Subjective acceleration clauses
Short-term obligations expected to be refinance
Example of short-term obligation expected to be refinance
ASC 470-20, Debt with Conversion and Other Options
Example of the market value method
Accrued interest upon conversion of convertible debt
Convertible bonds with a “premium put”
Debt convertible into the stock of a consolidated subsidiary
Accounting for a convertible instrument granted or issued to a nonemployee
Convertible bonds with issuer option to settle for cash upon conversion
Own-share lending arrangements related to a convertible debt issuance
Convertible Securities with Beneficial or Contingent Conversion Features
Example 1: Intrinsic value of a conversion feature—fixed dollar terms
Example 2: Intrinsic value of a conversion feature—variable terms
Example 3: Intrinsic value of a conversion feature—contingent price terms
Example 4: Intrinsic value of a conversion feature—contingent feature
Example 5: Intrinsic value of a conversion feature—contingent conversion with variable terms
Example of extinguishment of debt with an embedded conversion feature
Contingent conversion rights triggered by issuer call
Disclosure of contingently convertible securities
Determining applicability of ASC 470-20
Example of induced conversion expense
Debt Issued with Stock Warrants
Example of accounting for a bond with a detachable warrant
Debt Issued with Conversion Features and Stock Warrants
Example of convertible debt issued with stock warrants
ASC 470-30, Participating Mortgage Loans
Accounting by participating mortgage loan borrowers
ASC 470-40, Product Financing Arrangements
Example of a product financing arrangement
ASC 470-50, Modifications and Extinguishments
Modifications to conversion privileges
Gain or loss on debt extinguishment
Example of accounting for the extinguishment of debt
ASC 470-60, Troubled Debt Restructurings by Debtors
Is the debtor experiencing financial difficulty?
Has the creditor granted a concession?
Example 1: Settlement of debt by exchange of assets
Example 2: Restructuring with gain/loss recognized (payments are less than carrying value)
Example 3: Restructuring with no gain/loss recognized (payments exceed carrying value)
Example 4: Contingent payments
Measuring Liabilities at Fair Value
ASC 470, Debt, consists of six subtopics:
ASC 470-20. ASC 470-20 is divided into two subsections:
General Subsection. The guidance in the General Subsections does not apply to those instruments within the scope of the Cash Conversion Subsections. The guidance on own-share lending arrangements applies to an equity-classified share-lending arrangement on an entity's own shares when executed in contemplation of a convertible debt offering or other financing.
The guidance in this Section shall be considered after consideration of the guidance in Subtopic 815-15 on bifurcation of embedded derivatives, as applicable (see paragraph 815-15-55-76A).
Cash Conversion Subsections. The guidance in the Cash Conversion Subsections applies only to convertible debt instruments that may be settled in cash (or other assets) upon conversion, unless the embedded conversion option is required to be separately accounted for as a derivative instrument under Subtopic 815-15.
The Cash Conversion Subsections do not apply to any of the following instruments:
For purposes of determining whether an instrument is within the scope of the Cash Conversion Subsections, a convertible preferred share shall be considered a convertible debt instrument if it has both of the following characteristics:
ASC 470-30. ASC 470-30 does not apply to creditors in participating mortgage loan arrangements and to the following transactions:
ASC 470-40. The guidance in ASC 470-40 applies to product financing arrangements for “products that have been produced by or were originally purchased by the sponsor or purchased by another entity on behalf of the sponsor.” The arrangement must have the following characteristics:
(ASC 470-40-15-2)
ASC 470-40 does not apply to the following transactions and activities:
(ASC 470-40-15-3)
ASC 470-50. ASC 470-50 does not apply to the following transactions and activities:
(ASC 470-50-15-3)
Long-term (or noncurrent) liabilities are liabilities that will be paid or otherwise settled over a period of more than one year, or if longer, greater than one operating cycle.
Debt remains on the books of the debtor until it is extinguished. In most cases, a debt is extinguished at maturity, when the required principal and interest payments have been made and the debtor has no further obligation to the creditor. In other cases, the debtor may desire to extinguish the debt before its maturity. For example, if market interest rates are falling, a debtor may choose to issue debt at the new lower rate and use the proceeds to retire older higher-interest-rate debt. ASC 405-20-40-1 states that a debt is extinguished if either of two conditions is met.
If a debtor experiences financial difficulties before the debt is repaid, a creditor may need to recognize an impairment of the debt. Under ASC 310-10-35-16, an impairment of the debt is recognized when the present value of the expected future cash flows discounted at the debt's original effective interest rate is less than the recorded investment in the debt. If for economic or legal reasons related to the debtor's financial difficulties, the creditor grants the debtor concessions that would not otherwise have been granted, the debtor must determine how to recognize the effects of the troubled debt restructuring (ASC 470-60).
Some debt is issued with terms that allow it to be converted to an equity instrument (common or, less often, preferred stock) at a future date. When issued, under current GAAP, no value is attributed to the conversion feature. When the debt is converted, the stock issued is generally valued at the carrying value of the debt (ASC 470). In certain situations, a debtor will modify the conversion privileges after issuance of the debt in order to induce prompt conversion of the debt into equity, in which case the debtor must recognize an expense for this consideration (ASC 470-20-40-16).
Debt can also be issued with stock warrants, which allow the holder to purchase a stated number of common shares at a certain price within a defined time period. If debt is issued with detachable warrants, the proceeds of issuance are allocated between the two financial instruments (ASC 470-20-05).
Source: ASC 470
Beneficial Conversion Feature. A nondetachable conversion feature that is in the money at the commitment date.
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.
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.
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).
Debt. A receivable or 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 liability in the creditor's or debtor's balance sheet at the time of the restructuring.
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.
Firm Commitment. An agreement with an unrelated party, binding on both parties and usually legally enforceable, with the following characteristics:
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.
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.
Operating Cycle. The average time intervening between the acquisition of materials or services and the final cash realization constitutes an operating cycle.
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 Entity. An entity that meets any of the following criteria:
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.
Reasonably Possible. The chance of the future event or events occurring is more than remote but less than likely.
Recorded Investment in the Receivable. The recorded investment in the receivable is the face amount increased or decreased by applicable accrued interest and unamortized premium, discount, finance charges, or acquisition costs and may also reflect a previous direct write-down of the investment.
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.
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).
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.
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.
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.
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.
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.
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.
The currently maturing portion of long-term debt or of capital lease obligations are classified as current liabilities if the obligations are to be liquidated by using assets classified as current. However, if the currently maturing debt is to be liquidated by using noncurrent assets (i.e., by using a sinking fund that is properly classified as a noncurrent investment) then these obligations are to be classified as long-term liabilities.
Obligations that, by their terms, are due on demand (ASC 47010-45-10) or will be due on demand within one year (or the reporting entity's operating cycle, if longer) from the statement of financial position date, even if liquidation is not expected to occur within that period, are required to be classified as current liabilities.
Even noncurrent debt may be due on demand under certain circumstances. Long-term obligations that contain creditor call provisions are to be classified as current liabilities, if as of the statement of financial position date the debtor is in violation of the agreement and either:
If either of these two conditions exist, the long-term obligation is required to be classified as a current liability unless either:
If either of these situations applies, management is required to disclose the circumstances in the financial statements.
Demand notes with scheduled repayment terms. In some instances, a demand loan will include a repayment schedule calling for scheduled principal reductions. The loan agreement may contain language such as the following examples:
This term note shall mature in monthly installments as set forth herein, or on demand, whichever is earlier.
Principal and interest are due on demand, or if demand is not made, in quarterly installments commencing on . . .
Under ASC 470-10-45-10, an obligation containing such terms is considered due on demand even though the debt agreement specifies repayment terms. In either instance, the creditor, at its sole discretion, can demand full repayment at any time. This situation is distinguished from a subjective acceleration clause, which is addressed separately below.
Arrangements commonly referred to as “increasing-rate notes” are debt instruments that mature at a defined, near-term date, but which can be continually extended (renewed) by the borrower for a defined longer period of time with predefined increases in the interest rate as extensions are elected.
