ASC 470-50-40-12(a) provides guidance on the cash flows of a new debt instrument to be included in the 10% test.

The term “any amounts paid,” as used in ASC 470-50-40-12(a), does not indicate if the amounts must be cash, or whether non-cash consideration, such as freestanding financial instruments like warrants or preferred stock, should be considered an amount paid. We believe the fair value of non-cash consideration should be included as a day-one cash flow for purposes of determining the cash flows to be used in the 10% test. We believe the form of consideration should not affect the accounting. Treating warrants or preferred stock issued to a lender as a day-one cash flow is consistent with guidance in ASC 470-60-55-12 for troubled debt restructurings, which requires the fair value of any new or modified non-cash consideration (e.g., options, warrants, guarantees, letters of credit) to be included in the calculation to determine whether a lender is granting a concession. If non-cash consideration is not exercisable for a period of time, that delay should be considered in determining its fair value.

If a restructuring is considered a modification based on the 10% test, then any non-cash consideration should be capitalized similarly to a cash fee paid to a lender. The capitalized amount, along with any existing unamortized debt discount or premium, should be amortized as an adjustment to interest expense over the remaining term of the modified debt instrument using the effective interest method.

If a restructuring is accounted for as a debt extinguishment, then the fair value of any non-cash consideration is associated with the extinguishment of the original debt instrument (i.e., treated as an amount paid to extinguish the debt) and included in determining the extinguishment gain or loss.

A debt modification may involve changes to embedded features (e.g., covenants, collateral, or seniority position) that have no effect on cash flows. Modifications to these non-cash terms would not impact the cash flows used for the 10% test.

If a debt modification involves a modification or an exchange of a freestanding equity-classified written call option held by the same creditor, ASU 2021-04 stipulates that an increase or a decrease in the fair value of the call option held by the creditor be included in the application of the 10% test.

ASU 2021-04 also states that the increase or decrease in the fair value of the freestanding equity-classified written call option be accounted for in the same manner as any non cash consideration between the debtor and creditor as discussed in the paragraphs above. If the debt modification is accounted for as an extinguishment, the increase or decrease in fair value is included in determining the gain or loss. If the debt modification is accounted for as a modification, the increase or decrease in fair value should be treated as a capitalized cost and amortized as an adjustment of interest expense.

Refer to FG 8.3 for further discussion on ASU 2021-04.

If a debt instrument is modified such that the currency in which it is denominated changes, the change in currency should be included in the cash flows as part of the 10% test. To convert the cash flows on the new debt into the currency of the original debt, we believe there are two acceptable methods, use (1) the spot rate in effect at the debt modification or exchange date, or (2) the forward rates corresponding to each cash flow (i.e., interest payment and principal) payment date.

When performing the 10% test, the effect of the required amortization of basis adjustments due to the application of fair value hedge accounting should be ignored for the purposes of calculating the effective interest rate of the original debt instrument. The goal of the 10% test is to determine whether the terms of the relationship between the debtor and lender before and after a modification or exchange are substantially different. The fact that the debtor designated the debt as the hedged item in a fair value hedging relationship does not affect the relationship between the debtor and lender.

Application of the guidance to a term loan debt restructuring is more complicated when the principal balance changes as a result of the restructuring. Increases and decreases in the principal balance of a loan should be included in the cash flows of the new debt used to perform the 10% test based on the guidance in ASC 470-50-40-12(a), which specifically refers to considering “any” amounts paid or received by the debtor. If the principal received is net of a discount, the principal amount net of the discount should be used as the principal balance for purposes of applying this guidance.

An increase in principal should be treated as a day-one cash inflow in the cash flows of the new debt instrument, and a decrease should be treated as a day-one cash outflow.

A borrower should account for unamortized fees, new creditor fees, and third-party costs in the same manner it would had there not been a change in principal. That is, when a loan is modified, unamortized fees should continue to be deferred, new creditor fees should be capitalized and amortized as part of the effective yield and new fees paid to third parties should be expensed. When a loan is extinguished, unamortized fees and new creditor fees should be expensed, and new fees paid to third parties should be capitalized and amortized as debt issuance costs associated with the new debt. See Example FG 3-7 for an illustration of the application of this guidance.

It depends on the borrower’s accounting policy.

Some borrowers continue to defer the unamortized debt issuance costs when they pay down a portion of their debt in connection with a modification (which is accounted for as a modification), based on the view that the prepayment is factored into the terms agreed to on the modified debt. In other words, they believe it is not possible to separately identify the prepayment amount.

