52   ASC 835 INTEREST

Perspective and Issues

Subtopics

Scope and Scope Exceptions

Overview

Definitions of Terms

Concepts, Rules, and Examples

ASC 835-20, Capitalization of Interest

Interest cost

Capitalization interest rate

Capitalizable base

Example of accounting for capitalized interest costs

Determining the time period for interest capitalization

Capitalization of interest costs incurred on tax-exempt borrowings

Summary of interest capitalization requirements

ASC 835-30, Imputation of Interest

Receivables

Note issued solely for cash

Note issued for cash and rights or privileges

Example of accounting for a note issued for both cash and a contractual right

Note issued in exchange for property, goods, or services

Example of accounting for a note exchanged for goods

Notes and bonds

Summary of ASC 835-30

Notes issued solely for cash

Example of bonds issued for cash

Notes issued for cash and a right or privilege

Example of accounting for a note issued for both cash and a contractual right

Noncash transactions

Example of accounting for a note exchanged for property

Example of accounting for a note exchanged to property

Redeemable instruments

Sales of future revenue

Effective Interest Method

Example of applying the effective interest method

Example of note issued between payment dates

PERSPECTIVE AND ISSUES

Subtopics

ASC 835, Interest, contains three Subtopics:

• ASC 835-10, Overall, which merely points to other Topics with guidance on interest
• ASC 835-20, Capitalization of Interest, which provides guidance on capitalization of interest in connection with an asset investment
• ASC 835-30, Imputation of Interest, which provides guidance where imputation of interest is required.

Scope and Scope Exceptions

All assets that require a time period to get ready for their intended use should include a capitalized amount of interest. However, accomplishing this level of capitalization would usually violate a reasonable cost/benefit test because of the added accounting and administrative costs that would be incurred. In many such situations, the effect of interest capitalization would be immaterial. Accordingly, interest cost is only capitalized as a part of the historical cost of the following qualifying assets when such interest is considered to be material. (ASC 835-20-15-2) Common examples include

1. Assets constructed for an entity's own use or for which deposit or progress payments are made
2. Assets produced as discrete projects that are intended for lease or sale
3. Equity-method investments when the investee is using funds to acquire qualifying assets for principal operations that have not yet begun.

(ASC 835-20-15-5)

Many entities use threshold levels to determine whether or not interest costs related to inventory or property, plant, and equipment should be capitalized. (ASC 835-20-15-4)

The capitalization of interest costs does not apply to the following situations:

1. When the effects of capitalization would not be material, compared to the effect of expensing interest
2. When qualifying assets are already in use or ready for use
3. When qualifying assets are not being used and are not awaiting activities to get them ready for use
4. When qualifying assets are not included in a statement of financial position of the parent company and its consolidated subsidiaries.
5. When principal operations of an investee accounted for under the equity method have already begun
6. When regulated investees capitalize both the cost of debt and equity capital
7. When assets are acquired with grants and gifts that are restricted by the donor (or grantor) to the acquisition of those assets, to the extent that funds are available from those grants and gifts. For this purpose, interest earned on the temporary investment of those funds that is subject to similar restriction is to be considered an addition to the gift or grant.

(ASC 835-10-15-6)

Accretion costs related to exit costs and asset retirement obligations are covered by the guidance in ASC 420 or ASC 410-20. So, too, the interest cost component of net periodic pension cost falls under the ASC 715-30 guidance.

Overview

ASC 835 provides guidance in two instances - where interest capitalization in connection with an investment in an asset and where imputation of interest is required.

Per ASC 835-20, the recorded amount of an asset includes all of the costs necessary to get the asset set up and functioning properly for its intended use, including interest. The principal purposes accomplished by the capitalization of interest costs are:

1. To obtain a more accurate measurement of the costs associated with the investment in the asset
2. To achieve a better matching of costs related to the acquisition, construction, and development of productive assets to the future periods that will benefit from the revenues that the assets generate.

ASC 835-30 specifies when and how interest is to be imputed when the receivable is noninterest-bearing or the stated rate on the receivable is not reasonable. It applies to transactions conducted at arm's length between unrelated parties, as well as to transactions in which captive finance companies offer favorable financing to increase sales of related companies.