Management of the borrower estimates the effective outstanding term of the debt after considering its plans, ability and intent to service the debt. Based upon this estimated term, the borrower's periodic interest rate is determined using the interest method. Thus, a constant yield is computed over the estimated term resulting in the accrual of additional interest during the earlier portions of the term.
Debt interest costs are amortized over the estimated outstanding term of the debt using the interest method. Any excess accrued interest resulting from repaying the debt prior to the estimated maturity date is an adjustment of interest expense in the period of repayment. The adjustment is not permitted to be treated as an extraordinary item.
The classification of the debt as current or noncurrent is based on the expected source of repayment. Thus, this classification need not be consistent with the period used to determine the periodic interest cost. For example, the time frame used for the estimated outstanding term of the debt could be a year or less, but because of a planned long-term refinancing agreement the noncurrent classification could be used.
Furthermore, the term-extending provisions of the debt instrument are evaluated to ascertain whether they constitute a derivative financial instrument under ASC 815. If so, the derivative element of the instrument is, in all likelihood, not considered “clearly and closely related” to the host instrument (the debt), and thus would have to be reported separately at fair value with changes in fair value reported in net income each period.
Long-term obligations that contain subjective acceleration clauses are classified as current liabilities if circumstances (such as recurring losses or liquidity problems) indicate that it is probable that the lender will exercise its rights under the clause and demand repayment within one year (or one operating cycle, if longer). If, on the other hand, the likelihood of the acceleration of the due date is remote, the obligation continues to be classified as long-term debt on the statement of financial position. Situations between the probable and remote thresholds (i.e., it is deemed reasonably possible that the lender would demand repayment) require disclosure of the existence of the provision of the agreement (ASC 470-10-45).
Most commercial debt agreements contain a range of financial covenants. These covenants legally bind the borrower to comply with their requirements as a condition of the lender extending credit. The failure by the borrower to comply with these conditions often provides the lender with the contractual right to accelerate the due date, commonly to declare the full amount of the debt due and payable on demand. Unless a properly worded waiver is obtained by the borrower in such a situation, its statement of financial position would have to reflect the debt, that which would otherwise be classified as long-term, as a current liability. This in turn might create or complicate issues for management with respect to the assessment of whether there is substantial doubt about the ability of the reporting entity to continue as a going concern.
While a complete waiver, effectively a promise by the lender that it will not exercise its rights under the financial covenants for at least one year from the statement of financial position date, makes it possible to continue presenting the debt as noncurrent, great care must be exercised in interpreting the substance of such an agreement.
In practice, many waivers are not effective and cannot form the basis for continued accounting for the debt as noncurrent. For example, a waiver “as of” the current statement of financial position date provides no real comfort, since the lender is entitled to assert its rights as soon as the very next day. Likewise, a waiver pending (i.e., conditioned on) compliance with the covenants at the next scheduled submission of a borrower's covenant compliance letter (generally quarterly, possibly monthly) offers no assurance that the borrower will successfully meet its obligations, and hence also affords no basis for presentation of the debt as noncurrent.
A loan covenant may require that compliance determinations be made at quarterly or semiannual intervals. A borrower may be in violation of the covenant at the end of its fiscal year and obtain a waiver from the lender, for a period greater than one year, of the lender's right to demand repayment arising from that specific year-end violation. Often, however, the lender will include language in the waiver document that reserves its right to demand repayment should another violation occur at a subsequent measurement date, including those dates that occur during the ensuing year.
Under these circumstances, management of the borrower/reporting entity considers whether both of the following conditions exist under the specific circumstances:
If both of these conditions are present, the borrower is required to classify the debt as a current liability; otherwise, it can continue to classify the debt as noncurrent.
Borrowings outstanding under a revolving credit agreement sometimes include both a subjective acceleration clause (as discussed above) and a requirement to maintain a lockbox into which the borrower's customers send remittances that are then used to reduce the debt outstanding. These borrowings are short-term obligations and are classified as current liabilities unless the entity has the intent and ability to refinance the revolving credit agreement on a long-term basis (i.e., the conditions in ASC 470-10-45, as discussed below, are met). However, if the lockbox is a springing lockbox, which is a lockbox agreement in which remittances from the borrower's customers are forwarded to its general bank account and do not reduce the debt outstanding unless the lender exercises the subjective acceleration clause, the obligations are still considered to be long-term since the remittances do not automatically reduce the debt outstanding if the acceleration clause has not been exercised.
Occasionally, debt instruments are issued with guaranteed and contingent payments. The contingent payments may be linked to a specific index, like the S&P 500 or the price for a specific commodity. If the right to receive the indexing feature is separable from the debt instrument, the proceeds are allocated between the debt instrument and investor's stated right to receive the contingent payment. (ASC 410-10-25-3 and 25-4)
Short-term obligations that arise in the normal course of business and are due under customary trade terms are classified as current liabilities. Under certain circumstances, however, the reporting entity is permitted to exclude all or a portion of these obligations from current liabilities. To qualify for this treatment, management must have both the intent and ability to refinance the obligation on a long-term basis. Management's intent is to be supported by either of the following (ASC 470-10-45-14):
For the purposes of condition 2b above, violation of a provision is defined as a failure of the reporting entity to meet a condition included in the agreement; or the violation of a provision such as a restrictive covenant, representation, or warranty. A violation is not to be disregarded for this purpose, even if the agreement contains a grace period to cure it and/or if the lender is required to give the borrower notice. The requirement that compliance be objectively determinable or measurable precludes commitments that include subjective acceleration clauses (discussed previously) from being considered qualified financing agreements.
The above scenario is based on an assumption that the refinancing will take place subsequent to the date of the statement of financial position. If, instead, prior to the date of the statement of financial position, the reporting entity receives cash proceeds from long-term financing intended to be used to repay a short-term obligation after the date of the statement of financial position, the cash received is to be classified on the statement of financial position in noncurrent assets if the short-term obligation to be settled with that cash is classified in noncurrent liabilities.
The amount of short-term debt to be reclassified is not permitted to exceed the amount raised by the replacement debt or equity issuance, nor can it exceed the amount specified in the financing agreement. If the amount specified in the financing agreement can fluctuate, then the maximum amount of short-term debt that can be reclassified is equal to a reasonable estimate of the minimum amount expected to be available on any date from the due date of the maturing short-term obligation to the end of the succeeding fiscal year. If no estimate can be made of the minimum amount available under the financing agreement, none of the short-term debt can be reclassified as long-term.
If the short-term debt is refinanced by issuing equity instruments, the portion excluded from current liabilities is to be classified under noncurrent liabilities. Under no circumstances would the reclassified debt be shown in the equity section of the statement of financial position.
If debt or other agreements limit the ability of the reporting entity to fully utilize the proceeds of the refinancing agreement (for example, a clause in another debt agreement sets a maximum debt-to-equity ratio), then only the amount that can be borrowed without violating the limitations expressed in those other agreements can be reclassified as long-term.
ASC 470-10-45-15 states that if an entity uses current assets after the statement of financial position date to repay a current obligation, and then replaces those current assets by issuing either equity securities or long-term debt before the issuance of the statement of financial position, the currently maturing debt must continue to be classified as a current liability at the date of the statement of financial position.
Duboe Distribution Co. has obtained $3,500,000 of bridge financing in the form of a construction loan to assist it in completing construction of a new public warehouse. All construction is completed by the date of the statement of financial position, after which Duboe has the following three choices for refinancing the bridge loan:
The presentations illustrated above would be accompanied by note disclosures under ASC 470-10-50-4 of the general terms of the financing agreement, as well as the terms of the new obligation incurred, or expected to be incurred, as a result of the refinancing. If part or all of the refinancing will be achieved through the issuance of equity, the notes should disclose a description of the securities issued or expected to be issued as a result of the refinancing. In addition, should the debtor decide on the third course of action, the notes would be supplemented with the required related-party disclosures.
Bonds are frequently issued with the right to convert into common stock of the company at the holder's option. Convertible debt is typically used for two reasons. First, when a specific amount of funds is needed, convertible debt often allows a lesser number of shares to be issued (assuming conversion) than if the funds were raised by directly issuing the shares. Thus, less dilution occurs. Second, the conversion feature allows debt to be issued at a lower interest rate and with fewer restrictive covenants than if the debt was issued without it.
