Chapter 4 — Identification of and Accounting for Embedded Derivatives

4.3 Bifurcation Criteria

4.3.1 Overall Framework

ASC 815-15

25-1 An embedded derivative shall be separated from the host contract and accounted for as a derivative instrument pursuant to Subtopic 815-10 if and only if all of the following criteria are met:

The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract.
The hybrid instrument is not remeasured at fair value under otherwise applicable generally accepted accounting principles (GAAP) with changes in fair value reported in earnings as they occur.
A separate instrument with the same terms as the embedded derivative would, pursuant to Section 815-10-15, be a derivative instrument subject to the requirements of Subtopic 815-10 and this Subtopic. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.)

Once an entity has identified the embedded features that require evaluation, it should determine whether those features must be accounted for separately as a derivative. Under ASC 815-15-25-1, an entity is required to separately account for a feature embedded within another contract (the host contract) if all of the following three conditions are met:

The embedded feature and the host contract have economic characteristics and risks that are not clearly and closely related (see Section 4.3.2). For example, changes in the fair value of an equity interest — such as an equity conversion feature — are not clearly and closely related to the interest rates on a debt host contract (see Section 6.2.2.2).
The hybrid instrument (i.e., the combination of the embedded feature and its host contract) is not remeasured at fair value, with changes in fair value recorded through earnings (e.g., an investment in an equity security subject to ASC 321, an instrument accounted for under the fair value option in ASC 815-15 or ASC 825-10; see Section 4.3.3).
The embedded feature — if issued separately — would be accounted for as a derivative instrument under ASC 815-10. In evaluating whether this condition is met, the entity considers both (1) the definition of a derivative in ASC 815-10 (see Section 4.3.4) and (2) the scope exceptions from derivative accounting in ASC 815-10 and ASC 815-15 (see Sections 2.3 and 4.3.5).

There is no requirement to evaluate the bifurcation conditions in any particular order. Because all three conditions must be met, the analysis ends if any one condition is not satisfied. For example:

If the hybrid instrument is accounted for at fair value, with changes in fair value recognized in earnings, the entity does not need to identify potential embedded derivatives and can omit an evaluation of whether any embedded features (1) are clearly and closely related to the host contract or (2) would have been accounted for as derivatives if they were freestanding contracts.
If an embedded feature is clearly and closely related to its host contract, an evaluation of whether it meets the definition of a derivative is not required.
If an embedded feature does not meet the definition of a derivative (e.g., it does not satisfy the net settlement characteristic in the definition of a derivative), it is unnecessary to evaluate whether it (1) is subject to any scope exception related to derivative accounting or (2) is clearly and closely related to its host contract, because in either case, the feature would not be bifurcated as a derivative.
If the feature is subject to a derivative scope exception, the entity can omit an evaluation of whether the feature is clearly and closely related to its host contract since bifurcation as a derivative is prohibited.

In lieu of bifurcating an identified embedded derivative, an entity may elect to account for the entire hybrid instrument at fair value under ASC 815-15-25-4 provided that the instrument is a financial asset or financial liability, with changes recognized in earnings and, if applicable, other comprehensive income (OCI) (see Chapter 12 of Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the Fair Value Option) for further detail).

4.3.2 Condition 1 — Not Clearly and Closely Related

4.3.2.1 Background

ASC 815-15

25-1 An embedded derivative shall be separated from the host contract and accounted for as a derivative instrument pursuant to Subtopic 815-10 if and only if all of the following criteria are met:

The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract. . . .

The first bifurcation condition in ASC 815-15-25-1 is that the embedded feature and the host contract have economic characteristics and risks that are not clearly and closely related to each other. In evaluating whether this condition is met, the entity must determine the nature of the host contract and identify the economic characteristics and risks of the embedded feature. The evaluation of the clearly-and-closely-related criterion will depend on the nature of the host contract, which is most often a debt, equity, or lease host, but could also be a supply contract or insurance agreement. Chapter 5 focuses on evaluating common embedded features that are unique to a debt host contract, while Chapter 6 includes evaluation of embedded features that are commonly present in all host contracts. The discussion below describes the framework for evaluating Condition 1.

4.3.2.2 Hybrid Contracts in the Legal Form of Debt

If the hybrid instrument is in the legal form of debt (i.e., the holder has creditor rights), the host contract is considered to have the economic characteristics and risks of a debt instrument.

Although a hybrid instrument may include embedded features that have the economic characteristics and risks of an equity instrument (e.g., a dividend participation right or a payment feature based on the entity’s stock price), the host contract would nevertheless be considered a debt instrument if the legal form of the hybrid instrument is debt.

For hybrid instruments with debt host contracts, the entity must identify the terms of such debt host contract on the basis of the stated or implied substantive terms of the hybrid instrument (e.g., a fixed rate, a variable rate, or a zero coupon; see Section 4.3.2.5). An entity is not permitted to impute terms in the debt host contract that would result in the identification of an embedded derivative that is not clearly present in the hybrid instrument.

4.3.2.3 Hybrid Contracts in the Legal Form of an Outstanding Share

4.3.2.3.1 Overview

ASC 815-15

25-16 If the host contract encompasses a residual interest in an entity, then its economic characteristics and risks shall be considered that of an equity instrument and an embedded derivative would need to possess principally equity characteristics (related to the same entity) to be considered clearly and closely related to the host contract.

25-17 Because the changes in fair value of an equity interest and interest rates on a debt instrument are not clearly and closely related, the terms of convertible preferred stock shall be analyzed to determine whether the preferred stock (and thus the potential host contract) is more akin to an equity instrument or a debt instrument.

25-17A For a hybrid financial instrument issued in the form of a share, an entity shall determine the nature of the host contract by considering all stated and implied substantive terms and features of the hybrid financial instrument, weighing each term and feature on the basis of the relevant facts and circumstances. That is, in determining the nature of the host contract, an entity shall consider the economic characteristics and risks of the entire hybrid financial instrument including the embedded derivative feature that is being evaluated for potential bifurcation. In evaluating the stated and implied substantive terms and features, the existence or omission of any single term or feature does not necessarily determine the economic characteristics and risks of the host contract. Although an individual term or feature may weigh more heavily in the evaluation on the basis of the facts and circumstances, an entity should use judgment based on an evaluation of all of the relevant terms and features. For example, an entity shall not presume that the presence of a fixed-price, noncontingent redemption option held by the investor in a convertible preferred stock contract, in and of itself, determines whether the nature of the host contract is more akin to a debt instrument or more akin to an equity instrument. Rather, the nature of the host contract depends on the economic characteristics and risks of the entire hybrid financial instrument.

25-17B The guidance in paragraph 815-15-25-17A relates to determining whether a host contract within a hybrid financial instrument issued in the form of a share is considered to be more akin to a debt instrument or more akin to an equity instrument for the purposes of evaluating one or more embedded derivative features for bifurcation under paragraph 815-15-25-1(a). It is not intended to address when an embedded derivative feature should be bifurcated from the host contract or the accounting when such bifurcation is required. In addition, the guidance in paragraph 815-15-25-17A is not intended to prescribe the method to be used in determining the nature of the host contract in a hybrid financial instrument that is not issued in the form of a share.

If the host contract is in the legal form of a share (e.g., preferred stock), the evaluation of whether the contract should be considered a debt host or an equity host is not based solely on its legal form or whether it qualifies for presentation as equity (including temporary equity) under GAAP. Instead, an entity is required to use a “whole-instrument approach” under which it determines the nature of the host contract by considering all of its stated or implied substantive terms and features. Accordingly, an entity must further analyze the economic characteristics and risks of the hybrid contract to determine whether the contract should be considered a debt host or an equity host. For example, an outstanding share that is classified as a liability under ASC 480 or as temporary equity under ASC 480-10-S99-3A could potentially qualify as a debt host contract depending on its terms and conditions. An entity is not permitted to use (1) a “chameleon approach” under which the nature of the host contract is determined on the basis of an analysis that excludes the embedded feature that is evaluated for bifurcation or (2) a “pure host” approach under which the nature of the host contract is determined by excluding all potential embedded derivative features.

An entity must identify the nature of the host contract as of the hybrid instrument’s initial recognition date (i.e., upon its issuance or acquisition). The entity is required to reassess that determination upon a modification or exchange of the hybrid instrument that is accounted for as an extinguishment. The determination of whether a reassessment is required for a modification or exchange that is not accounted for as an extinguishment depends on the relevant facts and circumstances.

