Debt instruments for which a fair value option is not elected

If the debt is not subsequently measured at fair value because it was not required or elected, the value allocated to the debt instrument (including the debt host instrument or liability component if there are features to be separately accounted for) is classified as a liability and generally accreted or amortized to par. The subsequent accounting for indexed debt is different, as discussed in section 2.2.6.4.

Subsequent changes in market interest rates or the issuer’s credit rating are generally not considered, but the carrying amount of debt may be adjusted for hedge accounting pursuant to ASC 815 or foreign currency transaction gains or losses pursuant to ASC 830.

Other features of an instrument or units of account that should be considered include:

• Premiums and discounts and deferred debt issuance costs (section 2.4.3.1)

• Paid-in-kind (PIK) interest (section 2.4.3.2)

• Embedded features not bifurcated from the host debt instrument (section 2.4.3.3)

• Embedded features bifurcated from the host debt instrument as a derivative and classified as an asset or liability (e.g., conversion options, certain term-extending options and certain contingent interest features) (section 2.4.3.4)

• Embedded conversion features separated from the host debt instrument and classified as a component of equity (section 2.4.3.5)

• Contingent beneficial conversion features (refer to Appendix D)

• Debt payable in a currency other than the issuing entity’s functional currency (refer to section 1.1.2 of our Financial Reporting Developments publication, Foreign currency matters (SCORE BB2103), for further guidance)

2.4.3.1 Premiums, discounts and debt issuance costs

Debt may be issued either at par, a discount or a premium. Debt premiums or discounts may arise for several reasons, including the following:

• A difference between the market rate of interest upon issuance and the contractual rate of interest specified in the instrument (e.g., issuing debt with a stated coupon of 6% when the market yield for a debt instrument with similar terms and similar risks is 8%, resulting in initial proceeds of less than par to compensate investors for the lower coupon return)

• Allocating proceeds to multiple instruments upon issuance (e.g., when debt is issued with detachable warrants and the proceeds are allocated between the two elements)

• Bifurcating embedded derivatives in accordance with ASC 815 (e.g., certain put/call features or contingent interest)

• Separating a conversion feature under the cash conversion guidance

• Separating a beneficial conversion feature under the beneficial conversion feature guidance If debt is issued between coupon payment dates, as a matter of convenience the investor may pay an amount equal to the interest accrued to the issuance date to facilitate the issuer simply making a full coupon payment at the next interest payment date. This amount does not represent a premium.

A discount or premium is not an asset or liability separable from the associated debt instrument. Rather, the premium or discount is reported in the balance sheet as an adjustment to the carrying amount of the debt liability and not presented as a deferred charge or deferred credit, pursuant to ASC 835-30-45-1A.

Debt discounts or premiums and debt issuance costs are amortized into interest expense using the effective interest method pursuant to ASC 835-30-35-2 through 35-3.

Prepayment and other features (e.g., put option held by the creditor) may result in the amortization period being shorter than the instrument’s stated contractual life. For convertible debt instruments that are subject to the cash conversion guidance or contain beneficial conversion features, there is specific guidance on the amortization of premiums, discounts and deferred debt issuance costs. Costs incurred to secure lines of credit or revolving credit arrangements, generally are deferred and amortized over the life of the line of credit or revolving line using an appropriate interest method based, in part, on the provisions in ASC 470-50-40-21.

2.4.3.1.1 Effective interest method

Application of the effective interest method results in the recognition of interest expense equal to a constant rate of interest that is applied to the carrying amount of the debt at the beginning of each period (i.e., the outstanding face amount less any unamortized discount plus any unamortized premium less deferred issuance costs).

Other methods of amortization may be used if the results obtained are not materially different from the results under the effective interest method, as stated in ASC 835-30-35-4.

ASC 835-30-35-5 states that the amounts chargeable to interest expense under the guidance in ASC 835-30, which includes the amortization of any premiums or discounts, is eligible to be capitalized pursuant to ASC 835-20.

2.4.3.1.2 Determining the expected life of a debt instrument

Initial issuance premiums or discounts and issuance costs are generally amortized over the contractual life of a debt contract. For perpetual debt, which is described in section 2.1.2.8, interest expense is typically recognized based on an assumption of the life of the instrument.