DEFINITIONS OF TERMS

Source: ASC 835

Activities. The term activities is to be construed broadly. It encompasses physical construction of the asset. In addition, it includes all the steps required to prepare the asset for its intended use. For example, it includes administrative and technical activities during the preconstruction stage, such as the development of plans or the process of obtaining permits from governmental authorities. It also includes activities undertaken after construction has begun in order to overcome unforeseen obstacles, such as technical problems, labor disputes, or litigation.

Capitalization Rate. Rate used to determine amount of interest to be capitalized in an accounting period.

Discount. The difference between the net proceeds, after expense, received upon issuance of debt and the amount repayable at its maturity. See Premium.

Expenditures. Expenditures to which capitalization rates are to be applied are capitalized expenditures (net of progress payment collections) for the qualifying asset that have required the payment of cash, the transfer of other assets, or the incurring of a liability on which interest is recognized (in contrast to liabilities, such as trade payables, accruals, and retainages on which interest is not recognized).

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.

Imputed Interest Rate. The interest rate that results from a process of approximation (or imputation) required when the present value of a note must be estimated because an established exchange price is not determinable and the note has no ready market.

Intended Use. Intended use of an asset embraces both readiness for use and readiness for sale, depending on the purpose of acquisition.

Interest Cost. Interest cost includes interest recognized on obligations having explicit interest rates, interest imputed on certain types of payables in accordance with Subtopic 835-30, and interest related to a capital lease determined in accordance with Subtopic 840-30. With respect to obligations having explicit interest rates, interest cost includes amounts resulting from periodic amortization of discount or premium and issue costs on debt.

Interest Method. The method used to arrive at a periodic interest cost (including amortization) that will represent a level effective rate on the sum of the face amount of the debt and (plus or minus) the unamortized premium or discount and expense at the beginning of each period.

Premium. The excess of the net proceeds, after expense, received upon issuance of debt over the amount repayable at its maturity. See Discount.

CONCEPTS, RULES, AND EXAMPLES

ASC 835-20, Capitalization of Interest

Interest cost.

Generally, inventories and land that are not undergoing preparation for intended use are not qualifying assets. When land is being developed, it is a qualifying asset. If land is developed for lots, the capitalized interest cost is added to the cost of the land. The capitalized interest will then be properly matched against revenues when the lots are sold. If, however, the land is developed for a building, then the capitalized interest cost is added to the cost of the building, in which case the capitalized interest will be matched against related revenues as the building is depreciated.

The amount of interest to be capitalized. Interest cost includes the following:

1. Interest on debt having explicit interest rates (fixed or floating)
2. Interest related to capital leases
3. Interest required to be imputed on payables (i.e., those due in over one year, per ASC 835-30).

Capitalization Interest Rate.

The most appropriate rate to use as the capitalization rate is the rate applicable to specific new debt resulting from the need to finance the acquired assets. If there is no specific new debt, the capitalization rate is a weighted-average of the rates of the other borrowings of the entity. This latter case reflects the fact that the previously incurred debt of the entity could be repaid if not for the acquisition of the qualifying asset. Thus, indirectly, the previous debt is financing the acquisition of the new asset and its interest is part of the cost of the new asset. The selection of borrowings to be used in the calculation of the weighted-average of rates requires judgment. The amount of interest to be capitalized is that portion which could have been avoided if the qualifying asset had not been acquired. Thus, the capitalized amount is the incremental amount of interest cost incurred by the entity to finance the acquired asset.

If the reporting entity uses derivative financial instruments as fair value hedges to affect its borrowing costs, ASC 815-25-35 specifies that the interest rate to use in capitalizing interest is to be the effective yield that takes into account gains and losses on the effective portion of a derivative instrument that qualifies as a fair value hedge of fixed interest rate debt. The amount of interest subject to capitalization could include amortization of the adjustments of the carrying amount of the hedged liability under ASC 815, if the entity elects to begin amortization of those adjustments during the period in which interest is eligible for capitalization. Any ineffective portion of the fair value hedge is not reflected in the capitalization rate.

Capitalizable Base.

Once the appropriate rate has been established, the base to which that rate is to be applied is the average amount of accumulated net capital expenditures incurred for qualifying assets during the relevant time frame. Capitalized costs and expenditures are not the same terms. Theoretically, a capitalized cost financed by a trade payable for which no interest is recognized is not a capital expenditure to which the capitalization rate is applied. Reasonable approximations of net capital expenditures are acceptable, however, and capitalized costs are generally used in place of capital expenditures unless there is expected to be a material difference.