Liability-classified outstanding shares will generally contain debt host contracts. However, it is possible for such a share to contain an equity host contract. Furthermore, some equity-classified hybrid instruments will contain debt hosts (in which case the evaluation of embedded derivatives is the same as that for a hybrid instrument that is in the legal form of debt). The sections below discuss the guidance on determining the nature of the host contract for a hybrid instrument in the form of a share.

4.3.2.3.2 Framework for Determining Whether an Outstanding Share Is a Debt Host or an Equity Host

ASC 815-15

25-17C When applying the guidance in paragraph 815-15-25-17A, an entity shall determine the nature of the host contract by considering all stated and implied substantive terms and features of the hybrid financial instrument, determining whether those terms and features are debt-like versus equity-like, and weighing those terms and features on the basis of the relevant facts and circumstances. That is, an entity shall consider not only whether the relevant terms and features are debt-like versus equity-like, but also the substance of those terms and features (that is, the relative strength of the debt-like or equity-like terms and features given the facts and circumstances). In assessing the substance of the relevant terms and features, each of the following may form part of the overall analysis and may inform an entity’s overall consideration of the relative importance (and, therefore, weight) of each term and feature among other terms and features:

The characteristics of the relevant terms and features themselves (for example, contingent versus noncontingent, in-the-money versus out-of-the-money)
The circumstances under which the hybrid financial instrument was issued or acquired (for example, issuer-specific characteristics, such as whether the issuer is thinly capitalized or profitable and well- capitalized)
The potential outcomes of the hybrid financial instrument (for example, the instrument may be settled by the issuer issuing a fixed number of shares, the instrument may be settled by the issuer transferring a specified amount of cash, or the instrument may remain legal-form equity), as well as the likelihood of those potential outcomes. The assessment of the potential outcomes may be qualitative in nature.

25-17D The following are examples (and not an exhaustive list) of common terms and features included within a hybrid financial instrument issued in the form of a share and the types of information and indicators that an entity (an issuer or an investor) may consider when assessing the substance of those terms and features in the context of determining the nature of the host contract, as discussed in paragraph 815-15-25-17C:

Redemption rights. The ability for an issuer or investor to redeem a hybrid financial instrument issued in the form of a share at a fixed or determinable price generally is viewed as a debt-like characteristic. However, not all redemption rights are of equal importance. For example, a noncontingent redemption option may be given more weight in the analysis than a contingent redemption option. The relative importance (and, therefore, weight) of redemption rights among other terms and features in a hybrid financial instrument may be evaluated on the basis of information about the following (among other relevant) facts and circumstances:
1. Whether the redemption right is held by the issuer or investors
2. Whether the redemption is mandatory
3. Whether the redemption right is noncontingent or contingent
4. Whether (and the degree to which) the redemption right is in-the-money or out-of-the-money
5. Whether there are any laws that would restrict the issuer or investors from exercising the redemption right (for example, if redemption would make the issuer insolvent)
6. Issuer-specific considerations (for example, whether the hybrid financial instrument is effectively the residual interest in the issuer [due to the issuer being thinly capitalized or the common equity of the issuer having already incurred losses] or whether the instrument was issued by a well-capitalized, profitable entity)
7. If the hybrid financial instrument also contains a conversion right, the extent to which the redemption price (formula) is more or less favorable than the conversion price (formula), that is, a consideration of the economics of the redemption price (formula) and the conversion price (formula), not simply the form of the settlement upon redemption or conversion.
Conversion rights. The ability for an investor to convert, for example, a preferred share into a fixed number of common shares generally is viewed as an equity-like characteristic. However, not all conversion rights are of equal importance. For example, a conversion option that is noncontingent or deeply in-the-money may be given more weight in the analysis than a conversion option that is contingent on a remote event or deeply out-of-the-money. The relative importance (and, therefore, weight) of conversion rights among other terms and features in a hybrid financial instrument may be evaluated on the basis of information about the following (among other relevant) facts and circumstances:
1. Whether the conversion right is held by the issuer or investors
2. Whether the conversion is mandatory
3. Whether the conversion right is noncontingent or contingent
4. Whether (and the degree to which) the conversion right is in-the-money or out-of-the-money
5. If the hybrid financial instrument also contains a redemption right held by the investors, whether conversion is more likely to occur before redemption (for example, because of an expected initial public offering or change-in-control event before the redemption right becoming exercisable).
Voting rights. The ability for a class of stock to exercise voting rights generally is viewed as an equity-like characteristic. However, not all voting rights are of equal importance. For example, voting rights that allow a class of stock to vote on all significant matters may be given more weight in the analysis than voting rights that are only protective in nature. The relative importance (and, therefore, weight) of voting rights among other terms and features in a hybrid financial instrument may be evaluated on the basis of information about the following (among other relevant) facts and circumstances:
1. On which matters the voting rights allow the investor’s class of stock to vote (relative to common stock shareholders)
2. How much influence the investor’s class of stock can exercise as a result of the voting rights.
Dividend rights. The nature of dividends can be viewed as a debt-like or equity-like characteristic. For example, mandatory fixed dividends generally are viewed as a debt-like characteristic, while discretionary dividends based on earnings generally are viewed as an equity-like characteristic. The relative importance (and, therefore, weight) of dividend terms among other terms and features in a hybrid financial instrument may be evaluated on the basis of information about the following (among other relevant) facts and circumstances:
1. Whether the dividends are mandatory or discretionary
2. The basis on which dividends are determined and whether the dividends are stated or participating
3. Whether the dividends are cumulative or noncumulative.
Protective covenants. Protective covenants generally are viewed as a debt-like characteristic. However, not all protective covenants are of equal importance. Covenants that provide substantive protective rights may be given more weight than covenants that provide only limited protective rights. The relative importance (and, therefore, weight) of protective covenants among other terms and features in a hybrid financial instrument may be evaluated on the basis of information about the following (among other relevant) facts and circumstances:
1. Whether there are any collateral requirements akin to collateralized debt
2. If the hybrid financial instrument contains a redemption option held by the investor, whether the issuer’s performance upon redemption is guaranteed by the parent of the issuer
3. Whether the instrument provides the investor with certain rights akin to creditor rights (for example, the right to force bankruptcy or a preference in liquidation).

To determine the nature of the host contract under the whole-instrument approach, an entity performs the following steps:

Identify all of the hybrid financial instrument’s stated and implied substantive terms and features (see Section 4.3.2.3.3).
Determine whether each of the identified terms and features is more debt-like or equity-like (see Section 4.3.2.3.4).
Consider the relative weight of the identified terms and features “on the basis of the relevant facts and circumstances” (see Section 4.3.2.3.5).
Reach a conclusion about the nature of the host contract (see Section 4.3.2.3.6).

4.3.2.3.3 Step 1 — Identify the Hybrid Instrument’s Substantive Terms and Features

The first step in applying the whole-instrument approach is to identify all of the substantive terms and features of the hybrid financial instrument, whether stated or implied. ASC 815-15-25-17D lists common terms and features in hybrid instruments that are in the form of shares.

4.3.2.3.4 Step 2 — Determine Whether the Identified Terms and Features Are More Debt-Like or Equity-Like

The next step in applying the whole-instrument approach is to determine whether the identified substantive terms and features of the hybrid instrument are more debt- or equity-like. To make this determination, an entity should analyze the terms’ or features’ economic characteristics and risks.

ASC 815-15-25-16 explains that a host contract is considered equity-like if it “encompasses a residual interest in an entity.” By contrast, a term or feature that is not consistent with a residual interest in the issuing entity would most likely be considered debt-like. ASC 815-15-25-17D provides examples of common terms and features, discusses whether such terms and features are generally debt- or equity- like, and lists factors that an entity might consider in determining the relative weight to assign to such terms and features.

The following chart illustrates which characteristics are generally more debt-like or equity-like:

Instrument may be settled by the issuer’s transfer of a specified amount of cash or a variable number of shares equal to a fixed dollar amount.

