Box D(C) and Boxes D1, D2 and D3 — Evaluating other potential

A debt instrument may have a variety of features that can affect the timing and amount of future cash flows in a way similar to a derivative. Those features should be evaluated pursuant to the criteria in ASC 815 (discussed above in section 2.2.3) to determine if they require bifurcation. A careful analysis of the underlying agreements is necessary to identify all potential features to be evaluated.

While not all instruments have potential embedded derivatives, some of the more common ones

observed in practice are contingent interest features, interest make-whole features (which appear more often in convertible debt) and term-extending options.

2.2.6.1 Contingent interest features

Some debt instruments contain features that require additional interest to be paid to the holder if certain events occur (e.g., the issuer fails to file SEC reports or fails to meet certain financial covenants or the price of its common stock exceeds a certain target).

Generally, contingent interest features require bifurcation from a host nonderivative debt contract because the contingent interest features meet the definition of a derivative and the economic characteristics of the embedded feature are not clearly and closely related to those of the host debt instrument. For example, a contingent interest feature that increases the interest rate on the instrument if the market price of the issuer’s common stock falls (or rises) to a specified level should be bifurcated and separately accounted for pursuant ASC 815 as the underlying (i.e., the issuer’s common stock price) is not clearly and closely related to the debt host in a convertible debt instrument.

Another common example of a contingent interest feature is one requiring additional interest on a failure to comply with a debt covenant or in the event of a default, as defined in the debt agreement. Generally, an interest rate that adjusts on the creditworthiness of the issuer is clearly and closely related to a debt host instrument as discussed in ASC 815-15-25-46, which states:

The creditworthiness of the debtor and the interest rate on a debt instrument shall be considered to be clearly and closely related. Thus, for debt instruments that have the interest rate reset in the event of any of the following conditions, the related embedded derivative shall not be separated from the host contract:

a. Default (such as violation of a credit-risk-related covenant) b. A change in the debtor’s published credit rating

c. A change in the debtor’s creditworthiness indicated by a change in its spread over US Treasury bonds

However, some default interest provisions are still required to be bifurcated. The guidance stresses that the default should be a violation of a credit-risk-related covenant and not simply labeled a ―default‖

provision. Many covenants are not directly credit risk related. Therefore, the nature of the underlying trigger for the contingent interest should be carefully evaluated.

In some convertible debt instruments, the trigger for the contingent interest is expressed in terms of the market price of the entire hybrid instrument (such as $120 market price on a $100 par convertible bond). In these instances, although the market price is affected by both the interest rate and credit risk of the issuer and the equity share price, the predominant underlying is the issuer’s common stock price because it is unlikely that changes in interest rates or the issuer’s credit rating would explain such a difference between the par value and fair value of the instrument. In other cases, it may be even more clear that the feature is not clearly and closely related to the debt host, because the contingent interest may be triggered based solely on the issuer’s share price (e.g., whenever the share price exceeds 125%

of the conversion price).

A contingently convertible instrument that provides holders with additional interest equal to the fair value of any dividends received by the holders of the stock into which the instrument may be converted should also be bifurcated and separately accounted for under ASC 815, as the underlying (i.e., dividend payments) is not clearly and closely related to the debt host instrument. This contingently convertible instrument should be evaluated as a potential participating security for EPS purposes pursuant to ASC 260, Earnings per share.

While less frequent, some contingent interest features may qualify for an exception to derivative accounting. For example, if a debt instrument required additional interest only if the issuer’s sales volume failed to reach a specified threshold, that feature may meet the scope exception in ASC 815-10-15-59. If a contingent interest feature is not required to be bifurcated pursuant to ASC 815, interest expense related to the contingent feature generally should be recognized pursuant to the provisions in ASC 470-10-25-3 through 25-4 and 35-4 or ASC 450, Contingencies, depending on the facts and circumstances. Judgment is required when determining whether the trigger is an index or a contingency.

Refer to Chapter 3 of our Financial Reporting Developments publication, Derivative instruments and hedging activities (SCORE No. BB0977), for further discussion on embedded derivatives. Also refer to the discussion of contingent interest payments in connection with registration rights agreements in section 5.11 in Chapter 5.

