to the intermediary. That is, a supplier is able to factor its receivable to the intermediary on a discounted basis before the invoice due date. Specifically, the intermediary offers vendors the following two payment options: (1) payment on the due date in 60 days or (2) advance payment in 30 days at a 2.5 percent discount.
- The SVPP does not relieve the entity of its obligation to its suppliers under invoices eligible for factoring under the SVPP. The supplier maintains recourse against the entity for nonpayment and for any commercial dispute related to the invoice.
- The SVPP does not change the payment terms, timing, or amount with respect to the entity’s obligation to its supplier. The entity’s obligation to the supplier is neither affected nor reduced by any separate contract between the intermediary and the supplier.
- The payment terms are consistent with those typically offered in the entity’s industry.
- The entity will not participate in any negotiations between suppliers and the intermediary.
- Although the entity may request such information from the intermediary, it will not be automatically notified of any advance payment or other transactions between the supplier and intermediary.
- The entity is not obligated to pay any fees directly to the intermediary and will not receive any amounts or benefits from the intermediary in the form of a rebate or other incentives. The entity is obligated to pay the full invoice amount even if the intermediary paid the supplier at a discount.
- The legal form of the trade payable has not changed.
If a trade payable arrangement involving an intermediary
must be classified as a borrowing, an entity should consider the
associated cash flow statement implications (see also Section 7.2 of
Deloitte’s Roadmap Statement of Cash Flows). At the December
2005 AICPA Conference on Current SEC and PCAOB Developments, SEC
Associate Chief Accountant Joel Levine stated, in part:
The situation
addressed by the staff dealt with a transaction similar to the
purchase of non-[X] products financed through [X]. For example, say
a dealer purchases [Y and Z] financed under a floor-plan arrangement
with [X]. [X] pays the supplier directly and then is repaid later by
the dealer. In this case, the financing arrangement is not with the
supplier, as it was when the dealer purchased [X] products;
therefore, it does not represent a trade loan. It represents a
third-party financing arrangement. Not a big deal, except that the
inventory purchase, an operating activity, has taken place without
the dealer physically delivering the cash. Based on the view that
the financing entity effectively has acted as the dealer’s agent, we
concluded that upon purchase of the inventory, the dealer should
report the increase in the third-party loan in substance as a
financing cash inflow, with a corresponding operating cash outflow
for the increase in inventory. Upon repayment, the cash outflow
would be reported as a financing activity. Here, the cash flows
statement would depict the substance of the transactions — with the
end result being similar to the previous example where the net
effect on operating cash flows is the amount of gross profit
generated.
In accordance with this speech, when the debt owed to a
bank for a good or service purchased from a supplier is recognized, the
amount must be treated as an operating cash outflow and a financing cash
inflow even though the entity actually did not have any cash outflow to
the supplier. This is because an entity must apply, in substance, a
“constructive cash payment/receipt” approach to the transaction when
preparing the statement of cash flows. The subsequent cash paid to
satisfy the amount owed to the bank is classified as a financing cash
outflow.
14.3.1.3.2 Disclosure
ASC 405-50
05-1
This Subtopic addresses the disclosures applicable
for an entity that uses a supplier finance program
in connection with the purchase of goods and
services (the buyer in a supplier finance
program). A supplier finance program also may be
referred to as a reverse factoring, payables
finance, or structured payables arrangement.
10-1
The objective of this Subtopic is to establish
disclosures that enhance the transparency of a
supplier finance program used by an entity in
connection with the purchase of goods and services
(the buyer in a supplier finance program).
10-2
This Subtopic does not address either of the
following:
-
A buyer’s recognition, measurement, or financial statement presentation of an obligation in connection with a supplier finance program
-
The accounting and disclosure for other parties involved in a supplier finance program.
15-1
The guidance in this Subtopic applies to all
entities that use supplier finance programs in
connection with the purchase of goods and services
(buyers in a supplier finance program).
15-2
The guidance in this Subtopic applies to
obligations in connection with supplier finance
programs. A supplier finance program is an
arrangement that has all the following
characteristics:
-
An entity enters into an agreement with a finance provider or an intermediary.
-
The entity confirms supplier invoices as valid to the finance provider or intermediary under the agreement described in (a).
-
The entity’s supplier has the option to request early payment from a party other than the entity for invoices that the entity has confirmed as valid.
15-3
Although not determinative, an indicator that an
entity may have a supplier finance program is the
commitment to pay a party other than the supplier
for a confirmed invoice without offset, deduction,
or any other defenses to payment.
15-4 In
determining whether an entity has established a
supplier finance program and, therefore, is
subject to the disclosures required by this
Subtopic, all available evidence shall be
considered, including arrangements between the
entity and its finance provider or intermediary
and between the entity and its suppliers whose
invoices the entity has confirmed as valid to the
finance provider or intermediary.
50-1
The objective of the requirements in this Subtopic
is for an entity to disclose sufficient
information to enable users of financial
statements to understand the nature, activity
during the period, changes from period to period,
and potential magnitude of the entity’s supplier
finance programs. To achieve that objective, an
entity shall disclose qualitative and quantitative
information about its supplier finance
programs.
50-2 An
entity shall consider the level of detail
necessary to satisfy the disclosure objective. If
an entity uses more than one supplier finance
program, the entity may aggregate disclosures, but
not to the extent that useful information is
obscured by the aggregation of programs that have
substantially different characteristics.
50-3 In
each annual reporting period, an entity shall
disclose all the following information about its
supplier finance programs:
-
The key terms of the program, including, but not limited to:
-
A description of the payment terms, including payment timing and the basis for its determination
-
Assets pledged as security or other forms of guarantees provided for the committed payment to the finance provider or intermediary.
See paragraphs 405-50-55-1 through 55-3 for an illustrative example. -
-
The amount of obligations outstanding at the end of the reporting period that the entity has confirmed as valid to the finance provider or intermediary under the program (that is, the amount of obligations confirmed under the program that remains unpaid by the entity) and the following information about those obligations:
-
Where those obligations are presented in the balance sheet. If those obligations are presented in more than one balance sheet line item, then the entity shall disclose the amount outstanding at the end of the reporting period in each line item.
-
A rollforward of those obligations showing, at a minimum, all the following:
-
The amount of those obligations outstanding at the beginning of the reporting period
-
The amount of those obligations added to the program during the reporting period
-
The amount of those obligations settled during the reporting period
-
The amount of those obligations outstanding at the end of the reporting period.
-
-
50-4 In
each interim reporting period, an entity shall
disclose the amount of obligations outstanding
that the entity has confirmed as valid to the
finance provider or intermediary under the
supplier finance program at the end of the
reporting period.
ASC 405-50 requires the buyer in a supplier finance
program to disclose qualitative and quantitative information about the
program. Under ASC 405-50-15-2, such a program is defined as an
“arrangement that has all the following characteristics:”
-
“An entity enters into an agreement with a finance provider or an intermediary.”
-
“The entity confirms supplier invoices as valid to the finance provider or intermediary under the agreement.”
-
“The entity’s supplier has the option to request early payment from a party other than the entity for invoices that the entity has confirmed as valid.”
The disclosure requirements in ASC 405-50 apply regardless of whether the
entity classifies its liabilities under a supplier finance program as a
trade payable or on another balance sheet line (e.g., debt).
ASC 405-50 does not apply to any of the following:
- The intermediary or supplier in a supplier finance program.
- Traditional credit card programs for which an intermediary is directed to pay the supplier on behalf of an entity.
- Payment processing arrangements that do not give a supplier the option to request early payment.
- Arrangements that extend, or give an entity the option to extend, the payment terms associated with the payment due date in the related invoice.
- Credit enhancements, such as letters of credit or financial guarantees, provided by an intermediary to a supplier on an entity’s behalf.
ASC 405-50-50-3 and 50-4 specify the disclosures for
annual and interim periods, and ASC 405-50-55-4 and 55-5 illustrate how
to disclose the rollforward information required under ASC
405-50-50-3(b)(2). (Note that entities do not have to provide these
disclosures until fiscal years beginning after December 15, 2023,
although early adoption is permitted.)
ASC 405-50
Example
2: Disclosure of a Rollforward of Obligations
Confirmed as Valid Under a Supplier Finance
Program
55-4
This Example provides an illustration of the
guidance in paragraph 405-50-50-3(b)(2) based on
the assumptions that Entity A provides one
comparative balance sheet and that its supplier
finance program is denominated in Entity A’s
reporting currency.
55-5
The following illustrates the disclosures in a
tabular format.
The
rollforwards of Entity A’s outstanding obligations
confirmed as valid under its supplier finance
program for years ended December 31, 20X2, and
20X1, are as follows (in thousands):
Connecting the Dots
ASC 405-50-50-3(b) requires entities to provide
certain disclosures related to “[t]he amount of obligations
outstanding at the end of the reporting period that the entity
has confirmed as valid to the finance provider or intermediary
under the program.” Questions have arisen related to whether
these disclosures are limited to the amount that the finance
provider or intermediary has funded (i.e., the amount the
supplier has been paid by the finance provider or intermediary
before the related invoice due date). However, this requirement
applies to the amount that remains unpaid by the entity
irrespective of whether the supplier has been paid. There is no
requirement in ASC 405-50 to disclose the amount funded by the
finance provider or intermediary.
14.3.1.4 Separate Presentation of Debt Measured at Fair Value
ASC 825-10
45-1A An
entity shall separately present financial assets and
financial liabilities by measurement category and
form of financial asset (that is, securities or
loans and receivables) in the statement of financial
position or the accompanying notes to the financial
statements.
45-1B
Entities shall report assets and liabilities that
are measured at fair value pursuant to the fair
value option in this Subtopic in a manner that
separates those reported fair values from the
carrying amounts of similar assets and liabilities
measured using another measurement attribute.
45-2 To
accomplish that, an entity shall either:
- Present the aggregate of fair value and non-fair-value amounts in the same line item in the statement of financial position and parenthetically disclose the amount measured at fair value included in the aggregate amount
- Present two separate line items to display the fair value and non-fair-value carrying amounts.
ASC 815-15
45-1 In each
statement of financial position presented, an entity
shall report hybrid financial instruments measured
at fair value under the election and under the
practicability exception in paragraph 815-15-30-1 in
a manner that separates those reported fair values
from the carrying amounts of assets and liabilities
subsequently measured using another measurement
attribute on the face of the statement of financial
position. To accomplish that separate reporting, an
entity may do either of the following:
- Display separate line items for the fair value and non-fair-value carrying amounts
- Present the aggregate of the fair value and non-fair-value amounts and parenthetically disclose the amount of fair value included in the aggregate amount.
An entity must disaggregate financial liabilities by measurement category
either on the face of the balance sheet or in the notes to the financial
statements. A debtor that has measured debt instruments at fair value under
ASC 825-10 (see Section 4.4) or ASC 815-15 (including
those measured at fair value because the entity is unable to reliably
identify and measure an embedded derivative that would otherwise need to be
bifurcated; see Sections 8.5.5 and
8.5.6) must present those debt instruments on the
balance sheet in a manner that separates them from the carrying amounts of
similar debt instruments that are measured by using an attribute other than
fair value (e.g., debt that is accounted for by using the interest method in
ASC 835-30; see Section 6.2). ASC 825 and ASC 815-15
identify two ways to accomplish such presentation: (1) separate line items
or (2) parenthetical disclosure of fair value amounts.
In the absence of regulations that require separate presentation of accrued
interest, the fair value amount presented on the balance sheet for an
interest-bearing financial asset or financial liability accounted for at
fair value through earnings should include any interest earned or incurred
but not paid (accrued interest). It would, however, be acceptable for an
entity to parenthetically disclose the amount of the fair value measurement
that represents accrued interest in the financial statement line item for
which the interest-bearing financial asset or financial liability accounted
for under the fair value option is presented.
If there are regulations that require presentation of accrued interest
separately from the related interest-bearing financial asset or financial
liability for which the fair value option has been elected, an entity must
do one of the following to comply with the disclosure requirements in ASC 825:
- Present the aggregate amount of accrued interest, which represents part of the fair value of the asset or liability, in a separate line item in the statement of financial position.
- Parenthetically disclose the amount of the fair value measurement that represents accrued interest in the financial statement line item for which the interest-bearing financial asset or financial liability is presented.
14.3.1.5 SEC Requirements
The FASB has not prescribed which specific line items an entity must present
related to debt on its balance sheet, although debtors typically present
short-term borrowings separately from long-term debt (see Chapter
13). Entities that file financial statements with the SEC
must comply with the balance sheet requirements in Regulation S-X, including
those that apply to the following types of entities:
- Commercial and industrial companies (see the next section).
- Bank holding companies (see Section 14.3.1.5.2).
- Insurance companies (see Section 14.3.1.5.3).
- Registered investment companies (see Section 14.3.1.5.4).
14.3.1.5.1 Commercial and Industrial Companies
SEC Rules, Regulations, and Interpretations
Regulation S-X, Rule 5-02, Balance Sheets
[Reproduced in ASC 210-10-S99-1]
The purpose of this rule is to indicate the
various line items and certain additional
disclosures which, if applicable, and except as
otherwise permitted by the Commission, should
appear on the face of the balance sheets or
related notes filed for the persons to whom this
article pertains (see § 210.4-01(a)). . . .
Liabilities and Stockholders’ Equity
Current Liabilities, When Appropriate
19. Accounts and notes payable.
(a) State separately amounts
payable to
(1) banks for borrowings;
(2) factors or other financial institutions
for borrowings;
(3) holders of commercial paper;
(4) trade creditors;
(5) related parties (see §
210.4-08(k));
(6) underwriters, promoters, and employees
(other than related parties); and
(7) others.
Amounts applicable to (1), (2) and (3) may be
stated separately in the balance sheet or in a
note thereto.
(b) The amount and terms
(including commitment fees and the conditions
under which lines may be withdrawn) of unused
lines of credit for short-term financing shall be
disclosed, if significant, in the notes to the
financial statements. The weighted average
interest rate on short term borrowings outstanding
as of the date of each balance sheet presented
shall be furnished in a note. The amount of these
lines of credit which support a commercial paper
borrowing arrangement or similar arrangements
shall be separately identified.
20. Other current liabilities. State separately,
in the balance sheet or in a note thereto, any
item in excess of 5 percent of total current
liabilities. Such items may include, but are not
limited to, accrued payrolls, accrued interest,
taxes, indicating the current portion of deferred
income taxes, and the current portion of long-term
debt. Remaining items may be shown in one
amount.
21. Total current liabilities, when
appropriate.
Long-Term Debt.
22. Bonds, mortgages and other long-term debt,
including capitalized leases.
(a) State separately, in the
balance sheet or in a note thereto, each issue or
type of obligation and such information as will indicate:
(1) The general character of each type of
debt including the rate of interest;
(2) the date of maturity, or, if maturing
serially, a brief indication of the serial
maturities, such as “maturing serially from 1980
to 1990”;
(3) if the payment of principal or interest
is contingent, an appropriate indication of such
contingency;
(4) a brief indication of priority; and
(5) if convertible, the basis. For amounts
owed to related parties, see § 210.4-08(k).
(b) The amount and terms
(including commitment fees and the conditions
under which commitments may be withdrawn) of
unused commitments for long-term financing
arrangements that would be disclosed under this
rule if used shall be disclosed in the notes to
the financial statements if significant.
23. Indebtedness to related parties — noncurrent.
Include under this caption indebtedness to related
parties as required under § 210.4-08(k). . . .
Regulation S-X requires SEC registrants subject to Rule 5-02 (i.e.,
commercial and industrial companies) to present current liabilities
separately from long-term debt on the face of the balance sheet. When
appropriate, a total of current liabilities must also be shown.
Within current liabilities, accounts and notes payable are presented
separately from other current liabilities on the face of the balance
sheet. Within accounts and notes payable, the amounts of borrowings from
(1) banks, (2) factors and other financial institutions, and (3)
commercial paper holders are shown separately either on the face of the
balance sheet or in the notes. Further, amounts due to (1) trade
creditors (e.g., payables for goods or services); (2) related parties;
(3) underwriters, promoters, and employees (other than related parties);
and (4) others are stated separately on the face of the balance sheet.
Other current liabilities include, for example, accrued interest and the
current portion of long-term debt. Any item within the other current
liabilities category in excess of 5 percent of total current liabilities
must be displayed separately on the face of the balance sheet or in the
notes.
Within noncurrent liabilities, bonds, mortgages, and other long-term
debt, are shown separately from related-party debt. For each issue or
type of obligation of bonds, mortgages, and other long-term debt, the
entity states separately either on the face of the balance sheet or in a
note (1) the general character of each debt type; (2) the interest rate;
(3) the maturity date or, for serial-maturity debt (e.g., amortizing
debt), the serial maturity period; (4) an indication of any contingency
associated with the payment of principal or interest (e.g., additional
interest contingent upon an event of default or delayed filings); (5)
priority (e.g., senior or subordinated debt); and (6) if applicable,
conversion terms.
14.3.1.5.2 Bank Holding Companies
SEC Rules, Regulations, and Interpretations
Regulation
S-X, Rule 9-03, Balance Sheets [Reproduced in ASC
942-210-S99-1]
The purpose of this rule is to indicate the
various items which, if applicable, should appear
on the face of the balance sheets or in the notes
thereto. . . .
13. Short-term borrowing. Disclosure separately
on the balance sheet or in a note, amounts payable
for
(1) Federal funds purchased
and securities sold under agreements to
repurchase;
(2) commercial paper,
and
(3) other short-term borrowings.
(a) Disclose any unused lines of credit for
short-term financing: (§ 210.5-02.19(b)). . .
.
16. Long-term debt. Disclose in
a note the information required by § 210.5-02.22.
. . .
Regulation S-X requires SEC registrants subject to Rule 9-03 (i.e., bank
holding companies) to present separate balance sheet captions for
short-term borrowings and long-term debt. However, such entities are not
required to present a classified balance sheet with separate subtotals
for short-term and long-term liabilities.
Within the short-term borrowings category, entities separately disclose
federal funds purchased and securities sold under repurchase agreements,
commercial paper, and other short-term borrowing either on the face of
the balance sheet or in the notes. For each issue or type of obligation
of bonds, mortgages, and other long-term debt, the entity states in a
note (1) the general character of each debt type; (2) the interest rate;
(3) the maturity date or, for serial-maturity debt (e.g., amortizing
debt), the serial maturity period; (4) an indication of any contingency
associated with the payment of principal or interest (e.g., additional
interest contingent on an event of default or delayed filings); (5)
priority (e.g., senior or subordinated debt); and (6) if applicable,
conversion terms.
14.3.1.5.3 Insurance Companies
SEC Rules, Regulations, and Interpretations
Regulation S-X, Rule 7-03, Balance Sheets
[Reproduced in ASC 944-210-S99-1]
(a) The purpose of this rule is to indicate the
various items which, if applicable, and except as
otherwise permitted by the Commission, should
appear on the face of the balance sheets and in
the notes thereto filed for persons to whom this
article pertains. (See § 210.4-01(a).). . .
16. Notes payable, bonds, mortgages and similar
obligations, including capitalized leases.
(a) State separately in the
balance sheet the amounts of (1) short-term debt
and (2) long-term debt including capitalized
leases.
(b) The disclosure required
by § 210.5-02.19(b) shall be given if the
aggregate of short-term borrowings from banks,
factors and other financial institutions and
commercial paper issued exceeds five percent of
total liabilities.
(c) The disclosure
requirements of § 210.5-02.22 shall be followed
for long-term debt.
17. Indebtedness to related parties. (See §
210.4-0.8(k).) . . .
Regulation S-X requires SEC registrants subject to Rule
7-03 (i.e., insurance companies) to divide their presentation of amounts
for notes payable, bonds, mortgages, and similar obligations between
short-term debt and long-term debt (including capitalized leases) on the
face of the balance sheet. However, such entities are not required to
present a classified balance sheet with separate subtotals for
short-term and long-term liabilities.
For each issue or type of obligation of long-term debt, the entity
discloses separately either on the face of the balance sheet or in a
note (1) the general character of each debt type; (2) the interest rate;
(3) the maturity date or, for serial-maturity debt (e.g., amortizing
debt), the serial maturity period; (4) an indication of any contingency
associated with the payment of principal or interest (e.g., additional
interest contingent on an event of default or delayed filings); (5)
priority (e.g., senior or subordinated debt); and (6) if applicable,
conversion terms.
14.3.1.5.4 Registered Investment Companies
SEC Rules, Regulations, and Interpretations
Regulation S-X, Rule 6-04, Balance Sheets
[Reproduced in ASC 946-210-S99-1]
This section is applicable to balance sheets
filed by registered investment companies and
business development companies except for persons
who substitute a statement of net assets in
accordance with the requirements specified in §
210.6-05, and issuers of face-amount certificates
which are subject to the special provisions of §
210.6-06. Balance sheets filed under this rule
shall comply with the following provisions: . .
.
13. Notes payable, bonds and similar debt.
(a) State separately amounts
payable to:
(1) Banks or other financial institutions for
borrowings;
(2) controlled companies;
(3) other affiliates; and
(4) others, showing for each category amounts
payable within one year and amounts payable after
one year.
(b) Provide in a note the
information required under § 210.5-02.19(b)
regarding unused lines of credit for short-term
financing and § 210.5-02.22(b) regarding unused
commitments for long-term financing arrangements.
. . .
Regulation S-X requires SEC registrants subject to Rule 6-04 (i.e.,
registered investment companies) to present the amount of notes payable,
bonds, and similar debt on the face of the balance sheet with a
breakdown of amounts payable to (1) banks or other financial
institutions for borrowings, (2) controlled companies, (3) other
affiliates, and (4) others. For each category, amounts payable within
one year and amounts payable after one year are shown. However, such
entities are not required to present a classified balance sheet with
separate subtotals for short-term and long-term liabilities.