4.3.2.3.5 Step 3 — Weigh the Identified Terms and Features

The third step is to weigh each of the hybrid financial instrument’s substantive terms and features — qualitatively, quantitatively, or both — “on the basis of the relevant facts and circumstances,” as described in ASC 815-15-25-17C. The entity determines the “relative strength” or weight of each of the hybrid financial instrument’s substantive terms and features by considering the following:

The characteristics of the relevant terms and features themselves — For example, for a redemption option, the entity should consider whether the option is (1) mandatory or optional and (2) contingent or noncontingent. A mandatory redemption right would be given more weight than an optional redemption right, and a noncontingent redemption right would be given more weight than a contingent redemption right. ASC 815-15-25-17D provides a list of characteristics that a reporting entity should consider in its analysis. Although not an all-inclusive list, these characteristics are discussed further in the table below.
The circumstances under which the hybrid financial instrument was issued or acquired — This condition is generally meant to help an entity assess whether the hybrid financial instrument is, in substance, a residual interest in the issuing entity. For example, a hybrid financial instrument issued by a thinly capitalized entity (or one with an accumulated deficit) might be considered more equity-like than a hybrid financial instrument issued by a well-capitalized profitable entity. This is because in a thinly capitalized entity, the hybrid financial instrument may, in substance, represent a residual interest in that issuing entity even if other classes of equity are more subordinated.
The potential outcomes of the hybrid financial instrument as well as the likelihood of those potential outcomes — This condition is meant to help an entity assess the hybrid financial instrument’s likely economic return. For example, a hybrid financial instrument that is expected to be settled in a fixed number of common shares (thus providing a more equity-like return) might be viewed as more equity-like than a hybrid financial instrument that is expected to be settled in a specified amount of cash or a variable number of shares that is equal to a fixed dollar amount (thus providing a more debt-like return).

The table below provides examples of indicators that a reporting entity should consider in determining whether to assign more or less weight to the general view related to whether a term or feature is debt-like or equity-like in the entity’s analysis of the nature of the host contract for a hybrid instrument issued in the form of a share. This table does not apply to hybrid instruments issued in the form of debt.

General View	Indicators That the General View Should Be Given More Weight	Indicators That the General View Should Be Given Less Weight
Redemption rights are debt-like	The redemption rights are held by an investor. The instrument is mandatorily redeemable. The redemption rights are noncontingent. The term or feature is in-the-money (the degree to which the term or feature is in-the-money should also be considered). For instruments with both redemption and conversion features, the redemption price or formula is more favorable than the conversion price or formula. The issuer is well capitalized and profitable. There are no laws restricting the exercise of the redemption rights. The redemption rights can be exercised in circumstances besides liquidations. The redemption feature can be settled by the issuer’s transfer of a specified amount of cash or a variable number of shares that is equal to a fixed dollar amount. (A redemption amount that varies with the passage of time, such as how interest on a debt instrument accrues, would be a debt-like feature.)	The redemption rights are held by the issuer. The instrument is not mandatorily redeemable. The redemption rights are contingent. The term or feature is out-of-the-money (the degree to which the term or feature is out-of-the-money should also be considered). For instruments with both redemption and conversion features, the redemption price or formula is less favorable than the conversion price or formula. The issuer is thinly capitalized and incurring losses. Laws might restrict the exercise of the redemption rights. The redemption rights can only be exercised in the event of a liquidation. The settlement value of the redemption feature is not fixed. (A redemption amount that varies with the passage of time, such as how interest on a debt instrument accrues, would be a debt-like feature.)
Conversion rights are an equity-like term or feature	The conversion rights are held by an investor. The instrument is mandatorily convertible. The conversion rights are noncontingent. The conversion term or feature is in-the-money (the degree to which the term or feature is in-the-money should also be considered). For instruments with both redemption and conversion features, conversion is more likely to occur before redemption. The instrument can be converted into or otherwise settled in a fixed number of common shares.	The conversion rights are held by the issuer. The instrument is not mandatorily convertible. The conversion rights are contingent. The conversion term or feature is out-of-the-money (the degree to which the term or feature is out-of-the-money should also be considered). For instruments with both redemption and conversion features, conversion is less likely to occur before redemption. The instrument is convertible into a variable number of shares equal to a fixed dollar amount.
Voting rights are an equity-like term or feature	The voting rights allow holders of a class of stock to vote on all significant matters (i.e., exercise significant influence). The voting rights allow the investor class to vote on the same matters as common stockholders. The investor is granted the right to appoint board members.	The voting rights are only protective (i.e., influence is not significant). The voting rights of the investor class are more restrictive than those of the common stockholders. The investor does not have the right to appoint board members.
Protective covenants are a debt-like term or feature	For redemption options, redemption is guaranteed by the issuer’s parent. The investor has certain rights that are akin to creditor rights (e.g., the right to force bankruptcy or a liquidation preference). The investor has collateral requirements that are akin to those for collateralized debt.	For redemption options, redemption is not guaranteed by any entity other than the issuer. The investor has no rights that are akin to creditor rights. There are no collateral requirements.
Dividends are either a debt-like or an equity-like feature	Dividend rights that are mandatory, stated, or cumulative add weight to the view that a debt host is more debt-like. Dividend rights that are discretionary, participating, or noncumulative add weight to the view that a debt host is more equity-like.

4.3.2.3.6 Step 4 — Reach a Conclusion About the Nature of the Host Contract

The final step is to reach a conclusion regarding the nature of the host contract on the basis of the results of the analyses performed in the previous steps. As explained in ASC 815-15-25-17A, “[i]n evaluating the stated and implied substantive terms and features, the existence or omission of any single term or feature does not necessarily determine the economic characteristics and risks of the host contract. Although an individual term or feature may weigh more heavily in the evaluation on the basis of the facts and circumstances, an entity should use judgment based on an evaluation of all of the relevant terms and features.” To further emphasize this point, ASC 815-15-25-17A states by way of example that “an entity shall not presume that the presence of a fixed-price, noncontingent redemption option held by the investor in a convertible preferred stock contract, in and of itself, determines whether the nature of the host contract is more akin to a debt instrument or more akin to an equity instrument.” If the nature of the host contract is still not clear, the entity should consider the expected outcome of the hybrid financial instrument in reaching a conclusion. Given the complexity of determining the nature of a host contract of a hybrid instrument with both conversion and redemption features, entities are encouraged to consult with their accounting advisers.

4.3.2.4 Other Host Contract Types

The following sections discuss host contracts other than those in the form of a share or a debt instrument, including types of embedded features that are often identified in such hosts.

4.3.2.4.1 Lease Hosts

ASC 815-15

25-21 Rentals for the use of leased assets and adjustments for inflation on similar property are considered to be clearly and closely related. Thus, unless a significant leverage factor is involved, the inflation-related derivative instrument embedded in an inflation-indexed lease would not be separated from the host contract.

25-22 The obligation to make future payments for the use of leased assets and the adjustment of those payments to reflect changes in a variable-interest-rate index are considered to be clearly and closely related. Thus, leases that include variable lease payments based on changes in the prime rate would not have the embedded derivative that is related to the variable lease payment separated from the host contract.

A lease host contract conveys the right to use property, plant, or equipment in exchange for consideration during what is typically a stated period. If a feature embedded in a lease host contract modifies future cash flows under the contract, an entity is required to evaluate the feature as a possible embedded derivative. Whether the lease takes the form of an operating lease or a finance lease, as applicable under ASC 842, has no impact on the determination of the nature of a host contract. If the contract meets the definition of a lease under ASC 842-10-15-3, the contract is considered to contain a lease host in the evaluation of the contract for embedded derivatives. However, a contract that does not meet the definition of a lease under ASC 842-10-15-3 may also contain a lease host. An entity should consult with its accounting advisers regarding the determination of the nature of the host contract to ensure that the facts and circumstances are appropriately weighed.

The guidance on accounting for lease host contracts in ASC 815-15 is relatively brief in comparison to the detailed considerations provided for debt and equity host contracts. In practice, embedded derivatives in a lease host often qualify for the scope exception in ASC 815-10-15-59 (see Section 2.3.5.3) for contracts not traded on an exchange whose settlement is based on sales volume or revenue. This scope exception substantially reduces the number of possible features that could require bifurcation from a lease host.

A feature that gives the lessee an option to purchase the leased asset at the end of the lease term or provides a guarantee of the residual value of the leased asset would be another common example of a lease-specific feature that qualifies for a derivative scope exception and, accordingly, would not require bifurcation from a lease host contract. The scope exception in ASC 815-10-15-59(b)(2) indicates that if settlement is based on the value of a nonfinancial asset of one of the parties (i.e., the value of the leased asset), the feature would not be accounted for as a derivative. This scope exception further reduces the number of possible features that could require bifurcation from a lease host.

Separately, some of the more common features embedded in a lease host agreement are term extension features that give the lessee the option to extend the lease at the end of the stated term. Term extension features do not meet the definition of a derivative under ASC 815-10-15-83 because they do not meet the net settlement criterion and therefore would not require bifurcation under ASC 815-15-25-1.

Complexity associated with the identification of an embedded derivative in a lease host is generally related to whether the embedded feature is clearly and closely related to the lease host. ASC 815-15-25-21 specifically notes that adjustments for inflation are clearly and closely related to a lease host unless (1) a significant leverage factor is involved or (2) the inflation metric used to adjust payments is unrelated to the location of the asset. ASC 815-15-25-22 further indicates that variable lease payments based on changes in interest rates do not contain embedded derivatives that require bifurcation.