If the average capitalized expenditures exceed the specific new borrowings for the time frame involved, then the excess expenditures are multiplied by the weighted-average of rates and not by the rate associated with the specific debt. This requirement more accurately reflects the interest cost incurred by the entity to acquire the fixed asset.

The interest being paid on the debt may be simple or compound. Simple interest is computed on the principal alone, whereas compound interest is computed on the principal and on any interest that has not been paid. Most fixed assets will be acquired with debt subject to compound interest.

The total amount of interest actually incurred by the entity is the ceiling for the amount of interest cost capitalized. The amount capitalized cannot exceed the amount actually incurred during the period involved. On a consolidated basis, the ceiling is defined as the total of the parent's interest cost plus that of the consolidated subsidiaries. If financial statements are issued separately, the interest cost capitalized is limited to the amount that the separate entity has incurred, and that amount includes interest on intercompany borrowings. The interest incurred is a gross amount and is not netted against interest earned except in cases involving externally restricted tax-exempt borrowings.

Determining the time period for interest capitalization.

Three conditions must be met before capitalization commences.

1. Necessary activities are in progress to get the asset ready to function as intended
2. Qualifying asset expenditures have been made
3. Interest costs are being incurred.

As long as these conditions continue, interest costs are capitalized.

Necessary activities are interpreted in a very broad manner. They start with the planning process and continue until the qualifying asset is substantially complete and ready to function. Brief, normal interruptions do not stop the capitalization of interest costs. However, if the entity intentionally suspends or delays the activities for some reason, interest costs are not capitalized from the point of suspension or delay until substantial activities regarding the asset resume.

If the asset is completed in parts, the capitalization of interest costs stops for each part as it becomes ready. An asset that must be entirely complete before the parts can be used capitalizes interest costs until the total asset becomes ready.

Interest costs continue to be capitalized until the asset is ready to function as intended, even in cases where lower of cost or market rules are applicable and market is lower than cost. The required write-down is increased accordingly.

Capitalization of interest costs incurred on tax-exempt borrowings.

If qualifying assets have been financed with the proceeds from tax-exempt, externally restricted borrowings, and if temporary investments have been purchased with those proceeds, a modification is required. The interest costs incurred from the date of borrowing must be reduced by the interest earned on the temporary investment in order to calculate the ceiling for the capitalization of interest costs. This procedure is followed until the assets financed in this manner are ready. When the specified assets are functioning as intended, the interest cost of the tax-exempt borrowing becomes available to be capitalized by other qualifying assets of the entity. Portions of the tax-exempt borrowings that are not restricted are eligible for capitalization in the normal manner.

Assets acquired with gifts or grants. Qualifying assets that are acquired with externally restricted gifts or grants are not subject to capitalization of interest. The principal reason for this treatment is the concept that there is no economic cost of financing when a gift or grant is used in the acquisition.

Summary of interest capitalization requirements.

The diagram that follows summarizes the accounting for interest capitalization.

ASC 835-30, Imputation of Interest

Receivables.

If a receivable is due on terms exceeding one year, the proper valuation is the present value of future payments to be received, determined by using an interest rate commensurate with the risks involved at the date of the receivable's creation. In many situations the interest rate commensurate with the risks involved is the rate stated in the agreement between the payee and the debtor. However, if the receivable is noninterest-bearing or if the rate stated in the agreement is not indicative of the market rate for a debtor of similar creditworthiness under similar terms, interest is imputed at the market rate. A valuation allowance is used to adjust the face amount of the receivable to the present value at the market rate. The balance in the valuation allowance is amortized as additional interest income so that interest income is recognized using a constant rate of interest over the life of the agreement. Initial recording of such a valuation allowance also results in the recognition of an expense, typically (for customer receivables) reported as selling expense or as a contra revenue item (sales discounts).

ASC 835-30-25 divides receivables into three categories for discussion: notes issued solely for cash, notes issued for cash and rights or privileges, and notes issued in exchange for property, goods, or services.

Note issued solely for cash.