14.3.2 Cash Flow Statement
ASC 230-10
45-14 All of
the following are cash inflows from financing
activities: . . .
b. Proceeds from issuing bonds, mortgages,
notes, and from other short- or long-term
borrowing . . . .
45-15 All of
the following are cash outflows for financing
activities: . . .
b. Repayments of amounts borrowed, including
the portion of the repayments made to settle
zero-coupon debt instruments that is attributable
to the principal or the portion of the repayments
made to settle other debt instruments with coupon
interest rates that are insignificant in relation
to the effective interest rate of the borrowing
that is attributable to the principal.
c. Other principal payments to creditors who
have extended long-term credit. See paragraph
230-10-45-13(c), which indicates that most
principal payments on seller-financed debt
directly related to a purchase of property, plant,
and equipment or other productive assets are
financing cash outflows. . . .
e. Payments for debt issue costs. . . .
g. Payments for debt prepayment or debt
extinguishment costs, including third-party costs,
premiums paid, and other fees paid to lenders that
are directly related to the debt prepayment or
debt extinguishment, excluding accrued
interest.
45-17 All of
the following are cash outflows for operating activities:
a. Cash payments to acquire materials for
manufacture or goods for resale, including
principal payments on accounts and both short- and
long-term notes payable to suppliers for those
materials or goods. The term goods includes
certain loans and other debt and equity
instruments of other entities that are acquired
specifically for resale, as discussed in paragraph
230-10-45-21. . . .
d. Cash payments to lenders and other creditors
for interest, including the portion of the
payments made to settle zero-coupon debt
instruments that is attributable to accreted
interest related to the debt discount or the
portion of the payments made to settle other debt
instruments with coupon interest rates that are
insignificant in relation to the effective
interest rate of the borrowing that is
attributable to accreted interest related to the
debt discount. For all other debt instruments, an
issuer shall not bifurcate cash payments to
lenders and other creditors at settlement for
amounts attributable to accreted interest related
to the debt discount, nor classify such amounts as
cash outflows for operating activities. . .
.
Under ASC 230, proceeds from borrowings are classified as cash inflows from
financing activities, whereas repayment of amounts borrowed, payments for debt
issue costs, and payments for debt prepayment or debt extinguishment costs are
classified as cash outflow for financing activities. However, principal payments
on notes payable to suppliers for materials or goods are classified as cash
outflows for operating activities.
Although ASC 230 does not address debt modifications accounted
for under ASC 470-50, when debt is restructured and is accounted for as a
modification rather than as an extinguishment, an entity should apply the
principles in ASC 230 and classify fees paid to the creditor on the modification
date as a financing cash outflow (see Section 6.2.1 of Deloitte’s Roadmap
Statement of Cash
Flows). Further, any fees paid to a third party other
than the creditor in connection with a debt modification should generally be
classified as operating cash outflows because, in accordance with ASC
470-50-40-18(b), the payment must be expensed.
An entity that issues zero-coupon bonds to an investor records
the proceeds from the bonds’ issuance as a financing cash inflow. Unless the
debtor elects to account for the bonds at fair value under the fair value
option, the bonds are accreted to their redemption value in accordance with the
interest method (see Section
6.2); that is, the carrying amount of the bonds increases from
issuance until maturity (or earlier if prepayment is allowed) for the accrued
interest to arrive at the bonds’ redemption value. On the maturity date (or
earlier if prepayment is allowed), the entity repays (1) the original proceeds
(the principal amount of the bonds) and (2) the accrued interest from the date
of issuance. Before the bonds’ maturity (or the date of prepayment, if earlier),
the interest expense is presented in the statement of cash flows as a
reconciling item between net income and cash flows from operating activities,
since no interim cash payments are made for the periodic accrual of interest. At
redemption, the cash paid to settle the interest component is reflected as a
cash outflow from operating activities in the statement of cash flows in
accordance with ASC 230-10-45-17(d) as the accrued interest is recognized in
earnings. The cash paid to settle the principal component (excluding the
interest component) is reflected as a cash outflow from financing activities in
the statement of cash flows in accordance with ASC 230-10- 45-15(b). For an
illustration of this accounting, see Example 6-9 in Deloitte’s Roadmap
Statement of Cash
Flows.
In addition to zero-coupon bonds, the guidance in ASC 230-10-45-17(d) also
applies to other debt instruments “with coupon interest rates that are
insignificant in relation to the effective interest rate of the borrowing that
is attributable to the principal.” The objective of including these other debt
instruments (rather than all debt instruments) is to improve comparability
related to entities’ presentation of economically similar transactions. ASC 230
does not define the term “insignificant” or otherwise provide guidance on what
would constitute insignificant coupon rates. Consequently, entities that issue
other debt instruments with coupon rates that are insignificant in relation to
the effective interest rate attributable to the principal will most likely need
to exercise greater judgment in evaluating the portion of the rates that is
insignificant. We generally believe that an entity should determine whether an
interest rate is insignificant by looking to the market. For example, a 1
percent coupon rate may not be insignificant if the market rate is 2 percent.
However, an entity may conclude that a 1 percent coupon rate is insignificant
compared with a market rate of 10 percent.
As discussed in Section 6.4.3 of Deloitte’s Roadmap
Statement of Cash
Flows, the guidance in ASC 230-10-45-17(d) applies to all
debt instruments that are economically similar to zero-coupon instruments,
including debt instruments that contain periodic interest coupons that are
payable in kind.
For additional discussion about the application of ASC 230, see
Deloitte’s Roadmap Statement of Cash Flows.
14.3.3 Earnings per Share
While a detailed discussion of the guidance in ASC 260-10 is
beyond the scope of this Roadmap, this section briefly discusses how debt could
affect an issuer’s EPS calculations. For a comprehensive discussion of the
guidance in ASC 260-10, see Deloitte’s Roadmap Earnings per Share.
14.3.3.1 Participating Securities
Sometimes, debt securities (e.g., certain convertible debt)
have a nondiscretionary and objectively determinable participation right in
the debtor’s undistributed earnings (e.g., a right to participate on an
if-converted basis in any dividends or other distributions to holders of
common stock). For such securities, the debtor should consider whether EPS
must be calculated by using the two-class method under ASC 260. The
two-class method applies to both basic and diluted EPS. Potential common
shares (e.g., convertible debt) are subject to the two-class method of
calculating diluted EPS if the effect is more dilutive than the application
of another dilutive method of calculating diluted EPS (i.e., the treasury
stock, if-converted, or contingently issuable share method). For a detailed
discussion of these requirements, see Chapter 5 of Deloitte’s Roadmap
Earnings per
Share.
14.3.3.2 Convertible Debt
When debt is convertible into the debtor’s shares of common
stock, the if-converted method should be applied in the computation of
diluted EPS. For convertible debt that is a participating security, the
two-class method should be applied in the computation of diluted EPS if it
is more dilutive than the if-converted method (see the previous
section).
If a convertible debt instrument does not represent a
participating security, the if-converted method is used to reflect the
impact of the embedded conversion option on diluted EPS. Under the
if-converted method, an entity may need to adjust both the numerator and
denominator. Since an entity using the if-converted method assumes that a
convertible debt instrument was converted into common shares at the
beginning of the reporting period (or the date of issuance, if later), the
numerator is adjusted to reverse any recognized interest expense (including
any amortization of discounts), net of tax, unless the principal amount must
be settled in cash. The common shares issuable upon conversion are added to
the denominator on the basis of the most favorable conversion terms
available to the holder. Except for convertible debt for which the principal
amount must be settled in cash upon conversion and certain contingently
convertible debt instruments, the if-converted method, if dilutive, must be
applied even if the embedded conversion option is out-of-the-money. For a
detailed discussion of these requirements, see Sections 4.4 and 6.2 of Deloitte’s
Roadmap Earnings per
Share.
If a convertible debt instrument does not represent a
participating security and the debtor can settle all or a portion of it in
cash or common stock upon conversion, the debtor must consider the guidance
in ASC 260 on contracts that may be settled in stock or cash. Under that
guidance, an entity presumes that a contract that may be settled in either
cash or stock will be settled in common stock for diluted EPS purposes. That
presumption cannot be overcome (e.g., on the basis of past experience or a
stated policy). If the principal amount must be settled in cash and the
conversion spread in shares, only the net number of shares equivalent to the
conversion spread is reflected in the computation of diluted EPS. If the
entire obligation can be settled in shares, the full number of shares
underlying the conversion feature is reflected in the application of the
if-converted method.
Special considerations are necessary if:
- An induced conversion occurs (see Section 6.6.1 of Deloitte’s Roadmap Earnings per Share).
- The conversion feature is nonsubstantive at inception and becomes exercisable only upon the exercise of a call option (see Section 6.6.2 of Deloitte’s Roadmap Earnings per Share).
- The embedded conversion option is separated as a derivative under ASC 815-15 (see Section 6.6.3 of Deloitte’s Roadmap Earnings per Share).
- The issuer has elected the fair value option in ASC 815-15 or ASC 825-10 (see Section 6.6.4 of Deloitte’s Roadmap Earnings per Share).
- The convertible debt contains an embedded put or call option (see Section 6.6.5 of Deloitte’s Roadmap Earnings per Share).
- The conversion feature is contingent (see Section 4.4.3 of Deloitte’s Roadmap Earnings per Share).
In addition, ASC 470-20-45-2A contains EPS guidance for own-share lending
arrangements executed in contemplation of a convertible debt offering or
other financing. Under this guidance, loaned shares are excluded from EPS
unless the counterparty to the arrangement defaults on its obligation to
return the loaned shares (or an equivalent amount of consideration). If the
counterparty defaults, the shares are included in both basic and diluted
EPS. (Note that under ASC 470-20-45-2A, the counterparty would need to
default for the loaned shares to be included in EPS, whereas under ASC
470-20-35-11A, the counterparty’s default must be probable for a loss to be
recognized.)
In practice, own-share lending arrangements often require the counterparty to
reimburse the issuer for any dividends paid on the loaned shares. If the
counterparty does not reimburse the issuer for such dividends, however, the
issuer must deduct the corresponding amount and any participation right in
undistributed earnings from income available to common stockholders.
For more discussion of the EPS accounting for own-share lending arrangements,
see Deloitte’s Roadmap Earnings per
Share, in particular Sections
3.3.2.8, 4.8.3.5,
5.3.3.9, and 8.5.
14.3.3.3 Contracts That May Be Settled in Stock or Cash
Some debt instruments allow for settlement in stock or cash (e.g., certain
convertible debt and variable-share settleable instruments). The specific
guidance in ASC 260 on diluted EPS applies to contracts that may be settled
in such a manner whether the option to elect the form of settlement is
controlled by the entity or the counterparty to the arrangement. ASC
260-10-45-45 states:
The effect of potential share settlement shall be
included in the diluted EPS calculation (if the effect is more dilutive)
for an otherwise cash-settleable instrument that contains a provision
that requires or permits share settlement (regardless of whether the
election is at the option of an entity or the holder, or the entity has
a history or policy of cash settlement). An example of such a contract
accounted for in accordance with this paragraph and paragraph
260-10-45-46 is a written call option that gives the holder a choice of
settling in common stock or in cash. An election to share settle an
instrument, for purposes of applying the guidance in this paragraph,
does not include circumstances in which share settlement is contingent
upon the occurrence of a specified event or circumstance (such as
contingently issuable shares). In those circumstances (other than if the
contingency is an entity’s own share price), the guidance on
contingently issuable shares should first be applied, and, if the
contingency would be considered met, then the guidance in this paragraph
should be applied. Share-based payment arrangements that are payable in
common stock or in cash at the election of either the entity or the
grantee shall be accounted for pursuant to this paragraph and paragraph
260-10-45-46, unless the share-based payment arrangement is classified
as a liability because of the requirements in paragraph 718-10-25-15
(see paragraph 260-10-45-45A for guidance for those instruments). If the
payment of cash is required only upon the final liquidation of an
entity, then the entity shall include the effect of potential share
settlement in the diluted EPS calculation until the liquidation occurs.
Except for certain share-based payment arrangements, an
entity must assume in the calculation of diluted EPS that any contract that
allows for settlement in shares will be settled in shares. This assumption
must be made regardless of (1) the likelihood of share settlement or (2) the
intent of the party that has the right to elect settlement in stock or cash.
Accordingly, an entity uses the if-converted method to include potential
common shares in the denominator of diluted EPS when a debt instrument may
be settled in stock or cash at the option of the issuer or investor. The
numerator in the calculation of diluted EPS may also need to be adjusted for
these instruments. For more information about the accounting for diluted EPS
for contracts that may be settled in stock or cash, see Section 4.7 of
Deloitte’s Roadmap Earnings per Share.
14.4 Disclosure
14.4.1 Significant Debt Terms
ASC 470-10
50-5
Paragraph 505-10-50-3 requires that an entity explain,
in summary form within its financial statements, the
pertinent rights and privileges of various securities
outstanding.
ASC 505-10
50-3 An
entity shall explain, in summary form within its
financial statements, the pertinent rights and
privileges of the various securities outstanding.
Examples of information that shall be disclosed are
dividend and liquidation preferences, participation
rights, call prices and dates, conversion or exercise
prices or rates and pertinent dates, sinking-fund
requirements, unusual voting rights, and significant
terms of contracts to issue additional shares or terms
that may change conversion or exercise prices (excluding
standard antidilution provisions). An entity shall
disclose within its financial statements the number of
shares issued upon conversion, exercise, or satisfaction
of required conditions during at least the most recent
annual fiscal period and any subsequent interim period
presented. An entity also shall disclose within the
financial statements actual changes to conversion or
exercise prices that occur during the reporting period
(excluding changes due to standard antidilution
provisions).
For each debt instrument outstanding, a debtor is required to disclose summary
information about the rights and privileges (i.e., significant terms) of each
debt instrument outstanding, such as participation rights, call prices and
dates, and sinking fund requirements. (Disclosures about equity conversion terms
are addressed in Section 14.4.9.)
SEC Rules, Regulations, and Interpretations
Regulation S-X, Rule 5-02, Balance Sheets [Reproduced
in ASC 210-10-S99-1]
The purpose of this rule is to indicate the various line
items and certain additional disclosures which, if
applicable, and except as otherwise permitted by the
Commission, should appear on the face of the balance
sheets or related notes filed for the persons to whom
this article pertains (see § 210.4-01(a)). . . .
22. Bonds, mortgages and other long-term debt, including
capitalized leases.
(a) State separately, in the balance
sheet or in a note thereto, each issue or type of
obligation and such information as will indicate:
(1) The general character of each type of debt
including the rate of interest;
(2) the date of maturity, or, if maturing
serially, a brief indication of the serial
maturities, such as “maturing serially from 1980
to 1990”;
(3) if the payment of principal or interest is
contingent, an appropriate indication of such
contingency;
(4) a brief indication of priority; and
(5) if convertible, the basis. For amounts owed
to related parties, see § 210.4-08(k). . . .
SEC registrants must disclose the following information for each issue or type of
obligation of bonds, mortgages, and other long-term debt either on the face of
the balance sheet or in a note:
- The general character of each debt type.
- The interest rate.
- The maturity date or, for serial-maturity debt (e.g., amortizing debt), the serial maturity period.
- An indication of any contingency associated with the payment of principal or interest (e.g., additional interest contingent upon an event of default or delayed filings).
- Priority (e.g., senior or subordinated debt).
- If applicable, conversion terms.
14.4.2 Face Amount and Effective Interest Rate
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.
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.
45-2 Paragraph 835-30-45-1A
provides requirements for the balance sheet presentation
for the discount or premium and debt issuance costs of a
note. The description of the note shall include the
effective interest rate. The face amount of the note
also shall be presented in the financial statements or
disclosed in the notes to financial statements. (See
paragraph 835-30-50-1.)
For each debt instrument outstanding, a debtor must provide the following
information either in the notes or on the face of the financial statements:
- The face amount (i.e., the stated principal amount).
- The effective interest rate that is used for accounting purposes (see Section 6.2.3.3).
The debt’s face amount may differ from its net carrying amount because the debt
was issued at a discount or premium (see Chapter 4), the
debtor incurred debt issuance costs (see Chapter 5), or the
debt proceeds were attributable to multiple units of account, such as debt with
detachable warrants (see Chapter 3). ASC 835-30-45-1A
requires discounts, premiums, or issuance costs to be presented as a direct
deduction or addition to the amount on the face of the balance sheet. In the
income statement, the debtor reports the amortization of discounts, premiums,
and issuance costs as interest expense (see ASC 835-30-45-3). However, the
guidance in ASC 835-30-45 on the amortization of discounts, premiums, and
issuance costs does not apply to debt reported at fair value, such as debt
reported under the fair value option in ASC 815-15 or ASC 825-10 (see ASC
835-30-45-1).
ASC 835-30
Example 2: Balance Sheet Presentation of Discounted
Notes
55-8 This
Example is an illustration of the guidance in paragraphs
835-30-45-1 through 45-3 related to the balance sheet
presentation of notes that are discounted.
Note 1 — Long-Term Debt
Long-term debt at December 31, 20X2, consisted of the
following:
ASC 835-30-55-8 illustrates the presentation and disclosure of (1) a noninterest
bearing note receivable with an imputed discount and (2) long-term debt issued
at a discount and for which debt issuance costs were incurred. The illustration
shows how the discount and issuance costs related to a debt instrument may be
presented either in the line item caption for the debt or broken out as a
separate amount on the face of the balance sheet. Further, it displays how the
notes may show a breakdown of individual debt instruments along with their
amounts of debt discounts and issuance costs when the balance sheet line item
includes multiple debt instruments. If a debt instrument was issued at a premium
instead of a discount, the related descriptions would be amended
accordingly.
14.4.3 Pledged Assets and Restrictive Debt Covenants
ASC 440-10
50-1
Notwithstanding more explicit disclosures required
elsewhere in this Codification, all of the following
situations shall be disclosed in financial statements: .
. .
c. Assets pledged
as security for loans . . .
f. Commitments, including: . . .
2. An obligation to reduce debts
3. An obligation to maintain working
capital
4. An obligation to restrict dividends.
Nonauthoritative AICPA Guidance
Technical Q&As Section 3500, “Commitments”
.06 Covenants Imposed by Loan
Agreements
Inquiry — Restrictive covenants under certain loan
agreements of Company A require the Company to maintain
a special level of working capital, reduce the amount of
its debts, and restrict the amount of retained earnings
available for dividend payments. Should the restrictive
covenants be disclosed?
Reply — FASB ASC 440-10-50-1 requires the
disclosure of restrictive covenants.
A debtor is required to disclose information about assets pledged as collateral
for debt and restrictive debt covenants, such as commitments to maintain a
specific amount of working capital (see Section 13.3.3.2),
reduce the amount of debt, or restrict dividend payments (e.g., provisions that
prevent the payment of dividends on common or preferred stock).
14.4.4 Weighted Average Interest Rate on Short-Term Borrowings
ASC 470-10
15-1 The
guidance in this Subtopic applies to all entities.
Pending Content
(Transition Guidance: ASC 105-10-65-7)
15-1 The guidance in this
Subtopic applies to all entities, excluding
paragraph 470-10-50-7, which applies to public
business entities only.
50-7 A public business
entity shall disclose the weighted-average
interest rate on short-term borrowings outstanding
as of the date of each balance sheet
presented.
SEC Rules, Regulations, and Interpretations
Regulation S-X, Rule 5-02, Balance Sheets [Reproduced
in ASC 210-10-S99-1]
The purpose of this rule is to indicate the various line
items and certain additional disclosures which, if
applicable, and except as otherwise permitted by the
Commission, should appear on the face of the balance
sheets or related notes filed for the persons to whom
this article pertains (see § 210.4-01(a)). . . .
19. Accounts and notes payable. . . .
(b) . . . The weighted average interest rate on
short term borrowings outstanding as of the date
of each balance sheet presented shall be furnished
in a note. . . .
SEC Rules, Regulations, and Interpretations
FRR 203.01. Reasons for Requirements (ASR 148)
The management of liquidity is an important part of the
financial management of a business entity. The
maintenance of short-term borrowing capacity and the
ability to obtain such funds at reasonable cost are
major elements of such a management responsibility. If
investors are to understand the financial policies of
management, disclosure relative to these elements is
necessary. . . .
The interest paid for short-term borrowings is . . . of
significance in appraising the financial policies and
operating results of business entities. Changes in this
rate over time may have a significant impact on
profitability. The relationship of the rate paid at year
end to short-term rates generally being charged at that
date to corporate borrowers may be indicative of the
future level of interest costs to be incurred by the
corporation under varying conditions in the credit
markets. In addition, information as to the magnitude of
such borrowings during a fiscal period should further
assist investors in determining the impact of changing
credit conditions on business operations.
SEC registrants must disclose in a note the weighted average interest rate on
short-term borrowings outstanding as of each balance sheet date.
14.4.5 Defaulted Debt, Covenant Violations, and Waivers
SEC Rules, Regulations, and Interpretations
Regulation S-X, Rule 4-08, General Notes to Financial
Statements [Reproduced in ASC 235-10-S99-1]
If applicable to the person for which the financial
statements are filed, the following shall be set forth
on the face of the appropriate statement or in
appropriately captioned notes. The information shall be
provided for each statement required to be filed, except
that the information required by paragraphs (b), (c),
(d), (e) and (f) of this section shall be provided as of
the most recent audited balance sheet being filed and
for paragraph (j) of this section as specified therein.
When specific statements are presented separately, the
pertinent notes shall accompany such statements unless
cross-referencing is appropriate. . . .
(c) Defaults. The
facts and amounts concerning any default in principal,
interest, sinking fund, or redemption provisions with
respect to any issue of securities or credit agreements,
or any breach of covenant of a related indenture or
agreement, which default or breach existed at the date
of the most recent balance sheet being filed and which
has not been subsequently cured, shall be stated in the
notes to the financial statements. If a default or
breach exists but acceleration of the obligation has
been waived for a stated period of time beyond the date
of the most recent balance sheet being filed, state the
amount of the obligation and the period of the waiver. .
