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6.8 Recognition of interest income on structured notes
Publication date: 31 May 2022
us Loans & investments guide
ASC 320-10-35-40 through ASC 325-10-35-42 provide guidance on interest recognition for certain structured notes. This guidance applies to instruments that are not accounted for as derivatives and in which the “structured payments” are not bifurcated and separately accounted for as derivatives under the guidance in ASC 815. The guidance also does not apply to instruments classified as trading.
The guidance requires the use of the retrospective interest method.
Entities shall use the retrospective interest method for recognizing income on structured note securities that are classified as available-for-sale or held-to-maturity debt securities and that meet any of the following conditions:
a. Either the contractual principal amount of the note to be paid at maturity or the original investment amount is at risk (for other than failure of the borrower to pay the contractual amounts due). Examples include principal-indexed notes that base principal repayment on movements in the Standard & Poor's S&P 500 Index or notes that base principal repayment on the occurrence of certain events or circumstances.
b. The note's return on investment is subject to variability (other than due to credit rating changes of the borrower) because of either of the following:
1. There is no stated coupon rate or the stated coupon is not fixed or prespecified, and the variation in the return on investment or coupon rate is not a constant percentage of, or in the same direction as, changes in market-based interest rates or interest rate index, for example, the London Interbank Offered Rate (LIBOR) or the U.S. Treasury Bill Index.
2. The variable or fixed coupon rate is below market rates of interest for traditional notes of comparable maturity and a portion of the potential yield (for example, upside potential for principal) is based on the occurrence of future events or circumstances. (Examples of instruments that meet this condition include inverse floating-rate notes, dual-index floating notes, and equity-linked bear notes.)
c. The contractual maturity of the bond is based on a specific index or on the occurrence of specific events or circumstances outside the control of the parties to the transaction, excluding the passage of time or events that result in normal covenant violations. Examples of instruments that meet this condition include index amortizing notes and notes that base contractual maturity on the price of oil.
Under the retrospective interest method, the income recognized for a reporting period would be measured as the difference between the amortized cost of the security at the end of the period and the amortized cost at the beginning of the period, plus any cash received during the period. The amortized cost would be calculated as the present value of estimated future cash flows using an effective yield, which is the yield that equates all past actual and current estimated future cash flow streams to the initial investment. If the effective yield is negative (that is, the sum of the newly estimated undiscounted cash flows is less than the security's amortized cost), the amortized cost would be calculated using a zero percent effective yield. Example 1 (see paragraph 320-10-55-16) illustrates the application of the retrospective interest method.
For purposes of determining the effective yield at which income will be recognized, all estimates of future cash flows shall be based on quoted forward market rates or prices in active markets, when available; otherwise, they shall be based on current spot rates or prices as of the reporting date.
An example of an instrument subject to this guidance is an inflation-linked bond in which the contractual principal is indexed to an inflation rate. See ASC 320-10-55-10 for a description of structured notes that may also be subject to this guidance.
ASC 320-10-55-11 and ASC 320-10-55-12 provide a description of the procedures required to calculate the interest income on a retrospective basis.
Paragraph 320-10-35-40 requires the retrospective interest method to recognize income on certain securities. The amortized cost amount is calculated as the present value of estimated future cash flows using an effective yield, which is the yield that equates all past actual and current estimates of future cash flow streams to the initial investment. If the effective yield is negative, the amortized cost amount should be calculated using a zero percent effective yield. Thus, the following procedures would be required for each reporting period:
a. Calculate the effective yield that equates all past actual cash flows and current estimates of future cash flows to the initial investment amount.
b. Using the rate calculated in (a), or zero percent if negative, calculate the present value of the estimated future cash flows. That amount represents the amortized cost at the end of the period.
c. Adjust the amortized cost balance to the amount calculated in (b) with the offsetting amount recognized as income for the period.
The preadjusted amortized cost balance should represent the amortized cost balance at the beginning of the period less any cash received on the investment during the period.
See ASC 320-10-55-16 through ASC 320-10-55-19 for an illustrative example of the application of this guidance.
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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