When a note is issued solely for cash, its present value is necessarily assumed to be equal to the cash proceeds. The interest rate is that rate which equates the cash proceeds received by the borrower to the amounts to be paid in the future. For example, if a borrower agrees to pay $1,060 in one year in exchange for cash today of $1,000, the interest rate implicit in that agreement is 6%. A valuation allowance of $60 is applied to the face amount ($1,060) so that the receivable is included in the statement of financial position at its present value ($1,000).

Note issued for cash and rights or privileges.

When a note receivable that bears an unrealistic rate of interest is issued in exchange for cash, an additional right or privilege is usually granted, unless the transaction was not conducted at arm's length. If there was an added right or privilege involved, the difference between the present value of the receivable and the cash advanced is the value assigned to the right or privilege. It will be accounted for as an addition to the cost of the products purchased for the purchaser/lender, and as additional revenue to the debtor.

Note issued in exchange for property, goods, or services.

When a note is issued in exchange for property, goods, or services and the transaction is entered into at arm's length, the stated interest rate is presumed to be fair unless (1) no interest rate is stated, (2) the stated rate is unreasonable, (3) the face value of the note receivable is materially different from fair value of the property, goods, or services received, or (4) the face value of the note receivable is materially different from the current market value of the note at the date of the transaction. According to ASC 835, when the rate on the note is not fair, the note is to be recorded at the fair market value of the property, goods, or services sold or the market value of the note, whichever is the more clearly determinable. The difference is recorded as a discount or premium and amortized to interest income.

If neither the fair value of the property, goods, or services sold nor the fair value of the note receivable is determinable, then the present value of the note must be determined using an imputed market interest rate. This rate will then be used to establish the present value of the note by discounting all future payments on the note at that rate. General guidelines for determining the appropriate interest rate, which are provided by ASC 835, include the prevailing rates of similar instruments with debtors having similar credit ratings and the rate the debtor could obtain for similar financing from other sources. Other factors to be considered include any collateral or restrictive covenants involved, the current and expected prime rate, and other terms pertaining to the instrument. The objective is to approximate the rate of interest that would have resulted if an independent borrower and lender had negotiated a similar transaction under comparable terms and conditions. This determination is as of the issuance date, and any subsequent changes in market interest rates are irrelevant.

Notes and Bonds.

The appropriate valuation of long-term debt at the date of issuance is the present value of the future payments, using an interest rate commensurate with the risks involved. In many situations this is the rate stated in the agreement between the borrower and the creditor. However, in other situations the debt may be noninterest-bearing, or the rate stated in the agreement may not be indicative of the rate applicable to a borrower having similar creditworthiness and debt having similar terms. In other words, the rate stated in the agreement is not commensurate with the risks involved. To reflect the liability at the appropriate value, interest must be imputed at the market rate, and the resulting premium or discount is amortized as interest over the life of the agreement

Notes are a common form of exchange in business transactions for cash, property, goods, and services. Notes represent debt issued to a single investor without intending for the debt to be broken up among many investors. A note's maturity, usually lasting one to seven years, tends to be shorter than that of a bond.

Bonds are primarily used to borrow funds from the general public or institutional investors when a contract for a single amount (a note) is too large for any one lender to supply. Dividing up the amount needed into $1,000 or $10,000 units makes it easier to sell the bonds. Bonds also result from a single agreement.

Notes and bonds share common characteristics. They both are promises to pay sums of money at designated maturity dates, plus periodic interest payments at stated rates. They each feature written agreements stating the amounts of principal, the interest rates, when the interest and principal are to be paid, and the restrictive covenants, if any, that must be met.

The interest rate is affected by many factors, including the cost of money, the business risk factors, and general and industry-specific inflationary expectations. The stated rate on a note or bond often differs from the market rate at the time of issuance. When this occurs, the present value of the interest and principal payments will differ from the maturity, or face value. (For a complete discussion of present value techniques see Chapter 1.) If the market rate exceeds the stated rate, the cash proceeds will be less than the face value of the debt because the present value of the total interest and principal payments discounted back to the present yields an amount that is less than the face value. Because an investor is rarely willing to pay more than the present value, the bonds must be issued at a discount. The discount is the difference between the issuance price (present value) and the face, or stated, value of the bonds. This discount is then amortized over the life of the bonds to increase the recognized interest expense so that the total amount of the expense represents the actual bond yield. When the stated rate exceeds the market rate, the bond will sell for more than its face value (at a premium) to bring the effective rate to the market rate. Amortization of the premium over the life of the bonds will decrease the total interest expense.