. .
SEC registrants must disclose information about:
- Debt in default, including “the facts and amounts concerning any default in principal, interest, sinking fund, or redemption provisions.”
- Covenant violations, including “any breach of covenant of a related indenture or agreement, which default or breach existed at the date of the most recent balance sheet being filed and which has not been subsequently cured.”
- Waivers of defaults and covenant violations, including “the amount of the obligation and the period of the waiver.”
14.4.6 Five-Year Table of Debt Maturities
ASC 470-10
50-1 The combined aggregate
amount of maturities and sinking fund requirements for
all long-term borrowings shall be disclosed for each of
the five years following the date of the latest balance
sheet presented. (See paragraph 505-10-50-11 for related
disclosure guidance on redeemable securities.) See
Example 3 (paragraph 470-10-55-10) for an illustration
of this disclosure requirement.
50-2 If an
obligation under paragraph 470-10-45-11(b) is classified
as a long-term liability (or, in the case of an
unclassified balance sheet, is included as a long-term
liability in the disclosure of debt maturities), the
circumstances shall be disclosed.
Example 3: Disclosure of Long-Term
Obligations
55-10 This
Example provides an illustration of the guidance in
paragraph 470-10-50-1 for disclosures for long-term
borrowings and preferred stock with mandatory redemption
requirements. This Example has the following
assumptions.
55-11 Entity D has outstanding
two long-term loans, one convertible debt, and one issue
of preferred stock with mandatory redemption
requirements. The first loan is a $100 million sinking
fund debenture with annual sinking fund payments of $10
million in 19X2, 19X3, and 19X4, $15 million in 19X5 and
19X6, and $20 million in 19X7 and 19X8. The second loan
is a $50 million note due in 19X5. The convertible debt
has a principal amount of $70 million that is not
convertible before maturity in 19X9. This convertible
debt requires a 2 percent annual cumulative sinking fund
payment of $1.4 million until settled. The $30 million
issue of preferred stock requires a 5 percent annual
cumulative sinking fund payment of $1.5 million until
retired.
55-12 Entity
D’s disclosure might be as follows.
Maturities and
sinking fund requirements on long-term loans and
convertible debt and sinking fund requirements on
preferred stock subject to mandatory redemption are as
follows (in thousands).
Nonauthoritative AICPA Guidance
Technical Q&As Section 3200, “Long-Term
Debt”
.15 Disclosure of Five-Year Maturities on Long-Term
Debt
Inquiry — A company entered into
a 10-year loan agreement with a lender. The mortgage
note contains a variable interest rate based on prime
plus one percent. In accordance with Financial
Accounting Standards Board (FASB) Accounting
Standards Codification (ASC) 440,
Commitments, the company will disclose the
maturities on the debt for each of the next five
succeeding years. Should the disclosure include
principal and interest?
Reply — No. The required disclosure of the amount
of scheduled repayments for each of the five succeeding
fiscal years relates only to principal repayments and
should not include interest. Disclosure is also called
for when interest rates vary with the prime rate.
A debtor is required to disclose the aggregate amount of maturities (i.e.,
principal repayments) of long-term debt during each of the five annual periods
after the balance sheet date (ASC 470-10-50-1 and 470-10-55-12). The amounts
disclosed do not include interest payments (AICPA Technical Q&As Section
3200.15).
If a debtor has included a long-term obligation in the table of
maturities of long-term obligation in the following scenario, it must disclose
the circumstances (ASC 470-10-50-2; see also Section
13.5.4):
- The debtor has violated a provision of the debt.
- The debt will become repayable on demand if the debtor does not cure the violation within a specified grace period.
- It is probable that the debtor will cure the violation within the grace period.
14.4.7 Significant Changes in Outstanding Debt
SEC Rules, Regulations, and Interpretations
Regulation S-X, Rule 4-08, General Notes to Financial
Statements [Reproduced in ASC 235-10-S99-1]
If applicable to the person for which the financial
statements are filed, the following shall be set forth
on the face of the appropriate statement or in
appropriately captioned notes. The information shall be
provided for each statement required to be filed, except
that the information required by paragraphs (b), (c),
(d), (e) and (f) of this section shall be provided as of
the most recent audited balance sheet being filed and
for paragraph (j) of this section as specified therein.
When specific statements are presented separately, the
pertinent notes shall accompany such statements unless
cross-referencing is appropriate. . . .
(f) Significant
changes in bonds, mortgages and similar debt. Any
significant changes in the authorized or issued amounts
of bonds, mortgages and similar debt since the date of
the latest balance sheet being filed for a particular
person or group shall be stated.
SEC registrants must disclose information about significant changes in the
authorized or outstanding amount of bonds, mortgages, and similar debt since the
most recent balance sheet date.
14.4.8 Unused Lines of Credit and Other Loan Commitments
ASC 440-10
50-1
Notwithstanding more explicit disclosures required
elsewhere in this Codification, all of the following
situations shall be disclosed in financial
statements:
- Unused letters of credit . . . .
ASC 470-10
Pending Content (Transition
Guidance: ASC 105-10-65-7)
50-6 An entity shall
separately disclose the following in the notes to
financial statements:
- The amount and terms of unused commitments for long-term financing arrangements (including commitment fees and the conditions under which commitments may be withdrawn)
- The amount and terms of unused lines of credit for short-term financing arrangements (including commitment fees and the conditions under which lines may be withdrawn) and the amount of those lines of credit that support commercial paper borrowing arrangements or similar arrangements.
SEC Rules, Regulations, and Interpretations
Regulation S-X, Rule 5-02, Balance Sheets [Reproduced
in ASC 210-10-S99-1]
The purpose of this rule is to indicate the various line
items and certain additional disclosures which, if
applicable, and except as otherwise permitted by the
Commission, should appear on the face of the balance
sheets or related notes filed for the persons to whom
this article pertains (see § 210.4-01(a)). . . .
19. Accounts and notes payable. . . .
(b) The amount and terms (including commitment
fees and the conditions under which lines may be
withdrawn) of unused lines of credit for
short-term financing shall be disclosed, if
significant, in the notes to the financial
statements. The weighted average interest rate on
short term borrowings outstanding as of the date
of each balance sheet presented shall be furnished
in a note. The amount of these lines of credit
which support a commercial paper borrowing
arrangement or similar arrangements shall be
separately identified. . . .
22. Bonds, mortgages and other long-term debt, including
capitalized leases. . . .
(b) The amount and terms (including commitment
fees and the conditions under which commitments
may be withdrawn) of unused commitments for
long-term financing arrangements that would be
disclosed under this rule if used shall be
disclosed in the notes to the financial statements
if significant. . . .
SEC Rules, Regulations, and Interpretations
FRR 203.04. Unused Lines of Credit or Commitments (ASR
148)
Rules 5-02.19 and 5-02.22 of Regulation S-X . . . call
for the disclosure of the amount and terms of unused
lines of credit and commitments if significant. Various
factors should be considered in determining significance
such as total debt by term of such debt, total capital,
total cash requirements, and the like.
The disclosure of unused lines and commitments supplies
the investor with information regarding borrowing
potential and future liquidity under varying money
market conditions. It is recognized that lines of credit
or commitments are frequently extended to a borrower
subject to the condition that the borrower maintain
certain standards of credit worthiness, and that the
existence of such lines or commitments therefore does
not assure the availability of credit under conditions
of deteriorating financial position. Accordingly, the
rule provides that disclosure be made of the conditions
under which lines or commitments may be withdrawn. It is
also recognized that such lines and commitments are
occasionally offered by financial institutions as a
marketing device and accepted by corporations without
any intention of use and not as part of their financing
plan. Disclosure of such lines is not contemplated by
this rule.
Unused lines disclosed as supporting commercial paper or
other debt arrangements should include only usable
lines. For this purpose usable lines are construed to be
total lines used to support commercial paper less lines
needed to meet “clean-up” provisions of a borrowing
arrangement. Such provisions require borrowers to retire
credit extended at a bank or banks at some specified
interval for a specified period. Total lines outstanding
are therefore not necessarily a measure of the total
credit available on a continuing basis. Similarly, if a
corporation has lines arranged with several banks which
in total exceed borrowing levels permitted under
existing lending agreements, disclosure should be
limited to usable amounts.
Rule 5-02.22 would include disclosure of commitments such
as standby commitments, commitments for future
disbursements, and unused revolving credits maturing
after one year.
Nonauthoritative AICPA Guidance
Technical Q&As Section 3500, “Commitments”
.07 Disclosure of Unused Lines of
Credit
Inquiry — Should nonpublic companies disclose the
existence of unused lines of credit that are available
as of the balance sheet date?
Reply — Although public companies are required
[pursuant to SEC Regulation S-X, section 210.5-02.19(b)]
to disclose significant unused lines of credit for
short-term financing in the notes, there is no such
explicit requirement for nonpublic companies under
generally accepted accounting principles. However, under
certain circumstances, disclosure by nonpublic companies
may be advisable based on the general principle of
adequate disclosure.
The notes, as well as the financial statements, should be
informative of matters that may affect their use,
understanding, and interpretation.
Under ASC 440-10-50-1(a) and ASC 470-10-15-6, respectively, all
entities must disclose unused letters of credit and certain information about
unused commitments and lines of credit. In addition, Regulation S-X, Rule 5-02,
requires SEC registrants to disclose the “amount and terms (including commitment
fees and the conditions under which lines may be withdrawn)” of significant
unused (1) lines of credit for short-term financing and (2) commitments for
long-term financing arrangements, such as “standby commitments, commitments for
future disbursements, and unused revolving credits maturing after one year.” FRR
203.04 indicates that an entity should consider “various factors . . . in
determining significance such as total debt by term of such debt, total capital,
total cash requirements.” Lines of credit that “support a commercial paper
borrowing arrangement or similar arrangements” must be identified separately.
The purpose of the requirement to disclose the conditions under which lines of
credit and other commitments may be drawn is to help investors assess “the
availability of credit under conditions of deteriorating financial position”
(e.g., whether the availability of the commitment depends on the entity’s
creditworthiness).
14.4.9 Convertible Debt
14.4.9.1 General
ASC 470-20
50-1A The objective of the
disclosure about convertible debt instruments is to
provide users of financial statements with:
- Information about the terms and features of convertible debt instruments
- An understanding of how those instruments have been reported in an entity’s statement of financial position and statement of financial performance
- Information about events, conditions, and circumstances that can affect how to assess the amount or timing of an entity’s future cash flows related to those instruments.
50-1B An entity shall explain
the pertinent rights and privileges of each
convertible debt instrument outstanding, including,
but not limited to, the following information:
- Principal amount
- Coupon rate
- Conversion or exercise prices or rates and number of shares into which the instrument is potentially convertible
- Pertinent dates, such as conversion date(s) and maturity date
- Parties that control the conversion rights
- Manner of settlement upon conversion and any alternative settlement methods, such as cash, shares, or a combination of cash and shares
- Terms that may change conversion or exercise prices, number of shares to be issued, or other conversion rights and the timing of those rights (excluding standard antidilution provisions)
- Liquidation preference and unusual voting rights, if applicable
- Other material terms and features of the instrument that are not listed above.
50-1C An entity shall provide
the following incremental information for
contingently convertible instruments or the
instruments that are described in paragraphs
470-20-05-8 through 05-8A:
- Events or changes in circumstances that would adjust or change the contingency or would cause the contingency to be met
- Information on whether the shares that would be issued if the contingently convertible securities were converted are included in the calculation of diluted earnings per share (EPS) and the reasons why or why not
- Other information that is helpful in understanding both the nature of the contingencies and the potential impact of conversion.
50-1D
An entity shall disclose the
following information for each convertible debt
instrument as of each date for which a statement of
financial position is presented.
- The unamortized premium, discount, or issuance costs and, if applicable, the premium amount recorded as paid-in capital in accordance with paragraph 470-20-25-13
- The net carrying amount
- For public business entities, the fair value of the entire instrument and the level of the fair value hierarchy in accordance with paragraphs 825-10-50-10 through 50-15.
See Example 11 (paragraph 470-20-55-69A) for an
illustration of this disclosure requirement.
50-1E An entity shall
disclose the following information as of the date of
the latest statement of financial position
presented:
- Changes to conversion or exercise prices that occur during the reporting period other than changes due to standard antidilution provisions
- Events or changes in circumstances that occur during the reporting period that cause conversion contingencies to be met or conversion terms to be significantly changed
- Number of shares issued upon conversion, exercise, or satisfaction of required conditions during the reporting period
- Maturities and sinking fund requirements for convertible debt instruments for each of the five years following the date of most recent statement of financial position presented in accordance with paragraph 470-10-50-1.
50-1F An entity shall
disclose the following information about interest
recognized for each period for which a statement of
financial performance is presented:
- The effective interest rate for the period
- The amount of interest recognized for the
period disaggregated by both of the following (see
Example 12 [paragraph 470-20-55-69D] for an
illustration of this disclosure requirement):
- The contractual interest expense
- The amortization of the premium, discount, or issuance costs.
50-1G If the conversion
option of a convertible debt instrument is accounted
for as a derivative in accordance with Subtopic
815-15, an entity shall provide disclosures in
accordance with Topic 815 for the conversion option
in addition to the disclosures required by this
Section, if applicable.
50-1H If a convertible
debt instrument is measured at fair value in
accordance with the Fair Value Option Subsections of
Subtopic 825-10, an entity shall provide disclosures
in accordance with Subtopic 820-10 and Subtopic
825-10 in addition to the disclosures required by
this Section, if applicable.
50-1I An entity shall
disclose the following information about derivative
transactions entered into in connection with the
issuance of convertible debt instruments within the
scope of this Subtopic regardless of whether such
derivative transactions are accounted for as assets,
liabilities, or equity instruments:
- The terms of those derivative transactions (including the terms of settlement)
- How those derivative transactions relate to the instruments within the scope of this Subtopic
- The number of shares underlying the derivative transactions
- The reasons for entering into those derivative transactions.
An example of a derivative transaction entered into
in connection with the issuance of a convertible
debt instrument within the scope of this Subtopic is
the purchase of call options that are expected to
substantially offset changes in the fair value or
the potential dilutive effect of the conversion
option. Derivative instruments also are subject to
the disclosure guidance in Topic 815.
Example 11:
Disclosure of the Information in the Statement of
Financial Position
55-69A This Example
provides an illustration of the guidance in
paragraph 470-20-50-1D based on the assumption that
Entity A is a public business entity and has two
convertible debt instruments outstanding as of
December 31, 20X7, and 20X6.
55-69B The following
illustrates the disclosures in a tabular format.
The following is a summary of Entity
A’s convertible debt instruments as of December 31,
20X7 (in thousands).
The following is a summary of Entity A’s convertible
debt instruments as of December 31, 20X6 (in
thousands).
55-69C The disclosures may
be provided alternatively in narrative
descriptions.
1.2 Percent Convertible Debt
Instrument Due on December 31, 20X8
As of December 31, 20X7, and
20X6, the net carrying amount of the convertible
debt instrument was $982,000 and $965,000,
respectively, with unamortized debt discount and
issuance costs of $18,000 and $35,000. The estimated
fair value (Level 2) of the convertible debt
instrument was $1,100,000 and $1,015,000,
respectively, as of December 31, 20X7, and 20X6.
Zero-Coupon Convertible Debt
Instrument Due on December 31, 20X9
As of December 31, 20X7, and
20X6, the net carrying amount of the convertible
debt instrument was $491,000 and $486,000,
respectively, with unamortized debt discount and
issuance costs of $9,000 and $14,000. The estimated
fair value (Level 3) of the convertible debt
instrument was $462,000 and $450,000, respectively,
as of December 31, 20X7, and 20X6.
Example 12:
Disclosure of the Information in the Statement of
Financial Performance
55-69D This Example
provides an illustration of the guidance in
paragraph 470-20-50-1F(b) based on the assumption
that Entity A has two convertible debt instruments
issued before January 1, 20X5, and still outstanding
as of December 31, 20X7.
55-69E The following
illustrates the disclosures in a tabular format.
The following provides a summary of
the interest expense of Entity A’s convertible debt
instruments (in thousands).
55-69F The disclosures may be
provided alternatively in narrative
descriptions.
For the years ended December 31,
20X7, 20X6, and 20X5, the total interest expense was
$34,000, $34,000, and $33,000 with coupon interest
expense of $12,000 for each year and the
amortization of debt discount and issuance costs of
$22,000, $22,000, and $21,000, respectively.
ASC 470-20 requires an entity to provide detailed disclosures about
outstanding convertible debt instruments, including certain information
related to the following:
-
Significant terms and features, with specific disclosures for contingently convertible debt instruments (see ASC 470-20-50-1B and 50-1C).
-
Carrying amounts and fair value amounts (public business entities only) as of each balance sheet date (see ASC 470-20-50-1D).
-
Information about conversion terms, shares issued, and cash flow requirements as of the latest balance sheet date (see ASC 470-20-50-1E).
-
Interest amounts for each income statement (see ASC 470-20-50-1F).
-
Information about bifurcated conversion features (see ASC 470-20-50-1G and ASC 815-15-50).
-
Fair value information for convertible debt instruments measured at fair value through earnings (see ASC 470-20-50-1H and Section 14.4.10).
-
Derivative transactions executed in conjunction with convertible debt issuances (e.g., capped call and call spread transactions; see ASC 470-20-50-1I).
14.4.9.2 Own-Share Lending Arrangements
ASC 470-20
50-2A An entity that enters
into a share-lending arrangement on its own shares
in contemplation of a convertible debt offering or
other financing shall disclose all of the following.
The disclosures must be made on an annual and
interim basis in any period in which a share-lending
arrangement is outstanding.
- A description of any outstanding share-lending arrangements on the entity’s own stock
- All significant terms of the
share-lending arrangement including all of the
following:
- The number of shares
- The term
- The circumstances under which cash settlement would be required
- Any requirements for the counterparty to provide collateral.
- The entity’s reason for entering into the share-lending arrangement
- The fair value of the outstanding loaned shares as of the balance sheet date
- The treatment of the share-lending arrangement for the purposes of calculating earnings per share
- The unamortized amount of the issuance costs associated with the share-lending arrangement at the balance sheet date
- The classification of the issuance costs associated with the share-lending arrangement at the balance sheet date
- The amount of interest cost recognized relating to the amortization of the issuance cost associated with the share-lending arrangement for the reporting period
- Any amounts of dividends paid related to the loaned shares that will not be reimbursed.
50-2B An entity that enters
into a share-lending arrangement on its own shares
in contemplation of a convertible debt offering or
other financing shall also make the disclosures
required by Topic 505.
50-2C In the period in which
an entity concludes that it is probable that the
counterparty to its share-lending arrangement will
default, the entity shall disclose the amount of
expense reported in the statement of earnings
related to the default. The entity shall disclose in
any subsequent period any material changes in the
amount of expense as a result of changes in the fair
value of the entity’s shares or the probable
recoveries. If default is probable but has not yet
occurred, the entity shall disclose the number of
shares related to the share-lending arrangement that
will be reflected in basic and diluted earnings per
share when the counterparty defaults.
Own-share lending arrangements are initially recognized as a debt issuance
cost, with an offset to APIC. Under ASC 835-30-45-1A, debt issuance costs
are reported as a direct deduction from the par amount of the debt on the
face of the balance sheet. They are not classified as a deferred charge.
ASC 470-20 provides disclosure requirements for own-share lending
arrangements executed in contemplation of a convertible debt offering or
other financing. These requirements supplement the general guidance in ASC
505-10 on the issuer’s disclosure of information about securities.
14.4.10 Fair Value Information
ASC 825-10
50-2A The
disclosure guidance in this Subsection applies to public
business entities . . . .
50-8 In part,
this Subsection requires disclosures about fair value
for all financial instruments, whether recognized or not
recognized in the statement of financial position,
except that the disclosures about fair value prescribed
in paragraphs 825-10-50-10 through 50-13 and
825-10-50-15 are not required for any of the following:
. . .
b. Substantively extinguished debt subject to
the disclosure requirements of Subtopic 405-20 . .
.
m. Trade receivables and payables due in one
year or less
n. Deposit liabilities with no defined or
contractual maturities
o. Liabilities resulting from the sale of
prepaid stored-value products within the scope of
paragraph 405-20-40-3.
50-9
Generally accepted accounting principles (GAAP) require
disclosure of or subsequent measurement at fair value
for many classes of financial instruments. Those
requirements are not superseded or modified by this
Subsection.
50-10 A
reporting entity shall disclose either in the body of
the financial statements or in the accompanying notes,
the fair value of financial instruments and the level of
the fair value hierarchy within which the fair value
measurements are categorized in their entirety (Level 1,
2, or 3). . . .
For financial instruments recognized at fair value in the
statement of financial position, the disclosure
requirements of Topic 820 also apply.
50-11 Fair
value disclosed in the notes shall be presented together
with the related carrying amount in a form that
clarifies both of the following:
- Whether the fair value and carrying amount represent assets or liabilities
- How the carrying amounts relate to what is reported in the statement of financial position.
50-12 If the
fair value of financial instruments is disclosed in more
than a single note, one of the notes shall include a
summary table. The summary table shall contain the fair
value and related carrying amounts and cross-references
to the location(s) of the remaining disclosures required
by this Section.
50-15 In
disclosing the fair value of a financial instrument, an
entity shall not net that fair value with the fair value
of other financial instruments — even if those financial
instruments are of the same class or are otherwise
considered to be related (for example, by a risk
management strategy) — except to the extent that the
offsetting of carrying amounts in the statement of
financial position is permitted under either of the
following:
- The general principle in paragraph 210-20-45-1
- The exceptions for master netting arrangements in paragraph 815-10-45-5 and for amounts related to certain repurchase and reverse repurchase agreements in paragraphs 210-20-45-11 through 45-17.
