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
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
Convertible debt is issued at a substantial premium.
The debt is subsequently accounted for at fair value under the fair
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 (after the adoption of ASU 2020-06), 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
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
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
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
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
For a comprehensive discussion of the classification, initial
and subsequent measurement, and presentation and disclosure of debt, including
convertible debt, see Deloitte’s Roadmap Issuer’s Accounting for Debt, which
incorporates the guidance in ASU 2020-06. For a discussion of the issuer’s
accounting for such debt before that ASU’s adoption, see Deloitte’s Roadmap
(Before Adoption of ASU 2020-06).