Example 4-6

Lease Contract With Adjustments That Are Based on Interest Rate Changes

Company D has 10-year operating leases for retail stores and a distribution center. The operating lease payments are part of a synthetic lease transaction in which an off-balance-sheet special-purpose entity (SPE) has obtained debt financing and equity that it will use to construct the retail stores and distribution center. The SPE will lease these buildings to D. The leases require D to make quarterly variable lease payments on the basis of the SOFR interest rate and all financing by the SPE. If the SPE has drawn cash to begin construction on one of the new retail stores, D must begin to make interest payments to the SPE on that drawn amount.

The operating leases for the retail stores and distribution center have embedded derivatives that result in adjustments to the lease payment that are based on interest rates (e.g., SOFR). The embedded derivative does not need to be bifurcated because the obligation to make future payments for the use of the leased assets and the adjustment of those payments for changes in a variable interest rate index are considered clearly and closely related to the host contracts under ASC 815-15-25-22. (Note that SPEs should be evaluated to determine whether they are subject to ASC 810-10. Some “synthetic lease” transactions may be required to be consolidated under ASC 810-10.)

Example 4-7

Lease Contract With Embedded Inflation Index Feature

A U.S. company leases property, and the lease payments require an adjustment that is based on two times the change in the CPI. This embedded derivative is not clearly and closely related to the lease host because it is leveraged; therefore, it should be accounted for separately. Alternatively, if the lease payments were only adjusted for changes in CPI with no leveraging, the embedded derivative would be clearly and closely related and, therefore, would not need to be accounted for separately.

Lease host contracts may contain unique embedded features beyond those discussed in this Roadmap, so entities should discuss any such features with their accounting advisers. For further details on embedded features that could be identified in a lease host, see Chapter 6.

4.3.2.4.2 Insurance Hosts

An insurance contract is another host contract type that could contain an embedded derivative. In a manner similar to lease host contracts, embedded features in insurance host contracts often meet specific insurance-related scope exceptions (see Section 2.3.3).

In the event that an embedded feature in an insurance contract does not qualify for a scope exception, the determinative step in the evaluation of whether the embedded feature requires bifurcation often focuses on the clearly-and-closely-related criterion. Some of the more common features that could be present in an insurance contract include equity-indexed annuities, equity-linked cash surrender values, and foreign-currency options — none of which would be clearly and closely related to an insurance host. Equity-indexed annuities and equity-linked cash surrender values would not be considered clearly and closely related to the insurance host because their values are derived from an equity-related index, whose risks and rewards are presumably distinct from those of an insurance host contract. The evaluation of features involving certain currencies is more complex and is discussed in further detail in Section 4.3.5.5.

Given the industry-specific nuances associated with insurance contracts, entities should work with their accounting advisers to evaluate such provisions.

Connecting the Dots

ASU 2018-12 amended the accounting model for certain universal life-type contracts and contracts that contain features that could provide nontraditional contract benefits beyond those provided by the insured’s account balance. An insurer that writes such contracts should first assess whether those features meet the definition of market risk benefits under ASC 944-40-25-25C and ASC 944-40-25-25D. If the features do not meet the definition of market risk benefits, the insurer should assess whether to account for the features as embedded derivatives in accordance with ASC 815.

4.3.2.4.3 Executory Contract Hosts

There are a variety of possible contract types that would have an executory contract host. We commonly see executory contracts in the form of commodity purchase and sale contracts, raw materials purchase and sale contracts, and purchased power agreements.

Executory contracts often meet the definition of a derivative in their entirety, and in such cases, an entity would not be required to bifurcate any embedded derivatives. In addition, the NPNS scope exception may be applied to an executory contract that would otherwise require derivative accounting if the conditions outlined in ASC 815-15-15-25 are met (see Section 2.3.2). In the event that the executory contract qualifies for the NPNS election, the entity would not further evaluate the executory contract for potential embedded derivatives.

If the contract as a whole does not meet the definition of a derivative and the entity has not elected the NPNS scope exception, the entity should apply the guidance in ASC 815-15-25-1 to determine whether any embedded features require bifurcation.

Features embedded in executory host contracts commonly include caps and floors based on the selling price of the asset that is the subject of the purchase or sale contract. ASC 815-15-25-19 states that the “economic characteristics and risks of a floor and cap on the price of an asset embedded in a contract to purchase that asset are clearly and closely related to the purchase contract, because the options are indexed to the purchase price of the asset that is the subject of the purchase contract.” Accordingly, such caps or floors generally do not require bifurcation from the executory host contract.

Executory payments that are indexed to inflation are clearly and closely related to the host unless (1) a significant leverage factor is involved or (2) the inflation index is unrelated to the economic environment of the parties to the contract.

In addition, executory contracts could be payable in another currency, which would be an embedded feature that the entity should evaluate for possible bifurcation (see Section 4.3.5.5). Given the variety of possible features embedded in this broader host contract type, entities are encouraged to discuss the potential embedded derivatives with their accounting advisers.

4.3.2.5 Host Contract Terms

ASC 815-15

25-24 The characteristics of a debt host contract generally shall be based on the stated or implied substantive terms of the hybrid instrument. Those terms may include a fixed-rate, variable-rate, zero-coupon, discount or premium, or some combination thereof.

25-25 In the absence of stated or implied terms, an entity may make its own determination of whether to account for the debt host as a fixed-rate, variable-rate, or zero-coupon bond. That determination requires the application of judgment, which is appropriate because the circumstances surrounding each hybrid instrument containing an embedded derivative may be different. That is, in the absence of stated or implied terms, it is appropriate to consider the features of the hybrid instrument, the issuer, and the market in which the instrument is issued, as well as other factors, to determine the characteristics of the debt host contract. However, an entity shall not express the characteristics of the debt host contract in a manner that would result in identifying an embedded derivative that is not already clearly present in a hybrid instrument. For example, it would be inappropriate to do either of the following:

Identify a variable-rate debt host contract and an interest rate swap component that has a comparable variable-rate leg in an embedded compound derivative, in lieu of identifying a fixed-rate debt host contract
Identify a fixed-rate debt host contract and a fixed-to-variable interest rate swap component in an embedded compound derivative in lieu of identifying a variable-rate debt host contract.

A contract in the legal form of debt is always considered a debt host contract (see Section 4.3.2.2). If the contract is in the legal form of an outstanding share, the entity must determine whether it has the characteristics and risks of a debt host contract or an equity host contract (see Section 4.3.2.3).

The terms of a debt host contract are identified on the basis of the terms of the hybrid debt instrument. For example, a fixed-rate hybrid debt contract would have a fixed-rate debt host contract, and a variable-rate hybrid debt contract would have a variable-rate debt host contract. An entity is not permitted to impute terms in the host contract that are not clearly present in the hybrid instrument, such as artificial terms that “introduce leverage, asymmetry, or some other risk exposure not already present in the hybrid instrument” (see ASC 815-15-30). For example, a debtor cannot impute a pay-fixed, receive-variable interest rate swap and identify the debt host contract as variable-rate debt if the hybrid debt instrument makes fixed interest payments.

4.3.2.6 Determining Whether an Embedded Feature Is Clearly and Closely Related to Its Host Contract

ASC 815 contains extensive application guidance on evaluating whether particular types of embedded features should be considered clearly and closely related to their host contracts. An embedded feature needs to possess principally debt-like characteristics to be considered clearly and closely related to a debt host contract. Contractual terms could potentially qualify as a debt-like feature if they are based on market interest rates, the issuer’s credit risk, or inflation. However, an entity cannot assume that a feature that is based on one of those underlyings is clearly and closely related to a debt host contract without further analysis under the detailed provisions in ASC 815-15 (e.g., the negative-yield test and the double-double test for underlyings based on interest rates; see Section 5.2.3). To be considered clearly and closely related to an equity host contract, a feature embedded in the host should be related to the equity of the issuer.

The following table highlights some of the economic characteristics that are and are not generally considered to be clearly and closely related to debt, equity, lease, insurance, and purchase- or sale-related host contracts.