Under ASC 825-10, public business entities must disclose information about the
fair value of financial assets and financial liabilities (such as debt, lines of
credit, revolving-debt arrangements, and term loan commitments) except for
financial instruments that are specifically exempt under ASC 825-10-50-8 (e.g.,
trade payables due in less than one year and obligations related to prepaid
stored-value products). This disclosure requirement applies irrespective of
whether a financial instrument is recognized in the financial statements and how
it is measured (e.g., amortized cost). The required disclosures include:
- The fair value as of the reporting date (see Section 14.2.2).
- The level of the fair value hierarchy (Level 1, 2, or 3) within which each fair value measurement is categorized in its entirety (see Chapter 8 of Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the Fair Value Option)).
An entity may provide these disclosures either in the body of the financial
statements or in the notes. If the information is provided in the notes, fair
values must be presented “together with the related carrying amount” and it must
be clear (1) “[h]ow the carrying amounts relate to what is reported” in the
balance sheet and (2) whether the amounts represent assets or liabilities. If
the information is included in more than one note, an entity must provide a
summary table that contains the fair values and carrying amounts and
cross-references to the locations of the remaining disclosures under ASC
825-10-50.
An entity cannot net the fair value of financial instruments
unless the conditions in ASC 210-20 or ASC 815-10 for balance sheet offsetting
are met (see Section
14.3.1.1). Further, the fair values disclosed should be
consistent with the unit of account. For example, as discussed in ASC
825-10-25-13, “[f]or the issuer of a liability issued with an inseparable
third-party credit enhancement . . . the unit of accounting for the liability .
. . disclosed at fair value does not include the third-party credit
enhancement.” Under ASC 470-20-50-1D, fair value information and the related
level in the fair value hierarchy must be presented separately for each
convertible debt instrument (see Section
14.4.9).
For financial instruments that are not measured at fair value in the financial
statements after initial recognition, an entity is not required to provide the
disclosures specified in ASC 820-10-50 (see Section
14.4.11), such as information about valuation techniques and inputs
used, changes in the valuation approach or valuation technique, and significant
unobservable inputs.
Entities other than public business entities are not required to provide
disclosures about the fair value of financial assets and financial liabilities
that are not measured at fair value in the statement of financial position.
14.4.11 Fair Value Option Liabilities
14.4.11.1 General
ASC 825-10
50-9
Generally accepted accounting principles (GAAP)
require disclosure of or subsequent measurement at
fair value for many classes of financial
instruments. Those requirements are not superseded
or modified by this Subsection.
50-27 The
disclosure requirements in paragraphs 825-10-50-28
through 50-30 do not eliminate disclosure
requirements included in other Subtopics, including
other disclosure requirements relating to fair value
measurement. Entities are encouraged but are not
required to present the disclosures required by this
Subtopic in combination with related fair value
information required to be disclosed by other
Subtopics (for example, the General Subsection of
this Section and Topic 820).
If a debtor has elected the fair value option in ASC 815-15 (see
Section 8.5.6) or ASC 825-10 (see Section
4.4) for a financial liability, it must disclose
comprehensive information about the related fair value measurements under
ASC 820-10-50 and ASC 825-10-50. As discussed in ASC 825-10-50-9 and ASC
825-10-50-27, the disclosure requirements of other U.S. GAAP are not
superseded by the incremental disclosure requirements in ASC 825-10-50 for
items measured at fair value under the fair value option.
For a discussion of the disclosures required by ASC
820-10-50 and ASC 825-10-50, see Chapter 11 of Deloitte’s Roadmap
Fair Value
Measurements and Disclosures (Including the Fair Value
Option). This section outlines the incremental disclosure
requirements in ASC 825-10 that apply to financial liabilities for which the
fair value option has been elected.
14.4.11.2 Objective
ASC 825-10
50-24 The
principal objectives of the disclosures required by
paragraphs 825-10-50-28 through 50-32 are to
facilitate both of the following comparisons:
- Comparisons between entities that choose different measurement attributes for similar assets and liabilities
- Comparisons between assets and liabilities in the financial statements of an entity that selects different measurement attributes for similar assets and liabilities.
50-25 Those
disclosure requirements are expected to result in
the following:
- Information to enable users of its financial statements to understand management’s reasons for electing or partially electing the fair value option
- Information to enable users to understand how changes in fair values affect earnings for the period
- The same information about certain items (such as equity investments and nonperforming loans) that would have been disclosed if the fair value option had not been elected
- Information to enable users to understand the differences between fair values and contractual cash flows for certain items.
To meet those objectives, the disclosures described
in paragraphs 825-10-50-28 through 50-32 are
required for items measured at fair value under the
option in this Subtopic and the option in paragraph
815-15-25-4. Those disclosures are not required for
securities classified as trading securities under
Topic 320, life settlement contracts measured at
fair value pursuant to Subtopic 325-30, or servicing
rights measured at fair value pursuant to Subtopic
860-50. Those Subtopics include disclosure
requirements not affected by this Subtopic.
50-26
Entities shall provide the disclosures required by
paragraphs 825-10-50-28 through 50-32 in both
interim and annual financial statements.
ASC 825-10-50-24 through 50-26 identify the objectives of the disclosure
requirements for items measured at fair value in accordance with the fair
value option in ASC 825-10 or ASC 815-15 (e.g., comparability with similar
items not measured at fair value by the same entity or other entities).
14.4.11.3 Balance Sheet Disclosures
ASC 825-10
50-28 As of
each date for which a statement of financial
position is presented, entities shall disclose all
of the following:
- Management’s reasons for electing a fair value option for each eligible item or group of similar eligible items
- If the fair value option is
elected for some but not all eligible items within
a group of similar eligible items, both of the
following:
- A description of those similar items and the reasons for partial election
- Information to enable users to understand how the group of similar items relates to individual line items on the statement of financial position.
- For each line item in the
statement of financial position that includes an
item or items for which the fair value option has
been elected, both of the following:
- Information to enable users to understand how each line item in the statement of financial position relates to major classes of assets and liabilities presented in accordance with the fair value disclosure requirements of Topic 820. (Paragraph 825-10-50-11 also requires an entity to relate carrying amounts that are disclosed in accordance with that paragraph to what is reported in the statement of financial position.)
- The aggregate carrying amount of items included in each line item in the statement of financial position that are not eligible for the fair value option, if any.
- The difference between the
aggregate fair value and the aggregate unpaid
principal balance of each of the following: . . .2. Long-term debt instruments that have contractual principal amounts and for which the fair value option has been elected. . . .
For each interim or annual period with a statement of financial position, the
disclosures above are required for items accounted for at fair value by
using the fair value option, including information about:
- Management’s reasons for electing the fair value option.
- How balance sheet line items with items for which the fair value option has been elected are related to major classes of assets and liabilities for which fair value disclosures are provided under ASC 820.
- The aggregate amount of ineligible items included in line items with items for which the fair value option has been elected and those not eligible for the fair value option.
- The difference between the aggregate fair value and the aggregate unpaid principal balance of long-term debt instruments for which an entity has elected the fair value option.
See Section 14.4.11.6 for examples illustrating these
disclosures.
14.4.11.4 Income Statement Disclosures
ASC 825-10
50-30 For
each period for which an income statement is
presented, entities shall disclose all of the
following about items for which the fair value
option has been elected:
a. For each line item in the
statement of financial position, the amounts of
gains and losses from fair value changes included in
earnings during the period and in which line in the
income statement those gains and losses are
reported. This Subtopic does not preclude an entity
from meeting this requirement by disclosing amounts
of gains and losses that include amounts of gains
and losses for other items measured at fair value,
such as items required to be measured at fair
value.
b. A description of how interest
and dividends are measured and where they are
reported in the income statement. This Subtopic does
not address the methods used for recognizing and
measuring the amount of dividend income, interest
income, and interest expense for items for which the
fair value option has been elected. . . .
d. For liabilities, all of the
following about the effects of the
instrument-specific credit risk and changes in it:
1. The amount of change, during the period
and cumulatively, of the fair value of the
liability that is attributable to changes in the
instrument-specific credit risk . . . .
3. How the gains and losses attributable to
changes in instrument-specific credit risk were
determined.
4. If a liability is settled during the
period, the amount, if any, recognized in other
comprehensive income that was recognized in net
income at settlement.
For each interim or annual period with an income statement, the disclosures
above are required for items accounted for at fair value by using the fair
value option See Section 14.4.11.6 for examples
illustrating these disclosures. ASC 825-10 does not prescribe how an entity
should report gains and losses within the income statement.
A debtor must disclose information about the effects of
instrument-specific credit risk and changes in it related to financial
liabilities for which it has elected the fair value option.
14.4.11.5 Other Required Disclosures
ASC 825-10
50-31 In
annual periods only, an entity shall disclose the
methods and significant assumptions used to estimate
the fair value of items for which the fair value
option has been elected. For required disclosures
about the method(s) and significant assumptions used
to estimate the fair value of financial instruments,
see paragraph 820-10-50-2(bbb) except that an entity
is not required to provide the quantitative
disclosures about significant unobservable inputs
used in fair value measurements categorized within
Level 3 of the fair value hierarchy required by that
paragraph.
50-32 If an entity elects the
fair value option at the time one of the events in
paragraph 825-10-25-4(d) through (e) occurs, the
entity shall disclose both of the following in
financial statements for the period of the
election:
- Qualitative information about the nature of the event
- Quantitative information by line item in the statement of financial position indicating which line items in the income statement include the effect on earnings of initially electing the fair value option for an item.
In annual periods, an entity that has elected the fair value
option must disclose the methods and significant assumptions used to
estimate fair value, including the information required to be disclosed
under ASC 820-10-50-2(bbb). See Chapter 11 of Deloitte’s Roadmap
Fair Value
Measurements and Disclosures (Including the Fair Value
Option) for more information about these disclosures.
ASC 825-10-50-32 contains additional disclosure requirements
related to fair value option elections that occur after a qualifying event
under ASC 825-10-25-4(d) and (e). Those events are discussed in Sections 12.3.2.1 and
12.3.2.2 of
Deloitte’s Roadmap Fair
Value Measurements and Disclosures (Including the Fair Value
Option).
14.4.11.6 Illustrations
ASC 825-10
Example 1: Fair Value Measurements and Changes
in Fair Values Included in Current-Period
Earnings
55-6 The
following Cases illustrate selected disclosure
requirements for items reported at fair value under
this Subtopic:
- The Fair Value Option Subsection of 825–10–50 disclosures with voluntary integration of the General Subsection of 825–10–50 disclosures (Case A)
- The Fair Value Option Subsection of 825–10–50 disclosures without voluntary integration of the General Subsection of 825–10–50 disclosures (Case B).
55-7 Cases A
and B represent suggested forms for presenting
disclosure information. While the suggested forms of
presentation illustrate selected required
disclosures, the suggested forms of presentation are
not mandated by this Subtopic. Aggregation of
related fair value disclosures is encouraged but not
required.
55-8 The
statement of financial position for Entity XYZ as of
December 31, 20X1, is provided to assist in
understanding the illustrative fair value
disclosures in Cases A and B.
Case A: Disclosures With Voluntary Integration
55-9 The
objective is to provide information about all of the
following:
- Assets and liabilities measured at fair value on a recurring basis (as required by Subtopic 820-10)
- Changes in fair values of assets and liabilities for which the fair value option has been elected in a manner that relates to the statement of financial position (as required by this Subtopic)
- Fair value estimates and corresponding carrying amounts for major categories of assets and liabilities that include items measured at fair value on a recurring basis (in accordance with the General Subsection of 825–10–50).
55-10 The
following table represents the fair value tabular
disclosure required by paragraph 820-10-50-2(b),
supplemented to do both of the following:
- Provide information about where in the income statement changes in fair values of assets and liabilities reported at fair value are included in earnings
- Voluntarily integrate selected disclosures required annually by the General Subsection of 825-10-50.
Disclosures required by paragraphs 825-10-50-28(c)
and 825-10-50-30(a) are illustrated in the narrative
disclosure that follows the table.
55-11 An
entity might provide either of the following
additional disclosures required by paragraph
825-10-50-28(a) through (b) after the following
table:
- Management’s reasons for electing a fair value option for each eligible item or group of similar eligible items
- If the fair value option is
elected for some but not all eligible items within
a group of similar eligible items, both of the
following:
- A description of those similar items and the reasons for partial election
- Information to enable users to understand how the group of similar items relates to individual line items on the statement of financial position.
Case B: Disclosures Without Voluntary Integration
55-12 The
following table illustrates an alternative
presentation that does not integrate disclosures
required annually by this Subtopic or the additional
gain and loss amounts voluntarily displayed in the
table in Case A. The following table represents the
fair value hierarchy table set forth in Topic 820,
supplemented to provide information about where in
the income statement changes in fair values of
assets and liabilities for which the fair value
option has been elected are included in earnings.
Disclosures required by paragraphs 825-10-50-28(c)
and 825-10-50-30(a) are illustrated in the narrative
disclosure that follows the table.
55-13 An
entity might provide either of the following
additional disclosures required by paragraph
825-10-50-28(a) through (b) after the table:
- Management’s reasons for electing a fair value option for each eligible item or group of similar eligible items
- If the fair value option is
elected for some but not all eligible items within
a group of similar eligible items, both of the
following:
- A description of those similar items and the reasons for partial election
- Information to enable users to understand how the group of similar items relates to individual line items on the statement of financial position.
14.4.12 Guarantors and Collateralizations of Securities
Debt or preferred stock that is registered under the Securities Act of 1933 (the
“Securities Act”) may be guaranteed by one or more affiliates of the issuer.
Guarantees of registered securities are considered securities themselves under
the Securities Act. As a result, both the guaranteed securities and the
guarantees of those securities must be registered with the SEC unless they are
exempt from registration. Further, a registrant may pledge the capital stock of
one or more affiliates as collateral for debt or preferred stock registered
under the Securities Act. In the event of a default, the debt holder may enforce
the collateral provisions and, as a result, become a holder of the affiliate’s
equity.
Regulation S-X requires registrants to disclose certain financial information
about (1) guarantors and issuers of guaranteed securities and (2) affiliates
whose securities collateralize debt or preferred stock. The requirements are
based on the premise that investors in guaranteed debt or collateralized
securities rely on the consolidated financial statements of the registrant as
their primary source of financial information. Although registration of
guaranteed securities under the Securities Act can result in requirements for
both the issuer of the guaranteed security and the guarantor of the security to
file periodic reports (i.e., Form 10-K and Form 10-Q) in accordance with the
Securities Exchange Act of 1934, the SEC has typically provided relief from this
requirement for subsidiary issuers and guarantors.
Regulation S-X, Rule 3-10, allows registrants to provide
alternative nonfinancial disclosures and alternative financial disclosures
(collectively, the “alternative disclosures”) in lieu of separate financial
statements when certain criteria have been met. While Rule 3-10 outlines the
eligibility conditions that must be met for a registrant to qualify for the
alternative disclosures, the specific disclosure requirements are set forth in
Regulation S-X, Rule 13-01. Disclosure requirements for smaller reporting
companies are prescribed in Note 3 of Regulation S-X, Rule 8-01.
Regulation S-X, Rule 13-02, requires the registrant to provide “summarized
financial information” and other narrative disclosures, to the extent material,
of each affiliate whose securities collateralize the securities that are
registered or being registered.
If a registered security contains both a guarantee by one or
more subsidiaries and a pledge of affiliates’ equity, the registrant must
consider the disclosure requirements in both Rule 13-01 and Rule 13-02 because
(1) the guarantee and pledge constitute separate credit enhancements and (2) the
disclosure requirements for each may be different. As a result, the alternative
disclosures necessary for compliance with Rules 13-01 and 13-02 may differ, even
if the affiliates whose equity is pledged as collateral and the subsidiaries
that guarantee the security are the same entities.
A detailed discussion of these requirements is beyond the scope
of this Roadmap. For further discussion, see Deloitte’s Roadmap SEC Reporting Considerations for
Guarantees and Collateralizations.
Chapter 15 — Comparison of U.S. GAAP and IFRS Accounting Standards
Chapter 15 — Comparison of U.S. GAAP and IFRS Accounting Standards
15.1 Background
Under IFRS Accounting Standards, accounting requirements related to
the issuer’s accounting for debt are primarily located in IFRS 9, which addresses
recognition, derecognition, and measurement of financial assets and financial
liabilities (including derivatives and hedge accounting), and IAS 32, which focuses
on the classification of financial instruments (or components thereof) as
liabilities or equity and balance sheet offsetting. Further, IAS 1 includes
requirements for financial statement presentation and classification of assets and
liabilities (including debt) as current or noncurrent. In addition, IFRS 7 addresses
the disclosures entities should provide about financial instruments (including
debt).
15.2 Key Differences
15.2.1 Background
The table below summarizes key differences between U.S. GAAP and IFRS Accounting
Standards related to the issuer’s accounting for debt. The table is followed by
a detailed explanation of each difference.
|
U.S. GAAP
|
IFRS Accounting Standards
| |
|---|---|---|
|
Interest method — changes in contractual cash flows
(Section
15.2.2.1)
|
There is no broadly applicable guidance on the accounting
for changes in estimated contractual cash flows.
Prescriptive guidance exists for TDRs and modifications
or exchanges that are not accounted for as
extinguishments of the original debt.
|
If an entity revises its estimate of future contractual
cash flows of a financial liability (e.g., as a result
of a debt modification or exchange that is not accounted
for as an extinguishment of the original debt), it must
adjust the amortized cost to the present value of the
estimated future contractual cash flows, discounted by
using the liability’s original effective interest rate,
and recognize the adjustment in profit or loss.
|
|
Interest method — special accounting for certain debt
transactions (Section
15.2.2.2)
|
Special accounting models apply to certain transactions
involving sales of future revenue, participating
mortgages, indexed debt, and extendable increasing-rate
debt.
|
There is no special accounting guidance on sales of
future revenue, participating mortgages, indexed debt,
or extendable increasing-rate debt.
|
|
Fair value option — qualifying criteria (Section 15.2.3.1)
|
The limitations in IFRS Accounting
Standards on a debtor’s ability to elect the fair value
option for a financial liability do not apply under U.S.
GAAP.
|
A debtor is permitted to elect the fair value option for
a financial liability only if (1) doing so would
eliminate or reduce an accounting mismatch; (2) a group
of financial liabilities, or a group of financial assets
and financial liabilities, is managed and its
performance is evaluated on a fair value basis; or
(3) the contract contains one or more embedded
derivatives that have certain characteristics.
|
|
Fair value option — fair value changes attributable to
credit risk (Section
15.2.3.2)
|
For financial liabilities for which the fair value option
has been elected, fair value changes attributable to
instrument-specific credit risk are deferred in OCI and
released to earnings upon derecognition of the financial
liability.
|
For financial liabilities for which the fair value option
has been elected, fair value changes associated with
credit risk are deferred in OCI unless deferring them
would create or increase an accounting mismatch. The
balance in AOCI is not released to earnings upon
derecognition of the financial liability.
|
|
Convertible debt — separation of equity component (see
Section
15.2.4)
|
A debtor accounts for convertible debt
as a liability in its entirety unless the convertible
debt (1) has a conversion feature that must be
bifurcated as a derivative liability, (2) was issued at
a substantial premium, (3) was modified or exchanged if
extinguishment accounting did not apply and the fair
value of the conversion feature increased, or (4) has a
bifurcated conversion option derivative that was
reclassified as equity. Different separation methods are
used depending on the applicable accounting model.
|
A debtor separates convertible debt into liability and
equity components unless the embedded conversion feature
must be bifurcated as a derivative liability. The
liability and equity components are separated on the
basis of the fair value of the liability component.
|
|
Embedded derivatives — debt with embedded put or call
option (Section
15.2.5.1)
|
A put, call, or prepayment option embedded in a debt
contract is considered not clearly and closely related
to a debt host contract if (1) it is indexed to an
underlying other than interest rates, credit risk, or
inflation; (2) the debt involves a substantial discount
or premium and the option is contingent; or (3) the
option is not contingent and the negative-yield or
double-double test is passed.
|
A put, call, or prepayment option embedded in a debt
contract is not considered closely related to a debt
host contract unless the exercise price is approximately
equal on each exercise date to the host debt contract’s
amortized cost (before the separation of any equity
component) or the exercise price results in
reimbursement to the lender for an amount up to the
approximate present value of lost interest for the
remaining term.
|
|
Embedded derivatives — debt with embedded equity
conversion feature (Section
15.2.5.2)
|
An equity conversion feature embedded in
a debt contract is not bifurcated as a derivative
liability if (1) it is considered indexed to the
entity’s own equity under ASC 815-40-15 and (2) the
debtor could not be forced to settle it in cash under
ASC 815-40-25. Further, an equity conversion feature is
not bifurcated if it must be physically settled and the
shares that would be delivered upon conversion are not
readily convertible to cash. A down-round protection
feature does not affect the assessment. Certain exercise
contingencies and settlement terms would preclude a
conclusion that a conversion feature is indexed to the
entity’s own equity.
|
An equity conversion feature embedded in a debt contract
is bifurcated as a derivative liability if it can be
settled net by either or both parties (e.g., net in
shares or net in cash). Bifurcation is also required for
an equity conversion feature with a down-round
protection feature. Exercise contingencies and the fact
that the shares that would be delivered upon conversion
are not readily convertible to cash do not affect the
assessment.
|
|
Debt extinguishments — expected breakage (Section 15.2.6.1)
|
An entity derecognizes a financial liability related to a
prepaid stored-value product on the basis of expected
breakage even if the obligation has not been legally
extinguished.
|
An entity cannot derecognize a financial liability on the
basis of expected breakage.
