2 Debt
2.2 Issuer’s initial accounting for debt instruments (including flowchart)
2.2.5 Box D(B) and Boxes D1, D2 and D3 — Evaluating embedded redemption
Like embedded conversion options, redemption features are also evaluated for bifurcation pursuant to ASC 815-15-25-1. Redemption is the repayment of the principal amount at or before maturity, but is most frequently used to describe repayment before maturity through exercise of a call or put option embedded in the debt instrument.
An embedded call option gives the issuer the right to fully or partially retire the debt before the scheduled maturity date, usually at par or at a premium (e.g., 101% of par). A call feature enables the issuer to refinance the debt at a lower borrowing rate if rates have declined since issuance.
An embedded put option is an option granted to the creditor by the issuer giving the debt holder the right to fully or partially sell the debt back to the issuer before the scheduled maturity date, usually at par or at a premium (e.g. 101% of par). The put option permits the creditor to force the issuer to redeem the debt when interest rates rise after the debt’s issuance, enabling the creditor to reinvest the proceeds at higher market rates.
Frequently, debt agreements contain a put option that enables the investor to put the debt to the issuer upon the occurrence of a fundamental change (certain change in control transactions as defined in the agreement). This redemption feature is commonly referred to as a ―change of control put.‖ Although specific to each arrangement, the following are common examples of fundamental change events:
• A person or group becoming the direct or indirect ultimate beneficial owner of more than 50% of the voting power of the issuer’s common equity
• Sale of all or substantially all of the issuer’s net assets
• Consummation of any share exchange, consolidation or merger of the issuer into another entity
• Specified changes in the board of directors
• Shareholders approving any plan or proposal for the liquidation or dissolution of the issuing entity
• The issuer’s common stock ceasing to be quoted or listed
Depending on the specific terms of the debt, embedded put or call options may be exercisable at any time after issuance, after the passage of time (e.g., on or after the fifth anniversary) or upon the occurrence of specified contingent events, and may coincide with each other.
2.2.5.1 Determining whether put and call features are considered clearly and closely related to the debt host instrument
As discussed in section 2.2.3, if the economic characteristics and risks of an embedded redemption feature are considered clearly and closely related to the economic characteristics and risks of the host contract or the redemption feature does not meet the definition of a derivative, the embedded feature should not be bifurcated pursuant to ASC 815.
ASC 815-15-25-40 and 25-41, as well as 25-26 through 25-29, provide guidance in determining whether the characteristics and risks of embedded puts and calls are clearly and closely related to the economic characteristics and risks of a debt host contract. Those paragraphs are supplemented by ASC 815-15-25-42, 25-43 and 55-13 and ASC 815-15-25-37 through 25-39.
To determine whether a put or call is considered clearly and closely related to the host debt instrument, the put and call guidance in ASC 815-15-25-40 and 25-41, as clarified by the four-step evaluation described in ASC 815-15-25-42 and 25-43, is applied. Those steps are (steps 2, 3 and 4 are further discussed below):
Step 1: Is the amount paid upon settlement (also referred herein as the ―payoff‖) adjusted based on changes in an index (rather than simply being the repayment of principal at par, together with any unpaid accrued interest)? If yes, continue to Step 2. If no, continue to Step 3.
Step 2: Is the payoff indexed to an underlying other than interest rates or credit risk? If yes, then that embedded feature is not clearly and closely related to the debt host contract and further analysis under Steps 3 and 4 is not required. If no, that embedded feature should be analyzed under Steps 3 and 4 as well as the provisions of ASC 815-15-25-1 and 815-15-25-26.
Step 3: Does the debt involve a substantial premium or discount (refer to section 2.2.5.2)? If yes, continue to Step 4. If no, in accordance with ASC 815-15-25-40 through 25-41, further analysis of the contract under ASC 815-15-25-26 is required to determine whether the call or put is clearly and closely related to the debt host contract if ASC 815-15-25-26 is applicable.
Step 4: Does a contingently exercisable call or put accelerate the repayment of the contractual principal amount? If yes, the call or put is not clearly and closely related to the debt instru-ment. If not contingently exercisable, in accordance with ASC 815-15-25-40 through 25-41, further analysis of the contract under ASC 815-15-25-26 is required to determine whether the call or put is clearly and closely related to the debt host contract.