The following example illustrates the accounting for a contingent interest feature:

Illustration 2-1

On 1 January 20X4, Company A issues at par a series of convertible bonds with a face amount of

$1,000 that mature 31 December 20Y4. The bonds have a yield to maturity of 2% per annum, computed semiannually.

Each $1,000 par value bond is convertible into 10 shares of the issuer’s common stock for a conversion price of $100 (assume the conversion option is not bifurcatable, not cash convertible and not

beneficial). Holders may convert the bonds into shares of common stock in any calendar quarter commencing after 31 March 20X4 if, as of the last day of the preceding calendar quarter, the closing price of the Company’s common stock for at least 20 trading days in a period of 30 consecutive trading days ending on the last trading day of the preceding calendar quarter is 125% of the conversion price.

Beginning 31 March 20X4, if the average market price of Company A’s common stock is equal to or greater than 125% of the conversion price of the bonds (i.e., share price is $125) for any 20 out of the last 30 trading days before such date or any 1 January or 1 July thereafter, the coupon rate will be increased to 2.5%.

The contingent interest feature in this example meets the definition of a derivative and is indexed to the value of the common stock, which is not related to the economic characteristics of the debt host.

Additionally, this feature is not eligible for the exception in (ASC 815-10-15-74(a)) used for a conversion option because the contingent interest feature, if freestanding, would not be classified in stockholders’

equity as it is settled in cash. Accordingly, the contingent interest feature is considered an embedded derivative that should be bifurcated from the host instrument.

The contingent interest feature should be bifurcated individually at fair value (or as a component of a single compound derivative if other embedded features require bifurcation). That fair value

measurement should consider the volatility of the issuer’s stock and likelihood the share price would exceed the $125 trigger as required under the instrument. It is measured in subsequent periods at fair value with changes in fair value recognized in earnings.

If the contingency is resolved and the issuer is required to make additional interest payments to the holder, the cash settlements of this derivative should be accounted for as a credit to cash and debit to the liability for the bifurcated embedded derivative.

2.2.6.2 Interest make-whole features

Debt instruments may include some form of an interest make-whole provision, which provides that, in certain circumstances (e.g., early conversion or redemption), an amount is due to the creditor equal to the present value of the debt’s remaining contractual interest cash flows, generally discounted at a specified small spread over the then-current US Treasury rate. This make-whole amount compensates the investor forgoing future interest payments on the debt after conversion or redemption.

The triggers for those make-whole provisions can vary, but frequently occur at a conversion or

redemption either by the passage of time or upon a change in control event. The consideration paid may be paid in cash or in a variable number of shares equal to the interest make-whole amount, usually at the issuer’s option. For example, assume that a 5-year 10% convertible bond contains a conversion option that permits the holder to convert the note into common stock of the issuer at any time after issuance.

The bond is callable at any time by the issuer after year 2 at par plus an amount equal to the then-present value of all the future contractual interest cash flows discounted at the current US Treasury rate plus 50 basis points. The indenture also provides that upon conversion, in addition to the common shares that the holder receives for each $1,000 principal amount of the notes, it will also receive a similarly calculated amount for future interest. The issuer has the option to settle this interest make-whole amount in either cash or shares.

An interest make-whole feature could be constructed in a table that, on the surface looks like a time value make-whole (discussed in section 2.2.4.5). However, a tabular interest make-whole feature would result in, for a given date, the same amount to be paid regardless of the stock price.

The bifurcation analysis of an interest make-whole feature can be complex and will depend on the terms of the transaction. Following are some considerations:

• When evaluating the interest make-whole in conjunction with a redemption event, the amount may be viewed as a premium in connection with the redemption feature and therefore should be analyzed as discussed above in section 2.2.5.