Features of convertible debt typically include (1) a conversion price 15-20% greater than the fair value of the stock when the debt is issued; (2) conversion features (price and number of shares) which protect against dilution from stock dividends, splits, etc.; and (3) a callable feature at the issuer's option, which is usually exercised once the conversion price is reached (thus forcing conversion or redemption).
Convertible debt also has its disadvantages. If the stock price increases significantly after the debt is issued, the issuer would have been better off by simply issuing the stock. Additionally, if the price of the stock does not reach the conversion price, the debt will never be converted (a condition known as overhanging debt).
When convertible debt is issued and the conversion price is greater than the fair value of the stock on the issuance date, no value is apportioned to the conversion feature when recording the issue (ASC 470-20-05). The debt and its interest are reported as if it were a nonconvertible debt. Upon conversion, the stock may be valued at either the book value or the fair value of the bonds.
If the book value approach is used, the new stock is valued at the carrying value of the converted bonds. This method is widely used since no gain or loss is recognized upon conversion, and the conversion represents the transformation of contingent shareholders into shareholders. It does not represent the culmination of an earnings cycle. The primary weakness of this method is that the total value attributed to the equity security by the investors is not given accounting recognition.
Assume that a $1,000 bond with an unamortized discount of $50 and a fair value of $970 is converted into 10 shares of $10 par common stock whose fair value is $97 per share. Conversion using the book value method is recorded as follows:
The alternative market value approach assumes the new stock issued is valued at market (i.e., the fair value of the stock issued or the fair value of the bonds converted, whichever is more easily determinable). A gain (loss) occurs when the fair value of the stocks or bonds is less (greater) than the carrying value of the bond.
Assume the same facts as the example above. The entry to record the conversion is
The weakness of this method is that a gain or loss can be reported as a result of an equity transaction. Only the existing shareholders are affected, as their equity will increase or decrease, but the firm as a whole is unaffected. For this reason, the market value approach is not widely used.
When convertible debt is retired, the transaction is handled in the same manner as nonconvertible debt: the difference between the acquisition price and the carrying value of the bond is reported currently as a gain or loss.
Per ASC 470-20-40-11, if terms of the convertible debt instrument provide that any accrued interest at the date of conversion is forfeited by the former debt holder, the accrued interest (net of income tax) from the last payment date to the conversion date should be charged to interest expense and credited to capital as a part of the cost basis of the securities issued.
Some convertible bonds contain mutually exclusive features, with one obviously being the right to convert to the issuer's common or preferred stock. In some instances, the other feature is the right, usually on specified dates before or at the stated maturity of the debt, to cause the issuer to repurchase the debt at a price higher than par or the issuance price. This is known as a “premium put” feature. An early view of premium puts held that the issuer should accrue a liability for the put premium over the period from the date of issuance to the initial put date, and that this accrual should continue regardless of fair value changes. It further held if the put expires unexercised and if—as would be highly likely if the holders chose to ignore the right to put the debt back to the issuer—the fair value of the common stock exceeds the put price at expiration date, the put premium should be credited to additional paid-in capital. Additionally, it held that if the put were to expire unexercised (in the situation where the debt maturity is later than the last put exercise date) and if the put price exceeds the fair value of the common stock at that date, the put premium should be amortized as a yield adjustment over the remaining term of the debt, reducing interest cost.
Under ASC 815, an embedded put is a derivative instrument subject to that standard. This “grandfathered” permission for entities not to account separately for embedded premium puts in pre-1998 or pre-1999 hybrid instruments issued at par; the earlier view was to continue to apply to an entity which elected not to separately account for the embedded derivative. However, separate accounting was required for convertible debt not “grandfathered” under this provision, and thus, ASC 815 does apply to more recently issued convertible debt having premium put features.
ASC 460-10 requires explicit recognition of guarantees at their inceptions (see Chapter 19 for complete discussion of this topic). A premium put is a form of guarantee arrangement, and thus the fair value of the put must now be recognized at the date of issuance of the convertible debt bearing this feature, unless the put is accounted for as a derivative (and thus also recorded at fair value) under ASC 815. As a practical matter, in either case a liability will be recognized for the fair value of the put option embedded in the convertible debt.
Under ASC 815 this derivative financial instrument will be marked to fair value at each financial reporting date. Whether the adjustment increases or decreases the recorded amount from one period to the next depends largely on the price performance of the issuer's stock, since increasing value of the stock raises the likelihood of conversion and thus decreases the perceived value of the put option. In the author's opinion, any adjustment to the carrying value of the put option should result in adjustments to the entity's interest expense for the period.
According to ASC 47020-25, in the consolidated financial statements, (1) debt issued by a consolidated subsidiary that is convertible into that subsidiary's stock and (2) debt issued by a parent company that is convertible into the stock of a consolidated subsidiary should be accounted for in accordance with ASC 470-20-05. That is, no portion of the proceeds from the issuance of the debt should be accounted for as attributable to the conversion feature. ASC 470-20-25 did not apply to convertible debt instruments that require a cash settlement by the issuer of an in-the-money conversion feature, that provide the holder an option to receive cash for an in-the-money conversion feature, or that have a beneficial conversion feature.
ASC 470-20-30 describes the accounting for a convertible instrument that is used to pay a nonemployee for goods or services if that instrument contains a nondetachable conversion option. The measurement date under ASC 505-50 should be used to measure the intrinsic value of the conversion option rather than the commitment date. The proceeds from issuing the instrument for purposes of determining whether a beneficial conversion option exists is the fair value of the instrument or the fair value of the goods and services received, whichever is more reliably measured. The fair value of the convertible instrument can be measured by applying ASC 505-50. (For details, see Chapter 26.) Once the convertible instrument is issued, distributions paid or payable are financing costs rather than adjustments of the cost of the goods or services received.
If a purchaser of a convertible instrument that contains an embedded beneficial conversion option provides goods or services to the issuer under a separate contract, the contracts should be considered separately unless the separately stated pricing is not equal to fair value. If not equal to fair value, the terms of the respective transactions should be adjusted. The convertible instrument should be recognized at its fair value with a corresponding increase or decrease to the purchase price of the goods or services.
ASC 81515-55 addressed a variant of convertible bonds that give the issuer (the reporting entity) the option of settling for cash, rather than stock, at the time conversion is elected by holders. In some versions of this arrangement, the debtor would be obligated to settle in cash, based on the stock price at the conversion date. In others, the issuer would have the option to deliver shares or cash based on the contractual conversion rate, or more complex formulae might cause partial settlement in cash.
ASC 815 requires that in the situation of a mandatory cash settlement upon conversion, the embedded derivative (which is a cash-settled written call option) must be accounted for separately from the debt, and changes in the derivative's fair value will be reported currently in earnings. When the conversion option can be settled in stock, however, the embedded derivative is indexed only to the issuer's stock and thus, under ASC 815-40 would not be separately accounted for.
If a convertible bond is issued with terms that require the issuer to satisfy the obligation (the amount accrued to the benefit of the holder exclusive of the conversion spread) in cash and to satisfy the conversion spread (the excess conversion value over the accreted value) in either cash or stock, the debt should be accounted for like convertible debt (that is, as a combined instrument under current GAAP) if the conversion spread meets the requirements of ASC 815-40. If the conversion spread feature does not meet those provisions, ASC 815 requires that the embedded derivative be separated from the debt host contract and accounted for by the issuer separately as a derivative instrument.
If a convertible bond is issued with terms that permit the issuer to satisfy the entire obligation in either stock or cash, the bond should be accounted for as conventional convertible debt. If the holder exercises the conversion and the issuer pays cash, the debt is extinguished and the issuer should account for the transaction in accordance with ASC 470-50. ASC 47050-45-1 removed the mandatory extraordinary item treatment for any gain or loss on debt extinguishment, but if the criteria in ASC 225-20-45 are met (which is thought to be unlikely) extraordinary classification is still possible.