Judgment is required in determining the amortization period when considering the potential effects of substantive embedded features, such as investor put options. We generally believe that amortization to the first put date is preferable. While the individual facts and circumstances should be carefully

evaluated, the amortization period should generally not be to the first call date. The basis for conclusions in FSP APB 14-1 (which was not codified) acknowledged diversity in practice in this area.

For convertible debt instruments within the scope of either the cash conversion guidance or beneficial conversion feature guidance, specific guidance is provided in ASC 470-20 for the amortization of discounts, premiums and deferred issuance costs.

2.4.3.1.3 Amortization for cash convertible instruments

For convertible instruments within the scope of the cash conversion guidance, ASC 470-20-35-12 through 35-16 requires the discount in the liability component created by the allocation of proceeds and any bifurcation of embedded derivatives to be amortized over the period of the expected cash flows inherent in the recorded liability (i.e., the expected life from the valuation of the liability component). This period may not be the full contractual term of the instrument if it contains put or call rights. Once the amortization period is determined, it is not reassessed unless the instrument is modified.

Refer to section C3.4 in Appendix C for a discussion of the subsequent measurement for those instruments.

2.4.3.1.4 Amortization of instruments with beneficial conversion features

For convertible instruments within the scope of the beneficial conversion feature guidance, ASC 470-20-35-7 states that the amortization period should be from the date of issuance to the stated redemption date of the convertible instrument. While that redemption date would be the maturity date based on a literal application, we believe it could also be reasonably interpreted to be the first date at which the holder could put the instrument. We generally believe the first conversion date should generally not be considered unless an instrument has no stated redemption date (perpetual debt).

For further guidance, refer to the discussion in section D4.1 in Appendix D.

2.4.3.2 Paid-in-kind interest

Some debt instruments may require or permit the issuer to make coupon payments in the form of additional underlying debt instruments. This type of interest is often referred to as paid-in-kind (or PIK) interest.

While the accounting for PIK interest is not clearly defined in the accounting guidance, the following methods may be appropriate, based on the facts and circumstances:

• Required PIK interest — An instrument that requires interest to be paid in kind functions much the same as a zero-coupon bond, as no cash interest payments are required until maturity or upon redemption of the debt. In that regard, interest should be accrued at its stated rate assuming that the interest compounds.

For example, 10% interest PIK on three-year debt with a principal amount of $100 would accrue (assuming annual compounding for simplicity) interest expense of $10 (10% X $100) in the first year (paid with additional debt), $11 (10% X $110) in the second year (paid with additional debt) and

$12.10 (10% X $121.00) in the third year (paid as additional debt), with the entire $133.10 settled at maturity. The same result would have been achieved by issuing a zero-coupon instrument for

$100 that matures in three years for $133.10. However, if the instrument accrued simple interest of 10% each year on the initial principal (i.e., no compounding), only $130 would be due at maturity. We generally believe this also represents PIK interest, and the issuer should derive an effective interest rate that, when applied to $100 at issuance, would result in $130 at maturity.

• Discretionary PIK interest — If an instrument permits the issuer to elect to pay the interest in kind or in cash, we generally believe that interest should be accrued at the contractual rate for cash interest.

If the interest is paid in kind, we generally believe the issuer may either (1) adjust the interest expense to the fair value of the incremental instruments issued or (2) not adjust the interest accrued at the contractual rate and assume that the value of the payment in kind is equal to the amount accrued, based on the individual facts and circumstances. The approach followed should be consistently applied. If the contractual rate for PIK interest is higher than the interest rate for cash payments, the issuer should accrue interest based on the expected method of payment and adjust the accrual at the payment date if settled differently.

If convertible debt requires or permits PIK interest, ASC 470-20-30-16 through 30-18 describes how to evaluate the interest accrual for a potential beneficial conversion option. Refer to section D3.3.1 in Appendix D for further discussion of beneficial conversion features.

2.4.3.3 Embedded features not bifurcated from the host debt instrument

The accounting for embedded features that are not bifurcated from debt hosts is generally based on the nature of the feature. Following are common examples:

• Contingent interest — A nonbifurcated contingent interest feature in a debt instrument is accounted for pursuant to the provisions of ASC 450, or the provisions of ASC 470-10-25-3 through 25-4 and 35-4, depending on the facts and circumstances.