• When evaluating the interest-make whole in conjunction with a conversion event, the feature may be viewed as a separate feature from the conversion option. The economic characteristics of this interest make-whole feature are based on an occurrence or nonoccurrence of a conversion event that is not interest or credit related. Therefore, the feature is not clearly and closely related to the economic characteristics and risks of the debt host. This feature generally does not qualify for the scope exception from derivative accounting described in ASC 815-10-15-74(a) because the settlement amount of the interest make-whole is not indexed to the issuer’s equity (rather, it is based on stated interest cash flows that are present-valued by using a current US Treasury rate).

Accordingly, the interest make-whole feature under this approach is an embedded derivative that should be bifurcated from the host instrument and accounted for separately.

If the feature were viewed together with the conversion option as one unit of analysis, the entire conversion option would be bifurcated as the conversion (including the interest make-whole feature) is not considered indexed to the issuer’s stock because part of the settlement amount, the interest make-whole amount, is not indexed to the issuer’s stock.

2.2.6.3 Term-extension features

Section 2.1.2.3 describes debt with term-extending features. An embedded term extension feature is an embedded feature that unilaterally enables one party to extend significantly the remaining term to maturity or automatically extends the maturity when triggered by a specific event or condition.

Term-extending provisions should be analyzed to determine whether they constitute an embedded derivative. ASC 815-15-25-44 provides that if the instrument’s interest rate is not reset to the approximate current market rate for the extended term and the debt instrument initially involved no significant discounts, the feature is not clearly and closely related to the debt host. The other criteria for bifurcation, including the definition of a derivative, should also be evaluated.

Some believe that term-extending options should be viewed similarly to term-shortening options such as calls and puts. For example, some believe there is no difference between ten-year debt that is callable in year five and five-year debt that is extendable for another five years at the same rate. However, the derivatives guidance is clear that the form of the instrument and the term are important in the analysis.

ASC 815-15-25-44 addresses only debt hosts, not other hosts such as leases, in which term-extending options are frequently embedded.

2.2.6.4 Debt indexed to inflation and other variables (indexed debt)

Indexed debt is described in section 2.1.2.5. Those debt instruments are typically issued with both fixed and contingent payments. The contingent payments may be indexed to practically any available statistic, but are typically indexed to quoted market measures or broad economic statistics, such as commodity prices (e.g., oil, gold) or indices (e.g., the S&P 500 index). The indexing feature may be a separate freestanding financial instrument.

For indexing features that are not separable from the debt instrument, the feature should be first analyzed to determine whether it requires bifurcation as an embedded derivative pursuant to ASC 815 (as discussed in section 2.2.3). The guidance in ASC 815-15-25-48 and 25-49 generally provide that changes in the fair value of a commodity or an equity security (which affect the amount of interest and/or principal payments) are not clearly and closely related to a debt instrument. Because those features typically meet the definition of a derivative and generally do not qualify for any exceptions, they are often bifurcated.

Pursuant to ASC 815-15-25-50, inflation-indexed interest payments that are based on the rate of inflation in the economic environment for the currency in which the debt instrument is denominated should be considered clearly and closely related if they are not leveraged (e.g., four times the change in an inflation index times the notional amount). Inflation indices that are not consistent with the currency in which the debt is denominated may represent an embedded derivative requiring bifurcation (e.g., USD-denominated debt that is indexed to the inflation rate in Japan).

If the indexing feature is not required to be bifurcated as an embedded derivative pursuant to ASC 815 (e.g., because the debt was grandfathered from application of ASC 815’s provisions or requires the delivery of a commodity that is not readily convertible to cash), the entire instrument should be accounted for pursuant to ASC 470-10-25-3 through 25-4 and 35-4.

If the indexing feature is a separate freestanding financial instrument and not subject to the derivative accounting pursuant to ASC 815, it should also be accounted for pursuant to ASC 470-10-25-3 through 25-4 and 35-4.

That guidance generally provides that:

• If the indexing feature is a separate freestanding financial instrument, the proceeds should be allocated between the debt and the indexing feature. The resulting premium or discount should be amortized over the life of the debt using the effective interest method.