ASC 470-20-40-12 provides accounting guidance with respect to a financial instrument that contains the following provisions:
Questions have arisen regarding the accounting for the settlement of this instrument partially in cash (the recognized liability) and partially in stock (the unrecognized equity instrument). ASC 470-20-40-12 states that only the cash payment is to be considered in computing gain or loss on settlement of the recognized liability. Shares transferred to the holder to settle the excess conversion spread represented by the embedded equity instrument are not considered part of the settlement of the debt component of the instrument.
ASC 470-20 specifies that issuers of convertible debt instruments that may be settled in cash upon conversion should separately account for the liability and equity components in a manner that will reflect the entity's nonconvertible debt borrowing rate when interest cost is recognized in subsequent periods. An exception to this rule, however, is when an embedded conversion option must be accounted for as a derivative instrument. Convertible preferred shares categorized as equity in the statement of financial position are also excluded from the effects of ASC 470.
For instruments addressed by ASC 470, initial measurement of the carrying amount of the liability component is to be determined by measuring the fair value of a similar liability (including any embedded features other than the conversion option) that does not have an associated equity component. The carrying amount of the equity component represented by the embedded conversion option is then computed by deducting the fair value of the liability component from the initial proceeds ascribed to the convertible debt instrument as a whole. Embedded features that are determined to be nonsubstantive at the issuance date are not to affect the initial measurement of the liability component. In this context, an embedded feature other than the conversion option (including an embedded prepayment option) is to be considered nonsubstantive if, at issuance, the issuer concludes that it is probable that the embedded feature will not be exercised. If the allocation to the liability component using this methodology results in a difference in basis versus that reported for tax purposes, then interperiod tax allocation (deferred tax accounting) must also be applied.
Convertible debt instruments affected by the foregoing requirements are not available to be accounted for under the fair value option. Rather, the debt must be reported in subsequent periods at amortized cost. The variance between the convertible debt's face value and the amount of proceeds that are allocated to the debt instrument, net of the amount allocated to the conversion feature, must be treated as a discount to be accreted using the effective yield method as additional interest expense. The accretion period is to be based on the expected term of a similar instrument lacking the conversion feature. The expected life is not subject to reassessment in later periods, unless there is a modification to the terms of the instrument. The equity component would not be reassessed either, unless it ceases to meet the criteria set forth in ASC 470, in which case the difference between the amount previously recognized in equity and the fair value of the conversion option at the date of the reclassification as a liability at fair value is to be accounted for as an adjustment to stockholders' equity.
ASC 470-50 provides guidance on derecognition of convertible obligations that can be settled in whole or in part for cash. It stipulates that the proceeds transferred to effect the extinguishment of the liability and the reacquisition of the associated conversion feature are to be allocated first to the extinguishment of the liability component equal to the fair value of that component immediately prior to extinguishment. Any difference between the consideration attributed to the liability component and the sum of (1) the net carrying amount of the liability component and (2) any unamortized debt issuance costs is to be recognized in the statement of financial performance as a gain or loss on debt extinguishment. Following this, any remaining settlement consideration is to be assigned to the reacquisition of the equity component, with recognition of that amount as a reduction of stockholders' equity. Any costs incurred (e.g., banker fees) are to be allocated pro rata to the debt and equity in proportion to the allocation of consideration transferred at settlement, and accounted for as debt extinguishment costs and equity reacquisition costs, respectively.
If an instrument within the scope of the above-described staff position is modified such that the conversion option no longer requires or permits cash settlement upon conversion, it is necessary to account for the components of the instrument separately, unless the original instrument is required to be derecognized under ASC 470-50. If an instrument is modified or exchanged in a manner that requires derecognition of the original instrument under ASC 470-50 and the new instrument is a convertible debt instrument that may not be settled in cash upon conversion, the new instrument would be subject to ASC 470-50.
On the other hand, if a convertible debt instrument is not at first subject to this guidance, but is later modified so as to become subject to it, then ASC 470-50 is to be applied to ascertain whether the original instrument is to be derecognized. If not, the issuer is to apply the guidance in this staff position prospectively from the date of the modification. In such a circumstance, the liability component is to be measured at its fair value as of the modification date, with the carrying amount of the equity component represented by the embedded conversion option to be determined by deducting the fair value of the liability component from the overall carrying amount of the convertible debt instrument as a whole. At the modification date, a portion of any unamortized debt issuance costs incurred previously is to be reclassified and accounted for as equity issuance costs based on the proportion of the overall carrying amount of the convertible debt instrument that is allocated to the equity component.
Finally, there is the matter of an induced conversion. If the terms of an instrument addressed by this staff position are revised to induce early conversion (e.g., by offering a more favorable conversion ratio or paying other additional consideration in the event of conversion before a specified date), then the entity is to recognize a loss equal to the fair value of all securities and other consideration transferred in the transaction in excess of the fair value of consideration issuable in accordance with the original conversion terms. The settlement accounting (derecognition) treatment described above is then to be applied using the fair value of the consideration that was issuable in accordance with the original conversion terms. Derecognition transactions in which the holder does not exercise the embedded conversion option are not affected, however.
Expanded disclosures have also been mandated by this staff position. As of each date for which a statement of financial position is presented, the reporting entity is to disclose the following:
As of the date of the most recent statement of financial position that is presented, the reporting entity must disclose the following:
For each period for which a statement of financial performance is presented, the entity is to also disclose the following:
An entity may enter into a share-lending arrangement with an investment bank, whereby it lends shares to the bank to facilitate investors' ability to hedge the conversion option in the entity's convertible debt issuance. The entity issues the share in exchange for a nominal loan processing fee; the investment bank returns the shares upon the maturity or conversion of the convertible debt.
In a share-lending arrangement, the entity issuing shares measures them at their fair value and recognizes them as a debt issuance cost, which offsets the additional paid-in capital account. If it subsequently becomes probable that the counterparty will default, then the entity recognizes an expense equaling the fair value of any unreturned shares on that date, minus the fair value of probable share recoveries, which offsets the additional paid-in capital account. The entity continues to remeasure the fair value of unreturned shares until the consideration payable by the counterparty becomes fixed.
An entity having an outstanding own-share lending program should disclose the following:
Reporting entities sometimes issue convertible securities (debt or preferred stock) that are “in the money” at the issuance date (i.e., where it would be economically advantageous to the holders if the securities were converted immediately). That type of conversion feature is called an “embedded beneficial conversion feature.” Variations of such securities may be converted at a fixed price, a fixed discount to the fair value at date of conversion, a variable discount to the fair value at conversion, or the conversion price may be dependent upon future events. In addition, the conversion feature can be exercisable at issuance, at a stated date in the future, or upon the happening of a future event (such as an IPO). ASC 470-20 addressed the assorted accounting issues arising for issuers of such securities (the reporting entity or debtor).
In contrast with GAAP governing convertible securities lacking this feature, embedded beneficial conversion features are valued separately at issuance. The feature is recognized as additional paid-in capital by allocating a portion of the proceeds equal to the intrinsic value of the feature. The intrinsic value is computed at the commitment date as (1) the difference between the conversion price and the fair value of the common stock (or other securities) into which the security is convertible, multiplied by (2) the number of shares into which the security is convertible.
For convertible debt securities, a discount on the debt may result from the allocation of a portion of the proceeds to the conversion feature. For convertible instruments that have a stated redemption date, a discount resulting from recording a beneficial conversion option shall be required to be amortized from the date of issuance to the stated redemption date of the convertible instrument, regardless of when the earliest conversion date occurs. For convertible instruments that do not have a stated redemption date, such as perpetual preferred stock, a discount resulting from the accounting for a beneficial conversion option is to be amortized from the date of issuance to the earliest conversion date.
If the conversion feature has multiple steps, the computation of the intrinsic value is made using the conversion terms most beneficial to the investor. For example, if the security was convertible at a 10% discount to fair value after three months and then at a 25% discount to fair value after one year, the 25% discount terms would be used to measure the intrinsic value of the feature. Any resulting discount on the convertible debt would be amortized to the earliest date at which the particular discount (25% in this case) could be achieved (one year). However, at any financial statement date, the cumulative amortization recorded must be the greater of (1) the amount computed using the effective interest method of amortization or (2) the amount of the benefit the investor would receive if the securities were converted at that date. If the securities are converted prior to the full amortization of the discount, the unamortized discount is to be included in the amount transferred to equity upon conversion.
