A.8 Credit-Sensitive Payments
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).
With the exception of certain inflation-indexed payment features addressed in ASC 815-15-25-50, if a contingent payment feature embedded in a debt host contract is not an interest rate-related underlying and is not considered a credit-sensitive payment, it is not clearly and closely related to the debt host contract and must be bifurcated as an embedded derivative under ASC 815-15-25-1(a) if the conditions in ASC 815-15-25-1(b) and (c) are met.
Convertible debt instruments often contain provisions that require the issuer to pay additional interest upon the occurrence of an “event of default.” Depending on the situations that result in an event of default, as defined in the convertible debt agreement, such a contingent payment may not be considered a credit-sensitive payment and therefore may not be considered clearly and closely related to the debt host. The table below discusses common situations that may be described as events of default and whether such triggering events constitute a credit-sensitive payment.
Triggering Event | Credit-Sensitive Payment? |
|---|---|
Any representation or warranty made by the issuer that is not correct | Yes |
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 |
Bankruptcy or insolvency | Yes |
Cross default on other indebtedness | Yes, unless the default on the other indebtedness arises from events that are not credit-related |
Invalidity of or failure to maintain loan or collateral documents | Yes |
Nonpayment of principal or interest when due | Yes |
Judgments or orders against the issuer exceeding a specific amount | Yes |
Revocation of a license or permit to perform business operations that results in a material adverse effect | Yes |
Criminal events of the issuer | Yes |
A change in control of the issuer | No |
Key person event | Depends on facts and circumstances |