• Call option — A nonbifurcated call feature in debt that is callable (prepayable) by the issuer generally is not accounted for until the debt is called, at which time extinguishment accounting is applied.

• Put option — A nonbifurcated put feature in debt that is puttable (redeemable) at par by the investor generally is not accounted for until the debt is redeemed, at which time extinguishment accounting is applied. However, the put feature should generally be considered in determining the amortization period for premiums, discounts or deferred debt issuance costs, as discussed in section 2.4.3.1.

• Conversion option — A nonbifurcated or nonseparated conversion feature in a debt instrument is not accounted for until conversion occurs. At that time, conversion accounting is applied, as discussed in section 2.5.2.

• Increasing-rate (or a step-up) feature — A nonbifurcated interest feature that steps up over time is addressed in ASC 470-10-35-1 and 35-2. That guidance states that the periodic interest cost is determined using the interest method based on the estimated outstanding term of the debt. In estimating the term of the debt, the borrower considers its plans, ability and intent to service the debt.

Debt issuance costs are also amortized over the same period used in the interest cost determination.

2.4.3.3.1 Embedded derivative reassessment

Embedded features that were not bifurcated from the host debt instrument upon issuance either because the embedded feature (1) did not meet the definition of a derivative under ASC 815 or (2) met that definition but also qualified for an exception from derivative accounting (refer to section 2.2.4.3 for further discussion) should be reassessed at each reporting date. This would include conversion options, even if they were separately accounted for under the cash conversion or beneficial conversion feature guidance.

In reassessing embedded features for bifurcation, the initial conclusion of whether that feature was clearly and closely related to the host debt instrument pursuant to ASC 815-15-25-1(a) is not reevaluated (by reference to ASC 815-15-25-27). Accordingly, if initially deemed clearly and closely related (and therefore not bifurcated), that feature would not be bifurcated in the future. While this is not clear in the guidance, we generally believe that a modification of a debt instrument that was not

accounted for as an extinguishment pursuant to ASC 470-50-40 may require the embedded features to be reevaluated given that the modification results in a different legal arrangement. This determination should be made based on the individual facts and circumstances.

In reassessing the definition of a derivative, the characteristics of having an underlying or an initial net investment generally will not change with time. However, the application of the net settlement criteria may change. ASC 815 requires the reconsideration of market mechanism and readily convertible cash criteria pursuant to ASC 815-10-15-118 and 15-139, respectively. A contract that was (or was not) net settleable by its contractual terms will likely remain as such through its life. However, a market

mechanism to facilitate net settlement may emerge over time or an asset to be delivered in a physical settlement may become readily convertible to cash. ASC 815 requires the reconsideration of those elements (refer to ASC 815-10-15-118 and 15-139, respectively).

For example, a typical equity-linked embedded feature (e.g., conversion option), may not have met the definition of a derivative if gross settlement were required and the issuer was not a public company (i.e., the underlying shares were not readily convertible to cash). That condition could change if the company underwent an IPO and its shares now were readily convertible to cash. In that case, the embedded feature would meet the definition of a derivative for the first time and should be further evaluated for bifurcation (i.e., evaluated for an exception from bifurcation). That initial analysis would occur on the date the feature met the definition of a derivative (i.e., on the IPO date).

As another example, a public issuer with limited transaction volume for its shares compared with the conversion shares may develop additional volume such that the conversion shares are now considered readily convertible to cash (refer to ASC 815-10-55-101 to 55-108).

With respect to the reassessment of any scope exceptions, the most common exception from bifurcation for equity-linked embedded features is under ASC 815-10-15-74(a), which requires evaluation of whether the feature is indexed to the issuer’s own stock and would be classified in stockholders’ equity.

This reassessment should be performed at each reporting date for those features that meet the definition of a derivative, as follows:

• Reassessment of the indexation guidance — The conclusion under the indexation guidance generally would not be expected to change unless the contractual terms have changed.

For an embedded equity-linked feature (e.g., redemption feature) that meets the definition of a derivative for the first time (e.g., underlying stock becomes actively traded making it readily convertible to cash), the embedded feature should be assessed at that time for the exception pursuant to ASC 815-10-15-74(a). That assessment would be made under the then-current circumstances to determine whether the feature is considered indexed to the issuer’s shares.