If a convertible debt security having a beneficial feature is extinguished prior to conversion, a portion of the reacquisition price of the debt security is allocated to the beneficial conversion feature. That portion is measured as the intrinsic value of the conversion feature at the extinguishment date. Since the beneficial conversion feature was originally recognized as equity, the redemption or cancellation of this feature would give rise not to gain or loss, but rather to an adjustment within stockholders' equity. For example, if $2,000 of the redemption payment was identified with the beneficial feature to which $1,200 had originally been allocated, the net result would be that the original allocation would be eliminated and an $800 charge would be made against retained earnings (analogous to a loss on a treasury stock transaction). Any residual beyond the allocated cost of redeeming the beneficial conversion feature would be allocated to the retirement of the debt security, and a gain or loss on extinguishment would be reported in current earnings.
If the security becomes convertible only upon occurrence (or failure to occur) of a future event outside the control of the investor, or if the conversion terms change based on the occurrence (or failure to occur) of a future event, the value of the contingent beneficial conversion feature should be measured as of the commitment date; but it is not recognized in the financial statements until the contingency is resolved. This may be combined with a beneficial conversion feature. For example, a debt instrument issued with a conversion feature at 20% below then-fair value, to become effective conditioned on the consummation of a planned refinancing, would be contingently convertible with a beneficial feature. According to ASC 470-20, any contingent beneficial conversion feature should be measured at the commitment date, but not reflected in earnings until the contingent condition has been met.
The definition of “conventional contingently convertible debt instrument” is later addressed by ASC 815-40-25. The issue arises because of one of the requirements under ASC 815—namely, that embedded derivatives be bifurcated and accounted for separately under certain conditions, but with an exception for accounting for conversion privileges by issuers of certain convertible securities. Thus, instruments that provide holders the right to convert at a fixed ratio (or equivalent cash value, at the issuer's discretion), for which option exercise is based on either the passage of time or a contingent event, are deemed “conventional.”
ASC 815-15 also states that, when a previously bifurcated conversion option in a convertible debt instrument no longer meets the bifurcation criteria in ASC 815, one should reclassify the fair value of the liability for the conversion option to shareholders' equity. If a debt discount was recognized when the conversion option was bifurcated, then it should continue to be amortized. Disclosure requirements include a description of the changes causing the termination of bifurcation, as well as the amount of the liability reclassified to stockholders' equity.
ASC 470-20 covers convertible securities with beneficial conversion features. The following summarizes this topic:
Several tentative conclusions were also expressed, but have not been resolved.
The guidance in ASC 470-20 should be used to evaluate whether the issuer controls settlement of the conversion feature of convertible preferred stock. If the issuer does not control settlement, the convertible preferred stock is considered temporary equity.
Software Solutions issues $1,000,000 of convertible debt, which is convertible into $10 par common stock at a price of $50 per share. The fair value of the common stock on the commitment date of the issue is $60. The intrinsic value of the conversion feature is computed as follows:
Software Solutions would make the following entry to recognize the issuance of the bonds at 100:
If the price at which the bond is convertible to stock changes over the life of the bond, the intrinsic value should be computed using the terms that are most beneficial to the holder. The most favorable conversion price that would be in effect, assuming that there are no changes to the current circumstances except for the passing of time, should be used to measure the intrinsic value.
American National Biotech issues $1,000,000 of convertible debt, convertible into $10 par common stock at a price 15% below the commitment date fair value for years 1 and 2, 20% below the commitment date fair value for years 3 to 5, and 25% below the commitment date fair value for years 6 to maturity. The fair value of the common stock on the commitment date of the issue is $50. The intrinsic value of the conversion feature is computed as follows:
American National Biotech would make the following entry to recognize the issuance of the bonds at 100:
In some cases the conversion price will be dependent on a future event, or the bond becomes convertible only upon the occurrence of a future event. In those cases, the contingent beneficial conversion feature should be measured at the commitment date but not recognized in earnings until the contingency is resolved.
Major Manufacturing Co. issues $1,000,000 of convertible debt, which is convertible into $10 par common stock at a discount of 20% off of the conversion date fair value. The fair value of the common stock on the commitment date of the issue is $50. The intrinsic value of the conversion feature is computed as follows:
Because the conversion percentage is fixed, the intrinsic value is always $250,000.
Major Manufacturing Co. would make the following entry to recognize the issuance of bonds at 100:
Shoemaker Co. issues $1,000,000 of convertible debt, which is convertible into $10 par common stock at a discount of 25% below the commitment date fair value. The fair value of the common stock on the commitment date of the issue is $60, so the conversion price is $45. The debt is convertible only upon an initial public offering. The intrinsic value of the conversion feature is computed as follows:
Shoemaker Co. would not allocate any portion of the proceeds to the conversion feature at issuance. It would make the following entry to recognize the issuance of the bonds at 100:
Upon the occurrence of an initial public offering, Shoemaker would make the following entry:
Food Franchisers issues $1,000,000 of convertible debt, which is convertible into $10 par common stock at a price of $50. The fair value of the common stock on the commitment date of the issue is $60. The debt is convertible only upon an initial public offering. If the stock's fair value is at least 20% higher than the IPO price one year after the IPO, the conversion price will be 70% of the then fair value. The intrinsic value of the contingent conversion feature at issuance is computed as follows:
The intrinsic value of the contingent conversion price change is also computed at the commitment date using the assumptions that the IPO price will be the same as the current market price and that the stock price one year after the IPO is 20% higher, as follows:
Food Franchisers would not allocate any portion of the proceeds to the conversion feature at issuance. It would make the following entry to recognize the issuance of the bonds at 100:
Upon the occurrence of an initial public offering at $55, Food Franchisers would make the following entry:
If the stock price increased to $66 ($55 × 120%), Food Franchisers would make the following entry for the difference between the two intrinsic values:
If a bond with an embedded beneficial conversion feature is extinguished prior to conversion, a portion of the reacquisition price is allocated to the repurchase of the conversion feature. That portion is the intrinsic value of the conversion feature at the extinguishment date, which would be recorded as a decrease in additional paid-in capital. That accounting may result in a reduction in additional paid-in capital that is larger than the amount originally recorded in paid-in capital at issuance. However, no portion of the reacquisition price should be allocated to the conversion feature if that feature had no intrinsic value at the issuance date.
Software Solutions (Example 1, above) repurchases $500,000 face of its debt at 140. At the date of issuance, the following entry had been made relating to the debt that is later extinguished.
At the date of the repurchase, the fair value of the stock is $85, and the unamortized discount on the debt was $20,000. The intrinsic value of the conversion feature at the date of the repurchase is computed as follows:
Software Solutions would make the following entry to recognize the retirement of the bonds:
Questions have arisen regarding the accounting for the settlement of this instrument partially in cash (the recognized liability) and partially in stock (the unrecognized equity instrument). ASC 470-20-40-12 states that only the cash payment is to be considered in computing gain or loss on settlement of the recognized liability. Shares transferred to the holder to settle the excess conversion spread represented by the embedded equity instrument are not considered part of the settlement of the debt component of the instrument.
In some instances a debt instrument may include a contingent conversion privilege that becomes exercisable if the issuer attempts to call the debt before maturity, even if the stated contingency (e.g., the underlying stock price hitting some predefined threshold value) has not occurred, at which time the holders may elect to surrender the debt for cash (perhaps with a call premium, if the indenture contains such a provision) or to convert at a defined ratio for stock. If the debt remains outstanding until scheduled redemption, there will be no opportunity to convert. (Another variant exists where the debt has a contingent conversion feature at inception, e.g., where the debt becomes convertible if some other event, such as a refinancing, occurs, as well as if the issuer attempts to call the debt.)
ASC 470-20-40 states that no gain or loss should result from the creation of a conversion opportunity caused by the issuer's exercise of its call option, if the debt as originally issued contained a substantive conversion feature. In such circumstances, conversion of the debt to equity—assuming the existence of substantive rights in the original debt issuance—would be accounted for as a book value swap. On the other hand, if the conversion feature had not been substantive, the conversion triggered by the exercise by the issuer of its call option would be accounted for as a debt extinguishment, with the fair value of the equity being issued used to define the cost of the extinguishment. This would create a gain or loss to be recognized in virtually all situations. Such a gain or loss may no longer be permitted to be reported as extraordinary, however.
