EITF ABSTRACTS Issue No. 86-28 Title: Accounting Implications of Indexed Debt Instruments Dates Discussed: October 16, 1986; December 4, 1986 References: ISSUE FASB Statement No. 5, Accounting for Contingencies FASB Statement No. 12, Accounting for Certain Marketable Securities FASB Statement No. 80, Accounting for Futures Contracts FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities APB Opinion No. 14, Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants APB Opinion No. 21, Interest on Receivables and Payables AICPA Statement of Position 97-1, Accounting by Participating Mortgage Loan Borrowers AICPA Issues Paper No. 86-2, Accounting for Options An enterprise issues debt instruments with both guaranteed and contingent payments. The contingent payments may be linked to the price of a specific commodity (for example, oil) or a specific index (for example, the S&P 500). In some instances, the investor's right to receive the contingent payment is separable from the debt instrument. An example is the issuance of a bond having periodic interest of 5 percent payable in cash, with the final payment being the greater of the amount of initial proceeds or an amount based on the then existing S&P 500 index. Another example is that, instead of the S&P 500 index used as a reference point, the fair value of real estate owned by the issuer of the bond is used (the so-called participating mortgage). [Note: See STATUS section.] Superseded by the FASB Accounting Standards Codification The issues are (1) whether the proceeds should be allocated between the debt liability and the investor's right to receive a contingent payment and (2) the issuer's subsequent accounting for recognition of increases in the underlying commodity or index values. Page 1
EITF DISCUSSION The Task Force reached a consensus that, if the investor's right to receive the contingent payment is separable, the issuer should allocate the proceeds between the debt instrument and the investor's stated right to receive the contingent payments. The premium or discount on the debt instrument resulting from the allocation should be accounted for in accordance with Opinion 21. [Note: See STATUS section.] A consensus was not reached regarding transactions in which the investor's right to receive a contingent payment is not separable from the debt obligation because of questions regarding the applicability of Opinion 14. [Note: See STATUS section.] The Task Force also reached a consensus that, irrespective of whether any portion of the proceeds is allocated to the contingent payment, as the applicable index value increases such that the issuer would be required to pay the investor a contingent payment at maturity, the issuer should recognize a liability for the amount that the contingent payment exceeds the amount, if any, originally attributed to the contingent payment feature. The liability for the contingent payment feature should be based on the applicable index value at the balance sheet date and should not anticipate any future changes in the index value. When no proceeds are originally allocated to the contingent payment, the additional liability resulting from the fluctuating index value should be accounted for as an adjustment of the carrying amount of the debt obligation. [Note: See STATUS section.] The Task Force members discussed the appropriateness of hedge accounting to account for changes in the liability but expressed a number of concerns and reservations. The discussion Superseded by the FASB Accounting Standards Codification focused on the example of indexed debt in which the contingent payment feature is payable in cash and is separable so that the issuer allocates proceeds to the debt and the contingent payment feature. If the index increases and the issuer would be required to establish an additional liability, a majority of the Task Force favored recognizing the increase in the contingent payment Page 2
as a current expense, but a consensus was not reached. The Task Force Chairman indicated the staff's view that, in the above factual circumstances, (1) any notion of hedge accounting for a written option would not be permitted under the authoritative literature and could only be supported by reference to Issues Paper 86-2, and (2) the Issues Paper would limit the application of hedge accounting to the premium received on the written option and to assets carried at other than cost. If the index increases to a level that would require liability accrual, the staff believes the issuer should recognize the contingent payment as additional expense. [Note: See STATUS section.] While certain Task Force members would call for expense recognition in the above case, some of them would not require expense recognition if the contingent payment will be settled by delivery of the physical commodity rather than the value of the commodity or index in cash. An FASB staff representative indicated the staff's view that the means of settling the contingent payment feature could affect the accounting if the issuer owns or has the ability to acquire the commodity at a favorable price. The staff would view the possibility that the issuer would settle the contingent payment feature by delivering the actual commodity as