Other reporting entities have a policy of expensing the portion of the unamortized costs associated with the partial pay down based on the guidance in ASC 470-50-40-2 because the debt has been partially settled. Since the debt has been partially settled, these reporting entities believe it is appropriate to consider the debt extinguishment guidance for the partial settlement. See FG 3.7.1 for discussion on the treatment of unamortized costs in a partial pay down.

This policy choice is not available when the original debt does not have an existing prepayment option or for a prepayment of debt made outside of a debt modification. See FG 3.7.1 for information on how unamortized fees should be accounted for in these circumstances.

As discussed in ASC 470-50-40-12(f), if a debt instrument is restructured more than once in a twelve-month period, the debt terms (e.g., interest rate, prepayment penalties) that existed just prior to the earliest restructuring in that twelve-month period should be used to apply the 10% test, provided all previous restructurings in that twelve-month period were accounted for as a modification.

Example FG 3-5 illustrates the application of the 10% test when debt has been restructured multiple times within a twelve-month period and the debt was prepayable at any time both prior to and after any modification.

EXAMPLE FG 3-5
Multiple refinancing within a one-year period for prepayable debt

FG Corp has a term loan with monthly interest payments that is prepayable without penalty. Its credit rating has improved since the debt was issued in December 20X3. In June 20X4, FG Corp modified its debt to lower its borrowing costs.

FG Corp restructures its term loan again in December 20X4. After both modifications, the debt remained prepayable at any time, but a prepayment penalty was added.

The following table summarizes the terms of the original debt and new debt on the restructuring dates.

Should FG Corp account for the restructuring of its debt as a modification or an extinguishment?

The cash flows used in each respective 10% test are as follows:

June 20X4 restructuring: The June 20X4 restructuring was accounted for as a modification. The cash flows used in that 10% test are shown below.

December 20X4 restructuring: Because the December 20X4 restructuring was done less than twelve months after the June 20X4 restructuring (which was accounted for as a modification), FG Corp must consider the terms that existed just prior to the June 20X4 restructuring (because there were no other restructurings within twelve months of December 31, 20X4 and prior to June 20X4) when determining the cash flows of the original debt. FG Corp should compare the terms following the December restructuring to the terms that existed immediately prior to the June 20X4 modification and include lender fees paid for all modifications during those twelve months to determine if together these two restructurings resulted in more than a 10% change in cash flows as compared to the original debt. Since the original debt and the modified debt are prepayable at any time, FG Corp would calculate the cash flows for this test as follows.

FG Corp calculates the change in cash flows as follows:

A borrower may have several debt instruments outstanding with one lender. When performing the 10% test, there is a general presumption that all of a lender’s debt instruments should be included whether the debt was modified or not in order to accurately capture the economics of the transaction. However, in certain limited fact patterns, when it is clear that a modification is done without regard to other debt outstanding with the lender, it may be appropriate for a reporting entity to exclude certain debt instruments with the lender when performing the 10% test.

For example, if a borrower has two debt instruments outstanding with one lender, Tranche A and Tranche B, and the borrower (1) increases the principal balance of Tranche A, and (2) pays off Tranche B, the borrower should perform the 10% test by combining the cash flows of the original Tranche A and Tranche B debt instruments and comparing the combined cash flows to the new cash flows of the restructured Tranche A. When discounting the cash flows of the restructured Tranche A, we believe a weighted average effective interest rate based on the original Tranche A and Tranche B interest rates should be used.

See FG 3.6.1 for information on costs associated with the concurrent modification of non-revolving (i.e., term debt) and revolving debt arrangements.

ASC 470-50-55-3 provides guidance on applying the guidance in ASC 470-50-40 to publicly traded debt securities.

There is no guidance on how to account for a refinancing of publicly traded debt securities that does not involve an exchange or modification offer (i.e., when a reporting entity issues new debt securities to investors, which potentially may include holders of the issuer’s existing debt securities, and uses the proceeds to pay off existing publicly-traded debt securities potentially held by the same investors). If a literal interpretation of ASC 470-50-55-3 is applied, each individual investor should be evaluated to determine whether the individual investor holds both the new and old debt securities. When the debt securities are publicly traded, this determination may be impossible because the borrower is not privy to the ultimate lender information. In that case, we believe it is reasonable to consider the substance rather than the form of the transaction. Unless the facts and circumstances indicate otherwise, we believe it is reasonable to assume that the investors in a new publicly-traded debt security are not the same as the investors in an existing publicly-traded debt security; therefore, the refinancing of publicly-traded debt securities should be accounted for as an extinguishment. This guidance may also be applicable to private placement debt instruments (e.g., 144A bond offering) depending on the specific facts and circumstances and the information reasonably available with respect to the identities of the old and new investors.