ASC 470-20-40 defines a substantive conversion feature as a conversion feature that was, when the debt instrument was first issued, at least reasonably possible of being exercisable in the future, absent the issuer's exercise of a call option—where reasonably possible has the same meaning as under ASC 450. In practical terms, evaluation of whether the original conversion feature had been substantive, in the context of the facts and circumstances at the date of issuance, might include consideration of the interest yield of the contingently convertible debt compared to equivalent rates then required for debt lacking that feature, the likelihood of the occurrence of the defined contingent event, and the relative value of the conversion feature versus the related debt instrument.
Allegations had been raised that disclosures regarding contingently convertible securities have often been inconsistent across companies, and have often been inadequate. To address this problem, ASC 505-10-50 states how to disclose contingently convertible securities. This applies to all contingently convertible securities, even those that are not included in the computation of diluted EPS. ASC 50510-50-6 identifies the qualitative and quantitative terms that must be disclosed so that users can understand the potential impact of conversion, including: events or changes in circumstances that would cause the contingency to be met and features necessary to understand the conversion rights, the conversion price and number of shares, events or changes that could adjust or change any features of the securities, and the manner of settlement upon conversion. Disclosures should indicate whether shares that would be issued upon conversion are included in the calculation of EPS. Disclosures should also include information about derivative transactions related to the securities.
A special situation exists in which the conversion privileges of convertible debt are modified after issuance. These modifications may take the form of reduced conversion prices or additional consideration paid to the convertible debt holder. The debtor offers these modifications or “sweeteners” to induce prompt conversion of the outstanding debt.
ASC 470-20 specifies the accounting method used in these situations and only applies when the convertible debt is converted into equity securities. Upon conversion, the debtor must recognize an expense for the excess of the fair value of all the securities and other consideration given over the fair value of the securities specified in the original conversion terms. The reported expense should not be classified as an extraordinary item.
ASC 470-20 specifies the accounting for “sweeteners” used to induce the conversion of convertible debt. Traditionally, this involves enhancements offered by the debtor to encourage conversions, often motivated by the desire to bring an end to interest payments on the convertible debt. ASC 470-20-40-13 addresses the related circumstance of conversions when the enhanced terms are proposed or requested by the creditors/debtholders. In some instances, only the requesting parties are granted the sweetened terms. Thus, ASC 470-20 applies to all conversion of convertible debts that (1) occur pursuant to changed conversion privileges, (2) are exercisable only for a limited period of time, and (3) 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 debtholders.
The fair value of the incremental consideration paid by XYZ upon conversion is calculated for each bond converted before July 21, 2016.
Value of securities issued to debt holders:
The entry to record the debt conversion for each bond is
Warrants are certificates enabling the holder to purchase a stated number of shares of stock at a certain price within a certain time period. They are often issued with bonds to enhance the marketability of the bonds and to lower the bond's interest rate.
When bonds with detachable warrants are issued, the purchase price must be allocated between the debt and the stock warrants based on relative fair values (ASC 470-20). Since two separate instruments are involved, a fair value must be determined for each. However, if one value cannot be determined, the fair value of the other should be deducted from the total value to determine the unknown value.
The relative fair value of the bonds is 96.6% [995/(995 + 35)] and the warrant is 3.4% [35/(995 + 35)]. Thus, $34.85(3.4% × $1,025) of the issuance price is assigned to the warrants. The journal entry to record the issuance is:
The discount is the difference between the purchase price assigned to the bond, $990.15 (96.6% × $1,025), and its face value, $1,000. The debt itself is accounted for in the normal fashion. The entry to record the subsequent future exercise of the warrant would be:
ASC 470-20 states that when a debt instrument includes both detachable instruments such as warrants, and an embedded beneficial conversion option, the proceeds of issuance should first be allocated among the convertible instrument and the other detachable instruments based on their relative fair values. Following this, the ASC 470-20 model should be applied to the amount allocated to the convertible instrument to determine if the embedded conversion option has an intrinsic value.
Cellular Communicators issues $1,000,000 of convertible debt with 100,000 detachable warrants. The debt is convertible into $10 par common stock at a price of $50 per share. At the commitment date of this issuance, the common stock is trading at $46 per share. Immediately after the issuance, the bonds trade at 85 and the warrants trade at $2. The issuance proceeds of $1,000,000 are allocated to the two instruments as follows:
The intrinsic value of the conversion feature is next computed as follows:
Cellular Communicators would make the following entry to recognize the issuance of the bonds with warrants at 100:
A wide range of features may be incorporated into stock purchase warrants and it will often be a challenge to identify the substance of these features, and to then prescribe the proper accounting for each feature. One such example involves warrants that are issued with put options, sometimes called “puttable warrants.” Such warrants allow the holder to purchase a fixed number of the issuer's shares at a fixed price (common to all warrants), but also are puttable by the holder at a specified date for a fixed monetary amount that the holder could require the issuer to pay in cash. For example, assume the warrants are issued when the entity's shares are trading at $12, and each warrant permits the purchase of 100 shares at $15 through April 30, 2013. If not previously exercised, the warrant holders can put each warrant back to the issuer for the equivalent of $14 per share, that is, for 100 × ($14 − $12) = $200 per warrant. The warrant holder is thus assured (given the underlying stock price at inception) of at least $2 per share income, and of course may reap a much larger reward if the share price has risen beyond $15 by the expiration date.
Certain mortgage loan agreements provide, generally in exchange for a lower interest rate, that the lender shares in price appreciation of the property securing the loan. Other arrangements provide that the lender receives a share of the earnings or cash flows from the commercial real estate for which the loan was made. ASC 470-30 establishes the borrower's accounting for a participating mortgage loan if the lender participates in increases in the fair value of the mortgaged real estate project, the results of operations of that mortgaged real estate project, or both. It requires that certain disclosures be made in the financial statements. In addition, the codification requires the following:
ASC 470-40 addresses the issues involved with product financing arrangements. A product financing arrangement is a transaction in which an entity (referred to as the “sponsor”) simultaneously sells and agrees to repurchase inventory to and from a financing entity. The repurchase price is contractually fixed at an amount equal to the original sales price plus the financing entity's carrying and financing costs. The purpose of the transaction is to enable the sponsor enterprise to arrange financing of its original purchase of the inventory. The various steps involved in the transaction are illustrated by the diagram.
FASB ruled that the substance of this transaction is that of a borrowing transaction, not a sale. That is, the transaction is, in substance, no different from the sponsor directly obtaining third-party financing to purchase inventory. ASC 470-40 specifies that the proper accounting by the sponsor is to record a liability in the amount of the selling price when the funds are received from the financing entity in exchange for the initial transfer of the inventory. The sponsor proceeds to accrue carrying and financing costs in accordance with its normal accounting policies. These accruals are eliminated and the liability satisfied when the sponsor repurchases the inventory. The inventory is not removed from the statement of financial position of the sponsor and a sale is not recorded. Thus, although legal title has passed to the financing entity, for purposes of measuring and valuing inventory, the inventory is considered to be owned by the sponsor.
The Medieval Illumination Company (MIC) has borrowed the maximum amount it has available under its short-term line of credit. MIC obtains additional financing by selling $280,000 of its candle inventory to a third party financing entity. The third party obtains a bank loan at 6% interest to pay for its purchase of the candle inventory, while charging MIC 8% interest and $1,500 per month to store the candle inventory at a public storage facility. As MIC obtains candle orders, it purchases inventory back from the third party, which in turn authorizes the public warehouse to drop ship the orders directly to MIC's customers at a cost of $35 per order. Since this is a product financing arrangement, MIC cannot remove the candle inventory from its accounting records or record revenue from sale of its inventory to the third party. Instead, the following entry records the initial financing arrangement:
After one month, MIC records accrued interest of $1,867 ($280,000 × 8% interest × 1/12 year) on the loan, as well as the monthly storage fee of $1,500, as shown in the following entry:
On the first day of the succeeding month, MIC receives a prepaid customer order for $3,800. The margin on the order is 40% and, therefore, the related inventory cost is $2,280. MIC pays the third party $2,280 to buy back the required inventory as well as $35 to the public storage facility to ship the order to the customer, and records the following entries:
ASC 470-40 identifies variations of the terms of the above arrangement that also meet the criteria for being accounted for as product financing arrangements.