When the market and stated rates are equivalent at the time of issuance, no discount or premium exists and the instrument will sell at its face value. Changes in the market rate subsequent to issuance are irrelevant in determining the discount or premium or its amortization.

All commitments to pay (and receive) money at a determinable future date are subject to present value techniques and, if necessary, interest imputation with the exception of the following:

1. Normal accounts payable due within one year
2. Amounts to be applied to purchase price of goods or services or that provide security to an agreement (e.g., advances, progress payments, security deposits, and retentions)
3. Transactions between parent and subsidiary
4. Obligations payable at some indeterminable future date (e.g., warranties)
5. Lending and depositor savings activities of financial institutions whose primary business is lending money
6. Transactions where interest rates are affected by prescriptions of a governmental agency (e.g., revenue bonds, tax exempt obligations, etc.).

Summary – ASC 835-30.

ASC 835-30 specifies when and how interest is to be imputed when a debt is either noninterest-bearing or the stated rate is not reasonable. ASC 835-30 divides debt into three categories for discussion. The diagram below illustrates the accounting treatment for the three types of debt.

Notes issued solely for cash.

When a note is issued solely for cash, its present value is assumed to be equal to the cash proceeds. The interest rate is that rate equating the cash proceeds to the amounts to be paid in the future. For example, a $1,000 note due in three years that sells for $889 has an implicit rate of 4% (= $1,000 × .889, where .889 is the present value factor at 4% for a lump sum due three years hence). This implicit rate, 4%, is to be used when amortizing the discount.

In most situations, a bond will be issued at a price other than its face value. The amount of the cash exchanged is equal to the total of the present values of all the future interest and principal payments. The difference between the cash proceeds and the face value is recorded as a premium if the cash proceeds are greater than the face value or a discount if they are less. The journal entry to record a bond issued at a premium follows:

Notes issued for cash and a right or privilege.

Often when a note bearing an unrealistic rate of interest is issued in exchange for cash, an additional right or privilege is granted, such as the issuer agreeing to sell merchandise to the purchaser at a reduced rate. The difference between the present value of the receivable and the cash loaned is regarded as an addition to the cost of the products purchased for the purchaser/lender and as unearned revenue to the seller/issuer. This treatment stems from an attempt to match revenue and expense in the proper periods and to differentiate between those factors that affect income from operations and income or expense from nonoperating sources. In the situation above, the purchaser/lender will amortize the discount (difference between the cash loaned and the present value of the note) to interest income over the life of the note, and the contractual right to purchase inventory at a reduced rate will be allocated to inventory (or cost of sales) as the right expires. The seller/issuer of the note will amortize the discount to interest expense over the life of the note, and the unearned revenue will be recognized in sales as the products are sold to the purchaser/lender at the reduced price. Because the discount is amortized on a different basis than the contractual right, net income for the period is also affected.

Noncash transactions.

When a note is issued for consideration such as property, goods, or services, and the transaction is entered into at arm's length, the stated interest rate is presumed to be fair unless (1) no interest rate is stated; (2) the stated rate is unreasonable; or (3) the face value of the debt is materially different from the consideration involved or the current market value of the note at the date of the transaction. According to ASC 835-30, when the rate on the note is not considered fair, the note is to be recorded at the “fair market value of the property, goods, or services received or at an amount that reasonably approximates the market value of the note, whichever is the more clearly determinable.” When this amount differs from the face value of the note, the difference is to be recorded as a discount or premium and amortized to interest expense.

If the fair market value of the consideration or note is not determinable, then the present value of the note must be determined using an imputed interest rate. This rate will then be used to establish the present value of the note by discounting all future payments on the note at this rate. General guidelines for imputing the interest rate, which are provided by ASC 835-30, include the prevailing rates of similar instruments from creditors with similar credit ratings and the rate the debtor could obtain for similar financing from other sources. Other determining factors include any collateral or restrictive covenants involved, the current and expected prime rate, and other terms pertaining to the instrument. The objective is to approximate the rate of interest that would have resulted if an independent borrower and lender had negotiated a similar transaction under comparable terms and conditions. This determination is as of the issuance date, and any subsequent changes in interest rates would be irrelevant.

