On some debt instruments and preferred securities, interest may be paid in kind ("PIK"). This simply means that interest payments to the holder of a PIK security take the form of additional securities, rather than cash. A firm may prefer to issue PIK securities if it needs to conserve cash. For this reason, PIK securities are sometimes used to finance leveraged buyouts where the borrower has other, large debt service obligations that must be met with cash.
PIK instruments may feature a "PIK toggle" that lets the borrower pay interest in kind or in cash, usually at the borrower's option. They may also or alternatively pay PIK interest for a predetermined number of years, followed by cash interest until the security matures or is redeemed, or perhaps pay a portion of interest in kind for a period of time. Generally, PIK instruments pay higher coupons and dividends than non-PIK equivalent instruments because (a) the PIK feature usually benefits only the borrower, and (b) PIK interest is deferred, and future payment must be discounted to reflect the time value of money and the risk of non-payment.
Accounting for PIK Interest
Accounting for PIK interest is straightforward, as the following journal entry demonstrates. What you might miss is that because PIK interest is a non-cash expense, it must be added back to net income to compute cash flow from operations.
|Accounting for PIK interest|
|dr. Interest expense – PIK (SE ↓)|
|cr. Debt (L ↑)|
A Comprehensive Example
Accounting for PIK instruments is demonstrated in the spreadsheet below, with key takeaways highlighted in yellow. The PIK feature of the subordinated note in this example can be customized on the last row to implement a PIK toggle, partial PIK, PIK for a fixed period of time, etc.