fixing the issuer's cost of settlement. Subsequent increases in the value of the commodity and resulting value of the contingent payment feature would not be recognized. [Note: This issue has been partially nullified by Statement 133. See STATUS section.] STATUS At the February 26, 1987 meeting, the AcSEC Observer noted that the Board discussed Issues Paper 86-2 at its February 25, 1987 meeting. At that meeting, the Board reaffirmed its decision Superseded by the FASB Accounting Standards Codification to address the specific issues as a part of its project on financial instruments, as this will allow consideration of the accounting issues as they relate to a variety of instruments. While the Board has not yet examined the issues involved and therefore takes no position on the advisory conclusions in the Issues Paper, it noted that certain of the advisory conclusions conflict or are Page 3
inconsistent with existing authoritative accounting pronouncements and that the existing authoritative accounting pronouncements should be followed. At the July 23-24, 1997 meeting, the Task Force addressed the accounting for contingent consideration issued to effect a purchase business combination in Issue No. 97-8, Accounting for contingent Consideration Issued in a Purchase Business Combination. The Task Force observed that Issue 86-28 should be applied to indexed debt instruments that meet the criteria in Issue 97-8 for recording as part of the cost of the business acquired in a purchase business combination. On May 9, 1997, the AICPA s Accounting Standards Executive Committee issued SOP 97-1, which addresses the accounting by a borrower for a participating mortgage loan if the lender participates in increases in the market value of the mortgaged real estate project, the results of operations of that mortgaged real estate project, or both. Statement 133 was issued in June 1998 and has been subsequently amended. The effective date for Statement 133, as amended, is for all fiscal quarters of all fiscal years beginning after June 15, 2000. Statement 133 effectively nullifies Issue 86-28 prospectively. The Task Force consensuses would not apply to debt instruments that contain an embedded derivative that is accounted for under Statement 133. (Paragraph 50 [as amended by Statement 137] permits entities not to account separately for certain derivatives embedded in pre-1998 or pre-1999 hybrid instruments, including indexed debt instruments.) The indexing feature must be analyzed to determine whether it constitutes an embedded derivative that warrants separate accounting under Superseded by the FASB Accounting Standards Codification paragraphs 12 16 (and 60 and 61). Paragraphs 61(h) and (i) of Statement 133 indicate that, for an equity-related or commodity-related embedded derivative, the changes in fair value of an equity security or a commodity (which affect the amount of equity- and commodity-indexed interest payments) are not clearly and closely related to a debt instrument. Embedded Page 4
derivatives that are separately accounted for under Statement 133 may qualify to be designated as hedging instruments. (Written options can be designated as hedging instruments only if the additional criteria in paragraphs 20(c) and 28(c) are met.) If the entity cannot reliably identify and measure the embedded derivative for separation from the host contract, paragraph 16 requires that the entire contract be measured at fair value with the gain or loss recognized currently in earnings and may not be designated as a hedging instrument. However, paragraph 301 of Statement 133 clarifies that it should be unusual that an entity would conclude that it cannot reliably separate an embedded derivative from its host contract. If the derivative is legally separable from the debt obligation, it is not an embedded derivative, but simply an attached derivative that must be accounted for under Statement 133 as a freestanding derivative. If the indexing feature must be settled by delivery of a commodity, whether that commodity is readily convertible to cash is relevant to determining whether separate accounting is required. (See paragraphs 12(c) and 9(c).) If the indexing feature does not warrant separate accounting as an embedded derivative under Statement 133, the entire hybrid would be accounted for under Issue 86-28. The consensus for this Issue on subsequent recognition uses intrinsic value to measure the liability, whereas Statement 133 uses fair value. Statement 133 Implementation Issue No. B24, Interaction of the Requirements of EITF Issue No. 86-28 and Statement 133 Related to Structured Notes Containing Embedded Derivatives, also contains guidance related to the applicability of Statement 133 to indexed debt instruments. For embedded written options that must be accounted for under Statement 133, that Statement Superseded by the FASB Accounting Standards Codification permits the limited use of net written options for fair value and cash flow hedging purposes, provided the criteria in paragraphs 20(c) and 28(c), respectively, are met. Statement 133 applies to both the issuer and the investor. Page 5
No further EITF discussion is planned. Superseded by the FASB Accounting Standards Codification Page 6