Case 04-10: Cashless, Inc

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PROFESSORS DISCUSSION MATERIALS Objectives of the Case The case is intended to encourage participants to exercise professional judgment when evaluating the timing of expense recognition and to challenge participants to develop persuasive arguments in support of contrasting views. Applicable Professional Pronouncements ACS 230-10, Statement of Cash Flows: Overall (ASC 230-10) (EITF Issue No. 95-13, Classification of Debt Issue Costs in the Statement of Cash Flows) ASC 470-20, Debt: Debt With Conversion and Other Options (ASC 470-20) (EITF Issue No. 85-17, Accrued Interest Upon Conversion of Convertible Debt; EITF Issue No. 98-5, Accounting for Convertible Securities With Beneficial Conversion Features or Contingently Adjustable Conversion Ratios; and EITF Issue No. 00-27, Application of Issue No. 98-5 to Certain Convertible Instruments) ASC 470-50, Debt: Modifications and Extinguishments (ASC 470-50) (FASB Technical Bulletin No. 80-1, Early Extinguishment of Debt Through Exchange for Common or Preferred Stock) ASC 835-30, Interest: Imputation of Interest (ASC 835-30) (APB Opinion No. 21, Interest on Receivables and Payables) ASC 860-20, Transfers and Serving: Sales of Financial Assets (ASC 860-20) (EITF Issue No. 85-25, Sale of Preferred Stocks With a Put Option) FASB Statement No. 150, Accounting for Certain Financial Instruments With Characteristics of Both Liabilities and Equity (Statement 150) (codified in ASC 48010, Distinguishing Liabilities and Equity: Overall (ASC 480-10)). FASB Statement No. 155, Accounting for Certain Hybrid Financial Instruments an amendment of FASB Statements No. 133 and 140 (Statement 155) (codified in ASC 815-15, Derivatives and Hedging: Embedded Derivatives (ASC 815-15)) FASB Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities Including an amendment of FASB Statement No. 115 (Statement 159) (codified in ASC 825-10, Financial Instruments: Overall (ASC 825-10)) FASB Concepts Statement No. 6, Elements of Financial Statements (Concepts Statement 6) FASB Staff Position (FSP) No. APB 14-1, Accounting for Convertible Debt Instruments That May Be Settled in Cash Upon Conversion (Including Partial Cash Settlement) (FSP APB 14-1) (codified in ASC 470-10, Debt: Overall (ASC 470-10))

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Case 04-10: Cashless, Inc

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EITF Issue No. 07-5, Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entitys Own Stock (Issue 07-5) (codified in ASC 815-40, Derivative and Hedging: Contracts in Entitys Own Equity (ASC 815-40)) EITF Topic No. D-98, Classification and Measurement of Redeemable Securities (Topic D-98) SEC Staff Accounting Bulletin Topic 3.C, Redeemable Preferred Stock (SAB Topic 3.C) SEC Staff Accounting Bulletin Topic 2.A.6, Business Combinations Debt Issue Costs (SAB Topic 2.A.6) January 1991 SEC speech on redeemable securities by a professional accounting fellow

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Case 04-10: Cashless, Inc

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Discussion 1 What is the appropriate amortization period for the debt issue costs? Accounting Alternatives Alternative 1 Amortize the issuance costs over the 10-year life of the debt. Proponents of amortizing debt issue costs over the life of the debt believe that debt issue costs should be treated like a debt discount. Alternative 1 proponents cite paragraph 237 of Concepts Statement 6, which states, in part: Debt issue cost in effect reduces the proceeds of borrowing and increases the effective interest rate and thus may be accounted for the same as debt discount. ASC 835-30-35-2 requires that debt discounts be amortized over the life of the debt. Specifically, ASC 835-30-35-2 states, in part: [T]he difference between the present value and the face amount shall be treated as discount or premium and amortized as interest expense or income over the life of the note in such a way as to result in a constant rate of interest when applied to the amount outstanding at the beginning of any given period. Alternative 1 proponents believe that if this approach is taken, and the put is exercised at the end of year one, the accounting for the remaining issue costs, or the asset, would be charged to income regardless of the put being settled in cash or stock. To support income recognition, if there is a stock issuance, proponents of Alternative 1 cite ASC 470-50-402, which states, in part: A difference between the reacquisition price and the net carrying amount of the extinguished debt shall be recognized currently in income of the period of extinguishment as losses or gains and identified as a separate item. Gains and losses shall not be amortized to future periods. [Emphasis added] Alternative 2 Amortize the issuance costs over one year, up to the date of the first put. Proponents of Alternative 2 also refer to Concepts Statement 6 and ASC 835-30, agreeing that the debt issue costs should be treated like a debt discount. Alternative 2 proponents believe, however, that the life of the debt is one year, not 10 years, because the exercise of the put option at the end of year one is outside the debt issuers control. Stated another way, this debt instrument is economically similar to one-year debt that is extendable by the holder for an additional two years, followed by an additional seven years. Viewed this way, the debt issuance costs should be amortized over one year so that the carrying value of the debt is equal to the redemption amount as soon as it is redeemable at the holders option. In addition, Alternative 2 proponents support their position by analogizing to SAB Topic 3.C, which states, in part: The initial carrying amount of redeemable preferred stock should be its fair value at date of issue. Where fair value at date of issue is less than the mandatory redemption amount, the carrying amount shall be increased by periodic
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Case 04-10: Cashless, Inc