|
|
Debt extinguishments — convertible debt (Section 15.2.6.2)
|
When convertible debt is extinguished, a
debt extinguishment gain or loss is generally recognized
on the basis of the difference between the debt’s net
carrying amount and the consideration paid.
|
When convertible debt is extinguished, the debtor
allocates the consideration paid between the liability
and equity components on the basis of the fair value of
the liability component.
|
|
Debt modification or exchange — substantially different
terms (Section
15.2.7.1)
|
The terms of new or modified debt are considered
substantially different from the terms of the original
debt (such that the original debt is accounted for as
being extinguished) if the 10 percent cash flow test is
passed, a substantive conversion option is added or
removed, or the change in fair value of an embedded
conversion option is at least 10 percent of the original
carrying amount. This guidance does not apply to TDRs
(see below).
|
The terms of new or modified debt are considered
substantially different from the terms of the original
debt (such that the original debt is accounted for as
being extinguished) if the 10 percent cash flow test is
passed or, in limited circumstances, the terms are
determined to be qualitatively different.
|
|
Debt modification or exchange — terms
not substantially different (Section
15.2.7.2)
|
If the terms of new or modified debt are not considered
substantially different from the terms of the original
debt, the effect of the modification or exchange on the
debt’s cash flows is accounted for prospectively as a
yield adjustment.
|
If the terms of new or modified debt are not considered
substantially different from the terms of the original
debt, the debtor must recognize a modification gain or
loss in profit or loss on the basis of the difference
between (1) the carrying amount immediately before the
modification or exchange and (2) the present value of
the modified contractual cash flows discounted by using
the original effective interest rate.
|
|
Debt modification or exchange — increase
in the fair value of an embedded conversion option
(Section 15.2.7.3)
|
If the terms of the new or modified debt are not
considered substantially different from the terms of the
original debt, the debtor must recognize an increase
(but not a decrease) in the fair value of an embedded
conversion option in connection with the modification or
exchange by reducing the debt’s carrying amount with an
offset to equity.
|
There is no special guidance on the accounting for an
increase in the fair value of a conversion option.
|
|
Debt modification or exchange —
third-party costs (Section
15.2.7.4)
|
If the original debt is accounted for as being
extinguished, third-party costs are amortized over the
life of the new debt by using the interest method. If
the new debt is accounted for as a continuation of the
original debt, such costs are expensed as incurred.
|
If the original debt is accounted for as being
extinguished, third-party costs are expensed as
incurred. If the new debt is accounted for as a
continuation of the original debt, third-party costs are
amortized over the life of the new debt by using the
interest method.
|
|
TDRs (Section
15.2.8)
|
A debt modification or exchange is accounted for as a TDR
if the creditor grants a concession as a result of the
debtor’s financial difficulties. Gain recognition is
precluded unless the carrying amount exceeds the total
amount of the undiscounted future cash flows of the
restructured debt.
|
There is no special guidance on TDRs. Debtors apply the
guidance on a debt modification or exchange (see above).
|
|
Debt conversions — gain or loss recognition (Section 15.2.9)
|
No gain or loss is recognized upon the
conversion of debt into cash, other assets, or the
debtor’s equity shares in accordance with the original
terms of a conversion feature unless the conversion
occurred upon the debtor’s exercise of a call option and
the conversion option was not substantive at inception.
|
No gain or loss is recognized upon the
conversion of debt into the debtor’s equity shares in
accordance with the original terms of a conversion
feature. The conversion of debt into cash or other
assets is accounted for as an extinguishment.
|
|
Balance sheet classification of debt as
current or noncurrent — post-balance-sheet-date
refinancing (Section
15.2.10.1)
|
A short-term obligation is classified as noncurrent if it
is refinanced on a long-term basis (or a long-term
financing arrangement is in place) by the time the
financial statements are issued (or available to be
issued).
|
A short-term obligation is classified as current even if
the debtor refinances it on a long-term basis (or a
long-term financing arrangement is executed) after the
balance sheet date.
|
|
Balance sheet classification of debt as current or
noncurrent — waivers of covenant violations (Section 15.2.10.2)
|
A long-term obligation that has become repayable on
demand because of a covenant violation as of the balance
sheet date is not classified as current if the creditor
grants a qualifying waiver before the financial
statements are issued (or available to be issued).
|
A long-term obligation that has become repayable on
demand because of a covenant violation as of the balance
sheet date is classified as current even if the creditor
grants a waiver after the balance sheet date.
|
15.2.2 Interest Method
15.2.2.1 Changes in Contractual Cash Flows
If the timing or amount of the cash flows under a debt contract are modified
or vary on the basis of an underlying that does not have to be bifurcated as
a derivative, a question arises about how to apply the effective interest
method to changes in those contractual cash flows.
Under U.S. GAAP, different methods are appropriate or acceptable for
different types of debt transactions (see Sections 6.2.4, 6.2.5,
7.2, 7.3, 7.4, 10.4.3, and 11.4.4).
For example, there are three acceptable methods for applying the interest
method to sales of future revenue when there are changes to the timing or
amount of the estimated future cash flows (see Section 7.2.4). When debt is modified or exchanged and the
terms of the modified debt are not substantially different from the terms of
the original debt, ASC 470-50 requires the debtor to make a prospective
yield adjustment (see Section 10.4.3). When a debt
modification or exchange represents a TDR, ASC 470-60 requires the interest
rate to be reduced and potentially reset to zero so that a restructuring
gain is only recognized if the carrying amount exceeds the total
undiscounted future cash flows (see Section
11.4.4).
If an entity revises its estimate of future contractual cash flows of a
financial liability (e.g., as a result of a debt modification or exchange
that is not accounted for as an extinguishment of the original debt), the
entity is required under paragraph B5.4.6 of IFRS 9 to (1) adjust the
amortized cost to the present value of the estimated future contractual cash
flows discounted by using the liability’s original effective interest rate
and (2) recognize the resulting adjustment in profit or loss.
15.2.2.2 Special Accounting for Certain Debt Transactions
Under U.S. GAAP, special accounting models apply to certain transactions
involving the sales of future revenue (see Section 7.2), participating mortgages (see Section 7.3), indexed debt (see Section 7.4), and extendable increasing-rate
debt (see Section 6.2.4.5). IFRS 9
does not contain similar guidance. Instead, it requires entities to account
for such liabilities in a manner similar to other liabilities (i.e.,
typically at amortized cost by using the interest method).
15.2.3 Fair Value Option
15.2.3.1 Qualifying Criteria
IFRS 9 requires entities to meet certain qualifying criteria
before they can elect the fair value option for an otherwise eligible item;
there are no such qualifying criteria in ASC 825-10 (see Section 4.4). For financial liabilities, an
entity is permitted under paragraph 4.2.2 of IFRS 9 to elect the fair value
option when either of the following apply:
-
The fair value option “eliminates or significantly reduces a measurement or recognition inconsistency (sometimes referred to as ‘an accounting mismatch’) that would otherwise arise from measuring assets or liabilities or recognising the gains and losses on them on different bases.”
-
“[A] group of financial liabilities or financial assets and financial liabilities is managed and its performance is evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and information about the group is provided internally on that basis to the entity’s key management personnel.”
Further, paragraph 4.3.5 of IFRS 9 permits an entity to elect the fair value
option for a financial liability (or other host contract that is not an
asset within the scope of IFRS 9) if it contains one or more embedded
derivatives unless either of the following conditions is met:
-
“[T]he embedded derivative(s) do(es) not significantly modify the cash flows that otherwise would be required by the contract.”
-
“[I]t is clear with little or no analysis . . . that separation of the embedded derivative(s) is prohibited, such as a prepayment option embedded in a loan that permits the holder to prepay the loan for approximately its amortised cost.”
15.2.3.2 Fair Value Changes Attributable to Credit Risk
Under both ASC 825-10 and IFRS 9, changes in the fair value of a financial
liability for which the fair value option has been elected are recognized in
earnings (profit or loss) except for the portion of the change that is
attributable to the liability’s credit risk, which is recognized in OCI (see
Section 6.3.2). However, unlike
ASC 825-10, paragraph 5.7.8 of IFRS 9 contains an exception under which
recognition of the credit risk component through OCI is precluded if it
would “create or enlarge an accounting mismatch in profit or loss.”
Upon derecognition of a liability for which fair value changes attributable
to the liability’s credit risk have been recognized through OCI, ASC 825-10
requires the credit risk component to be released through earnings (see
Section 9.3.2). Under paragraph
B5.7.9 of IFRS 9, an entity is not permitted to subsequently release the
AOCI component into earnings (or profit or loss) upon derecognition of the
liability.
15.2.4 Convertible Debt — Separation of an Equity Component
The issuer of convertible debt is precluded by ASC 470-20 from
allocating to equity any of the proceeds received upon its issuance unless a
special accounting model applies. If the conversion feature does not have to be
bifurcated as a derivative liability under ASC 815-15, recognition of an equity
component may be required in accordance with special accounting models for
convertible debt that (1) was issued at a substantial premium (see Section 7.6.3), (2) was
modified or exchanged if extinguishment accounting did not apply and the fair
value of the conversion feature increased (see Section 10.4.3.3), or (3) has a bifurcated
conversion option derivative that was reclassified as equity (see Section 8.5.4.3). If the
equity conversion feature fails to satisfy the equity classification conditions
in ASC 815-40, it is bifurcated as an embedded derivative only if it meets the
bifurcation conditions in ASC 815-15 (including the net settlement
characteristic in the definition of a derivative in ASC 815-10; see Chapter 8).
Under paragraph 28 of IAS 32, the issuer of a convertible debt instrument must
separate it into liability and equity components if the feature meets the equity
classification conditions in IAS 32. The issuer separates the instrument into
its components by determining the fair value of the liability component and then
deducting that amount from the fair value of the instrument as a whole; the
residual amount is allocated to the equity component. If the equity conversion
feature does not satisfy the equity classification conditions in IAS 32, it is
bifurcated as an embedded derivative unless the issuer elects to apply the fair
value option to the convertible debt.
Note that the definition of a derivative and the conditions for
equity classification under U.S. GAAP and IFRS Accounting Standards are not
identical. Therefore, depending on the specific facts and circumstances, the
assessment of whether an equity conversion option must be separated as an
embedded derivative may differ under the two sets of standards (see Chapter 8 of Deloitte’s
Roadmap Contracts on an
Entity’s Own Equity).
15.2.5 Embedded Derivatives
15.2.5.1 Debt With Embedded Put or Call Option
Under both ASC 815-15 and IFRS 9, an entity must evaluate put, call, and
prepayment features embedded in debt host contracts to determine whether
they must be accounted for separately as a derivative. One of the criteria
for bifurcation is that the economic characteristics and risks of the
embedded feature are not “clearly and closely related” (or, under IFRS 9,
simply “closely related”) to those of the host contract (see Section 8.4.4). However, the guidance in
each set of standards differs on whether such features are considered
clearly and closely related.
In accordance with ASC 815-15, a put, call, or prepayment option that is
embedded is not clearly and closely related to a debt host contract if (1)
it is indexed to an underlying other than interest rates, credit risk, or
inflation (see Section 8.3.2); (2) the
debt involves a substantial discount or premium and the option is contingent
(see Section 8.4.4); or (3) the option
is not contingent and either the negative-yield or double-double test is
passed (see Section 8.4.1).
Under paragraph B4.3.5(e) of IFRS 9, a put, call, or prepayment option is not
closely related to a debt host contract unless (1) the option’s exercise
price is approximately equal to the debt’s amortized cost on each exercise
date (before separating any equity component) or (2) a prepayment option’s
exercise price “reimburses the lender for an amount up to the approximate
present value of lost interest for the remaining term of the host contract.”
Lost interest is computed, as of the prepayment date, as the prepaid
principal amount multiplied by the difference between the effective interest
rate of the host contract and the effective rate the lender would receive if
it reinvested the prepaid principal amount in a similar contract for the
remaining term of the host contract.
15.2.5.2 Debt With Embedded Equity Conversion Feature
Under both ASC 815 and IFRS 9, an embedded equity conversion feature is
exempt from the requirements for the bifurcation of a derivative if it
qualifies as equity. However, the circumstances in which an equity
conversion feature qualifies as equity differ. Further, the definition of a
derivative differs between ASC 815 and IFRS 9.
In accordance with ASC 815-15, an equity conversion feature
embedded in a debt contract qualifies as equity and is exempt from
derivative accounting if (1) it is considered indexed to the entity’s own
equity under ASC 815-40-15 and (2) the debtor could not be forced to settle
it in cash under ASC 815-40-25 (see Section 8.4.7). A down-round
protection feature does not affect the assessment of whether a conversion
feature is considered indexed to the entity’s own equity. However, exercise
contingencies preclude a conclusion that the conversion feature is indexed
to the entity’s own stock if they are based on an observable market other
than the market for the issuer’s stock or an observable index other than one
calculated or measured solely by reference to the issuer’s operations. In
addition, some settlement terms preclude an embedded equity conversion
feature from being considered indexed to the issuer’s stock. See Deloitte’s
Roadmap Contracts on an
Entity’s Own Equity for more information.
Under paragraph 10 of IAS 32, an equity conversion feature does not qualify
as equity if it can be settled net by either or both parties (e.g., an
equity conversion feature that can be settled net in shares). Further, an
equity conversion feature does not qualify as equity if it contains
down-round protection. However, exercise contingencies do not affect the
assessment of whether an equity conversion feature qualifies as equity.
In accordance with ASC 815, an equity conversion feature lacks the net
settlement characteristic in the definition of a derivative if it must be
physically settled and the shares that would be delivered upon conversion
are not readily convertible to cash (e.g., private-company stock).
Therefore, such a feature would not be bifurcated under ASC 815-15 even if
it does not qualify as equity under ASC 815-40. There is no net settlement
requirement under the definition of a derivative in Appendix A of IFRS 9.
Accordingly, equity conversion features that are settled in shares that are
not readily convertible to cash must be bifurcated if they do not qualify as
equity under IAS 32.
15.2.6 Debt Extinguishments
15.2.6.1 Expected Breakage
In accordance with an exception to the extinguishment conditions in ASC
405-20, an entity is required to derecognize a financial liability related
to a prepaid stored-value product on the basis of expected breakage even if
the obligation has not been legally extinguished (see Section 9.4). Under paragraph 3.3.1 of IFRS
9, a financial liability can only be derecognized when the obligation has
been extinguished.
15.2.6.2 Convertible Debt
When convertible debt is extinguished as a result of an
early redemption or repurchase, no amount is allocated to equity under U.S.
GAAP if the convertible debt was presented as debt in its entirety.
Under paragraph AG33 of IAS 32, when convertible debt is extinguished as a
result of an early redemption or repurchase, the issuer must allocate the
consideration paid between the liability and equity components on the basis
of the fair value of the liability component. This treatment does not apply
if the conversion feature is bifurcated as a derivative under IFRS 9 (see
Section 15.2.5.2).
15.2.7 Debt Modification or Exchange
15.2.7.1 Substantially Different Terms
Under ASC 470-50, the terms of new or modified debt are considered
substantially different from the terms of the original debt (such that the
original debt is accounted for as being extinguished) if the 10 percent cash
flow test is passed (see Section 10.3.3), a substantive
conversion option is added or removed (see Section
10.3.4.3), or the change in fair value of an embedded
conversion option is at least 10 percent of the original carrying amount
(see Section 10.3.4.2). This guidance does not apply to
TDRs.
Under IFRS 9, paragraph B.3.3.6 specifies that the terms of new or modified
debt are considered substantially different from the terms of the original
debt (such that the original debt is accounted for as being extinguished) if
the 10 percent cash flow test is passed or, in limited circumstances, the
terms are determined to be qualitatively different.
15.2.7.2 Terms Not Substantially Different
Under ASC 470-50, if the terms of new or modified debt are not considered
substantially different from the terms of the original debt, the debtor
should account for the effect of the modification or exchange on the debt’s
cash flows prospectively as a yield adjustment (see Section 10.4.3). Under IFRS 9, paragraph
B5.4.6, the debtor should recognize a modification gain or loss in profit or
loss on the basis of the difference between (1) the carrying amount
immediately before the modification or exchange and (2) the present value of
the modified contractual cash flows discounted by using the original
effective interest rate. This treatment is described in paragraph BC4.253 of
IFRS 9.
15.2.7.3 Increase in the Fair Value of Embedded Conversion Option
Under ASC 470-50, if the terms of the new or modified debt are not considered
substantially different from the terms of the original debt, the debtor must
recognize an increase (but not a decrease) in the fair value of an embedded
conversion option in connection with the modification or exchange by
reducing the debt’s carrying amount with an offset to equity (see
Section 10.4.3.3). IFRS 9 does not contain any
specific guidance on such scenarios. Under IAS 32, conversion features that
are recognized in equity are not remeasured.
15.2.7.4 Third-Party Costs
The guidance in ASC 470-50 and IFRS 9 differs on third-party costs incurred
in connection with a debt modification or exchange.
If the terms of the new debt are substantially different from the debt’s
original terms such that the original debt is accounted for as being
extinguished, ASC 470-50 requires third-party costs to be amortized over the
life of the new debt by using the interest method (see Section
10.4.2). Under paragraph B3.3.6 of IFRS 9, such costs must be
expensed as incurred.
If the terms of the new debt are not substantially different from the debt’s
original terms and the new debt is therefore accounted for as a continuation
of the original debt, ASC 470-50 requires third-party costs to be expensed
as incurred (see Section 10.4.3). Under paragraph
B3.3.6 of IFRS 9, such costs must be amortized over the life of the new debt
by using the interest method.
15.2.8 Troubled Debt Restructurings
Under ASC 470-60, a debt modification or exchange is accounted for as a TDR if
the creditor grants a concession as a result of the debtor’s financial
difficulties (see Section 11.3). When TDR
accounting applies, the debtor accounts for the effect of the modification to
the debt terms prospectively as an adjustment to the effective interest rate,
except the effective interest rate cannot be reduced below zero (see
Section 11.4.4). The debtor does not recognize a
restructuring gain (or corresponding adjustment to the net carrying amount)
unless the net carrying amount exceeds the total undiscounted future principal
and interest payments of the restructured debt.
IFRS 9 does not contain any special guidance for debt
modifications or exchanges that would have been accounted for as TDRs under ASC
470-60. Instead, an entity performs the 10 percent cash flow test to determine
whether the modification or exchange should be accounted for as an
extinguishment or a continuation of the original debt (see Section 15.2.7.1).
15.2.9 Debt Conversions — Gain or Loss Recognition
In accordance with ASC 470-20, no gain or loss is recognized
upon the conversion of debt into cash, other assets, or the debtor’s equity
shares in accordance with the original terms of a conversion feature unless the
conversion occurred upon the debtor’s exercise of a call option and the
conversion option was not substantive at inception, in which case debt
extinguishment accounting applies.
Under paragraph AG32 of IAS 32, no gain or loss is recognized
upon a conversion of convertible debt into the debtor’s equity shares in
accordance with the original terms of a conversion feature. The conversion of
debt into cash or other assets is accounted for as an extinguishment.
15.2.10 Balance Sheet Classification of Debt as Current or Noncurrent
15.2.10.1 Post-Balance-Sheet-Date Refinancing
Under ASC 470-10, certain short-term obligations (e.g., short-term debt or
the currently maturing portion of long-term debt) are classified as
noncurrent if the debtor has both the intent and ability to refinance the
obligation on a long-term basis (see Section
13.7). To demonstrate an ability to refinance a short-term
obligation on a long-term basis, the debtor must either (1) refinance the
obligation on a long-term basis after the balance sheet date, but before or
as of the date the financial statements are issued or available to be
issued, or (2) have a financing agreement that clearly permits it to
refinance the obligation on a long-term basis in place before or as of the
date the financial statements are issued or available to be issued.
In accordance with paragraph 72 of IAS 1, a debtor classifies a financial
liability as current if it is “due to be settled within twelve months after
the reporting period” even if the debtor executes an agreement to refinance
or reschedule the payments on a long-term basis after the balance sheet date
and before the financial statements are authorized for issue.
15.2.10.2 Waivers of Covenant Violations
Under ASC 470-10, a long-term obligation that has become repayable on demand
because of a covenant violation as of the balance sheet date is not
classified as current if the creditor grants a qualifying waiver before the
financial statements are issued (or available to be issued; see
Section 13.5.3).
If a debtor has breached a provision of a long-term obligation before the end
of the reporting period such that the obligation becomes repayable on
demand, paragraph 74 of IAS 1 requires the liability to be classified as
current even if the lender agrees, after the end of the reporting period and
before the financial statements are authorized for issue, not to demand
repayment as a consequence of the breach.
15.3 Additional Information
Other Deloitte Roadmaps contain information about key differences
between U.S. GAAP and IFRS Accounting Standards related to the accounting for debt.
