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6.3 Types of interest rates
Publication date: 31 May 2022
us Loans & investments guide
An interest rate is economically composed of different components designed to compensate lenders (investors) for their investment. The base component is a risk-free rate, or the amount a lender would charge if there was no possibility of default. Another component is a credit spread, which compensates the lender for the possibility that the borrower may default and fail to repay its loan. The interest rate demanded by the market may also include components for the liquidity risk of the instrument, other market considerations, and contractual features, such as prepayment options. In practice, the individual elements that compose the interest rate demanded by the market may be difficult to quantify.
Interest, in its simplest form, is calculated by applying a contractually-specified rate of return to the principal (par) amount of a receivable (investment) that has specified payment dates and a stated maturity date. The amount of interest earned can be impacted by other factors, such as whether a receivable was acquired at an amount less than its principal amount (a discount) or more than its principal amount (a premium).
Figure LI 6-1 describes some of the more common types of interest rates.
Figure LI 6-1
Types of interest rates
Types of interest rates
Interest type |
Description |
Fixed-rate interest
|
Interest rates set at issuance of the financial asset that do not change over time
|
Variable-rate interest
|
Interest rates that change over time, most often based on a published interest rate index, such as the London InterBank Offered Rate (LIBOR), Secured Overnight Financing Rate (SOFR) or a prime rate
|
Zero coupon
|
A zero-coupon bond is purchased for an amount lower than its face value, with the face value repaid at maturity.
There is no stated interest rate and the issuer does not make periodic interest payments. When the bond reaches maturity, its investor receives the face (or par) value. Although there are no regularly scheduled interest payments, interest is earned over time as the difference between the bond’s purchase price and its par value.
|
Paid-in-kind (PIK)
|
Interest on a financial asset paid by the issuance of a new bond as compensation for interest due, which in turn has its own stated terms, including interest, principal, and maturity.
|
Interest can be simple or compounded. Simple interest is computed on the amount of the principal only; compound interest is computed on principal and on any interest earned that has not been paid.
When the terms of a financial asset involve returns that vary in timing or amounts, the financial asset should be evaluated to determine if there are any freestanding or embedded derivatives that should be accounted for separately. See PwC's Derivative instruments and hedging activities guide (DH 4) for guidance on the evaluation of embedded features.
6.3.1 Imputed interest
When an entity originates a note that is non-interest bearing or has a stated interest rate that is not a market rate of interest, it may be required to impute interest based on the guidance in ASC 835-30. ASC 835-30-15-3 lists the transactions not subject to the requirement to impute interest.
ASC 835-30-15-3, post ASU 2020-10, Codification Improvements
With the exception of guidance in paragraphs 835-30-45-1A through 45-3 addressing the presentation of discount and premium in the financial statements, which is applicable in all circumstances, and the guidance in paragraphs 835-30-55-2 through 55-3 regarding the application of the interest method, the guidance in this Subtopic does not apply to the following:
- Payables arising from transactions with suppliers in the normal course of business that are due in customary trade terms not exceeding approximately one year
- Amounts that do not require repayment in the future, but rather will be applied to the purchase price of the property, goods, or service involved; for example, deposits or progress payments on construction contracts, advance payments for acquisition of resources and raw materials, advances to encourage exploration in the extractive industries (see paragraph 932-835-25-2)
- Amounts intended to provide security for one party to an agreement (for example, security deposits, retainages on contracts)
- The customary cash lending activities and demand or savings deposit activities of financial institutions whose primary business is lending money
- Transactions where interest rates are affected by the tax attributes or legal restrictions prescribed by a governmental agency (for example, industrial revenue bonds, tax exempt obligations, government guaranteed obligations, income tax settlements)
- Transactions between parent and subsidiary entities and between subsidiaries of a common parent
- The application of the present value measurement (valuation) technique to estimates of contractual or other obligations assumed in connection with sales of property, goods, or service, for example, a warranty for product performance
- Receivables, contract assets, and contract liabilities in contracts with customers, see paragraphs 606-10-32-15 through 32-20 for guidance on identifying a significant financing component in a contract with a customer
Question LI 6-1 and Question LI 6-2 discuss the application of ASC 835-30 to certain types of instruments.
Question LI 6-1
Does the imputed interest guidance in ASC 835-30 apply to loans payable on demand with no stated maturity date?
Does the imputed interest guidance in ASC 835-30 apply to loans payable on demand with no stated maturity date?
PwC response
No. ASC 835-30-15-2 states that the guidance applies to receivables that represent contractual rights to receive money on fixed or determinable dates. A loan payable on demand with no stated maturity date is not payable on a fixed or determinable date.
Question LI 6-2
Does the imputed interest guidance in ASC 835-30 apply to a long-term note that is non-interest bearing in the first year that bears a market rate of interest rate after the first year?
Does the imputed interest guidance in ASC 835-30 apply to a long-term note that is non-interest bearing in the first year that bears a market rate of interest rate after the first year?
