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1.4 Other types of debt
Publication date: 31 Dec 2022
us Financing guide
There are many other types of debt instruments. In the following sections we discuss the accounting considerations for some of the more common forms of structured debt instruments.
1.4.1 Increasing rate debt
ASC 470-10-35-1 and ASC 470-10-35-2 provide a description of and guidance on increasing rate debt.
A debt instrument may have a maturity date that can be extended at the option of the borrower at each maturity date until final maturity. In such cases, the interest rate on the note increases a specified amount each time the note is renewed. For guidance on accounting for interest, see Subtopic 835-30.
The borrower’s periodic interest cost shall be determined using the interest method based on the estimated outstanding term of the debt. In estimating the term of the debt, the borrower shall consider its plans, ability, and intent to service the debt. Debt issue costs shall be amortized over the same period used in the interest cost determination. The term-extending provisions of the debt instrument should be analyzed to determine whether those provisions constitute an embedded derivative that warrants separate accounting as a derivative under Subtopic 815-10.
The amortization period for debt issuance costs, discounts, and premiums associated with increasing rate debt should be the estimated life of the instrument.
As discussed in ASC 470-10-45-8, if increasing rate debt is repaid at par prior to its estimated maturity, the reversal of any excess interest accrued should be recognized as an adjustment of interest expense and not a part of the gain or loss on extinguishment.
ASC 815-15-25-44 provides guidance on whether a term-extending option should be separated and accounted for as a derivative. See FG 1.6.1.3 for information on term-extending options.
1.4.2 Special assessments and tax increment financing entities
A reporting entity that intends to develop real estate it owns or leases may form a tax increment financing entity (TIFE) to finance the construction of road, water, and other utility infrastructure for a specific project. The TIFE issues debt that is repaid through future user fees or tax assessments. ASC 970-470, Real Estate provides guidance on the accounting for a TIFE.
If the special assessment or the assessment to be levied by the tax increment financing entity on each individual property owner is a fixed or determinable amount for a fixed or determinable period, there is a presumption that an obligation shall be recognized by the property owner. Further, with respect to tax increment financing entities, factors such as the following indicate that an entity may be contingently liable for tax increment financing entity debt, and recognition of an obligation shall be evaluated under Topic 450:
a. The entity must satisfy any shortfall in annual debt service obligations.
b. There is a pledge of entity assets.
c. The entity provides a letter of credit in support of some or all of the tax increment financing entity debt or provides other credit enhancements.
If the entity is constructing facilities for its own use or operation, the presence of any of the factors in the preceding paragraph creates a presumption that the tax increment financing entity debt must be recognized as an obligation of the entity.
A reporting entity should also determine whether a TIFE is a variable interest entity and whether it qualifies for a scope exception under ASC 810-10-15-17. See CG 1.3.1 for additional information on consolidation of variable interest entities.
1.4.3 Debt payable in common stock
Debt that requires an issuing entity to make fixed (dollar value) payments of principal or interest in equity shares should be classified as a liability pursuant to the guidance in ASC 480-10-25-14 provided that it is an obligation to issue a variable number of shares and, at inception, the monetary value of the obligation is based solely or predominantly on a fixed dollar amount.
ASC 480-10-35-5 indicates that financial instruments other than those discussed in ASC 480-10-35-3 through 35-4A shall be subsequently measured at fair value, unless another Subtopic specifies another measurement model. Debt instruments that settle through the issuance of a variable number of shares with a then-current fair value equal to a fixed dollar amount are the economic equivalent of cash settled debt. As such, we believe these instruments are subject to ASC 470 and ASC 835 and therefore, we do not believe these instruments are required to be subsequently measured at fair value with changes in fair value recorded in earnings, despite being within the scope of ASC 480-10-25-14. Rather, subsequent measurement in a manner similar to term debt as discussed in FG 1.2 is acceptable. See FG 5.5 for information on the application of ASC 480.
1.4.4 Multi-modal public debt
Debt issued with a “multi-modal” option provides a reporting entity with a contractual right to call the debt to change the type of interest paid. A common example of multi-modal debt is a bond that provides a reporting entity with the ability to change the interest paid from an auction-based interest rate to a stated rate; the stated rate may be based on a variable interest rate or a fixed interest rate. To change the type of interest paid a reporting entity will typically perform the following steps.