	Clearly and Closely Related	Not Clearly and Closely Related
Debt host	Traditional interest rate indexes, such as LIBOR, commercial paper rates, etc. Nonleveraged inflation indexes, such as in U.S. treasury inflation-protected security (TIPS) bonds. Creditworthiness, if indexed to changes in the issuer’s credit (includes EBITDA-related adjustments to interest rates). Plain-vanilla interest rate puts and calls; interest rate floors and caps. Options to extend the term of debt if, upon exercise, the interest rate on the host debt instrument is reset to market levels.	Options that extend significantly the term of debt but the interest rate on the host is not reset to market levels. Equity-indexed payments (e.g., bank certificates of deposits indexed to the S&P 500 index). Commodities-indexed payments (e.g., silver bonds). Equity conversion features/convertible bonds/convertible redeemable preferred stock/warrants in financing arrangements. Certain leveraged interest payments or derivatives. Certain puts and calls on debt.
Equity host	Equity of issuer.	Interest rates. Inflation indexes. Creditworthiness. Certain puts and calls for cash on the equity instrument.
Lease host	Nonleveraged inflation indexes. Contingent rentals based on related sales or variable interest rates. Foreign currency payment features if payments are made in the functional currency of a substantial party to the lease.	Leveraged inflation indexes (e.g., two times consumer price index [CPI]). Inflation index adjustment based on an economic environment that is different from that in which payments are made (e.g., Mexican peso–denominated lease payments that vary on the basis of inflation rates in the United States if none of the parties to the lease are U.S. dollar functional entities). Certain leases payable in foreign-currency (e.g., lease payments in U.S. dollars between two Brazilian entities).
Insurance host	Market-adjusted-value prepayment option in an annuity contract. Policy loan commitments.	Equity-indexed annuities. Equity-linked cash surrender values. Foreign-currency options (e.g., foreign-currency option in a workers’ compensation policy).
Purchase/sales host	Caps and floors based on selling price of the asset that is the subject of the purchase or sale contract (e.g., contract to purchase a raw material in which the price cannot exceed $10 per unit or go below $8 per unit).	Certain contracts payable in foreign currency (e.g., contracts to buy aluminum priced in U.S. dollars between two Canadian-functional-currency entities). Warrants issued when benchmarks are met (e.g., if minimum quantities of purchases are made).

The evaluation of whether an embedded feature is clearly and closely related to its host contract is assessed at the inception of the contract and is not revisited unless the contract is modified.

See Chapters 5 and 6 for further discussion of the application of the embedded derivatives guidance to specific features and instruments, including how to evaluate whether features are clearly and closely related to the host contract in commonly observed scenarios.

4.3.3 Condition 2 — Hybrid-Instrument Accounting

ASC 815-15

25-1 An embedded derivative shall be separated from the host contract and accounted for as a derivative instrument pursuant to Subtopic 815-10 if and only if all of the following criteria are met: . . .

b. The hybrid instrument is not remeasured at fair value under otherwise applicable generally accepted accounting principles (GAAP) with changes in fair value reported in earnings as they occur. . . .

The second bifurcation condition in ASC 815-15-25-1 is that the hybrid instrument is not remeasured at fair value, with changes in fair value recognized in earnings. If an entity has applied the fair value option in ASC 815-15 or ASC 825-10 to a hybrid debt instrument, an embedded feature would not be bifurcated. This bifurcation condition would not be met for a financial liability for which the fair value has been elected even though changes in fair value attributable to instrument-specific credit risk are recognized in OCI under ASC 825-10-45-5.

ASC 825 prohibits an entity from electing the fair value option for a financial instrument that would be classified, in whole or in part, as equity. Because ASC 470-20 requires a convertible debt instrument issued at a substantial premium to be presented, in part, in equity (see Section 7.6 of Deloitte’s Roadmap Issuer’s Accounting for Debt), the issuer cannot elect the fair value option for it. Similarly, instruments classified in permanent equity and outside of permanent equity in accordance with ASC 480-10-S99-3A would be precluded from the fair value option as equity-classified instruments.

If a liability is measured at (1) intrinsic value under the indexed-debt guidance in ASC 470-10 or (2) settlement value in accordance with ASC 480-10-35-3 (see Sections 4.3.1.2 and 5.3.1.1 of Deloitte’s Roadmap Distinguishing Liabilities From Equity), an entity should not consider the liability to be accounted for at fair value when assessing whether an embedded feature must be bifurcated. Although the intrinsic value or settlement value might approximate fair value, it does not take into account all of an instrument’s attributes that are included in a fair value estimate — for example, the time value of an option. Thus, an instrument that is remeasured at intrinsic value or settlement value may contain an embedded feature that must be bifurcated.

Under ASC 321, investments in equity securities are considered instruments that are remeasured at fair value, with changes in fair value reported in earnings even if they are accounted for by using the measurement alternative described in ASC 321-10-35-2. Investments in debt securities classified as trading securities would not meet the condition in ASC 815-15-25-1(b); however, investments in debt securities classified as HTM or AFS would meet such condition.

4.3.3.1 Fair Value Versus Settlement Value

Although ASC 815-10-30-1 and ASC 480-10-30-1 through 30-3 require initial measurement at fair value, many instruments accounted for as liabilities under ASC 480-10-25 subsequently are adjusted to their “settlement value,” as detailed in ASC 480-10-35-3. Although it is possible for the settlement value to approximate fair value, certain attributes of an instrument included in an estimate of fair value are not contemplated in the calculation of its settlement value — for example, an option’s time value. Thus, an instrument that is remeasured at settlement value under ASC 480-10-35-3 would meet the condition in ASC 815-15-25-1(b) since it is not remeasured at fair value.

Example 4-8

Fair Value Versus Settlement Value

Company A issues 100,000 shares of mandatorily redeemable preferred stock for proceeds of $1 million. These shares must be redeemed in five years for an amount equal to the greater of (1) the initial $1 million investment or (2) an amount indexed to changes in the price of gold.

The preferred shares are classified as a liability in accordance with ASC 480-10-25 because of the mandatory redemption and will be measured subsequently at their settlement value because the amount to be paid upon settlement is not fixed. When analyzing ASC 815-15-25-1 to determine whether the redemption indexed to changes in the price of gold must be separated from the host contract and accounted for as a derivative, an entity should consider the condition in ASC 815-15-25-1(b) to be met because the shares are recorded at their redemption value rather than fair value. In this case, the conditions in ASC 815-15-25-1(a) and ASC 815-15-25-1(c) also are met. Therefore, the “gold index feature” of the preferred shares should be accounted for separately as a derivative unless A has (1) made the election in ASC 815-15-25-4 or (2) elected the fair value option in ASC 825-10 to measure the entire hybrid financial instrument at fair value, with changes in fair value recognized in earnings.

4.3.3.2 Fair Value Versus Redemption Value

Irrespective of whether a hybrid instrument requires presentation outside of permanent equity in accordance with ASC 480-10-S99-3A, the issuer must evaluate whether any embedded features exist that require bifurcation under ASC 815-15-25-1. If embedded derivatives requiring bifurcation are identified in a temporary equity classified instrument, the initial amount presented in temporary equity is the amount attributable to the hybrid instrument that remains after separation of the embedded derivative in accordance with ASC 815-15-30-2.

Even if a temporary-equity classified instrument is subject to the subsequent measurement adjustments in accordance with the SEC’s guidance, such instrument would meet the criteria in ASC 815-15-25-1(b); that is, it would not be subject to recurring fair value measurements. The subsequent measurement model for temporary-equity classified instruments requires entities to reflect certain instruments at their redemption value, which differs from their fair value.1

4.3.4 Condition 3 — Derivative Instrument

ASC 815-15

c. A separate instrument with the same terms as the embedded derivative would, pursuant to Section 815-10-15, be a derivative instrument subject to the requirements of Subtopic 815-10 and this Subtopic. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.)

The third bifurcation condition in ASC 815-15-25-1 is that the embedded feature would have been accounted for as a derivative instrument under ASC 815 if it were a separate freestanding instrument. To determine whether this condition has been satisfied, the entity evaluates whether the feature (1) would have met the definition of a derivative instrument in ASC 815-10 on a stand-alone basis and (2) meets any of the scope exceptions in ASC 815-10 and ASC 815-15. An embedded feature would not be bifurcated if it does not meet the definition of a derivative instrument on a freestanding basis or it qualifies for a scope exception.

The initial investment in a hybrid instrument is not considered the initial net investment for an embedded feature in that instrument (as noted in ASC 815-15-25-1). Instead, the initial net investment in the embedded feature is the amount an entity would have been required to invest in a freestanding contract with terms that are similar to those of the embedded feature, excluding the host contract of the hybrid instrument. That is, the initial investment needed to acquire or incur the host contract (e.g., the fair value of a debt host contract) does not form part of the initial investment of any embedded feature in the same hybrid instrument. Therefore, the initial net investment characteristic typically is met for embedded features in debt host contracts.