PwC response
Yes. See Example LI 6-2 for an example of how to apply the interest method to an instrument with an increasing interest rate.
6.3.1.1 Receipt of note for non-cash consideration
As noted in ASC 835-30-15-3(h), the imputed interest guidance in ASC 835-30 generally does not apply to receivables, contract assets, and contract liabilities in contracts with customers subject to ASC 606. ASC 606 provides guidance on the recognition of revenue from contracts with customers. ASC 606-10-32-15 through ASC 606-10-32-20 address the identification, measurement, and recognition of a significant financing component in contracts with customers. See RR 4.4 for additional guidance on significant financing components in contracts with customers.
For transactions not involving revenue from contracts with customers subject to ASC 606, ASC 835-30-25-7 through ASC 835-30-25-11 provide guidance on the initial recognition for notes received for property, goods, or services.
A note exchanged for property, goods, or service represents the following two elements, which may or may not be stipulated in the note:
- The principal amount, equivalent to the bargained exchange price of the property, goods, or service as established between the supplier and the purchaser
- An interest factor to compensate the supplier over the life of the note for the use of funds that would have been received in a cash transaction at the time of the exchange.
Notes exchanged for property, goods, or services are valued and accounted for at the present value of the consideration exchanged between the contracting parties at the date of the transaction in a manner similar to that followed for a cash transaction.
The difference between the face amount and the present value upon issuance is shown as either discount or premium.
In circumstances where interest is not stated, the stated amount is unreasonable, or the stated face amount of the note is materially different from the current cash sales price for the same or similar items or from the fair value of the note at the date of the transaction, the note, the sales price, and the cost of the property, goods, or service exchanged for the note shall be recorded at the fair value of the property, goods, or service or at an amount that reasonably approximates the fair value of the note, whichever is the more clearly determinable. That amount may or may not be the same as its face amount, and any resulting discount or premium shall be accounted for as an element of interest over the life of the note.
In the absence of established exchange prices for the related property, goods, or service or evidence of the fair value of the note (as described in paragraph 835-30-25-2), the present value of a note that stipulates either no interest or a rate of interest that is clearly unreasonable shall be determined by discounting all future payments on the notes using an imputed rate of interest. This determination shall be made at the time the note is issued, assumed, or acquired; any subsequent changes in prevailing interest rates shall be ignored.
If an established exchange price is not determinable and the note has no ready market, the reporting entity should impute an interest rate to determine the present value of the note. The rate should be equivalent to a rate that would be recorded in a market transaction with similar terms with the counterparty. This requires analyzing the economic substance of the transaction, rather than simply the form of the note.
6.3.1.2 Receipt of note for cash
When a debtor issues a note to an unrelated lender in exchange for cash and no other rights or privileges are exchanged, the note is assumed to have a present value at issuance equal to the amount of cash exchanged (assuming the transaction did not involve other elements). Because the total amount of interest recognized over the term of a cash loan is equal to the difference between cash exchanged at inception and the total amount that the borrower will repay over the term of the loan, any difference between cash exchanged at inception and the present value of cash flows repaid over the term of the loan is shown as a premium or discount to the original issuance. In these circumstances, the discount or premium on the note shall be amortized into interest income over the life of the note to arrive at a constant effective yield when applied to the outstanding amount of the note at the beginning of each period (i.e., the interest method) in accordance with ASC 835-20-35-2. See LI 6.5.
If a company issues or receives a note in exchange for only cash with no interest rate or a stated interest rate that appears to be other than a market rate of interest for similar transactions, the situation should be investigated to determine if additional rights or privileges were exchanged. In such cases, ASC 835-30-25-6 requires that the rights or privileges be given accounting recognition, which creates a discount or premium on the note. ASC 835-30-25-6 includes an example.
A note issued solely for cash equal to its face amount is presumed to earn the stated rate of interest. However, in some cases the parties may also exchange unstated (or stated) rights or privileges, which are given accounting recognition by establishing a note discount or premium account. In such instances, the effective interest rate differs from the stated rate. For example, an entity may lend a supplier cash that is to be repaid five years hence with no stated interest. Such a non-interest-bearing loan may be partial consideration under a purchase contract for supplier products at lower than the prevailing market prices. In this circumstance, the difference between the present value of the receivable and the cash loaned to the supplier is appropriately regarded as an addition to the cost of products purchased during the contract term. The note discount shall be amortized as interest income over the five-year life of the note, as required by Section 835-30-35.
Additional examples of unstated rights or privileges that may accompany cash loans include:
- A supplier contracts with a purchaser for cash sales of product for more than the prevailing market price and, simultaneously, lends the purchaser funds at a low interest rate.
- A supplier performs a purchaser’s warehousing for no additional charge in exchange for a non-interest-bearing loan from the purchaser.
- A company provides a service to another company at no charge in exchange for funds borrowed at a low interest rate.
In these circumstances, any discount or premium on the note would be accreted or amortized as interest income or expense using the interest method, as discussed in LI 6.5.
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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