• Reassessment of the equity classification guidance — In reassessing the criteria for equity classification related to settlement alternatives, a particular focus should be on the availability of shares to settle the instrument.

2.4.3.3.2 Subsequent bifurcation

While ASC 815 requires the reassessment of certain embedded features (e.g., those linked to an entity’s own equity) for potential bifurcation at each reporting date, it does not provide explicit guidance on how to bifurcate an embedded feature after the issuance date. We generally believe the most literal application of ASC 815 would be to bifurcate the embedded derivative as of the date it was required to be bifurcated at its then-current fair value from the carrying amount of the host debt instrument. Other approaches also may exist.

Under this approach, the bifurcated derivative should be recognized as an asset or liability with

subsequent changes in fair value recognized in earnings. This accounting is the same as if bifurcation was performed upon the initial issuance of the instrument.

When determining the fair value of the feature to be bifurcated, an option-based feature would use the contractual terms (refer to section 2.2.7.1) and a forward-based feature would use the terms that would have implied a fair value generally being equal to zero at the date the holder entered into the instrument (refer to section 2.2.7.2).

Any incremental discount or premium on the host instrument that results from the bifurcation would be amortized using the effective interest method over the remaining life of the instrument (refer to section 2.4.3.1.1). Because an unusual effective interest rate may result, other methods for accounting for a post-issuance bifurcation may result in a more reasonable effective interest rate.

For a previously nonbifurcated embedded equity-linked feature that was accounted for as a separate component of equity under the beneficial conversion feature guidance, we believe one reasonable approach would be to reclassify an amount equal to the then-current fair value of the derivative from equity to a liability. Because the debt host instrument was initially reflected at a residual value after allocating the intrinsic value to equity, the host instrument would be adjusted to the pro forma carrying amount of the debt (as discussed above in the alternative method). Various methods may be appropriate for determining whether any differences between (1) the amount initially allocated to equity and the amount reclassified to a liability and (2) the then-current carrying amount of the debt host and the pro forma carrying amount should affect earnings.

For a previously nonbifurcated embedded equity-linked feature that was accounted for as a separate component of equity under the cash conversion guidance, ASC 470-20-35-19 requires that the difference in the amount previously recognized in equity and the fair value of the feature at the date of reclassification be accounted for in equity. The guidance further provides that the reclassification would not affect the accounting for the liability component.

2.4.3.4 Embedded features bifurcated from the host debt instrument as a derivative and classified as an asset or liability

Embedded features bifurcated from the host debt instrument upon issuance and classified as an asset or a liability are measured at fair value at each reporting date with changes in the fair value recognized in earnings. Refer to the discussion on embedded derivatives in Chapter 3 of our Financial Reporting Developments publication, Derivative instruments and hedging activities (SCORE No. BB0977), for further discussion.

Bifurcated derivatives should be reassessed every reporting period to determine if they continue to require bifurcation. That is, they are reassessed to see if they still meet the definition of a derivative and still fail to qualify for any scope exception from derivative accounting. For example, an embedded feature may subsequently qualify for the exception from derivative accounting pursuant to ASC 815-10-15-74(a) for reasons including:

• The provision that caused the embedded feature not to be considered indexed to the issuer’s own stock may no longer apply. For example, assume the strike price of an embedded conversion feature is reduced to equal the selling price of any common shares sold at a price less than the original strike price for the first six months after the convertible notes are issued (refer to ASC 815-40-55-33 and 55-34). Once the initial six month period lapses, the conversion feature could be considered indexed to the issuer’s own stock under the indexation guidance.

• The issuer subsequently increases its number of authorized and unissued shares sufficient to cover the settlement of the embedded feature. This increase could result by obtaining additional share authorization from shareholders or purchasing additional treasury shares in the market.

An issuer may amend the terms of an agreement to qualify for the exception from derivative accounting (e.g., the issuer may add a cap to the number of shares required for settlement if it had previously issued a convertible debt instrument without a cap). In those cases, the issuer should consider the accounting for the modification of the instrument.

ASC 815-15-35-4 requires a previously bifurcated conversion option that no longer requires bifurcation to be reclassified from a liability to equity at its then-current fair value on the date of reclassification. The

ASC 815-15-35-4 requires a previously bifurcated conversion option that no longer requires bifurcation to be reclassified from a liability to equity at its then-current fair value on the date of reclassification. The