For example, see the guidance in:
Appendix A — Codification Guidance Relevant to Debt
Appendix A — Codification Guidance Relevant to Debt
To determine the appropriate
treatment of debt under GAAP, an entity must consider the guidance in multiple areas
of the Codification, including the following:
|
ASC
|
Guidance Relevant to Debt
|
Roadmap Discussion
|
|---|---|---|
|
210-10
|
General balance sheet presentation requirements
|
Sections 13.3.3 and
14.3
|
|
210-20
|
Balance sheet offsetting conditions
| |
|
230-10
|
Cash flow statement presentation
|
Section 14.3.2; also
see Deloitte’s Roadmap Statement of Cash
Flows
|
|
260-10
|
EPS guidance related to convertible debt and
participating debt securities
|
Section 14.3.3; also
see Deloitte’s Roadmap Earnings per
Share
|
|
405-20
|
Liability extinguishment conditions
| |
|
Derecognition of prepaid stored-value product liabilities
| ||
|
405-40
|
Accounting for joint-and-several obligations
| |
|
405-50
|
Accounting for supplier finance programs
| |
|
440-10
|
Disclosure of restrictive debt covenants and unused lines of
credit
| |
|
470-10
|
Balance sheet classification of debt as current or
noncurrent
| |
|
Accounting for sales of future revenue
| ||
|
Accounting for indexed debt
| ||
|
Accounting for extendable increasing-rate debt
| ||
|
470-20
|
Accounting for convertible debt
| |
|
470-30
|
Accounting for participating mortgages
| |
|
470-40
|
Accounting for product financing arrangements
| |
|
470-50
|
Accounting for debt extinguishments
| |
|
Accounting for debt modifications and exchanges
| ||
|
Accounting for modifications and exchanges of line-of-credit
and revolving-debt arrangements
| ||
|
470-60
|
Accounting for TDRs
| |
|
480-10
|
Identification of freestanding financial instruments
|
Section 3.3.2; also
see Chapter 3 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity and Chapter 3 of
Deloitte’s Roadmap Contracts on an Entity’s Own
Equity
|
|
Accounting for share-settled debt and other
liability-classified shares
|
Section 2.3.2.3; also
see Chapters 4 and 6 of Deloitte’s
Roadmap Distinguishing Liabilities From
Equity
| |
|
505-10
|
Disclosures about debt
| |
|
815-15
|
Accounting for derivatives embedded in debt
| |
|
815-20
|
General hedge accounting requirements applicable to debt
| |
|
815-25
|
Accounting for debt that is designated as a hedged item in a
fair value hedge
| |
|
815-30
|
Accounting for debt that is designated as a hedged item in a
cash flow hedge
| |
|
815-35
|
Accounting for debt that is designated as a hedging
instrument in a net investment hedge
| |
|
815-40
|
Evaluation of equity conversion features embedded in debt
|
Section 8.4.7; also
see Deloitte’s Roadmap Contracts on an Entity’s Own
Equity
|
|
820-10
|
Fair value measurements and disclosures
|
Section 14.4.10; also
see Deloitte’s Roadmap Fair Value Measurements and
Disclosures (Including the Fair Value
Option)
|
|
825-10
|
Fair value option liabilities
|
Sections 4.4,
5.5, 6.3, 9.3.4, and 14.4.11; also see
Chapter 12 of Deloitte’s Roadmap Fair Value
Measurements and Disclosures (Including the Fair
Value Option)
|
|
Financial instrument disclosures
| ||
|
825-20
|
Registration payment arrangements issued with debt
| |
|
830-10
|
Accounting for foreign-currency-denominated debt
|
Section 14.2.3; also
see Deloitte’s Roadmap Foreign Currency
Matters
|
|
835-20
|
Capitalization of interest
| |
|
835-30
|
Initial measurement of debt, including imputation of
interest
| |
|
Presentation of debt issuance costs
| ||
|
Application of the interest method
| ||
|
848
|
Reference rate reform
| |
|
860-30
|
Accounting for secured borrowings in connection with
financial asset transfers
|
Section 2.3.2.4; also
see Deloitte’s Roadmap Transfers and Servicing of Financial
Assets
|
Appendix B — Glossary of Selected Terms
Appendix B — Glossary of Selected Terms
The following are definitions of selected terms from the ASC master
glossary:
ASC Master Glossary
Active Market
A market in which transactions for the asset or liability
take place with sufficient frequency and volume to provide
pricing information on an ongoing basis.
Affiliate
A party that, directly or indirectly through one or more
intermediaries, controls, is controlled by, or is under
common control with an entity. See Control.
Agent
A party that acts for and on behalf of another party. For
example, a third-party intermediary is an agent of the
transferor if it acts on behalf of the transferor.
Antidilution
An increase in earnings per share amounts or a decrease in
loss per share amounts.
Auction Rate Notes
Auction rate notes are notes that generally have long-term
nominal maturities and interest rates that reset
periodically through a Dutch auction process, typically
every 7, 28, or 35 days. At an auction, existing holders of
auction rate notes and potential buyers enter a competitive
bidding process through a broker-dealer, specifying the
number of shares (units) to purchase with the lowest
interest rate they are willing to accept. Generally, the
lowest bid rate at which all shares can be sold at the
notes’ par value establishes the interest rate (also known
as the clearing rate) to be applied until the next
auction.
Baby Bonds
See Payment-in-Kind Bonds.
Basic Earnings per Share
The amount of earnings for the period available to each share
of common stock outstanding during the reporting period.
Benchmark Interest Rate
A widely recognized and quoted rate in an active financial
market that is broadly indicative of the overall level of
interest rates attributable to high-credit-quality obligors
in that market. It is a rate that is widely used in a given
financial market as an underlying basis for determining the
interest rates of individual financial instruments and
commonly referenced in interest-rate-related
transactions.
In theory, the benchmark interest rate should be a risk-free
rate (that is, has no risk of default). In some markets,
government borrowing rates may serve as a benchmark. In
other markets, the benchmark interest rate may be an
interbank offered rate.
Beneficial Interests
Rights to receive all or portions of specified cash inflows
received by a trust or other entity, including, but not
limited to, all of the following:
- Senior and subordinated shares of interest, principal, or other cash inflows to be passed-through or paid-through
- Premiums due to guarantors
- Commercial paper obligations
- Residual interests, whether in the form of debt or equity.
Bunny Bonds
See Payment-in-Kind Bonds.
Callable Obligation
An obligation is callable at a given date if the creditor has
the right at that date to demand, or to give notice of its
intention to demand, repayment of the obligation owed to it
by the debtor.
Capitalization Rate
Rate used to determine amount of interest to be capitalized
in an accounting period.
Capitalize
Capitalize is used to indicate that the cost would be
recorded as the cost of an asset. That procedure is often
referred to as deferring a cost, and the resulting asset is
sometimes described as a deferred cost.
Carrying Amount
For a receivable, the face amount increased or decreased by
applicable accrued interest and applicable unamortized
premium, discount, finance charges, or issue costs and also
an allowance for uncollectible amounts and other valuation
accounts.
For a payable, the face amount increased or decreased by
applicable accrued interest and applicable unamortized
premium, discount, finance charges, or issue costs.
Cash
Consistent with common usage, cash includes not only currency
on hand but demand deposits with banks or other financial
institutions. Cash also includes other kinds of accounts
that have the general characteristics of demand deposits in
that the customer may deposit additional funds at any time
and also effectively may withdraw funds at any time without
prior notice or penalty. All charges and credits to those
accounts are cash receipts or payments to both the entity
owning the account and the bank holding it. For example, a
bank’s granting of a loan by crediting the proceeds to a
customer’s demand deposit account is a cash payment by the
bank and a cash receipt of the customer when the entry is
made.
Cash Equivalents
Cash equivalents are short-term, highly liquid investments
that have both of the following characteristics:
- Readily convertible to known amounts of cash
- So near their maturity that they present insignificant risk of changes in value because of changes in interest rates.
Generally, only investments with original maturities of three
months or less qualify under that definition. Original
maturity means original maturity to the entity holding the
investment. For example, both a three-month U.S. Treasury
bill and a three-year U.S. Treasury note purchased three
months from maturity qualify as cash equivalents. However, a
Treasury note purchased three years ago does not become a
cash equivalent when its remaining maturity is three months.
Examples of items commonly considered to be cash equivalents
are Treasury bills, commercial paper, money market funds,
and federal funds sold (for an entity with banking
operations).
Cash Flow Hedge
A hedge of the exposure to variability in the cash flows of a
recognized asset or liability, or of a forecasted
transaction, that is attributable to a particular risk.
Cashless Exercise
See Net Share Settlement.
Collateral
Personal or real property in which a security interest has
been given.
Collateralized Financing Entity
A variable interest entity that holds financial assets,
issues beneficial interests in those financial assets, and
has no more than nominal equity. The beneficial interests
have contractual recourse only to the related assets of the
collateralized financing entity and are classified as
financial liabilities. A collateralized financing entity may
hold nonfinancial assets temporarily as a result of default
by the debtor on the underlying debt instruments held as
assets by the collateralized financing entity or in an
effort to restructure the debt instruments held as assets by
the collateralized financing entity. A collateralized
financing entity also may hold other financial assets and
financial liabilities that are incidental to the operations
of the collateralized financing entity and have carrying
values that approximate fair value (for example, cash,
broker receivables, or broker payables).
Common Stock
A stock that is subordinate to all other stock of the issuer.
Also called common shares.
Conduit Debt Securities
Certain limited-obligation revenue bonds, certificates of
participation, or similar debt instruments issued by a state
or local governmental entity for the express purpose of
providing financing for a specific third party (the conduit
bond obligor) that is not a part of the state or local
government’s financial reporting entity. Although conduit
debt securities bear the name of the governmental entity
that issues them, the governmental entity often has no
obligation for such debt beyond the resources provided by a
lease or loan agreement with the third party on whose behalf
the securities are issued. Further, the conduit bond obligor
is responsible for any future financial reporting
requirements.
Consolidated Financial Statements
The financial statements of a consolidated group of entities
that include a parent and all its subsidiaries presented as
those of a single economic entity.
Consolidated Group
A parent and all its subsidiaries.
Contingency
An existing condition, situation, or set of circumstances
involving uncertainty as to possible gain (gain contingency)
or loss (loss contingency) to an entity that will ultimately
be resolved when one or more future events occur or fail to
occur.
Contingently Convertible Instruments
Contingently convertible instruments are instruments that
have embedded conversion features that are contingently
convertible or exercisable based on either of the
following:
- A market price trigger
- Multiple contingencies if one of the contingencies is a market price trigger and the instrument can be converted or share settled based on meeting the specified market condition.
A market price trigger is a market condition that is based at
least in part on the issuer’s own share price. Examples of
contingently convertible instruments include contingently
convertible debt, contingently convertible preferred stock,
and the instrument described by paragraph 260-10-45-43, all
with embedded market price triggers.
Contract
An agreement between two or more parties that creates
enforceable rights and obligations.
Contract Asset
An entity’s right to consideration in exchange for goods or
services that the entity has transferred to a customer when
that right is conditioned on something other than the
passage of time (for example, the entity’s future
performance).
Contract Liability
An entity’s obligation to transfer goods or services to a
customer for which the entity has received consideration (or
the amount is due) from the customer.
Control
The possession, direct or indirect, of the power to direct or
cause the direction of the management and policies of an
entity through ownership, by contract, or otherwise.
Conversion Rate
The ratio of the number of common shares issuable upon
conversion to a unit of a convertible security. For example,
$100 face value of debt convertible into 5 shares of common
stock would have a conversion ratio of 5:1. Also called
conversion ratio.
Convertible Security
A security that is convertible into another security based on
a conversion rate. For example, convertible preferred stock
that is convertible into common stock on a two-for-one basis
(two shares of common for each share of preferred).
Credit Derivative
A derivative instrument that has both of the following
characteristics:
- One or more of its underlyings are related to any of
the following:
- The credit risk of a specified entity (or a group of entities)
- An index based on the credit risk of a group of entities.
- It exposes the seller to potential loss from credit-risk-related events specified in the contract.
Examples of credit derivatives include, but are not limited
to, credit default swaps, credit spread options, and credit
index products.
Credit Risk
For purposes of a hedged item in a fair value hedge, credit
risk is the risk of changes in the hedged item’s fair value
attributable to both of the following:
- Changes in the obligor’s creditworthiness
- Changes in the spread over the benchmark interest rate with respect to the hedged item’s credit sector at inception of the hedge.
- Default
- Changes in the obligor’s creditworthiness
- Changes in the spread over the contractually specified interest rate or the benchmark interest rate with respect to the related financial asset’s or liability’s credit sector at inception of the hedge.
Currency Risk
The risk that the fair value or future cash flows of a
financial instrument will fluctuate because of changes in
foreign exchange rates.
Current Assets
Current assets is used to designate cash and other assets or
resources commonly identified as those that are reasonably
expected to be realized in cash or sold or consumed during
the normal operating cycle of the business. See paragraphs
210-10-45-1 through 45-4.
Current Liabilities
Current liabilities is used principally to designate
obligations whose liquidation is reasonably expected to
require the use of existing resources properly classifiable
as current assets, or the creation of other current
liabilities. See paragraphs 210-10-45-5 through 45-12.
Customer
A party that has contracted with an entity to obtain goods or
services that are an output of the entity’s ordinary
activities in exchange for consideration.
Derecognize
Remove previously recognized assets or liabilities from the
statement of financial position.
Derivative Instrument
Paragraphs 815-10-15-83 through 15-139
define the term derivative instrument.
Diluted Earnings per Share
The amount of earnings for the period available to each share
of common stock outstanding during the reporting period and
to each share that would have been outstanding assuming the
issuance of common shares for all dilutive potential common
shares outstanding during the reporting period.
Dilution
A reduction in EPS resulting from the assumption that
convertible securities were converted, that options or
warrants were exercised, or that other shares were issued
upon the satisfaction of certain conditions.
Discount
The difference between the net proceeds, after expense,
received upon issuance of debt and the amount repayable at
its maturity. See Premium.
Discount Rate Adjustment Technique
A present value technique that uses a risk-adjusted discount
rate and contractual, promised, or most likely cash
flows.
Down Round Feature
A feature in a financial instrument that reduces the strike
price of an issued financial instrument if the issuer sells
shares of its stock for an amount less than the currently
stated strike price of the issued financial instrument or
issues an equity-linked financial instrument with a strike
price below the currently stated strike price of the issued
financial instrument.
A down round feature may reduce the strike price of a
financial instrument to the current issuance price, or the
reduction may be limited by a floor or on the basis of a
formula that results in a price that is at a discount to the
original exercise price but above the new issuance price of
the shares, or may reduce the strike price to below the
current issuance price. A standard antidilution provision is
not considered a down round feature.
Earnings per Share
The amount of earnings attributable to each share of common
stock. For convenience, the term is used to refer to either
earnings or loss per share.
Effective Notional Amount
The effective notional amount is the stated notional amount
adjusted for any leverage factor.
Embedded Credit Derivative
An embedded derivative that is also a credit derivative.
Embedded Derivative
Implicit or explicit terms that affect some or all of the
cash flows or the value of other exchanges required by a
contract in a manner similar to a derivative instrument.
Entry Price
The price paid to acquire an asset or received to assume a
liability in an exchange transaction.
Equity Kicker
See Expected Residual Profit.
Equity Restructuring
A nonreciprocal transaction between an entity and its
shareholders that causes the per-share fair value of the
shares underlying an option or similar award to change, such
as a stock dividend, stock split, spinoff, rights offering,
or recapitalization through a large, nonrecurring cash
dividend.
Equity Shares
Equity shares refers only to shares that are accounted for as
equity.
Error in Previously Issued Financial Statements
An error in recognition, measurement, presentation, or
disclosure in financial statements resulting from
mathematical mistakes, mistakes in the application of
generally accepted accounting principles (GAAP), or
oversight or misuse of facts that existed at the time the
financial statements were prepared. A change from an
accounting principle that is not generally accepted to one
that is generally accepted is a correction of an error.
Exchange Market
A market in which closing prices are both readily available
and generally representative of fair value. An example of
such a market is the New York Stock Exchange.
Exchange Rate
The ratio between a unit of one currency and the amount of
another currency for which that unit can be exchanged at a
particular time.
Exercise Contingency
A provision that entitles the entity (or the counterparty) to
exercise an equity-linked financial instrument (or embedded
feature) based on changes in an underlying, including the
occurrence (or nonoccurrence) of a specified event.
Provisions that accelerate the timing of the entity’s (or
the counterparty’s) ability to exercise an instrument and
provisions that extend the length of time that an instrument
is exercisable are examples of exercise contingencies.
Exit Price
The price that would be received to sell an asset or paid to
transfer a liability.
Expected Cash Flow
The probability-weighted average (that is, mean of the
distribution) of possible future cash flows.
Expected Residual Profit
The amount of profit, whether called interest or another
name, such as equity kicker, above a reasonable amount of
interest and fees expected to be earned by a lender.
Face Amount
See Notional Amount.
Fair Value
The price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between
market participants at the measurement date.
Fair Value Hedge
A hedge of the exposure to changes in the fair value of a
recognized asset or liability, or of an unrecognized firm
commitment, that are attributable to a particular risk.
Fed Funds Effective Rate Overnight Index Swap Rate
The fixed rate on a U.S. dollar, constant-notional interest
rate swap that has its variable-rate leg referenced to the
Fed Funds Effective Rate (an overnight rate) with no
additional spread over the Fed Funds effective rate on that
variable-rate leg. That fixed rate is the derived rate that
would result in the swap having a zero fair value at
inception because the present value of fixed cash flows,
based on that rate, equates to the present value of the
variable cash flows.
Financial Asset
Cash, evidence of an ownership interest in an entity, or a
contract that conveys to one entity a right to do either of
the following:
- Receive cash or another financial instrument from a second entity
- Exchange other financial instruments on potentially favorable terms with the second entity.
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.
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.
Financial Statements Are
Available to Be Issued
Financial statements are considered
available to be issued when they are complete in a form and
format that complies with GAAP and all approvals necessary
for issuance have been obtained, for example, from
management, the board of directors, and/or significant
shareholders. The process involved in creating and
distributing the financial statements will vary depending on
an entity’s management and corporate governance structure as
well as statutory and regulatory requirements.
Financial Statements Are
Issued
Financial statements are considered issued
when they are widely distributed to shareholders and other
financial statement users for general use and reliance in a
form and format that complies with GAAP. (U.S. Securities
and Exchange Commission [SEC] registrants also are required
to consider the guidance in paragraph 855-10-S99-2.)
Financing
Activities
Financing activities include obtaining
resources from owners and providing them with a return on,
and a return of, their investment; receiving restricted
resources that by donor stipulation must be used for
long-term purposes; borrowing money and repaying amounts
borrowed, or otherwise settling the obligation; and
obtaining and paying for other resources obtained from
creditors on long-term credit.
Firm Commitment
An agreement with an unrelated party,
binding on both parties and usually legally enforceable,
with the following characteristics:
- The agreement specifies all significant terms, including the quantity to be exchanged, the fixed price, and the timing of the transaction. The fixed price may be expressed as a specified amount of an entity’s functional currency or of a foreign currency. It may also be expressed as a specified interest rate or specified effective yield. The binding provisions of an agreement are regarded to include those legal rights and obligations codified in the laws to which such an agreement is subject. A price that varies with the market price of the item that is the subject of the firm commitment cannot qualify as a fixed price. For example, a price that is specified in terms of ounces of gold would not be a fixed price if the market price of the item to be purchased or sold under the firm commitment varied with the price of gold.
- The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable. In the legal jurisdiction that governs the agreement, the existence of statutory rights to pursue remedies for default equivalent to the damages suffered by the nondefaulting party, in and of itself, represents a sufficiently large disincentive for nonperformance to make performance probable for purposes of applying the definition of a firm commitment.
Forecasted
Transaction
A transaction that is expected to occur for
which there is no firm commitment. Because no transaction or
event has yet occurred and the transaction or event when it
occurs will be at the prevailing market price, a forecasted
transaction does not give an entity any present rights to
future benefits or a present obligation for future
sacrifices.
Foreign Currency
A currency other than the functional
currency of the entity being referred to (for example, the
dollar could be a foreign currency for a foreign entity).
Composites of currencies, such as the Special Drawing
Rights, used to set prices or denominate amounts of loans,
and so forth, have the characteristics of foreign
currency.
Foreign Currency
Transactions
Transactions whose terms are denominated in
a currency other than the entity’s functional currency.
Foreign currency transactions arise when a reporting entity
does any of the following:
- Buys or sells on credit goods or services whose prices are denominated in foreign currency
- Borrows or lends funds and the amounts payable or receivable are denominated in foreign currency
- Is a party to an unperformed forward exchange contract
- For other reasons, acquires or disposes of assets, or incurs or settles liabilities denominated in foreign currency.
Foreign Currency
Translation
The process of expressing in the reporting
currency of the reporting entity those amounts that are
denominated or measured in a different currency.
Foreign Entity
An operation (for example, subsidiary,
division, branch, joint venture, and so forth) whose
financial statements are both:
- Prepared in a currency other than the reporting currency of the reporting entity
- Combined or consolidated with or accounted for on the equity basis in the financial statements of the reporting entity.
Foreign Exchange Risk
The risk of changes in a hedged item’s fair value or
functional-currency-equivalent cash flows attributable to
changes in the related foreign currency exchange rates.
Freestanding Contract
A freestanding contract is entered into either:
- Separate and apart from any of the entity’s other financial instruments or equity transactions
- In conjunction with some other transaction and is legally detachable and separately exercisable.
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.
Functional Currency
An entity’s functional currency is the currency of the
primary economic environment in which the entity operates;
normally, that is the currency of the environment in which
an entity primarily generates and expends cash. (See
paragraphs 830-10-45-2 through 830-10-45-6 and 830-10-55-3
through 830-10-55-7.)
Gain Contingency
An existing condition, situation, or set of circumstances
involving uncertainty as to possible gain to an entity that
will ultimately be resolved when one or more future events
occur or fail to occur.
High-Yield Debt Securities
Corporate and municipal debt securities
having a lower-than-investment-grade credit rating (BB+ or
lower by Standard & Poor’s, or Ba or lower by Moody’s).
Because high-yield debt securities typically are used when
lower-cost capital is not available, they have interest
rates several percentage points higher than investment-grade
debt and often have shorter maturities. These high-yielding
corporate and municipal debt obligations are frequently
referred to as junk bonds.
Hybrid Instrument
A contract that embodies both an embedded derivative and a
host contract.
If-Converted Method
A method of computing EPS data that assumes conversion of
convertible securities at the beginning of the reporting
period (or at time of issuance, if later).
Immediate Family
Family members who might control or influence a principal
owner or a member of management, or who might be controlled
or influenced by a principal owner or a member of
management, because of the family relationship.