Similar accounting may be appropriate for “refunding” transactions on tax-exempt municipal bonds. If the tax-exempt municipal bond is widely held, it may be reasonable to conclude that an extinguishment has occurred. See NP 11.4.1 for additional information.

A third-party intermediary (e.g., an investment bank) may arrange a debt modification or exchange offer for a reporting entity. For example:

To determine the appropriate accounting treatment for a modification or exchange transaction arranged by a third-party intermediary, a reporting entity should determine whether the intermediary is a principal to the transaction (i.e., the investor in the bonds whose terms were modified) or the reporting entity’s agent (i.e., facilitating a refunding of the old bonds on behalf of the reporting entity through issuance of new debt).

ASC 470-50-55-7 provides indicators to be considered in evaluating whether a third-party intermediary is acting as principal or an agent.

There is a general presumption that a third-party intermediary is acting as an agent; however, this presumption can be overcome. The first indicator in ASC 470-50-55-7 is the most important; the third-party intermediary should be exposed to market risk to conclude it is acting as principal to the transaction. A reporting entity should evaluate all of the facts and circumstances to determine whether the third-party intermediary has funds at risk with regard to both the old bonds and new bonds. The following points should be considered.

If the third-party intermediary acts as an agent, the reporting entity has refinanced the original debt with new debt to other third-party investors and the reporting entity should consider the guidance in FG 3.4.8.

If the third-party intermediary is considered a principal to the transaction, it is the investor. In that case, the reporting entity should perform the 10% test based on the cash flows of the debt held by the third-party intermediary before and after the modification or exchange.

When a reporting entity issues new debt and uses the proceeds to pay off existing debt, it may incur issuance costs with the same party to (1) issue the new debt, and (2) reacquire the existing debt. For example, a reporting entity may use the same advisor to issue a tender offer for its existing debt and a private placement of its new debt. If the costs associated with each transaction are not separately identifiable, the reporting entity should allocate the total costs incurred between the issuance of the new debt and the reacquisition of the existing debt, on a rational basis.

A reporting entity may incur costs directly related to a debt modification or exchange that crosses a reporting period. To determine whether the costs should be capitalized as a prepaid expense or expensed in the period incurred, a reporting entity should consider the guidance in ASC 340-10-S99-1, SAB Topic 5.A, Expenses of Offering. Although this guidance relates to costs incurred in advance of an equity offering, we believe it can be analogized to costs incurred in advance of a debt restructuring. Based on that analogy, we believe that fees directly related to a debt restructuring incurred in advance of finalizing the transaction should be capitalized as a prepaid expense until the restructuring is finalized, unless facts and circumstances indicate that it is probable that the restructuring will be aborted or it is probable that the fees will be required to be expensed once the transaction is finalized in the subsequent period under the guidance in ASC 470-50-40. If it is probable that the restructuring will be aborted or that the fees will be expensed in the following period, they do not meet the definition of an asset (i.e., there is no present right to an economic benefit) and should not be capitalized.

For example, if a reporting entity incurred legal fees in advance of a debt restructuring and it finalized the debt restructuring transaction shortly after the balance sheet date, the reporting entity would likely have the information to assess the transaction using the guidance in ASC 470-50-40. If the reporting entity determined that the debt restructuring should be accounted for as a modification in the subsequent period, that guidance would require that all third-party fees be expensed. Therefore, by analogy to ASC 340-10-S99-1, the reporting entity should expense those legal fees in the period incurred because it is probable as of the balance sheet date that the fees would be expensed in the subsequent period.

If the reporting entity had not finalized its debt restructuring prior to issuing the financial statements and the reporting entity did not have enough information to determine if the transaction will be a modification or extinguishment in the subsequent period, the legal fees should be capitalized as a prepaid expense in the period incurred. However, we typically would not expect a long time lag between incurring such costs and the finalization of the debt restructuring since the costs must be directly related to the restructuring.

Once the debt restructuring is completed, the fees should be accounted for using the guidance in ASC 470-50-40. See Figure FG 3-4 for further information on the accounting treatment for fees.

On a consolidated basis, the debt of a consolidated subsidiary represents debt of the parent. Therefore, if debt of a consolidated subsidiary is exchanged for debt of the parent company, the guidance in ASC 470-50-40 should be applied to determine whether the exchange should be accounted for as a modification or an extinguishment in the consolidated financial statements.

A parent company may also acquire the debt of a consolidated subsidiary for cash. When this occurs, the requirements for extinguishment accounting in the subsidiary’s standalone financial statements are generally not met; however, on a consolidated basis, the consolidated entity has reacquired its own debt so extinguishment accounting is appropriate. See FG 3.7 for information on accounting for a debt extinguishment.