The concepts in ASC 815-15-25-42 and 25-43 are illustrated with several examples in ASC 815-15-55-13.
2.2.5.1.1 Application of ASC 815-15-25-26 and the double-double test
Steps 2, 3 and 4 may require calls and puts to be considered pursuant to ASC 815-15-25-26, as applicable.
ASC 815-15-25-26, as further interpreted in paragraphs ASC 815-15-25-27 through 25-29, is applicable only for embedded features in which the only underlying is an interest rate (including the debtor’s market rate of interest) or an interest rate index.
Therefore, ASC 815-15-25-26 is not applicable to a put or call exercisable upon a contingency (e.g., put option exercisable upon a change in control), because that feature has an underlying other than an interest rate or interest rate index (i.e., the occurrence or nonoccurrence of the contingent event).
Puts and calls that are exercisable at any time or only after a certain time period (e.g., upon the fifth anniversary of the debt’s issuance) are in the scope of ASC 815-15-25-26, because the passage of time is not a contingency or an underlying. If such a put or call’s settlement is adjusted based on an underlying other than interest rates or credit, that feature would not be in the scope of ASC 815-15-25-26.
However, ASC 815-15-25-42 and 25-43 should be considered to determine whether that feature is considered clearly and closely related.
ASC 815-15-25-26 through 25-29 indicate that if the embedded feature’s only underlying is interest-rate related, and it alters net interest payments that otherwise would be paid or received on an interest-bearing host contract, the embedded feature meets the clearly and closely related criteria unless one of the following conditions is present:
(1) The hybrid instrument could be contractually settled in such a way that the investor would not recover substantially all of its initial recorded investment.
(2) The embedded derivative meets both of the following conditions:
(a) There is a possible future interest rate scenario (even though it may be remote) under which the embedded derivative would at least double the investor’s initial rate of return on the host contract.
(b) For any of the possible interest rate scenarios under which the investor’s initial rate of return on the host contract would be doubled (as discussed in (1) above), the embedded derivative would at the same time result in a rate of return that is at least twice what otherwise would be the then-current market return (under the relevant future interest rate scenario) for a contract that has the same terms as the host contract and that involves a debtor with a credit quality similar to the issuer’s credit quality at inception.
Pursuant to ASC 815-15-25-29, the test under criterion (a) applies only where the investor (creditor) could be forced by the contractual terms of the hybrid instrument (i.e., by the issuer) to accept settlement at an amount that causes the investor not to recover substantially all of its initial recorded investment. However, if the investor has the option to settle before maturity in a manner in which it would not recover substantially all of its investment (e.g., because of market interest rate fluctuations), the clearly and closely related presumption would not be invalidated.
The test under criterion (b) is sometimes referred to as the ―double-double test‖ because it focuses on doubling both the initial rate of the return and a then-current rate of return. ASC 815-15-25-37 through 25-39 provides that the double-double test does not apply to a non-contingent embedded call option in a debt host contract if the right to accelerate the settlement of the debt can be exercised only by the debtor.
If the double-double test is applicable, a debt instrument issued at par and redeemable at par will generally pass. However, for debt that can be redeemed at a premium such as 101% of par, the double-double test should be carefully considered. The issuer should assume the option will be exercised as soon as
contractually possible. If the 101% of par redemption feature is assumed to be exercisable immediately, the feature will likely require bifurcation because the one-day rate of return for the investor is 1% if the put is exercised on the very next day. Assuming no compounding, a one-day rate of return of 1% on an instrument issued at par is the equivalent of a 365% per annum return, which should clearly double the investor’s initial rate of return, and any then-current rate of return, in any interest rate environment. Many redemption features are exercisable only on specific dates established to pass the double-double test.
Refer to Chapter 3 of our Financial Reporting Developments publication, Derivative instruments and hedging activities (SCORE No BB0977), for further discussion of the concept of clearly and closely related.
2.2.5.2 Meaning of “involve a substantial premium or discount”
In connection with the evaluation under step 3 in ASC 815-15-25-42 (as discussed in section 2.2.5.1), the issuer should determine whether the debt involves a significant premium or discount. For example, a premium or discount could exist in a debt instrument that (1) was issued with a premium or discount (like zero-coupon debt), (2) was issued in a basket transaction that required an allocation of proceeds to the debt instrument and other freestanding instruments or (3) was assumed in a business combination. We do not believe that issuance costs paid to third parties should be considered a discount for the analysis.