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accretions, using the interest method, so that the carrying amount will equal the mandatory redemption amount at the mandatory redemption date. The carrying amount shall be further periodically increased by amounts representing dividends not currently declared or paid, but which will be payable under the mandatory redemption features, or for which ultimate payment is not solely within the control of the registrant (e.g., dividends that will be payable out of future earnings). Alternative 2 proponents believe that the mandatory redemption date in SAB Topic 3.C can be analogized in this debt instrument to the first date on which the holder has the unilateral right to put the debt to Cashless Inc. (Cashless or the Company). They also believe the fact that Cashless may issue stock to settle the put option does not change the conclusion because SAB Topic 3.C addresses settlement using other securities, stating, in part: The accounting described in the preceding paragraph would apply irrespective of whether the redeemable preferred stock may be voluntarily redeemed by the issuer prior to the mandatory redemption date, or whether it may be converted into another class of securities by the holder. In addition, Alternative 1 proponents acknowledge that in ASC 470-20-35-7, a discount arising from a beneficial conversion option must be amortized to the stated redemption date. Alternative 2 proponents, however, believe the stated redemption date for this instrument is the first put date, since the put is within the control of the holder, not the issuer, of the debt instrument. Proponents of Alternative 2 disagree with the analogies to convertible debt used in Alternative 3. That the issuer has the right to honor the year-one put with stock merely makes this instrument a stock-settleable liability, which is not the same as the early conversion of convertible debt. Therefore, it is inappropriate to conclude that the yearone put can be ignored (Alternative 3). Alternative 3 Amortize the issuance costs over three years to the date of the first cashrequired put. Alternative 3 proponents and Alternative 2 proponents agree that amortization of the debt issue costs should not be over the entire nominal life of the debt. However, proponents of Alternative 3 think that amortization should be to the first cash-required put date (i.e., at the end of year three). They believe that the first put date can be ignored: if the holder exercises its put right at the end of year one, the issuer has the right to issue stock to settle the put. Alternative 3 proponents believe this is the same as any early exercise of convertible debt. In that case, the issuer would amortize the issue costs over three years and, if the holder converted at the end of year one, the remaining issue cost balance would be charged to equity, if stock is issued. There would be no income statement impact as there would be at the end of year three, if there was an unamortized debt discount balance and cash was paid. To support taking the remaining issue costs to equity if stock is issued at the end of year one, Alternative 3 proponents cite ASC 470-20-40-11, which states, in part:

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Case 04-10: Cashless, Inc

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[T]he net carrying amount of the debt, including any unamortized premium or discount and the related accrual for interest to the date of conversion, net of any related income tax effects, is a credit to the entitys capital. Solution 1 We support Alternative 2. As stated above, Concepts Statement 6 concludes that debt issuance costs should be treated similarly to debt discount. Paragraph 237 of Concepts Statement 6 states, in part: Debt issue cost also falls into the first group of elements and is either an expense or a reduction of the related debt liability. Debt issue cost is not an asset for the same reason that debt discount is not it provides no future economic benefit. Debt issue cost in effect reduces the proceeds of borrowing and increases the effective interest rate and thus may be accounted for the same as debt discount. The amortization period for debt discount is addressed in ASC 835-30-35-2, which states, in part: With respect to a note for which the imputation of interest is required, the difference between the present value and the face amount shall be treated as discount or premium and amortized as interest expense or income over the life of the note in such a way as to result in a constant rate of interest when applied to the amount outstanding at the beginning of any given period. Because Concepts Statement 6 states that debt issuance costs should be treated similarly to debt discount, deferred debt issuance costs related to the issuance of debt that has no investor redemption features typically are amortized over the life of the related debt by using the effective interest method. However, in this example, Cashless wrote put options to the holder, allowing the holder to put the debt to Cashless at certain dates. The exercise of the put options is outside the control of the debt issuer. Said another way, this debt instrument is economically similar to one-year debt that is extendable by the holder for an additional two years, followed by an additional seven years. Viewed this way, we believe the life of the debt is one year; therefore, the debt issuance costs should be amortized over one year so that the carrying value of the debt is equal to the redemption amount as soon as it is redeemable. Additional support for Alternative 2s accretion of the carrying value of debt to its redemption amount by the earliest redemption date is in several ASC sections including ASC 860-20 and ASC 470-20. Discussion 2 What if the put, in years one and three, were not controlled by the holder, but were contingent on an outside event? Over what period would the issuer amortize the debt issue costs? Solution 2 The Big 4 discussed this, analogizing to a January 1991 SEC speech on redeemable securities by a professional accounting fellow, stating, in part, the following:
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Case 04-10: Cashless, Inc

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If a securitys redemption is fixed (e.g., redeemable in five years for a fixed amount), the issuer should adjust the recorded amount to the redemption amount over the period prior to the redemption date. If the redemption amount is variable (e.g., redeemable in five years for market value), the security should be marked to its redemption value at each balance-sheet date. If redemption is uncertain (e.g., redeemable upon a change in control), the initial amount recorded does not have to be adjusted until redemption is deemed probable. At that time, the redeemable security should be adjusted to the full redemption amount. This analogy indicates that the discount would be amortized to the first probable redemption. Thus, if resolution of the contingency, triggering the first-year and third-year put, were not probable, the discount would start to be amortized over 10 years. The life would change if the trigger became probable. Addendum June 2004 In May 2003, the FASB issued Statement 150 (as codified in ASC 480-10). ASC 480-10 establishes how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. ASC 480-10 requires that an issuer classify a financial instrument that is within its scope as a liability because that financial instrument embodies an obligation of the issuer. ASC 480-10-25-14 specifies, in part, the following: A financial instrument that embodies an unconditional obligation, or a financial instrument other than an outstanding share that embodies a conditional obligation, that the issuer must or may settle by issuing a variable number of its equity shares shall be classified as a liability (or an asset in some circumstances) if, at inception, the monetary value of the obligation is based solely or predominantly on [a] fixed monetary amount known at inception (for example, a payable settleable with a variable number of the issuer's equity shares). ASC 480-10-55-22 gives an example of an obligation to issue shares with monetary value based on a fixed monetary amount, which would be classified as a liability. This guidance suggests that it would be inappropriate to conclude that the year-one put in the case can be ignored solely because the issuer has the right to issue stock to settle the put (Alternative 3). In Topic D-98, last discussed on September 10, 2008, the SEC staff expresses its view that if an equity security is not redeemable currently (for example, because a contingency has not been met), and it is not probable that the security will become redeemable, subsequent adjustment to the carrying amount is not necessary until it is probable that the security will become redeemable. If it is probable that the security will become redeemable, the SEC staff will not object to either of the following two accounting methods for changes in the redemption value: (1) to accrete such changes over the period from the date of issuance (or from the date that it becomes probable that the security will become redeemable) to the earliest redemption date of the security or (2) to recognize such changes immediately. This guidance does not affect the conclusions reached in this case.