Under provisions of ASC 470-50, the debtor's (issuer's) accounting for a modification of a debt issue or an exchange for another issue is based on whether the modifications are substantial. Based on the results of the analysis, extinguishment of the original debt could be found to have occurred, with financial reporting ramifications. The SEC takes a position on this matter that adds further complexity.
ASC 470-50-40 holds that debt extinguishment accounting be used if (1) the change in the fair value of the embedded conversion option is at least 10% of the carrying value of the original debt instrument just prior to the debt being modified or exchanged, or (2) the debt instrument modification or exchange adds or eliminates a substantive conversion option. If this analysis does not result in extinguishment accounting, then an increase in the fair value of the conversion option would reduce the debt and increase additional paid-in capital, while a decrease in the fair value of the conversion option would not be recognized.
ASC 470-50-40 also holds that the modification of a convertible debt instrument will affect subsequent recognition of interest expense for the associated debt instrument for changes in the fair value of the embedded conversion option. The change in the fair value of an embedded conversion option will be calculated as the difference between the fair value of the embedded conversion option immediately before and after the modification. The value exchanged by the holder for the modification of the conversion option is to be recognized as a discount (or premium) with a corresponding increase (or decrease) in additional paid-in capital.
Finally, ASC 470-50-40 concludes that issuers should not recognize a beneficial conversion feature or reassess an existing beneficial conversion feature at the date of the modification of a convertible debt instrument.
Management may reacquire or retire outstanding debt before its scheduled maturity. This decision is usually caused by changes in present or expected interest rates or in cash flows.
In-substance defeasance (irrevocably placing assets in a trust that is to be used solely to service the remaining debt payments) does not result in the extinguishment of a liability. Except for items excluded by ASC 405-20, a liability is removed from the statement of financial position only if:
If a debtor becomes secondarily liable, through a third-party assumption and a release by the creditor, the original debtor becomes a guarantor. A guarantee obligation, based on the probability that the third party will pay, is to be recognized and initially measured at fair value. The amount of guarantee obligation increases the loss or reduces the gain recognized on extinguishments.
Some financial instruments can have characteristics of either assets or liabilities depending on market conditions (forward contracts, swap contracts, and written commodity options). To be derecognized, those instruments must not only meet the two criteria above, but must also meet the surrender of control criteria of ASC 405-20.
An exchange of debt instruments with substantially different terms is a debt extinguishment and should be accounted for in accordance with ASC 405-20. Any substantial modification in the terms of an existing debt, other than for a troubled debt restructuring, should similarly be reported as a debt extinguishment.
An exchange or modification is considered substantial when the present value of cash flows under the new debt instrument is at least 10% different from the present value of the remaining cash flows under the terms of the original instrument (ASC 470-50-40-10). For the purpose of the 10% test, the effective interest rate of the original debt instrument is used as the discount rate.
Cash flows can be affected by changes in principal amounts, interest rates, maturity, or by fees exchanged between the parties. Substantial change can also result from changes in the following provisions:
Assuming the 10% test is met and the debt instruments are deemed to be substantially different, the new investment should be initially recorded at fair value and that amount should be compared to the book value of the old debt to determine debt extinguishment gain or loss to be recognized, as well as the effective rate of the new instrument. (ASC 470-50-4013) Fees paid by the debtor to the creditor or received by the debtor from the creditor should be included in determining debt extinguishment gain or loss. (ASC 470-50-40-17a) Additionally, any costs incurred with third parties should be amortized using the interest method in a manner similar to that used for debt issue costs (ASC 470-50-40-18).
Assuming the 10% test is not met and the debt instruments are not deemed to be substantially different, then the new effective interest is to be determined based on the carrying amount of the original instrument and the revised cash flows (ASC 470-50-40-14). Fees paid by the debtor to the creditor or received by the debtor from the creditor should be amortized as an adjustment to interest expense over the remaining term of the modified debt instrument using the interest method (ASC 470-50-40-17b). Additionally, any costs incurred with third parties should be expensed as incurred (ASC 470-50-40-18b).
According to ASC 470-50-40-2, the difference between the net carrying value and the price paid to acquire the debt instruments is to be recorded as a gain or loss. If the acquisition price is greater than the carrying value, a loss exists. A gain is generated if the acquisition price is less than the carrying value. These gains or losses are to be recognized in the period in which the retirement took place. Debt extinguishment gains and losses are reported as extraordinary only if the event creating the gain or loss is both unusual and infrequently occurring. It is expected that extinguishments of debt will rarely, if ever, meet these dual criteria. Hence, gains and losses on debt extinguishments will be reported in earnings before extraordinary items.
The unamortized premium or discount and issue costs should be amortized to the acquisition date and recorded prior to the determination of the gain or loss. If the extinguishment of debt does not occur on the interest date, the interest payable accruing between the last interest date and the acquisition date must also be recorded.
Troubled debt restructurings are defined by ASC 470-60 as situations in which the creditor, for economic or legal reasons related to the debtor's financial difficulties, grants the debtor a concession that would not otherwise be granted. As explained in ASC 470-60-55-5, no single characteristic or factor, taken alone, is determinative of whether a modification of terms or an exchange of a debt instrument is a troubled debt restructuring under ASC 470-60. Thus, making this determination requires the exercise of judgment. ASC 470-60-55 poses two questions to assist in making a determination of whether ASC 470-60 applies in a particular instance.
Both of these questions must be answered in the affirmative for ASC 470-60 to be applicable.
If the debtor's creditworthiness has deteriorated since the debt was originally issued, the debtor should evaluate whether it is experiencing financial difficulties. The following factors are indicators that this may be the case:
(ASC 470-60-55-8)
If both of the following factors are present, it would be concluded that the debtor is not experiencing financial difficulty:
(ASC 470-60-55-9)
The creditor has granted a concession when a restructuring results in its expectation that it will not collect all amounts due. If so, and if the payment of principal is mostly dependent on the value of collateral, the creditor should consider the current value of the collateral in deciding whether the principal will be paid.
If the creditor restructures a debt in exchange for additional collateral or guarantees, the creditor has granted a concession when the amount of these additional items is not adequate compensation for other terms of the restructuring.
If the debtor does not have access to funds at a market rate, then the creditor should consider the restructuring to be at a below-market rate; this is an indicator that the creditor has granted a concession. It may also be a concession when the interest rate in the restructuring agreement has increased, if the new rate is below the market interest rate for new debt having similar risk characteristics. If so, the creditor should consider all aspects of the restructuring agreement to determine whether it has granted a concession.
It is not a concession when a restructuring only results in a delay in payment that is insignificant. However, if the debt has been previously restructured, the creditor should consider the cumulative effect of the past restructurings when determining whether a delay in payment resulting from the most recent restructuring is insignificant.
However, in any of the following four situations, a concession granted by the creditor does not automatically qualify as a restructuring:
(ASC 470-60-55-12)
ASC 470-60-55-1 notes that ASC 470-60 does not apply to debtors in bankruptcy unless the restructuring does not result from a general restatement of the debtor's liabilities in bankruptcy proceedings. That is, ASC 470-60 applies only if the debt restructuring is isolated to the creditor.
A troubled debt restructuring can occur one of two ways. The first is a settlement of the debt at less than the carrying amount. The second is a continuation of the debt with a modification of terms (i.e., a reduction in the interest rate, face amount, accrued interest owed, or an extension of the payment date for interest or face amount). Accounting for such restructurings is prescribed for both debtors and creditors. ASC 470-60-15-3 points out that the debtor and creditor must separately apply ASC 470-60 to the specific fact situation, since the tests are not necessarily symmetrical and it is possible for one or the other, but not both, to have a troubled debt restructuring when the debtor's carrying amount and the creditor's recorded investment differ. ASC 310-10-35-16 specifies the accounting by creditors for troubled debt restructurings involving a modification of terms.