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.
Income Approach
Valuation approaches that convert future amounts (for
example, cash flows or income and expenses) to a single
current (that is, discounted) amount. The fair value
measurement is determined on the basis of the value
indicated by current market expectations about those future
amounts.
Inputs
The assumptions that market participants would use when
pricing the asset or liability, including assumptions about
risk, such as the following:
- The risk inherent in a particular valuation technique used to measure fair value (such as a pricing model)
- The risk inherent in the inputs to the valuation technique.
Inputs may be observable or unobservable.
In-Substance Defeasance
Placement by the debtor of amounts equal to the principal,
interest, and prepayment penalties related to a debt
instrument in an irrevocable trust established for the
benefit of the creditor.
Interest Cost
Interest cost includes interest recognized on obligations
having explicit interest rates, interest imputed on certain
types of payables in accordance with Subtopic 835-30, and
interest related to a finance lease determined in accordance
with Topic 842. With respect to obligations having explicit
interest rates, interest cost includes amounts resulting
from periodic amortization of discount or premium and issue
costs on debt.
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.
Interest Rate Risk
For recognized variable-rate financial instruments and
forecasted issuances or purchases of variable-rate financial
instruments, interest rate risk is the risk of changes in
the hedged item’s cash flows attributable to changes in the
contractually specified interest rate in the agreement.
For recognized fixed-rate financial instruments, interest
rate risk is the risk of changes in the hedged item’s fair
value attributable to changes in the designated benchmark
interest rate. For forecasted issuances or purchases of
fixed-rate financial instruments, interest rate risk is the
risk of changes in the hedged item’s cash flows attributable
to changes in the designated benchmark interest rate.
Intrinsic Value
The amount by which the fair value of the underlying stock
exceeds the exercise price of an option. For example, an
option with an exercise price of $20 on a stock whose
current market price is $25 has an intrinsic value of $5. (A
nonvested share may be described as an option on that share
with an exercise price of zero. Thus, the fair value of a
share is the same as the intrinsic value of such an option
on that share.)
Issued, Issuance, or Issuing of an Equity
Instrument
An equity instrument is issued when the issuing entity
receives the agreed-upon consideration, which may be cash,
an enforceable right to receive cash, or another financial
instrument, goods, or services. An entity may conditionally
transfer an equity instrument to another party under an
arrangement that permits that party to choose at a later
date or for a specified time whether to deliver the
consideration or to forfeit the right to the conditionally
transferred instrument with no further obligation. In that
situation, the equity instrument is not issued until the
issuing entity has received the consideration. The grant of
stock options or other equity instruments subject to vesting
conditions is not considered to be issuance.
Issuer
The entity that issued a financial instrument or may be
required under the terms of a financial instrument to issue
its equity shares.
Issuer’s Equity Shares
The equity shares of any entity whose financial statements
are included in the consolidated financial statements.
Junk Bonds
See High-Yield Debt Securities.
Lease
A contract, or part of a contract, that conveys the right to
control the use of identified property, plant, or equipment
(an identified asset) for a period of time in exchange for
consideration.
Lease Modification
A change to the terms and conditions of a
contract that results in a change in the scope of or the
consideration for a lease (for example, a change to the
terms and conditions of the contract that adds or terminates
the right to use one or more underlying assets or extends or
shortens the contractual lease term).
Legal Entity
Any legal structure used to conduct activities or to hold
assets. Some examples of such structures are corporations,
partnerships, limited liability companies, grantor trusts,
and other trusts.
Level 1 Inputs
Quoted prices (unadjusted) in active markets for identical
assets or liabilities that the reporting entity can access
at the measurement date.
Level 2 Inputs
Inputs other than quoted prices included within Level 1 that
are observable for the asset or liability, either directly
or indirectly.
Level 3 Inputs
Unobservable inputs for the asset or liability.
Liability Issued With an Inseparable Third-Party Credit
Enhancement
A liability that is issued with a credit enhancement obtained
from a third party, such as debt that is issued with a
financial guarantee from a third party that guarantees the
issuer’s payment obligation.
LIBOR Swap Rate
See London Interbank Offered Rate (LIBOR) Swap Rate.
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.
Loan Participation
A transaction in which a single lender makes a large loan to
a borrower and subsequently transfers undivided interests in
the loan to groups of banks or other entities.
Loan Syndication
A transaction in which several lenders share in lending to a
single borrower. Each lender loans a specific amount to the
borrower and has the right to repayment from the borrower.
It is common for groups of lenders to jointly fund those
loans when the amount borrowed is greater than any one
lender is willing to lend.
Local Currency
The currency of a particular country being referred to.
Lock-Box Arrangement
An arrangement with a lender whereby the borrower’s customers
are required to remit payments directly to the lender and
amounts received are applied to reduce the debt outstanding.
A lock-box arrangement refers to any situation in which the
borrower does not have the ability to avoid using working
capital to repay the amounts outstanding. That is, the
contractual provisions of a loan arrangement require that,
in the ordinary course of business and without another event
occurring, the cash receipts of a debtor are used to repay
the existing obligation.
London Interbank Offered Rate (LIBOR) Swap Rate
The fixed rate on a single-currency, constant-notional
interest rate swap that has its variable-rate leg referenced
to the London Interbank Offered Rate (LIBOR) with no
additional spread over LIBOR on that variable-rate leg. That
fixed rate is the derived rate that would result in the swap
having a zero fair value at inception because the present
value of fixed cash flows, based on that rate, equate to the
present value of the variable cash flows.
Long-Term Obligations
Long-term obligations are those scheduled to mature beyond
one year (or the operating cycle, if applicable) from the
date of an entity’s balance sheet.
Loss Contingency
An existing condition, situation, or set of circumstances
involving uncertainty as to possible loss to an entity that
will ultimately be resolved when one or more future events
occur or fail to occur. The term loss is used for
convenience to include many charges against income that are
commonly referred to as expenses and others that are
commonly referred to as losses.
Make-Whole Provision
A contractual option that gives a debtor (that is, an issuer)
the right to pay off debt before maturity at a significant
premium over the fair value of the debt at the date of
settlement.
Management
Persons who are responsible for achieving the objectives of
the entity and who have the authority to establish policies
and make decisions by which those objectives are to be
pursued. Management normally includes members of the board
of directors, the chief executive officer, chief operating
officer, vice presidents in charge of principal business
functions (such as sales, administration, or finance), and
other persons who perform similar policy making functions.
Persons without formal titles also may be members of
management.
Mandatorily Redeemable Financial Instrument
Any of various financial instruments issued in the form of
shares that embody an unconditional obligation requiring the
issuer to redeem the instrument by transferring its assets
at a specified or determinable date (or dates) or upon an
event that is certain to occur.
Market Approach
A valuation approach that uses prices and other relevant
information generated by market transactions involving
identical or comparable (that is, similar) assets,
liabilities, or a group of assets and liabilities, such as a
business.
Market-Corroborated Inputs
Inputs that are derived principally from or corroborated by
observable market data by correlation or other means.
Market Participants
Buyers and sellers in the principal (or most advantageous)
market for the asset or liability that have all of the
following characteristics:
- They are independent of each other, that is, they are not related parties, although the price in a related-party transaction may be used as an input to a fair value measurement if the reporting entity has evidence that the transaction was entered into at market terms
- They are knowledgeable, having a reasonable understanding about the asset or liability and the transaction using all available information, including information that might be obtained through due diligence efforts that are usual and customary
- They are able to enter into a transaction for the asset or liability
- They are willing to enter into a transaction for the asset or liability, that is, they are motivated but not forced or otherwise compelled to do so.
Market Risk
The risk that the fair value or future cash flows of a
financial instrument will fluctuate because of changes in
market prices. Market risk comprises the following:
- Interest rate risk
- Currency risk
- Other price risk.
Monetary Assets and Liabilities
Monetary assets and liabilities are assets and liabilities
whose amounts are fixed in terms of units of currency by
contract or otherwise. Examples are cash, short- or
long-term accounts and notes receivable in cash, and short-
or long-term accounts and notes payable in cash.
Monetary Value
What the fair value of the cash, shares, or other instruments
that a financial instrument obligates the issuer to convey
to the holder would be at the settlement date under
specified market conditions.
Net Carrying Amount of Debt
Net carrying amount of debt is the amount due at maturity,
adjusted for unamortized premium, discount, and cost of
issuance.
Net Cash Settlement
A form of settling a financial instrument under which the
entity with a loss delivers to the entity with a gain cash
equal to the gain.
Net Income
A measure of financial performance resulting from the
aggregation of revenues, expenses, gains, and losses that
are not items of other comprehensive income. A variety of
other terms such as net earnings or earnings may be used to
describe net income.
Net Share Settlement
A form of settling a financial instrument under which the
entity with a loss delivers to the entity with a gain shares
of stock with a current fair value equal to the gain.
New Basis Event
See Remeasurement Event.
Noncontrolling
Interest
The portion of equity (net assets) in a
subsidiary not attributable, directly or indirectly, to a
parent. A noncontrolling interest is sometimes called a
minority interest.
Nonfinancial
Asset
An asset that is not a financial asset.
Nonfinancial assets include land, buildings, use of
facilities or utilities, materials and supplies, intangible
assets, or services.
Nonperformance
Risk
The risk that an entity will not fulfill an
obligation. Nonperformance risk includes, but may not be
limited to, the reporting entity’s own credit risk.
Nonpublic Entity
Any entity that does not meet any of the
following conditions:
- Its debt or equity securities trade in a public market either on a stock exchange (domestic or foreign) or in an over-the-counter market, including securities quoted only locally or regionally.
- It is a conduit bond obligor for conduit debt securities that are traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local or regional markets).
- It files with a regulatory agency in preparation for the sale of any class of debt or equity securities in a public market.
- It is required to file or furnish financial statements with the Securities and Exchange Commission.
- It is controlled by an entity covered by criteria (a) through (d).
Not-for-Profit
Entity
An entity that possesses the following
characteristics, in varying degrees, that distinguish it
from a business entity:
- Contributions of significant amounts of resources from resource providers who do not expect commensurate or proportionate pecuniary return
- Operating purposes other than to provide goods or services at a profit
- Absence of ownership interests like those of business entities.
Entities that clearly fall outside this definition include
the following:
- All investor-owned entities
- Entities that provide dividends, lower costs, or other economic benefits directly and proportionately to their owners, members, or participants, such as mutual insurance entities, credit unions, farm and rural electric cooperatives, and employee benefit plans.
Notional Amount
A number of currency units, shares, bushels,
pounds, or other units specified in a derivative instrument.
Sometimes other names are used. For example, the notional
amount is called a face amount in some contracts.
Obligation
A conditional or unconditional duty or
responsibility to transfer assets or to issue equity shares.
Because Topic 480 relates only to financial instruments and
not to contracts to provide services and other types of
contracts, but includes duties or responsibilities to issue
equity shares, this definition of obligation differs from
the definition found in FASB Concepts Statement No. 6,
Elements of Financial Statements, and is applicable only for
items in the scope of that Topic.
Observable
Inputs
Inputs that are developed using market data,
such as publicly available information about actual events
or transactions, and that reflect the assumptions that
market participants would use when pricing the asset or
liability.
Operating Cycle
The average time intervening between the
acquisition of materials or services and the final cash
realization constitutes an operating cycle.
Operating
Activities
Operating activities include all
transactions and other events that are not defined as
investing or financing activities (see paragraphs
230-10-45-12 through 45-15). Operating activities generally
involve producing and delivering goods and providing
services. Cash flows from operating activities are generally
the cash effects of transactions and other events that enter
into the determination of net income.
Orderly
Transaction
A transaction that assumes exposure to the
market for a period before the measurement date to allow for
marketing activities that are usual and customary for
transactions involving such assets or liabilities; it is not
a forced transaction (for example, a forced liquidation or
distress sale).
Other Comprehensive
Income
Revenues, expenses, gains, and losses that
under generally accepted accounting principles (GAAP) are
included in comprehensive income but excluded from net
income.
Other Price Risk
The risk that the fair value or future cash
flows of a financial instrument will fluctuate because of
changes in market prices (other than those arising from
interest rate risk or currency risk), whether those changes
are caused by factors specific to the individual financial
instrument or its issuer or by factors affecting all similar
financial instruments traded in the market.
Parent
An entity that has a controlling financial
interest in one or more subsidiaries. (Also, an entity that
is the primary beneficiary of a variable interest
entity.)
Participating
Interest
Paragraph 860-10-40-6A defines the term
participating interest.
Participating
Security
A security that may participate in
undistributed earnings with common stock, whether that
participation is conditioned upon the occurrence of a
specified event or not. The form of such participation does
not have to be a dividend — that is, any form of
participation in undistributed earnings would constitute
participation by that security, regardless of whether the
payment to the security holder was referred to as a
dividend.
Participation
Rights
Contractual rights of security holders to
receive dividends or returns from the security issuer’s
profits, cash flows, or returns on investments.
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.
Payment
Provision
A payment provision specifies a fixed or
determinable settlement to be made if the underlying behaves
in a specified manner.
Physical
Settlement
A form of settling a financial instrument
under which both of the following conditions are met:
- The party designated in the contract as the buyer delivers the full stated amount of cash or other financial instruments to the seller.
- The seller delivers the full stated number of shares of stock or other financial instruments or nonfinancial instruments to the buyer.
PIK Bonds
See Payment-in-Kind Bonds.
Preferred Stock
A security that has preferential rights compared to common
stock.
Premium
The excess of the net proceeds, after expense, received upon
issuance of debt over the amount repayable at its maturity.
See Discount.
Prepayable
Able to be settled by either party before its scheduled
maturity.
Present Value
A tool used to link future amounts (cash flows or values) to
a present amount using a discount rate (an application of
the income approach). Present value techniques differ in how
they adjust for risk and in the type of cash flows they use.
See Discount Rate Adjustment Technique.
Principal Owners
Owners of record or known beneficial owners of more than 10
percent of the voting interests of the entity.
Private Company
An entity other than a public business entity, a
not-for-profit entity, or an employee benefit plan within
the scope of Topics 960 through 965 on plan accounting.
Probable
The future event or events are likely to occur.
Product Financing Arrangement
A product financing arrangement is a transaction in which an
entity sells and agrees to repurchase inventory with the
repurchase price equal to the original sale price plus
carrying and financing costs, or other similar
transactions.
Public Business Entity
A public business entity is a business entity meeting any one
of the criteria below. Neither a not-for-profit entity nor
an employee benefit plan is a business entity.
- It is required by the U.S. Securities and Exchange Commission (SEC) to file or furnish financial statements, or does file or furnish financial statements (including voluntary filers), with the SEC (including other entities whose financial statements or financial information are required to be or are included in a filing).
- It is required by the Securities Exchange Act of 1934 (the Act), as amended, or rules or regulations promulgated under the Act, to file or furnish financial statements with a regulatory agency other than the SEC.
- It is required to file or furnish financial statements with a foreign or domestic regulatory agency in preparation for the sale of or for purposes of issuing securities that are not subject to contractual restrictions on transfer.
- It has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market.
- It has one or more securities that are not subject to contractual restrictions on transfer, and it is required by law, contract, or regulation to prepare U.S. GAAP financial statements (including notes) and make them publicly available on a periodic basis (for example, interim or annual periods). An entity must meet both of these conditions to meet this criterion.
An entity may meet the definition of a public business entity
solely because its financial statements or financial
information is included in another entity’s filing with the
SEC. In that case, the entity is only a public business
entity for purposes of financial statements that are filed
or furnished with the SEC.
Public Debt Issuance
A public debt issuance occurs when a debtor issues a number
of identical debt instruments to an underwriter that sells
the debt instruments (in the form of securities) to various
investors.
Public Entity
An entity that meets any of the following criteria:
- Has equity securities that trade in a public market, either on a stock exchange (domestic or foreign) or in an over-the-counter market, including securities quoted only locally or regionally
- Makes a filing with a regulatory agency in preparation for the sale of any class of equity securities in a public market
- Is controlled by an entity covered by the preceding criteria. That is, a subsidiary of a public entity is itself a public entity.
An entity that has only debt securities trading in a public
market (or that has made a filing with a regulatory agency
in preparation to trade only debt securities) is not a
public entity.
Reacquisition Price of Debt
The amount paid on extinguishment, including a call premium
and miscellaneous costs of reacquisition. If extinguishment
is achieved by a direct exchange of new securities, the
reacquisition price is the total present value of the new
securities.
Readily Convertible to Cash
Assets that are readily convertible to cash have both of the
following:
- Interchangeable (fungible) units
- Quoted prices available in an active market that can rapidly absorb the quantity held by the entity without significantly affecting the price.
(Based on paragraph 83(a) of FASB Concepts Statement No. 5,
Recognition and Measurement in Financial Statements of
Business Enterprises.)
Reasonably Possible
The chance of the future event or events occurring is more
than remote but less than likely.
Reclassification Adjustments
Adjustments made to avoid double counting in comprehensive
income items that are displayed as part of net income for a
period that also had been displayed as part of other
comprehensive income in that period or earlier periods.
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).
Related Parties
Related parties include:
- Affiliates of the entity
- Entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of Section 825-10-15, to be accounted for by the equity method by the investing entity
- Trusts for the benefit of employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of management
- Principal owners of the entity and members of their immediate families
- Management of the entity and members of their immediate families
- Other parties with which the entity may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests
- Other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests.
Remeasurement Event
A remeasurement (new basis) event is an event identified in
other authoritative accounting literature, other than the
measurement of an impairment under Topic 321 or credit loss
under Topic 326, that requires a financial instrument to be
remeasured to its fair value at the time of the event but
does not require that financial instrument to be reported at
fair value continually with the change in fair value
recognized in earnings. Examples of remeasurement events are
business combinations and significant modifications of debt
as discussed in paragraph 470-50-40-6.
Remote
The chance of the future event or events occurring is
slight.
Reporting Currency
The currency in which a reporting entity prepares its
financial statements.
Reporting Entity
An entity or group whose financial statements are being
referred to. Those financial statements reflect any of the
following:
- The financial statements of one or more foreign operations by combination, consolidation, or equity accounting
- Foreign currency transactions.
Repurchase Agreement
An agreement under which the transferor (repo party)
transfers a financial asset to a transferee (repo
counterparty or reverse party) in exchange for cash and
concurrently agrees to reacquire that financial asset at a
future date for an amount equal to the cash exchanged plus
or minus a stipulated interest factor. Instead of cash,
other securities or letters of credit sometimes are
exchanged. Some repurchase agreements call for repurchase of
financial assets that need not be identical to the financial
assets transferred.
Repurchase Agreement Accounted for as a Collateralized
Borrowing
A repurchase agreement (repo) refers to a transaction in
which a seller-borrower of securities sells those securities
to a buyer-lender with an agreement to repurchase them at a
stated price plus interest at a specified date or in
specified circumstances. A repurchase agreement accounted
for as a collateralized borrowing is a repo that does not
qualify for sale accounting under Topic 860. The payable
under a repurchase agreement accounted for as a
collateralized borrowing refers to the amount of the
seller-borrower’s obligation recognized for the future
repurchase of the securities from the buyer-lender. In
certain industries, the terminology is reversed; that is,
entities in those industries refer to this type of agreement
as a reverse repo.
Restatement
The process of revising previously issued financial
statements to reflect the correction of an error in those
financial statements.
Retrospective Application
The application of a different accounting principle to one or
more previously issued financial statements, or to the
statement of financial position at the beginning of the
current period, as if that principle had always been used,
or a change to financial statements of prior accounting
periods to present the financial statements of a new
reporting entity as if it had existed in those prior
years.
Revenue
Inflows or other enhancements of assets of an entity or
settlements of its liabilities (or a combination of both)
from delivering or producing goods, rendering services, or
other activities that constitute the entity’s ongoing major
or central operations.
Reverse Repurchase Agreement Accounted for as a
Collateralized Borrowing
A reverse repurchase agreement accounted for as a
collateralized borrowing (also known as a reverse repo)
refers to a transaction that is accounted for as a
collateralized lending in which a buyer-lender buys
securities with an agreement to resell them to the
seller-borrower at a stated price plus interest at a
specified date or in specified circumstances. The receivable
under a reverse repurchase agreement accounted for as a
collateralized borrowing refers to the amount due from the
seller-borrower for the repurchase of the securities from
the buyer-lender. In certain industries, the terminology is
reversed; that is, entities in those industries refer to
this type of agreement as a repo.
Right of Setoff
A right of setoff is a debtor’s legal right, by contract or
otherwise, to discharge all or a portion of the debt owed to
another party by applying against the debt an amount that
the other party owes to the debtor.
Risk Premium
Compensation sought by risk-averse market participants for
bearing the uncertainty inherent in the cash flows of an
asset or a liability. Also referred to as a risk
adjustment.
Secured Overnight Financing Rate (SOFR) Overnight Index
Swap Rate
The fixed rate on a U.S. dollar, constant-notional interest
rate swap that has its variable-rate leg referenced to the
Secured Overnight Financing Rate (SOFR) (an overnight rate)
with no additional spread over SOFR on that variable-rate
leg. That fixed rate is the derived rate that would result
in the swap having a zero fair value at inception because
the present value of fixed cash flows, based on that rate,
equates to the present value of the variable cash flows.
Securities and Exchange Commission (SEC)
Filer
An entity that is required to file or furnish its financial
statements with either of the following:
-
The Securities and Exchange Commission (SEC)
-
With respect to an entity subject to Section 12(i) of the Securities Exchange Act of 1934, as amended, the appropriate agency under that Section.
Financial statements for other entities that are not
otherwise SEC filers whose financial statements are included
in a submission by another SEC filer are not included within
this definition.