Redeemable instruments.

ASC 470-10-55 addressed the classification of certain long-term debt that is subject to a demand from the holder for redemption, subject to a best efforts attempt by the issuer to remarket that date. Thus, there is a possibility that the demand for redemption would not be honored, although a bank letter of credit is also provided as additional security for the lender. Notwithstanding that possibility, this debt must be reported as a current obligation.

Sales of future revenue.

ASC 470-10-25 deals with the situation in which a reporting entity receives an initial payment from another party in exchange for a promised stream of royalties or other revenue-based receipts from a defined business, which could be a segment or product line of the reporting entity. Arguably, the up-front payment could be seen as an advance against the future payments, or as a borrowing by the reporting entity. The payment is not revenue to the reporting entity.

The codification states that the initial receipt would be accounted for as either debt or deferred revenue, depending on the facts and circumstances of the transaction. It identifies six factors that would cause the amounts to be recorded as debt, rather than as deferred income. These factors are:

1. The transaction does not purport to be a sale.
2. The reporting entity has significant continuing involvement in the generation of the cash flows due the other party (referred to as the investor in this consensus).
3. The transaction is cancelable by either party through payment of a lump sum or other transfer of assets by the entity.
4. The investor's rate of return is implicitly or explicitly limited by the terms of the transaction.
5. Variations in the reporting entity's revenue or income underlying the transaction have only a trifling impact on the investor's rate of return.
6. The investor has any recourse to the reporting entity relating to the payments due to the investor.

Amounts recorded as debt should be amortized under the interest method and amounts recorded as deferred income should be amortized under the units-of-revenue method. The proceeds classified as foreign-currency-denominated debt would be subject to recognition of foreign currency transaction (exchange) gains and losses under ASC 830-20.

ASC 815 established cash flow hedge accounting for hedges of the variability of the functional currency equivalent of future foreign-currency-denominated cash flows. If the proceeds are classified as deferred income, this would be a nonmonetary liability. Thus, no foreign exchange gains or losses would arise under ASC 830-20.

Effective Interest Method

The effective interest method is the preferred method of accounting for a discount or premium arising from a note or bond. Under the effective interest method, the discount or premium is amortized over the life of the debt in such a way as to result in a constant rate of interest when applied to the amount outstanding at the beginning of any given period. Therefore, interest expense is equal to the market rate of interest at the time of issuance multiplied by this beginning figure. The difference between the interest expense and the cash paid represents the amortization of the discount or premium.

Amortization tables are often created at the time of the bond's issuance to provide amounts necessary when recording the entries relating to the debt issue. They also provide a check of accuracy since the final values in the unamortized discount or premium and carrying value columns should be equal to zero and the bond's face value, respectively.

Although the effective interest method is the preferred method of amortizing a discount or premium, the straight-line method may be used if the results are not materially different. The amortized portion is equal to the total amount of the discount or premium divided by the life of the debt from issuance in months multiplied by the number of months the debt has been outstanding that year. Interest expense under the straight-line method is equal to the cash interest paid plus the amortized portion of the discount or minus the amortized portion of the premium.

When the interest date does not coincide with the year-end, an adjusting entry must be made to recognize the proportional share of interest payable and the amortization of the discount or premium. Within the amortization period, the discount or premium can be amortized using the straight-line method.

If bonds or notes are issued between interest payment dates, the interest and the amortization must be computed for the period between the sale date and the next interest date. The purchaser usually pays the issuer for the amount of interest that has accrued since the last payment date. That payment is recorded as a payable by the issuer. At the next interest date, the issuer pays the purchaser as though the bond had been outstanding for the entire interest period. The discount or premium is also amortized for the short period.

Costs may be incurred in connection with issuing bonds. Examples include legal, accounting, and underwriting fees; commissions; and engraving, printing, and registration costs. These costs theoretically should be treated as either an expense in the period incurred or a reduction in the related amount of debt, in much the same manner as a discount (CON 6). These costs do not provide any future economic benefit and, therefore, should not be an asset. Since these costs reduce the amount of cash proceeds, they in effect increase the effective interest rate and probably should be accounted for in the same way as an unamortized discount. However, in practice, issue costs are treated as deferred charges and amortized using the straight-line method.