Auditors are reminding companies again at the end of 2014 to be cautious of the financial reporting implications if they are issuing or modifying debt to take advantage of low interest rates.
Capital markets are starting to anticipate a move in 2015 by the Federal Reserve to increase interest rates for the first time after years of flat rates during economic strife. PwC says in an alert on a variety of year-end issues that it knows of many companies exploring issuance new debt or modification to existing debt to beat the expected rate increase. The firm is warning companies to take a close look at the contractual provisions for any signs of embedded derivatives that may need to be broken out and reported separately under accounting rules.
“Embedded derivatives rarely have the word ‘derivative’ associated with them in the debt agreement, making them more difficult to identify,” PwC warns. The firm points to five common features that generally suggest some additional evaluation is necessary to determine whether the agreement indeed contains an embedded derivative, which might require bifurcation, or separate recognition and measurement in financial statements.
Certain put options that give the holder the right to demand immediate repayment might constitute an embedded derivative, PwC says. Such options might specify the holder of the instrument can demand immediate repayment if there’s an event that leads to a change of control over the company, a default, or achievement of some specified milestone.
A call option or prepayment right, giving the issuer the right to prepay the debt before its maturity date, might also suggest the possibility of an embedded derivative, PwC says. Likewise, a stock conversion option, giving the holder the right to convert debt into a variable number of shares based on the fair value of the next round of equity financing might also constitute an embedded derivative.
At a recent national accounting conference, Hillary Salo, professional accounting fellow at the Securities and Exchange Commission, said the staff has faced questions lately on some hedge accounting issues, such as the impact of a derivative instrument’s “novation,” or the replacement of one counterparty with another, and how to treat a liability when its fair value exceeds the net proceeds a company receives for taking on a hybrid instrument.
With respect to novation, Salo outlined some specific criteria and circumstances companies would be expected to consider in determining whether hedge accounting will apply. As for the fair value question, acknowledging there may be some substantive reasons why companies would accept less than the fair value for assuming such a liability, Salo said the staff would expect companies to recognize a loss in earnings and explain it to investors. “Given the unique nature of these transactions, we would expect reporting entities to provide clear and robust disclosure of the nature of the transaction, including reasons why the entity entered into the transaction and the benefits received,” she said.
The Financial Accounting Standards Board recently finished new guidance meant to eliminate the use of different accounting methods when companies raise capital by offering shares that include embedded derivative features. The new guidance will help sort out whether the host contract of a hybrid instrument issued as a share should be treated like debt or equity. FASB is also working on a larger-scale update to hedge accounting, recently resuming work on a possible new standard.
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