Example 4-9

Initial Net Investment in Conversion Option Embedded in a Debt Instrument

The initial net investment in a conversion option embedded in a debt instrument is the option’s fair value; it is not the fair value of the convertible debt or the fair value of the shares that would be delivered upon exercise of the conversion feature. When evaluating whether the initial net investment characteristic is met, an entity compares the fair value of the conversion option on the date of the debt’s issuance with the fair value of the underlying shares that are deliverable to the holders upon exercise of the conversion option. If the fair value of the conversion option is less, by more than a nominal amount, than the fair value of the instrument into which the option is convertible on the date of issuance, the initial net investment characteristic is met.

As discussed in Section 1.4.3, one of the conditions for meeting the definition of a derivative in ASC 815-10-15-83 is that a contract must be net settleable, which can be achieved in any one of the following ways: (1) it can be settled net via the contract terms, (2) a market mechanism exists that facilitates net settlement, or (3) the asset is RCC. When applying these criteria to an embedded feature, an entity would consider the following:

Contractual net settlement — Under ASC 815-10-15-100, net settlement may be made in cash or by delivery of any other asset, and there cannot be a requirement for either party to deliver an asset that is associated with the underlying. For example, if a preferred stock contract with an equity host has an embedded conversion feature that contractually requires physical settlement in shares, the embedded feature would not meet the contractual net settlement criterion because shares must be delivered to the counterparty.
Market mechanism — This criterion is not applied to embedded features because they are not freestanding financial instruments that can be separately transferrable from the host contract.
RCC — Under ASC 815-10-15-119, if the asset to be delivered is RCC, the embedded feature requiring such delivery would meet the net settlement condition. For example, a preferred stock contract with an equity host that has an embedded conversion feature requiring physical settlement in shares could still meet the net settlement condition if the entity’s shares were publicly traded (and therefore considered RCC). Note that the application of this condition to conversion features often depends upon whether the entity is privately or publicly held.

Chapters 5 and 6 include further guidance on the application of the net settlement criterion to specific host contract types.

See Chapter 1 for further details on the definition of a derivative instrument and Chapter 2 on the applicable scope exceptions in ASC 815-10. The following section details the scope exceptions in ASC 815-15.

4.3.5 Scope Exceptions for Embedded Derivative Evaluation

ASC 815-15

15-3 The guidance in this Subtopic does not apply to any of the following items, as discussed further in this Section:

Normal purchases and normal sales contracts
Unsettled foreign currency transactions
Plain-vanilla servicing rights
Features involving certain aspects of credit risk
Features involving certain currencies.

An embedded derivative that meets a derivative accounting scope exception in ASC 815-10-15-13 or ASC 815-15-15-3 should not be bifurcated from its host contract. As described in Chapter 2, a contract that qualifies for a derivative scope exception in accordance with ASC 815-10-15-13 may still contain an embedded feature that requires bifurcation in accordance with ASC 815-15-25-1. In such case, the embedded feature would be bifurcated and recorded as a derivative, and the remaining host contract would be eligible for a scope exception and accounted for under applicable GAAP for that contract. See Chapter 2 for further discussion of the derivative scope exceptions in ASC 815-10.

The sections below detail the scope exceptions in ASC 815-15-15-3. These are incremental scope exceptions that only apply to embedded derivative analysis.

4.3.5.1 Normal Purchases and Normal Sales

ASC 815-15

15-4 A contract that meets the definition of a derivative instrument in its entirety but qualifies for the normal purchases and normal sales scope exception as discussed beginning in paragraph 815-10-15-22 shall not also be assessed under paragraph 815-15-25-1

The scope exception in ASC 815-15-15-4 refers to the NPNS scope exception in ASC 815-10 (see Section 2.3.2 for further discussion of the NPNS scope exception). The embedded derivative guidance in ASC 815-15 does not apply to a contract that qualifies for the NPNS scope exception because the existence of an embedded feature that is not clearly and closely related to the contract would disqualify the contract from being an NPNS contract.

4.3.5.2 Unsettled Foreign Currency Transactions

ASC 815-15

15-5 Unsettled foreign currency transactions, including financial instruments, shall not be considered to contain embedded foreign currency derivatives under this Subtopic if the transactions meet all of the following criteria:

They are monetary items.
They have their principal payments, interest payments, or both denominated in a foreign currency.
They are subject to the requirement in Subtopic 830-20 to recognize any foreign currency transaction gain or loss in earnings.

15-6 The proscription in paragraph 815-15-15-5 applies to available-for-sale or trading debt securities that have cash flows denominated in a foreign currency.

Case R: Short-Term Loan With a Foreign Currency Option

55-211 A U.S. lender issues a loan at an above-market interest rate. The loan is made in U.S. dollars, the borrower’s functional currency, and the borrower has the option to repay the loan in U.S. dollars or in a fixed amount of a specified foreign currency.

55-212 This instrument can be viewed as combining a loan at prevailing market interest rates and a foreign currency option. The lender has written a foreign currency option exposing it to changes in foreign currency exchange rates during the outstanding period of the loan. The premium for the option has been paid as part of the interest rate. Because the borrower has the option to repay the loan in U.S. dollars or in a fixed amount of a specified foreign currency, the provisions of paragraph 815-15-15-5 are not relevant to this Case. That paragraph addresses foreign-currency-denominated interest or principal payments but does not apply to foreign currency options embedded in a functional-currency-denominated debt host contract. Because a foreign currency option is not clearly and closely related to issuing a loan, the embedded option should be separated from the host contract and accounted for by both parties pursuant to the provisions of this Subtopic. In contrast, if both the principal payment and the interest payments on the loan had been payable only in a fixed amount of a specified foreign currency, there would be no embedded foreign currency derivative pursuant to this Subtopic.

Under ASC 815-15-15-5, debt with principal or interest payments (or both) that are denominated in a foreign currency is deemed not to contain an embedded foreign currency derivative if the amounts that are denominated in a foreign currency must be remeasured at spot rates under ASC 830-20. If the interest payments of a dual-currency bond whose principal is denominated in dollars are denominated in a different currency, for example, ASC 815-15-55-210 requires the interest payments to be accounted for by discounting the “future equivalent dollar interest payments determined by the current spot exchange rate” at the debt’s original effective interest rate. Under the interest method, the principal payment would also be discounted by using the debt’s original effective interest rate.

The exemption in ASC 815-15-15-5 does not apply to a foreign currency feature that is not required to be remeasured under ASC 830-20 for changes in spot foreign currency exchange rates. For example, the exemption does not apply to an option to pay principal or interest payments in one or more alternative currencies other than the debt’s currency of denomination unless the amount owed in the alternative currency is determined by applying the current spot exchange rate at the time of payment to the amount owed in the debt’s currency of denomination.

4.3.5.3 Plain-Vanilla Servicing Rights

ASC 815-15

15-7 Plain-vanilla servicing rights, which involve an obligation to perform servicing and the right to receive fees for performing that servicing, do not contain an embedded derivative that would be separated from those servicing rights and accounted for as a derivative instrument.

Under ASC 815-15-15-7, plain-vanilla servicing rights do not contain embedded derivatives that must be bifurcated and accounted for separately as derivatives.

4.3.5.4 Features Involving Certain Aspects of Credit Risk

Under ASC 815-15-15-9, there are certain features involving aspects of credit risk that do not require evaluation of the guidance in ASC 815-10-15-11 and ASC 815-15-25.

ASC 815-15

15-9 The transfer of credit risk that is only in the form of subordination of one financial instrument to another (such as the subordination of one beneficial interest to another tranche of a securitization, thereby redistributing credit risk) is an embedded derivative feature that shall not be subject to the application of paragraph 815-10-15-11 and Section 815-15-25. Only the embedded credit derivative feature created by subordination between the financial instruments is not subject to the application of paragraph 815-10-15-11 and Section 815-15-25. However, other embedded credit derivative features (for example, those related to credit default swaps on a referenced credit) would be subject to the application of paragraph 815-10-15-11 and Section 815-15-25 even if their effects are allocated to interests in tranches of securitized financial instruments in accordance with those subordination provisions. Consequently, the following circumstances (among others) would not qualify for the scope exception and are subject to the application of paragraph 815-10-15-11 and Section 815-15-25 for potential bifurcation:

An embedded derivative feature relating to another type of risk (including another type of credit risk) is present in the securitized financial instruments.
The holder of an interest in a tranche of that securitized financial instrument is exposed to the possibility (however remote) of being required to make potential future payments (not merely receive reduced cash inflows) because the possibility of those future payments is not created by subordination. (Note, however, that the securitized financial instrument may involve other tranches that are not exposed to potential future payments and, thus, those other tranches might qualify for the scope exception.)
The holder owns an interest in a single-tranche securitization vehicle; therefore, the subordination of one tranche to another is not relevant.