Securities Industry and Financial Markets Association
(SIFMA) Municipal Swap Rate
The fixed rate on a U.S. dollar, constant-notional interest
rate swap that has its variable-rate leg referenced to the
Securities Industry and Financial Markets Association
(SIFMA) Municipal Swap Index with no additional spread over
the SIFMA Municipal Swap Index on that variable-rate leg.
That fixed rate is the derived rate that would result in the
swap having a zero fair value at inception because the
present value of fixed cash flows, based on that rate,
equates to the present value of the variable cash flows.
Securitization
The process by which financial assets are transformed into
securities.
Security
A share, participation, or other interest in property or in
an entity of the issuer or an obligation of the issuer that
has all of the following characteristics:
- It is either represented by an instrument issued in bearer or registered form or, if not represented by an instrument, is registered in books maintained to record transfers by or on behalf of the issuer.
- It is of a type commonly dealt in on securities exchanges or markets or, when represented by an instrument, is commonly recognized in any area in which it is issued or dealt in as a medium for investment.
- It either is one of a class or series or by its terms is divisible into a class or series of shares, participations, interests, or obligations.
Set-Off Right
A common law right of a party that is both a debtor and a
creditor to the same counterparty to reduce its obligation
to that counterparty if that counterparty fails to pay its
obligation.
Share-Based Payment Arrangements
An arrangement under which either of the following conditions
is met:
- One or more suppliers of goods or services (including employees) receive awards of equity shares, equity share options, or other equity instruments.
- The entity incurs liabilities to suppliers that meet
either of the following conditions:
- The amounts are based, at least in part, on the price of the entity’s shares or other equity instruments. (The phrase at least in part is used because an award may be indexed to both the price of the entity’s shares and something other than either the price of the entity’s shares or a market, performance, or service condition.)
- The awards require or may require settlement by issuance of the entity’s shares.
The term shares includes various forms of ownership interest
that may not take the legal form of securities (for example,
partnership interests), as well as other interests,
including those that are liabilities in substance but not in
form. Equity shares refers only to shares that are accounted
for as equity.
Also called share-based compensation arrangements.
Shares
Shares includes various forms of ownership that may not take
the legal form of securities (for example, partnership
interests), as well as other interests, including those that
are liabilities in substance but not in form. (Business
entities have interest holders that are commonly known by
specialized names, such as stockholders, partners, and
proprietors, and by more general names, such as investors,
but all are encompassed by the descriptive term owners.
Equity of business entities is, thus, commonly known by
several names, such as owners’ equity, stockholders’ equity,
ownership, equity capital, partners’ capital, and
proprietorship. Some entities [for example, mutual
organizations] do not have stockholders, partners, or
proprietors in the usual sense of those terms but do have
participants whose interests are essentially ownership
interests, residual interests, or both.)
Short-Term Obligations
Short-term obligations are those that are scheduled to mature
within one year after the date of an entity’s balance sheet
or, for those entities that use the operating cycle concept
of working capital described in paragraphs 210-10-45-3 and
210-10-45-7, within an entity’s operating cycle that is
longer than one year.
Spot Rate
The exchange rate for immediate delivery of currencies
exchanged.
Springing Lock-Box Arrangement
Some borrowings outstanding under a revolving credit
agreement include both a subjective acceleration clause and
a requirement to maintain a springing lock-box arrangement,
whereby remittances from the borrower’s customers are
forwarded to the debtor’s general bank account and do not
reduce the debt outstanding until and unless the lender
exercises the subjective acceleration clause.
Standard Antidilution Provisions
Standard antidilution provisions are those that result in
adjustments to the conversion ratio in the event of an
equity restructuring transaction that are designed to
maintain the value of the conversion option.
Standstill Agreement
An agreement signed by the investee and investor under which
the investor agrees to limit its shareholding in the
investee.
Step Bonds
Bonds that involve a combination of deferred-interest payment
dates and increasing interest payment amounts over the bond
lives and, thus, bear some similarity to zero-coupon bonds
and to traditional debentures.
Stock Dividend
An issuance by a corporation of its own common shares to its
common shareholders without consideration and under
conditions indicating that such action is prompted mainly by
a desire to give the recipient shareholders some ostensibly
separate evidence of a part of their respective interests in
accumulated corporate earnings without distribution of cash
or other property that the board of directors deems
necessary or desirable to retain in the business. A stock
dividend takes nothing from the property of the corporation
and adds nothing to the interests of the stockholders; that
is, the corporation’s property is not diminished and the
interests of the stockholders are not increased. The
proportional interest of each shareholder remains the
same.
Stock Split
An issuance by a corporation of its own common shares to its
common shareholders without consideration and under
conditions indicating that such action is prompted mainly by
a desire to increase the number of outstanding shares for
the purpose of effecting a reduction in their unit market
price and, thereby, of obtaining wider distribution and
improved marketability of the shares. Sometimes called a
stock split-up.
Stub Period
Interest rate swaps with variable rates based on the London
Interbank Offered Rate (LIBOR) typically reset at
three-month or six-month intervals. Often, swaps may trade
on interim dates that do not correspond to a swap reset
date. Calendar dates that are swap reset and payment dates
are set by market convention. A swap that resets quarterly
may have a first payment period that is shorter than a full
quarter, such as 30 days versus 90 days. Because the first
payment period is not equal to a full quarter, it is
referred to as a stub period. That stub period is the period
that begins on the date coupon payments begin to accrue and
ends on the first payment date.
Stub Rate
The stub rate is the variable rate that corresponds to the
length of a stub period.
Subjective Acceleration Clause
A subjective acceleration clause is a provision in a debt
agreement that states that the creditor may accelerate the
scheduled maturities of the obligation under conditions that
are not objectively determinable (for example, if the debtor
fails to maintain satisfactory operations or if a material
adverse change occurs).
Subsequent Events
Events or transactions that occur after the balance sheet
date but before financial statements are issued or are
available to be issued. There are two types of subsequent
events:
- The first type consists of events or transactions that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements (that is, recognized subsequent events).
- The second type consists of events that provide evidence about conditions that did not exist at the date of the balance sheet but arose subsequent to that date (that is, nonrecognized subsequent events).
Subsidiary
An entity, including an unincorporated entity such as a
partnership or trust, in which another entity, known as its
parent, holds a controlling financial interest. (Also, a
variable interest entity that is consolidated by a primary
beneficiary.)
Substantive Conversion Feature
A conversion feature that is at least reasonably possible of
being exercisable in the future absent the issuer’s exercise
of a call option.
Synthetic Instrument Accounting
Synthetic instrument accounting views two or more distinct
financial instruments (generally a cash instrument and a
derivative instrument) as having synthetically created
another single cash instrument. The objective of synthetic
instrument accounting is to present those multiple
instruments in the financial statements as if they were the
single instrument that the entity sought to create.
Paragraph 815-10-25-4 states that synthetic instrument
accounting is prohibited.
Time of Issuance
The date when agreement as to terms has been reached and
announced, even though the agreement is subject to certain
further actions, such as directors’ or stockholders’
approval.
Time of Restructuring
Troubled debt restructurings may occur before, at, or after
the stated maturity of debt, and time may elapse between the
agreement, court order, and so forth, and the transfer of
assets or equity interest, the effective date of new terms,
or the occurrence of another event that constitutes
consummation of the restructuring. The date of consummation
is the time of the restructuring.
Time Value of an Option
The time value of an option is equal to the fair value of an
option less its intrinsic value.
Transaction
An external event involving transfer of something of value
(future economic benefit) between two (or more) entities.
(See FASB Concepts Statement No. 6, Elements of Financial
Statements.)
Transaction Costs
The costs to sell an asset or transfer a liability in the
principal (or most advantageous) market for the asset or
liability that are directly attributable to the disposal of
the asset or the transfer of the liability and meet both of
the following criteria:
- They result directly from and are essential to that transaction.
- They would not have been incurred by the entity had the decision to sell the asset or transfer the liability not been made (similar to costs to sell, as defined in paragraph 360-10-35-38).
Transaction Date
The date at which a transaction (for example, a sale or
purchase of merchandise or services) is recorded in
accounting records in conformity with generally accepted
accounting principles (GAAP). A long-term commitment may
have more than one transaction date (for example, the due
date of each progress payment under a construction contract
is an anticipated transaction date).
Transaction Gain or Loss
Transaction gains or losses result from a change in exchange
rates between the functional currency and the currency in
which a foreign currency transaction is denominated. They
represent an increase or decrease in both of the
following:
- The actual functional currency cash flows realized upon settlement of foreign currency transactions
- The expected functional currency cash flows on unsettled foreign currency transactions.
Translation
See Foreign Currency Translation.
Translation Adjustments
Translation adjustments result from the process of
translating financial statements from the entity’s
functional currency into the reporting currency.
Treasury Stock Method
A method of recognizing the use of proceeds that could be
obtained upon exercise of options and warrants in computing
diluted EPS. It assumes that any proceeds would be used to
purchase common stock at the average market price during the
period.
Troubled Debt Restructuring
A restructuring of a debt constitutes a troubled debt
restructuring if the creditor for economic or legal reasons
related to the debtor’s financial difficulties grants a
concession to the debtor that it would not otherwise
consider.
Underlying
A specified interest rate, security price, commodity price,
foreign exchange rate, index of prices or rates, or other
variable (including the occurrence or nonoccurrence of a
specified event such as a scheduled payment under a
contract). An underlying may be a price or rate of an asset
or liability but is not the asset or liability itself. An
underlying is a variable that, along with either a notional
amount or a payment provision, determines the settlement of
a derivative instrument.
Unit of Account
The level at which an asset or a liability is aggregated or
disaggregated in a Topic for recognition purposes.
Units-of-Revenue Method
A method of amortizing deferred revenue that arises under
certain sales of future revenues. Under this method,
amortization for a period is calculated by computing a ratio
of the proceeds received from the investor to the total
payments expected to be made to the investor over the term
of the agreement, and then applying that ratio to the
period’s cash payment.
Unobservable Inputs
Inputs for which market data are not available and that are
developed using the best information available about the
assumptions that market participants would use when pricing
the asset or liability.
Violation of a Provision
The failure to meet a condition in a debt agreement or a
breach of a provision in the agreement for which compliance
is objectively determinable, whether or not a grace period
is allowed or the creditor is required to give notice of its
intention to demand repayment.
Warrant
A security that gives the holder the right to purchase shares
of common stock in accordance with the terms of the
instrument, usually upon payment of a specified amount.
Weather Derivative
A forward-based or option-based contract for which settlement
is based on a climatic or geological variable. One example
of such a variable is the occurrence or nonoccurrence of a
specified amount of snow at a specified location within a
specified period of time.
Working Capital
Working capital (also called net working capital) is
represented by the excess of current assets over current
liabilities and identifies the relatively liquid portion of
total entity capital that constitutes a margin or buffer for
meeting obligations within the ordinary operating cycle of
the entity.
Zero-Coupon Method
A swap valuation method that involves computing and summing
the present value of each future net settlement that would
be required by the contract terms if future spot interest
rates match the forward rates implied by the current yield
curve. The discount rates used are the spot interest rates
implied by the current yield curve for hypothetical zero
coupon bonds due on the date of each future net settlement
on the swap.
Appendix C — Titles of Standards and Other Literature
Appendix C — Titles of Standards and Other Literature
AICPA Literature
Technical Questions and Answers
Section 1100, “Statement of Financial Position”
- Section 1100.14, “Classification of Convertible Debt”
Section 3200, “Long-Term Debt”
- Section 3200.12, “Balance Sheet Classification of Revolving Line of Credit”
- Section 3200.13, “Uncertainty Arising From Violation of Debt Agreement”
- Section 3200.15, “Disclosure of Five-Year Maturities on Long-Term Debt”
- Section 3200.17, “Disclosure of Covenant Violation and Subsequent Bank Waiver”
Section 3500, “Commitments”
- Section 3500.06, “Covenants Imposed by Loan Agreements”
- Section 3500.07, “Disclosure of Unused Lines of Credit”
Section 4110, “Issuance of Capital Stock”
- Section 4110.01, “Expenses Incurred in Public Sale of Capital Stock”
- Section 4110.10, “Costs Incurred in Shelf Registration”
Section 4160, “Contributed Capital”
- Section 4160.01, “Payment of Corporate Debt by Stockholders”
Section 5220, “Interest Expense”
- Section 5220.07, “Imputed Interest on Note Exchanged for Cash Only”
FASB Literature
ASC Topics
ASC 210, Balance Sheet
ASC 230, Statement of Cash Flows
ASC 235, Notes to Financial Statements
ASC 250, Accounting Changes and Error Corrections
ASC 260, Earnings per Share
ASC 310, Receivables
ASC 320, Investments — Debt Securities
ASC 323, Investments — Equity Method and Joint Ventures
ASC 326, Financial Instruments — Credit Losses
ASC 340, Other Assets and Deferred Costs
ASC 360, Property, Plant, and Equipment
ASC 405, Liabilities
ASC 410, Asset Retirement and Environmental Obligations
ASC 420, Exit or Disposal Cost Obligations
ASC 430, Deferred Revenue
ASC 440, Commitments
ASC 450, Contingencies
ASC 460, Guarantees
ASC 470, Debt
ASC 480, Distinguishing Liabilities From Equity
ASC 505, Equity
ASC 606, Revenue From Contracts With Customers
ASC 712, Compensation — Nonretirement Postemployment Benefits
ASC 715, Compensation — Retirement Benefits
ASC 718, Compensation — Stock Compensation
ASC 740, Income Taxes
ASC 805, Business Combinations
ASC 810, Consolidation
ASC 815, Derivatives and Hedging
ASC 820, Fair Value Measurement
ASC 825, Financial Instruments
ASC 830, Foreign Currency Matters
ASC 835, Interest
ASC 842, Leases
ASC 848, Reference Rate Reform
ASC 850, Related Party Disclosures
ASC 852, Reorganizations
ASC 855, Subsequent Events
ASC 860, Transfers and Servicing
ASC 940, Financial Services — Brokers and Dealers
ASC 942, Financial Services — Depository and Lending
ASC 944, Financial Services — Insurance
ASC 946, Financial Services — Investment Companies
ASC 960, Plan Accounting — Defined Benefit Pension Plans
ASC 962, Plan Accounting — Defined Contribution Pension Plans
ASC 980, Regulated Operations
ASU
ASU 2015-03, Interest — Imputation of Interest (Subtopic 835-30):
Simplifying the Presentation of Debt Issuance Costs
Concepts Statements
No. 5, Recognition and Measurement in Financial Statements of Business
Enterprises
No. 7, Using Cash Flow Information and Present Value in Accounting
Measurements
Proposed ASU
No. 2023-ED600, Debt — Debt with
Conversion and Other Options (Subtopic 470-20): Induced Conversions of
Convertible Debt Instruments — a consensus of the Emerging Issues
Task Force
IFRS Literature
IAS 1, Presentation of Financial Statements
IAS 32, Financial Instruments: Presentation
IFRS 7, Financial Instruments: Disclosures
IFRS 9, Financial Instruments
SEC Literature
Accounting Series Releases (ASRs)
No. 148 (FRR 203.01), Reasons for Requirements
No. 148 (FRR 203.04), Unused Lines of Credit or Commitments
No. 268 (FRR 211), Presentation in Financial Statements
of “Redeemable Preferred Stocks”
Codified Financial Reporting Release
Section 211, “Redeemable Preferred Stocks”
Regulation S-X
Rule 3-10, “Financial Statements of Guarantors and Issuers of Guaranteed
Securities Registered or Being Registered”
Rule 4-08, “General Notes to Financial Statements”
Rule 5-02, “Commercial and Industrial Companies; Balance
Sheets”
Rule 6-04, “Registered Investment Companies and Business
Development Companies; Balance Sheets”
Rule 7-03, “Insurance Companies; Balance Sheets”
Rule 8-01, “Preliminary Notes to Article 8”
Rule 9-03, “Bank Holding Companies; Balance Sheets”
Rule 13-01, “Guarantors and Issuers of Guaranteed Securities Registered or
Being Registered”
Rule 13-02, “Affiliates Whose Securities Collateralize Securities Registered
or Being Registered”
SAB Topics
No. 2.A.6, “Business Combinations; Debt Issue Costs in
Conjunction With a Business Combination”
No. 4.A, “Equity Accounts; Subordinated Debt”
No. 5.A, “Miscellaneous Accounting; Expenses of
Offering”
No. 6.H.2, “Interpretations of Accounting Series Releases
and Financial Reporting Releases; Classification of Short-Term Obligations —
Debt Related to Long-Term Projects”
Securities Act of 1933
Rule 144, “Selling Restricted and Control Securities”
Securities Exchange Act of 1934
Rule 10b-5, “Employment of Manipulative and Deceptive Practices”
Rule 12b-20, “Additional Information”
Section 12(i), “Registration Requirements for Securities; Securities Issued
by Banks”
Section 13, “Periodical and Other Reports”
Section 15(d), “Registration and Regulation of Brokers and Dealers;
Supplementary and Periodic Information”
Superseded Literature
EITF Abstract
Issue No. 02-4, “Determining Whether a Debtor’s Modification
or Exchange of Debt Instruments Is Within the Scope of FASB Statement No.
15”
Appendix D — Abbreviations
Appendix D — Abbreviations
|
Abbreviation
|
Description
|
|---|---|
|
AICPA
|
American Institute of Certified Public
Accountants
|
|
AOCI
|
accumulated other comprehensive income
|
|
APIC
|
additional paid-in capital
|
|
ARS
|
auction rate security
|
|
ASC
|
FASB Accounting Standards Codification
|
|
ASR
|
SEC Accounting Series Release
|
|
ASU
|
FASB Accounting Standards Update
|
|
CCF
|
cash conversion feature
|
|
CoCo
|
contingently convertible instrument
|
|
CPI
|
consumer price index
|
|
CUSIP
|
Committee on Uniform Security Identification
Procedures
|
|
EBITDA
|
earnings before interest, taxes,
depreciation, and amortization
|
|
EITF
|
FASB Emerging Issues Task Force
|
|
EPS
|
earnings per share
|
|
ESG
|
environmental, social, and governance
|
|
FASB
|
Financial Accounting Standards Board
|
|
GAAP
|
generally accepted accounting principles
|
|
GBP
|
British pound sterling
|
|
HLFV
|
hypothetical liquidation at fair value
|
|
IFRS
|
International Financial Reporting
Standard
|
|
IPO
|
initial public offering
|
|
LIBOR
|
London Interbank Offered Rate
|
|
OCA
|
SEC Office of the Chief Accountant
|
|
OCI
|
other comprehensive income
|
|
PCAOB
|
Public Company Accounting Oversight
Board
|
|
PIK
|
paid-in-kind
|
|
RPI
|
retail prices index
|
|
SAB
|
SEC Staff Accounting Bulletin
|
|
SAC
|
subjective acceleration clause
|
|
SBIC
|
small business investment company
|
|
SD
|
sum of the digits
|
|
SEC
|
Securities and Exchange Commission
|
|
SOFR
|
Secured Overnight Financing Rate
|
|
SVPP
|
structured vendor payable program
|
|
SYD
|
sum-of-the-years’ digits
|
|
TDR
|
troubled debt restructuring
|
|
USD
|
U.S. dollar
|
|
VIE
|
variable interest entity
|
|
VSF
|
variable-share forward
|
Appendix E — Roadmap Updates for 2024
Appendix E — Roadmap Updates for 2024
The table below summarizes the
substantive changes made in the 2024 edition of this Roadmap.
|
Section
|
Title
|
Description
|
|---|---|---|
|
Pushdown of Parent Debt to a Subsidiary
|
Added guidance on the pushdown of interest
expense in a subsidiary’s separate financial statements.
| |
|
Background
|
Included guidance on when the allocation
methods apply to debt issued with other instruments.
| |
|
Fair Value Exceeds Debt Proceeds
|
Added Connecting the Dots to
address the application of the guidance to instruments whose
fair value exceeds the proceeds received.
| |
|
Debt With Detachable Warrants
|
Simplified discussion and added considerations related to the
separate accounting for other transaction elements.
| |
|
Qualifying Debt Issuance Costs
|
Added Connecting the Dots
that provides the SEC staff’s view on costs incurred to
obtain audited financial statements.
| |
|
PIK Interest
|
Updated guidance on the accounting for PIK
interest.
| |
|
Equity Conversion Features
|
Added guidance on the unit of account for
embedded derivative features.
| |
|
Redemption Features
|
Added Connecting the Dots to
address the evaluation of certain call options.
| |
|
Cash Flows of New Debt
|
Clarified guidance on additional borrowings
and prepayments made in conjunction with a modification of
debt; also enhanced Example 10-3.
| |
|
Foreclosures and Repossessions
|
Revised guidance on settlements of
nonrecourse loans.
| |
|
Unit of Account
|
Amended guidance to more comprehensively
address the unit of account associated with a debtor’s
application of TDR accounting.
| |
|
Related-Party Transactions
|
Added guidance to address the debtor’s evaluation of whether
the creditor is a related party for TDR accounting purposes.
| |
|
Subsequent Accounting
|
Included guidance on contingent payments
that expire before the maturity date of restructured
debt.
| |
|
Scope
|
Simplified the discussion of the scope of
conversion accounting.
| |
|
Convertible Debt With No Equity
Component
|
Simplified the discussion of conversion accounting, including
(1) amending Connecting the
Dots in Section
12.3.2 to address the accounting implications
of an issuer’s irrevocable election to settle a conversion
partially or fully in cash and (2) adding Changing Lanes in Section 12.3.4.1 to discuss
a proposed ASU on the application of induced conversion
accounting.
| |
|
Convertible Debt With a Bifurcated Embedded Conversion
Feature
|
Simplified the discussion of the accounting
for conversion of a debt instrument with a bifurcated
embedded conversion option.
| |
|
Disclosure
|
Added guidance on the scope of the
disclosures for supplier finance programs.
|