• If the applicable index value increases and the issuer would be required to pay the investor a contingent payment at maturity, the issuer should recognize a liability for the amount that the contingent payment exceeds the amount, if any, originally attributed to the contingent payment feature (when the indexing feature is separable from the debt).

• If the indexing feature is embedded in the debt but bifurcation is not required, the additional liability resulting from the fluctuating index value should be accounted for as an adjustment of the carrying amount of the debt instrument.

The liability for the indexing feature should be based on the applicable index value at the balance sheet date and should not anticipate any future changes in the index value. The guidance does not explicitly address how changes in the indexed debt’s settlement value should be recorded, we generally believe an increase in the carrying amount of the debt should be recorded in earnings, but not adjusted below its amortized cost basis.⁴

Before Statement 133 was issued, the SEC staff did not object to the recognition of the change in an indexed debt obligation in a separate component of stockholders’ equity if the feature was akin to a forward purchase contract and indexed to the price of an equity security that the issuer classifies as available-for-sale pursuant to ASC 320, Investments — Debt and Equity Securities. However, we do not believe that pre-Statement 133 view by the SEC staff would generally be supportable today.

Refer to section 5.1 in Chapter 5 for further discussion of debt exchangeable into the common stock of another entity.

2.2.6.5 Participating mortgages

A participating mortgage entitles the lender to participate in (1) the appreciation in the market value of a mortgaged real estate project and/or (2) the results of operations of the mortgaged real estate project.

While the instrument has a provision that entitles the investor to participate in the appreciation of the real estate, bifurcation of this feature is not required because a separate contract with the same terms would be excluded from the scope of ASC 815 based on the exception in ASC 815-10-15-59, given that settlement is based on the value of a nonfinancial asset of one of the parties that is not readily

convertible to cash.

Pursuant to ASC 470-30, Debt — Participating Mortgages, the fair value of the participation feature at loan inception is recognized as a participation liability, with a corresponding debit to debt discount. The debt discount is then amortized using the interest method. Interest expense consists of all of the following:

• Amounts designated in the mortgage agreement as interest

• Amounts related to the lender’s participation in the results of operations of the mortgaged real estate project (the participation liability should be correspondingly credited)

• Amortization of debt discount related to the lender’s participation in the fair value appreciation of the mortgaged real estate project

At the end of each subsequent reporting period, the balance of the participation liability should be adjusted to equal the current fair value of the participation feature. The corresponding debit or credit should be to the related debt discount account and should be amortized prospectively, using the interest method (i.e., the entire amount of the change in the fair value of the participation feature should not be recognized in the current period income statement).

Each component of interest expense is eligible for capitalization pursuant to ASC 835-20, Interest — Capitalization of Interest. Once these expenses are capitalized, ASC 470-30-35-3 states that the amounts should not be adjusted for the effects of reversals of appreciation.

4 The SEC staff (Mallett, 1996) indicated that if the debt’s terms did not provide for settlement below the original principal amount, the change should generally be recorded in the income statement as the substance of the accounting is that of a written option.

2.2.6.6 Step-up bonds or increasing-rate debt

Step-up bonds are described in section 2.1.2.9. At initial issuance, provided the interest step up is triggered automatically with the passage of time and is not considered a contingent interest feature (i.e., triggered by the occurrence or nonoccurrence of an event), there is no initial accounting provided for the step-up feature. The subsequent accounting will incorporate the automatic step-ups into a constant effective interest rate to be used over the life of the debt. Contingent changes in interest rates should be considered under the contingent interest features in section 2.2.6.1. Refer to section 2.4.3.3 for further discussion.

2.2.6.7 Debt denominated in a currency other than the issuing entity’s functional currency

Debt payable in a foreign currency is initially measured and recorded in the functional currency using the exchange rate at the balance sheet date (i.e., the spot rate). There is no embedded derivative related to the foreign currency denomination pursuant to the exception to derivative accounting in ASC 815-15-15-5.

However, if the debt is convertible the conversion option will require bifurcation as discussed in section

However, if the debt is convertible the conversion option will require bifurcation as discussed in section

In document Issuer s accounting for debt and equity financings (Page 43-49)