4.3.5.5 Features Involving Certain Currencies

Under ASC 815-15-15-10, embedded features involving certain currencies do not require evaluation of the guidance in ASC 815-15-25.

ASC 815-15

15-10 An embedded foreign currency derivative shall not be separated from the host contract and considered a derivative instrument under paragraph 815-15-25-1 if all of the following criteria are met:

The host contract is not a financial instrument.
The host contract requires payment(s) denominated in any of the following currencies:
1. The functional currency of any substantial party to that contract
2. The currency in which the price of the related good or service that is acquired or delivered is routinely denominated in international commerce (for example, the U.S. dollar for crude oil transactions)
3. The local currency of any substantial party to the contract
4. The currency used by a substantial party to the contract as if it were the functional currency because the primary economic environment in which the party operates is highly inflationary (as discussed in paragraph 830-10-45-11).
Other aspects of the embedded foreign currency derivative are clearly and closely related to the host contract.

The evaluation of whether a contract qualifies for the scope exception in this paragraph shall be performed only at inception of the contract.

15-11 The decision about the currency of the primary economic environment in which a counterparty to a contract operates can be based on available information and reasonable assumptions about the counterparty; representations from the counterparty are not required.

15-12 When determining who is a substantial party to the contract for purposes of applying paragraph 815-15-15-10(b)(1), the entity shall do both of the following:

Consider all facts and circumstances pertaining to that contract (including whether the contracting party possesses the requisite knowledge, resources, and technology to fulfill the contract without relying on related parties)
Look through the legal form to evaluate the substance of the underlying relationships.

15-13 Example 1 (see paragraph 815-15-55-83) illustrates the application of this guidance.

15-14 The application of the phrase routinely denominated in international commerce in paragraph 815-15-15-10(b)(2) shall be based on how similar transactions for a certain product or service are routinely structured around the world, not just in one local area. If similar transactions for a certain product or service are routinely denominated in international commerce in various different currencies, the scope exception in that paragraph shall not apply to any of those similar transactions.

15-15 The guidance in paragraph 815-15-15-10 relating to embedded foreign currency derivatives within nonfinancial contracts relates to all embedded foreign currency caps or floors within such contracts. That guidance does not relate to all embedded foreign currency options within such contracts (such as an embedded foreign currency option that merely introduces a cap or floor on the functional currency equivalent price under a purchase contract). The embedded foreign currency cap or floor (or combination thereof) within a nonfinancial contract shall be considered clearly and closely related to the host nonfinancial contract, and thus not be accounted for separately as a derivative instrument, only if all of the following criteria are met:

The nonfinancial contract requires payment(s) denominated in any of the currencies permitted by paragraphs 815-15-15-10(b).
The embedded cap or floor (or combination thereof) does not contain leverage features.
The embedded cap or floor (or combination thereof) does not represent a written or net written option.

15-16 When an embedded cap or floor (or combination thereof) represents a purchased or net purchased option to one party to the contract, it represents a written or net written option to the counterparty to that contract. In that circumstance, that counterparty does not qualify for the paragraph 815-15-15-10 exclusion because the criterion in (c) in the preceding paragraph would not be met (due to the embedded foreign currency cap or floor [or combination thereof] representing a written or net written option).

15-17 If the embedded derivative represented a zero-cost collar (as described beginning in paragraph 815-20-25-88), both parties to the contract would meet the criterion in paragraph 815-15-15-15(c) and be eligible to qualify for the exclusion in paragraph 815-15-15-10.

15-18 If a financial or nonfinancial contract contained an option that allowed the payer to remit funds in an equivalent amount of a currency other than the functional currency of a substantial party to the contract at the payment date, that option shall not be separated from the host contract because the option merely allows the payer to make an equivalent payment in a choice of currencies (based on current spot prices).

15-19 The guidance in paragraphs 815-15-15-15 through 15-18 is not meant to address every possible type of foreign currency option that may be embedded in a nonfinancial contract, and an analogy to that guidance may not be appropriate for such foreign currency options.

The examples reproduced below illustrate the application of the guidance in ASC 815-15-15-10(b)(1), shown above.

ASC 815-15

Example 1: Features Involving Certain Currencies — Substantial Party to the Contract

55-83 The following Cases illustrate the application of paragraph 815-15-15-10(b)(1):

Guarantor not a substantial party to a two-party lease (Case A)
Requisite knowledge, resources, and technology (Case B)
Highly inflationary environment (Case C).

Case A: Guarantor Is Not a Substantial Party to a Two-Party Lease

55-84 A U.S. parent entity for which the U.S. dollar is the functional currency has a French subsidiary with a Euro functional currency. The subsidiary enters into a lease with a Canadian entity for which the Canadian dollar is the functional currency that requires lease payments denominated in U.S. dollars. The parent entity guarantees the lease.

55-85 The exception in paragraph 815-15-15-10(b)(1) does not apply to the contract. The substantial parties to a lease contract are the lessor and the lessee; a third-party guarantor is not a substantial party to a two-party lease, even if it is a related party (such as a parent entity). Thus, the functional currency of a guarantor is not relevant to the application of that paragraph.

55-86 The requirement in paragraph 815-15-15-10(b)(1) that the payments be denominated in the functional currency of at least one substantial party to the transaction ensures that the foreign currency is integral to the arrangement and thus considered to be clearly and closely related to the terms of the lease.

Case B: Requisite Knowledge, Resources, and Technology

55-87 A U.S.-based construction entity (the Parent) pursues business in a foreign country on a major construction contract. The Parent has an operating subsidiary (the Subsidiary) in that foreign country. The Subsidiary’s functional currency is determined to be the local currency (because of business activities unrelated to the construction contract), which is also the functional currency of the customer under the contract. The Parent’s functional currency is the U.S. dollar.

55-88 Primarily for tax and political reasons, the Parent causes its Subsidiary to enter into a contract with the customer (that is, the contract is legally between the Subsidiary and the customer). The contract requires payments by the customer in U.S. dollars. The payments are in U.S. dollars to facilitate the compensation of the Parent for its significant involvement in and management of the contract entered into by the Subsidiary.

55-89 The Subsidiary, by itself, does not possess the requisite financial, human, and other resources, technology, and knowledge to execute the construction contract on its own. The Parent provides the majority of the resources required under the contract, including direct involvement in negotiating the terms of the contract, managing and executing the contract throughout its duration, and maintaining all contract supporting functions, such as legal, tax, insurance, and risk management. Because it is controlled by the Parent, the Subsidiary does not have a choice of subcontractor for these resources and services and will always integrate the Parent into all phases of the contract. Without the Parent, the Subsidiary and the customer would probably never have entered into the construction contract because the Subsidiary could not perform under this contract without the help of the Parent.

55-90 In this Case, the Parent is a substantial party to the construction contract entered into by the Subsidiary for the purposes of applying paragraph 815-15-15-10(b)(1) because the Parent will be providing the majority of resources required under the contract on behalf of the Subsidiary, which is the legal party to the contract.

Case C: Highly Inflationary Environment

55-91 The following Cases illustrate the application of the scope exception in paragraph 815-15-15-10:

The contractual payments are denominated in a currency that, while not the functional currency, is used as if it were the functional currency due to a highly inflationary economy (Case C1).
The economy of the primary economic environment ceases to be highly inflationary after the inception of the contract (Case C2).

55-92 Cases C1 and C2 share the following assumptions. A U.S. parent entity for which the U.S. dollar (USD) is both the functional currency and the reporting currency has a Venezuelan subsidiary. The subsidiary’s sales, expenses, and financing are primarily denominated in the Mexican peso (MXN), and therefore the subsidiary considers MXN to be its functional currency as required by Topic 830. However, assume that the economy in Mexico is highly inflationary, and therefore that Topic requires that the parent entity’s reporting currency (that is, USD) be used as if it were the subsidiary’s functional currency. The subsidiary enters into a lease with a Canadian entity for property in Venezuela that requires the subsidiary to make lease payments in USD. Further, assume that the Canadian entity’s functional currency is the Canadian dollar (CAD). The Venezuelan subsidiary’s local currency is VEB (the Venezuelan bolivar).

Case C1: Highly Inflationary Economy Exists

55-93 The exception in paragraph 815-15-15-10 applies to contract because the subsidiary uses USD as if it were the functional currency. The conclusion is not affected by the fact that USD is not the currency of the primary economic environment in which either the Venezuelan subsidiary or the Canadian lessor operates (that is, USD is not the functional currency of either party to the lease). The forward contract to deliver USD embedded in the lease contract should not be bifurcated from the lease host. The exception in paragraph 815-15-15-10 would apply to the lease contract in this Example if the payments under that contract were denominated in any of the following four currencies: USD, MXN, VEB, or CAD. The exception applies to both of the substantial parties to the contract, the lessor and the lessee.