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Case 04-10: Cashless, Inc

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Addendum August 2006 Topic D-98 was discussed at the March 1718, 2004, meeting and again at the September 15, 2005, meeting. Paragraph 26 of Topic D-98 states, in part: [T]he SEC Observer clarified the SEC staffs position relating to the interaction of this SEC staff announcement and Statement 150 [as codified in ASC 480-10] for conditionally redeemable preferred shares. If a company issues preferred shares that are conditionally redeemable, for example, at the holders option or upon the occurrence of an uncertain event not solely within the companys control, the shares are not within the scope of Statement 150 [as codified in ASC 480-10] because there is no unconditional obligation to redeem the shares by transferring assets at a specified or determinable date or upon an event certain to occur. If the uncertain event occurs, the condition is resolved, or the event becomes certain to occur, then the shares become mandatorily redeemable under Statement 150 [as codified in ASC 480-10] and would require reclassification to a liability. This guidance does not affect the conclusions reached in this case. At the September 15, 2005, meeting, the SEC announced the SEC staff's position on the impact of certain redeemable securities on earnings-per-share calculations. None of these positions are relevant to the case, nor do they affect the conclusions reached. Addendum August 2007 In February 2006 and February 2007, the FASB issued, Statement 155 (as codified in ASC 815-15) and Statement 159 (as codified in ASC 825-10) respectively. ASC 815-1525-4 through 25-6 simplify the accounting for certain hybrid financial instruments by permitting fair value remeasurement for any hybrid financial instrument containing an embedded derivative that otherwise would require bifurcation. ASC 825-10 permits entities to choose to measure many financial instruments and certain other items at fair value. For new issuances of debt for which the fair value option is elected, costs and fees to issue debt must be recognized as incurred under ASC 825-10. For existing instruments for which the fair value option is elected at adoption, unamortized costs and fees must be written off through a cumulative-effect adjustment to retained earnings. Provided that the Company does not elect the fair value option for the notes, the above guidance does not affect the conclusions reached in the case. Addendum August 2008 In May 2008, the FASB issued FSP APB 14-1 (as codified in ASC 470-10) applicable to certain convertible debt instruments that allow the issuer to settle the conversion feature in cash or shares (including partial cash settlement). ASC 470-10 requires that an issuer of a convertible debt instrument that provides the issuer with the ability to settle the conversion option in cash or shares (including partial cash settlement) must separate the conversion option from the debt instrument and recognize that option as a component of
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equity (assuming equity classification of the conversion option is appropriate). ASC 47010 requires that the resulting discount to the debt instrument created by separating the conversion option be amortized over the expected life of a similar liability that does not have an associated equity component in such a manner to reflect the issuers nonconvertible debt borrowing rate. The debt discount must be amortized over the expected life of the instrument not considering the impact of the conversion option but considering the impact of other substantive features (e.g., substantive put options held by the holder of the convertible instrument). For this case study, the facts provided do not include the settlement terms of the conversion option. If the terms of the notes were to require that only shares can be delivered to settle the conversion option, the above guidance would not affect the conclusions reached in this case. However, if the terms of the notes were to permit full or partial cash settlement of the conversion option and the conversion option were not separately accounted for as a derivative, the conclusions reached in this case might be affected. The debt issuance costs would be amortized over the expected life of the debt instrument. The expected life of the debt instrument would be determined by ignoring the conversion option and considering the put rights, if they are substantive. Addendum July 2009 In June of 2008, the EITF issued Issue 07-5 (codified in ASC 815-40). When an equity-linked financial instrument (such as the conversion option described above) is considered indexed to the issuing entitys own equity, ASC 815-40 clarifies whether the instrument (or a feature embedded in the instrument requiring bifurcation) should be accounted for as a derivative instrument or classified within equity. Whether an instrument is considered indexed to the issuing entitys own equity depends on the settlement terms of the instrument. Specifically, ASC 815-40 provides that an instrument (or embedded feature) is considered indexed to an entitys own equity if (1) the instruments exercise contingency (or contingencies) embedded in the instrument (if any) is not based on, as stated in ASC 815-40-15-7A, (a) [a]n observable market, other than the market for the issuers stock or (b) [a]n observable index, other than an index calculated or measured solely by reference to the issuers own operations and (2) the settlement amount of the instrument equals the difference between the fair value of a fixed number of the entitys equity shares and a fixed monetary amount or a fixed amount of a debt instrument issued by the entity. Any adjustment to the settlement amount that is not consistent with the fixed-or-fixed notion above would preclude the instrument (or embedded feature) from being considered indexed to the entitys own equity unless the only variable that could affect the settlement amount of the instrument (or embedded feature) would be an input to the fair value of a fixed-or-fixed forward or option on the issuing entitys equity shares.

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Case 04-10: Cashless, Inc

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For this case study, the facts provided do not include the settlement terms of the conversion option. If the settlement terms of the conversion option included an exercise contingency that was based on an observable market (other than the issuers own stock) (e.g., the price of gold) or an observable index (other than the issuers own operations) (e.g., movements in the S&P 500), or if the settlement amount of the conversion option was impacted by variables other than those used to determine the fair value of a fixed-for-fixed forward or option on the issuing entitys own shares, the conversion option would not be considered indexed to the issuing entitys own stock and therefore would require the conversion option to be accounted for separately as a liability. The guidance in ASC 815-40 described above is effective for financial statements issued for fiscal years beginning after December 15, 2008 (and interim periods within those fiscal years). The guidance should be applied to all outstanding instruments as of the date of adoption.

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