Importantly, however, a premium or discount may also exist if the debt instrument contains either other bifurcated derivatives or equity-classified components that are accounted for separately.
There is no authoritative guidance on what constitutes a substantial premium or discount. However, ASC 470-50-40-10 describes debt that is substantially different based on at least a 10% difference in cash flows on a present value basis. By analogy to the term ―substantially different‖ in that guidance, some have argued that if a premium or discount (as discussed above) is approximately 10% or more of the principal amount of the note, it is substantial. This determination should be based on the specific facts and circumstances and requires professional judgment.
We generally believe a discount or premium resulting from the bifurcation of an embedded derivative that could be separately settled prior to or on redemption (e.g., those features are settled for consideration that is incremental to settlement of the contractual redemption feature) should be considered in analyzing a redemption feature. For example, a $1,000 debt instrument may be carried at $950 due to a bifurcated contingent interest feature of $50 that could be triggered and settled prior to the exercise of the
redemption feature. This discount would be considered because the holder could receive both the $50 contingent interest feature prior to redemption and then the $1,000 on redemption.
However, a discount or premium from a bifurcated embedded derivative (or an equity component that is separately accounted for in cash-convertible debt or beneficially convertible debt) that could not
separately settle on or before the redemption should not be considered in the redemption feature analysis. For example, assume a convertible bond was issued for $1,000 with an embedded conversion option that requires bifurcation at its fair value of $200. If that debt instrument were also puttable at par, one might first think there was a substantial discount (debt instrument of $800 puttable at $1,000, or a 20% discount). However, on redemption, the investor would not receive both $1,000 and the value of the conversion option. Instead, the investor would receive only the $1,000 initially invested in the single instrument purchased. Thus, the discount from the conversion option bifurcation should not be considered in evaluating the return provided from the redemption feature.
Another issue is how to determine whether the debt involves a substantial premium or discount. We generally believe it is important that the guidance uses the term ―involves‖ and not ―issued at.‖ If the debt is callable at a premium or a discount, we generally believe that premium or discount should be considered in relation to the initial offering proceeds, when determining whether the debt involves a substantial premium or discount under step 3 in ASC 815-15-25-42.
For example, if debt were issued at par with a redemption price of 110, we generally believe the debt redemption involves a premium even though the debt was issued at par. As another example, if debt were issued at 93, and were redeemable at 104, the premium involved on redemption is 11 (the difference between issuance proceeds and redemption price) rather than 4 (the difference between par and the redemption price) or 7 (the difference between the initial proceeds and par).
2.2.5.3 Determining whether put and call features meet the definition of a derivative subject to derivative accounting
If the redemption feature is not considered clearly and closely related to the debt host, it should be evaluated to determine whether the feature would meet the definition of a derivative if it were
freestanding. An embedded feature would be considered a derivative pursuant to ASC 815 only if all four characteristics of a derivative (discussed in section 2.2.3.4) were met. Typically, a redemption feature would meet all four criteria as outlined below:
• Underlying — The underlying is the fair value of the underlying debt instrument, which is a function of interest rates and credit risk.
• Notional amount — The principal amount of the debt instrument is the notional amount.
• No initial net investment — The fair value of the embedded redemption feature at inception is considered its initial investment (not the initial investment in the convertible debt instrument). That amount is generally less than the fair value of the underlying notes.
• Net settlement — Redemption features are generally physically settled and the underlying notes may or may not be publicly traded. ASC 815-10-15-107 through 15-109 concludes that the potential settlement of the debtor’s obligation to the creditor that would occur upon exercise of the put option or call option meets the net settlement criterion because (1) the debtor does not receive an asset when it settles the debt obligation in conjunction with exercise of the put option or call option and (2) the creditor does not receive an asset associated with the underlying, so that ―neither party is required to deliver an asset that is associated with the underlying…‖
In general, redemption features will not qualify for any of the exceptions from derivative accounting in ASC 815. We generally believe this includes scenarios where the call or put premium is received in shares, even if the shares are not readily convertible to cash (since there is a net settlement of the redemption feature on its own). Therefore, if a redemption feature is not considered clearly or closely related to the debt host, the redemption feature will likely require bifurcation from the host debt instrument and will be accounted for in the same manner as a freestanding derivative pursuant to ASC 815, with subsequent changes in fair value recorded in earnings each period.