Case C2: Highly Inflationary Economy Ceases to Exist

55-94 Assume that, during the term of the property lease, the Mexican economy ceases to be highly inflationary. Therefore, the Venezuelan subsidiary’s financial statements cease to be remeasured as if USD were the functional currency and, instead, those financial statements are remeasured using the subsidiary’s functional currency, MXN.

55-95 When the lease was entered into, the subsidiary used USD as if it were the functional currency; therefore, the foreign currency embedded derivative would have qualified for the exception in paragraph 815-15-15-10 for both the lessor and the lessee. The fact that the subsidiary subsequently ceased using USD as if it were the functional currency and, instead, now uses MXN (which was outside the control of management of the entity because it is contingent upon a change in the Mexican economy) does not affect the application of the exception because the subsidiary qualified for the exception at the inception of the contract. However, if the subsidiary would enter into an extension of the lease or a new lease that required payments in USD, the exception would not apply because at the time the new or extended lease was entered into, the subsidiary no longer used USD as if it were the functional currency.

The following example, which is reproduced from ASC 815-15-55-240 through 55-243, illustrates the application of ASC 815-15-15-15.

ASC 815-15

55-240 On March 1, 20X0, Entity A enters into a Japanese yen- (JPY-) denominated forward purchase agreement to purchase a specified quantity of widgets in six months from Entity B. Entity A’s functional currency is the U.S. dollar (USD) and Entity B’s functional currency is JPY. The spot JPY/USD foreign exchange rate at the inception of the agreement is USD 1.00 equals JPY 110.00. Entity A wishes to collar its foreign exchange rate risk by ensuring that it will never pay more than the JPY equivalent to USD 11.00 per widget in return for committing to Entity B that it will never pay less than the JPY equivalent to USD 8.80 per widget. The agreement defines the price according to the following schedule.

55-241 Entity A is exposed to foreign exchange risk in the range between JPY 100 and JPY 125, whereas Entity B is exposed outside that range. The following are various scenarios.

55-242 In essence, Entity A has not locked in a USD price or a JPY price for the purchased widgets. Instead, as desired, Entity A has locked in a price range in its functional currency (USD) between USD 8.80 and USD 11.00 for the purchased widgets. The final price to be paid within this range will be determined based on the JPY/USD foreign exchange rate. Based on the terms, the contract contains an embedded cap and floor (options). For purposes of this Example, assume that the combination of options represents a net purchased option for Entity A.

55-243 The embedded foreign currency options within Entity A’s purchase contract would qualify for the exclusion under paragraph 815-15-15-15 for purposes of Entity A’s accounting because all of the following conditions exist:

The options are denominated in JPY and USD (the functional currencies of both parties to the contract).
There is no leverage feature within the options.
The combination of foreign currency options represents a net purchased option.

Not all foreign currency embedded derivatives require separate accounting. ASC 815-15-15-10 provides an exception for a host contract that is not a financial instrument (e.g., an operating lease or supply contract is not a financial instrument) if it requires payments denominated in one of the following, as outlined in ASC 815-15-15-10(b):

The functional currency of any substantial party to that contract.
The currency in which the price of the related good or service that is acquired or delivered is routinely denominated in international commerce (for example, the U.S. dollar for crude oil transactions)
The local currency of any substantial party to the contract
The currency used by a substantial party to the contract as if it were the functional currency because the primary economic environment in which the party operates is highly inflationary.

If the criteria in ASC 815-15-15-10(b) are met, the forward contract to deliver (or receive) payment in a foreign currency is considered clearly and closely related to the host contract and, therefore, is not an embedded foreign currency derivative.

In accordance with ASC 815-15-15-10(b)(2), a contract for a good or service that is “routinely denominated in international commerce” would not be a foreign currency embedded derivative requiring separate accounting. For example, crude oil is only quoted in U.S. dollars in international commerce; therefore, a euro functional entity would not have an embedded derivative if it held a contract to buy crude oil that was denominated in U.S. dollars.

Example 4-10

International Commerce Considerations

Company A, a U.S. dollar functional currency entity, enters into an operating lease with Company B., whose functional currency is the euro. Company A will lease office space from B and pay €2,500,000 per year. From A’s perspective, embedded in the lease is a foreign currency forward contract to buy €2,500,000 annually over the life of the lease. Because A is required to make lease payments in euros, the functional currency of the lessor, A would not account for a foreign currency embedded derivative since it would be considered clearly and closely related to the host contract. Alternatively, if A was required to make lease payments in Canadian dollars, it would have to separately account for the foreign currency embedded derivative since Canada is not the primary economic environment of either A or B.

In determining the functional currency of the counterparty to a contract, the other party does not have to inquire about the counterparty’s functional currency but only needs to make a reasonable assumption about what its functional currency may be. For example, assume that a Brazilian subsidiary whose functional currency is the Real has a parent whose functional currency is the U.S. dollar. If the parent buys inventory under a long-term commitment at a fixed price in euros (assume that the contract is not a derivative) from a local sales office of a German company, the Brazilian subsidiary may conclude that the sales office has a euro functional currency if it is merely a pass-through entity for its German parent.

Example 4-11

Determining the Functional Currency

An Australian dollar functional company, Company X, enters into a forward contract to purchase products in U.S. dollars from a Norwegian company, Company Y, whose financial statements are issued in Norwegian krone. Company Y does not follow U.S. GAAP and does not refer to a functional currency in its financial statements. In reviewing Y’s financial statements and operations, X determines that Y’s primary sources of financing are U.S. dollars and that 95 percent of its sales are generated in U.S. dollars. Therefore, X would not have to bifurcate the U.S. dollar forward because the U.S. dollar appears to be Y’s primary operating currency. The primary operating currency of a company that does not follow U.S. GAAP should not be different from what its functional currency would be if it followed U.S. GAAP. In other words, an entity could not have a functional currency that is different from its primary operating currency.

The scope exception in ASC 815-15-15-10 also applies to certain insurance contracts that have features that involve certain currencies.

ASC 815-15

15-20 Although the scope exception in paragraph 815-15-15-10 does not apply to financial instruments, that paragraph applies if a normal insurance contract involves payment in the functional currency of either of the two parties to the contract.

15-21 Paragraph 815-15-15-10 applies also to a normal insurance contract if it involves payment in the local currency of the country in which the loss is incurred, irrespective of the functional currencies of the parties to the transaction.

55-1 Insurance contracts that provide coverage for various types of property and casualty exposure are commonly executed between U.S.-based insurance entities and multinational corporations that have operations in foreign countries. The contracts may be structured to provide for payment of claims in the functional currency of the insurer or in the functional currency of the entity experiencing the loss and will typically specify the exchange rate to be utilized in calculating loss payments.

55-2 Consider a contract that provides for the payment of losses in U.S. dollars (that is, the functional currency of the insurer). Losses are reported to the insurance entity in the functional currency of the entity experiencing the loss, but losses are paid by the insurer in U.S. dollars. From the perspective of the insurer, the contract terms may provide that the rate of exchange to be used to convert the losses from the functional currency of the foreign entity to the U.S. dollar for purposes of claim payments be one of the following:

The rate of exchange as of the settlement date (payment date) of the claim
The rate of exchange as of the loss occurrence date
The rate of exchange at inception of the contract.

The contract described in this guidance does not qualify as traditional insurance under paragraph 815-10-15-53(b) because it contains a foreign currency element.

55-3 Because the insurance entity does not record a claim liability in accordance with Subtopic 944-40 until losses are incurred, no foreign-currency-denominated liability exists (that would otherwise be subject to Subtopic 830-20, as contemplated by paragraph 815-15-15-10) during the period between the inception of the insurance contract and the loss occurrence date.

55-4 Insurance contracts are financial instruments that are not covered by the scope exception in paragraph 815-15-15-10 that applies to nonfinancial contracts; however, that paragraph applies to this situation in which a normal insurance contract involves payment in the functional currency of either of the two parties to the contract. The insurance contracts described in this guidance are covered by the exception in paragraph 815-15-15-10, because the insurance contracts do not give rise to a recognized asset or liability that would be measured under Subtopic 830-20 until an amount becomes receivable or payable under the contract. Therefore, as discussed in paragraph 815-15-15-20, the exception in paragraph 815-15-15-10 also applies to insurance contracts that involve payment of losses in the functional currency of either of the two parties to the contract.

Footnotes

See Section 9.5.2 of Deloitte’s Roadmap Distinguishing Liabilities From Equity for further discussion of the subsequent measurement of instruments classified in temporary equity.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.