- Issue a “Notice of Interest Rate Conversion” to inform investors of the interest rate conversion (i.e., exercise of the reporting entity’s call option)
- Investors legally surrender the bonds to a tender agent
- Simultaneously, new bonds bearing the new interest rate are issued (or sold) to investors; the investors may include new investors as well as investors that held the called bonds
- The proceeds received from the new bonds are used to pay former investors a pre-determined amount specified in the bond indenture (e.g., par value). If the proceeds from the new issue are insufficient, or if the bond remarketing fails, the reporting entity funds the shortfall
Because, in most cases, an interest rate conversion involves a tender of the old bonds and marketing of new bonds, it is similar to a traditional bond refunding. When existing investors have their debt paid off, the issuer should account for the refunding as a debt extinguishment. When existing investors continue to hold the new bonds, the issuer is not subject to the modification guidance in ASC 470-50-40-10 because the exchange of the old bonds for new bonds is considered an exercise of a provision in the original debt agreement. The effective interest rate of the bonds is adjusted prospectively. See FG 3.4 for information on the accounting for an exchange of a term loan or debt security.
1.4.5 Sales of future revenues
As discussed in ASC 470-10-25-1, a sale of future revenue typically involves a reporting entity receiving cash from an investor and agreeing to pay to the investor, for a defined period, a specified percentage or amount of the revenue or of a measure of income (e.g., gross margin, operating income, pretax income) of a particular product line, business segment, trademark, patent, or contractual right. Typically, immediate income recognition is not appropriate.
The cash flows to be provided to the investor in a sale of future revenue will vary based on the reporting entity’s future revenues or other measure of income. Generally, these features do not require bifurcation 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(d). This scope exception applies when the underlying on which settlement is based involves a specified volume of sales or service revenues of one of the parties to the contract. Refer to DH 3.2.7.3 for additional discussion on this scope exception.
ASC 470-10-25-2 provides a number of factors to be considered in determining whether the proceeds received from the investor should be classified as debt or deferred income.
While the classification of the proceeds from the investor as debt or deferred income depends on the specific facts and circumstances of the transaction, the presence of any one of the following factors independently creates a rebuttable presumption that classification of the proceeds as debt is appropriate:
a. The transaction does not purport to be a sale (that is, the form of the transaction is debt).
b. The entity has significant continuing involvement in the generation of the cash flows due the investor (for example, active involvement in the generation of the operating revenues of a product line, subsidiary, or business segment).
c. The transaction is cancelable by either the entity or the investor through payment of a lump sum or other transfer of assets by the entity.
d. The investor's rate of return is implicitly or explicitly limited by the terms of the transaction.
e. Variations in the entity's revenue or income underlying the transaction have only a trifling impact on the investor's rate of return.
f. The investor has any recourse to the entity relating to the payments due the investor.
In many cases, the reporting entity has significant continuing involvement in the generation of the cash flows due to the investor. The presence of this factor creates a rebuttable presumption that the proceeds should be classified as debt.
As described in ASC 470-10-35-3, in situations when debt classification is appropriate, the reporting entity must determine an effective interest rate and amortize the debt under the interest method. The effective interest rate should be determined based on the proceeds received and projections of the amounts and timing of the future cash outflows.
A reporting entity should revisit its estimate of future cash outflows each reporting period. When the amount and timing of the estimated future cash flows change, one of the following three methods should be applied:
- Prospective approach: A new effective interest rate is computed based on the current carrying value of the debt and the revised estimated remaining cash flows. Changes in cash flows from previous estimates are included in future interest expense on a prospective basis.
- Catch-up approach: The carrying value of the debt is adjusted to the present value of the revised estimated cash flows discounted at the original effective interest rate. Using this approach, the impact of the change in cash flows is recorded in the current period.
- Retrospective approach: A new effective interest rate is computed based on the original proceeds received, actual cash flows to date, and the revised estimate of remaining cash flows. The new effective interest rate is then used to adjust the carrying value of the debt to the present value of the revised estimated cash flows, discounted at the new effective interest rate. Using this approach, the impact of the change in cash flows is recorded in the current and future periods.
While a current period adjustment is recorded under both the catch-up and retrospective approaches, the key distinction relates to the effective interest rate. In a catch-up approach, cash flows are updated to reflect current estimates, but the rate used to discount those cash flows remains the original effective interest rate. Under the retrospective approach, the effective interest rate is changed to reflect the actual cash flows paid to date and the revised estimate of future cash flows.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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