If the debt is settled by the exchange of assets, a gain is recognized in the period of transfer for the difference between the carrying amount of the debt (defined as the face amount of the debt increased or decreased by applicable accrued interest and applicable unamortized premium, discount, or issue costs) and the consideration given to extinguish the debt (ASC 470-60-35-3). A two-step process is used: (1) any noncash assets used to settle the debt are revalued at fair value and the associated ordinary gain or loss is recognized and (2) the debt restructuring gain is determined and recognized. The gain or loss is evaluated under the “unusual and infrequent” criteria of ASC 225-20. If stock is issued to settle the liability, the stock is recorded at its fair value (ASC 470-60-35-4).
Assume the debtor company transfers land having a book value of $70,000 and a fair value of $80,000 in full settlement of its note payable. The note has a remaining life of five years, a principal balance of $90,000, and related accrued interest of $10,000 is recorded. The following entries are required to record the settlement:
If the debt is continued with a modification of terms, it is necessary to compare the total future cash flows of the restructured debt (both principal and stated interest) with the carrying value of the original debt. If the total amount of future cash payments is greater than the carrying value, no adjustment is made to the carrying value of the debt. However, a new lower effective interest rate must be computed. This rate makes the present value of the total future cash payments equal to the present carrying value of debt and is used to determine interest expense in future periods. The effective interest method must be used to compute the expense. If the total future cash payments of the restructured debt are less than the present carrying value, the current debt should be reduced to the amount of the future cash flows and a gain should be recognized. No interest expense would be recognized in subsequent periods, since only the principal is being repaid.
According to ASC 470-60, a troubled debt restructuring that involves only a modification of terms is accounted for prospectively. Thus, there is no change in the carrying value of the liability unless the carrying amount of the original debt exceeds the total future cash payments specified by the new agreement.
If the restructuring consists of part settlement and part modification of payments, the part settlement is accounted for first and then the modification of payments.
Assume that the note has a principal balance of $90,000, accrued interest of $10,000, an interest rate of 5%, and a remaining life of five years. The interest rate is reduced to 4%, the principal is reduced to $72,500, and the accrued interest at date of restructure is forgiven.
The following entries need to be recorded by the debtor to reflect the terms of the agreement:
Modify Example 2 as follows:
Assume the $100,000 owed is reduced to a principal balance of $95,000. The interest rate of 5% is reduced to 4%.
In this example, a new effective interest rate must be computed such that the present value of the future payments equals $100,000. A trial and error approach is used to calculate the effective interest rate that discounts the $95,000 principal and the $3,800 annual interest payments to $100,000, the amount owed prior to restructuring.
The following entries are made by the debtor to recognize the cash payments in the subsequent periods:
When the total future cash payments may exceed the carrying amount of the liability, no gain or loss is recognized on the books of the debtor unless the maximum future cash payments are less than the carrying amount of the debt. For example, if the debtor is required to make interest payments at a higher rate if its financial condition improves before the maturity of the debt, the debtor should assume that the larger payments would have to be made. The contingent payments would be included in the total future cash payments for comparison with the carrying amount of the debt. If the future cash payments exceed the carrying amount, a new effective interest rate should be determined. The new rate should be the rate that equates the present value of the future cash payments with the carrying amount of the liability. Interest expense and principal reduction are then recognized as the future cash payments are made.
Modify Example 2 as follows: The new agreement states that if financial condition at maturity improves as specified, an additional principal payment of $15,000 is required and additional 1% of interest must be paid in arrears for years 4 and 5.
When computing the new effective interest rate, only as many contingent payments as are needed to make the future cash payments exceed the carrying value are included in the calculation. Thus, the contingent principal payment would be included, but the contingent interest would not. The contingent interest payments would be recognized using the same criteria as are used in ASC 450; that is, the payments are recognized when they are both probable and reasonably estimable.
Under GAAP, long-term debt, until extinguished, is measured at the amount recorded at the date of issuance, reduced by payments made and adjusted for any amortization since issuance. This historical cost-based approach is not, however, universally viewed as contributing to the most meaningful financial reporting. In recent years, FASB has indicated its belief that more appropriate financial reporting would result if all financial liabilities (and assets) were reported at their respective fair values, rather than at amounts based on historical cost. Fair value of a liability is an estimated exit price that is, an estimate of the amount that would have been paid if the entity had settled the liability on the date of the statement of financial position.
Many preparers and users of financial statements question the relevance of information about the fair value of a financial liability, given that management does not intend, and may not even be able, to settle the obligation before the stated maturity. In effect, the fair value amounts are purely hypothetical and do not alter the real obligation represented by the cost-based carrying amount of the liability at issue.
On the other hand, under the current reporting model it is entirely possible that an entity will report gains from debt extinguishment as a result of the early retirement of a debt obligation carrying a below-market interest rate, even if that extinguishment is funded by the immediate issuance of debt bearing the current market rate. Notwithstanding that the entity's real economic position has not been improved (and may have been diminished), a gain has been reported, which many would agree is misleading. The following example illustrates this problem.
Company A and Company B are competitors, they both are publicly held, and both have bonds outstanding. On December 31, 2012, Company A owes $2,000,000 due in 6 years that carries a fixed interest rate of 10%. Company B also owes $2,000,000 due in 6 years, but Company B issued its bonds in a less favorable interest rate environment. Its debt carries an interest rate of 14%. The two companies have equivalent credit ratings. The prevailing market interest rate for both companies changes to 12% on December 31, 2012. Under historical cost-based GAAP, each company will report $2,000,000 of outstanding debt in its statement of financial position dated December 31, 2012. The fair value of Company A's debt at that date is $1,835,500, while the fair value of Company B's debt is $2,164,500—both fair values computed at the present value of the interest and principal payments at the prevailing market rate of 12%.
If Company A paid off its bonds, it would recognize a gain of $164,500 ($2,000,000 − $1,835,500). But for Company A to recognize its gain, it would have had to repay debt that carried a favorable interest rate. Company A would lose its economically advantageous position of being a company with below-market financing. In addition, if Company A had not used $1,835,500 to repay the debt, it could have invested that amount in its own operations and perhaps earned a higher return. Moreover, if Company A continues to need financing, it will have to refinance at the higher current interest rate. Repurchasing its bonds might not have been the best way for Company A to invest its resources, and might have been motivated, in part, by the desire to manage reported earnings in 2012.
If Company B retired its bonds, it would recognize a loss of $164,500 ($2,000,000 − $2,164,500). As an alternative, Company B could leave its bonds outstanding and realize its loss by paying above-market rates during the remaining 6 years of their term. Depending on the available alternative uses of its money, repaying the bonds and relieving future operations of the burden of above-market interest payments may be the best use of its resources, but Company B would suffer a loss as a result—a loss that can be avoided simply by choosing to not repay its debt.
Company A's gain and Company B's loss would be caused by changes in interest rates—not by a decision to repay debt. The existing measurement model for liabilities sometimes provides an incentive for unwise actions. If Company A wanted to report a gain, it could pay off its debt, even though that might not have been the best use of its resources. If Company B wanted to avoid a loss, it could allow its bonds to remain outstanding, even though the best economic decision would have been to retire them.
The effects of financing decisions, including that of leaving existing financing in place, whether made actively or indirectly through inattention, can significantly impact entity performance. Investors and creditors need information that will help them evaluate the effects of an entity's decision to settle a liability or allow it to remain outstanding. From this perspective, it is logical that information based on prices that reflect the market's assessment, under current conditions, of the present values of the future cash flows embodied in an entity's financial instruments would be more relevant for investors' and creditors' decisions than information based on historic, superseded fair value prices. Those older market prices reflect both an old interest rate and an outdated assessment of the amounts, timing, and uncertainty of future cash flows.
Liabilities are often issued with credit enhancements obtained from a third party. Given the ever-increasing inclination to mandate fair value reporting for financial assets and liabilities, questions have arisen regarding whether an issuer would consider the effect of these third-party credit enhancements when measuring the liability at fair value. ASC 820-10-05-3 requires the issuer of a liability with an inseparable third-party credit enhancement to not include the effect of the credit enhancement when calculating the fair value measurement of the liability.
3.145.186.83