Jillian Limited ( JL) issued a financial instrument with the following terms:
• A face value of $ 100.
• Not secured by any assets of the entity (unsecured).
• Redeemable in cash at the option of the issuer.
• Pays 5% of face value annually.
• The 5% doubles in five years (to 10%) if the financial instrument is not redeemed. In 10 years, the annual payments double again if not redeemed by that time. Other information to consider:
• Current interest rates are 4%. Rates are expected to remain stable or decline in the short to midterm.
• JL currently has a loan outstanding with the bank. Under the terms of the loan agreements, the debt- to- equity ratio may not exceed 2: 1. Currently, before accounting for the new instrument, the debt- to- equity ratio is 2: 1.
Required
Discuss how JL should account for the financial instrument on the balance sheet (debt or equity) assuming that that JL reports under U. S. GAAP.
SOLUTION
JL’s bank is a key user of the financial statements and will be watching the debt-to-equity ratio. If the ratio is exceeded, the loan becomes due and this is an undesirable outcome. JL may therefore be biased to ensure that the loan covenant is not breached when considering how to account for the financial instrument. Therefore, the equity classification would be the most attractive option. JL must ensure that the accounting reflects the economic substance for transparency.
The legal form of the instrument is unclear. However, it appears to have some attributes of both debt and equity.
The instrument appears to be share-like as it is not secured and does not have a repayment date. Is the 5% a dividend payment or interest?
If it is decided that the instrument is share-like, as long as ASC 480-10 does not specifically preclude the instrument from being accounted for as equity, it should be presented as such on the balance sheet. These instruments are not mandatorily redeemable since there is no set repayment date nor are they repayable in a variable number of shares. As a result, it would appear that ASC 480-10 does not specifically preclude classification as equity.
The only issue to consider is whether the escalating dividend/coupon payment represents economic compulsion to redeem the instruments, i.e., making it in essence mandatorily redeemable. Given that interest rates are only 4% currently, why would JL want to pay the potentially doubled rates of 10% or even 20%, especially since interest rates are expected to remain stable or decline?
U.S. GAAP is inconclusive on how to account for this instrument and so in the absence of specific guidance, a case could be made to record it as equity. In this scenario, JL would not violate its debt covenant. The payments would be considered a distribution of income and not a determinant of income.
Another option would be to treat the instrument as debt. This would have the negative consequence of recording an additional liability on the balance sheet and violating the debt covenant restriction. It would also lower income as the interest payments would be an expense.
A third option might be to bifurcate the instrument, recording a portion as debt and a portion as equity. Bifurcation is allowed in certain circumstances, e.g., bonds issued with detachable warrants, however, current U.S. practice does not allow bifurcation under this scenario, as noted earlier. In this case, the two market values of the bonds and the warrants are not mutually exclusive. JL will therefore have to treat the entire instrument as either debt or equity with no bifurcation.