Chapter 4 — Identification of and Accounting for Embedded Derivatives

4.4 Accounting for Embedded Derivatives

4.4.1 Background

This section discusses the guidance that an entity applies when it has determined that an embedded feature must be separated from its host contract and accounted for as a derivative under ASC 815. It addresses:

Initial recognition, including the identification of the terms of the host contract and the embedded derivative (see the next section).
Initial measurement, including the allocation of proceeds between the host debt contract and the embedded derivative, and subsequent measurement (see Section 4.4.3).
Embedded derivative reassessment requirements (see Section 4.4.4).
The accounting that applies if an entity is unable to reliably identify and measure an embedded feature that must be accounted for as a derivative (see Section 4.4.5).
The fair value election for hybrid financial instruments (see Section 4.4.6).

4.4.2 Initial Recognition

4.4.2.1 General

ASC 815-10

25-1 An entity shall recognize all of its derivative instruments in its statement of financial position as either assets or liabilities depending on the rights or obligations under the contracts.

Embedded derivatives should generally be presented on the balance sheet on a combined basis with the host contract, except in circumstances in which the embedded derivative is a liability and the host contract is equity. If a separated embedded derivative represents a non-option feature (e.g., an embedded forward or swap), its terms are identified in a manner that results in a fair value of zero for the derivative at initial recognition (see the next section). An option-based derivative is separated on the basis of the stated terms of the hybrid instrument, which usually results in the attribution of an initial fair value other than zero to the embedded derivative (see Section 4.4.2.3). If a host contract contains multiple embedded features that require bifurcation, they are separated as one compound embedded derivative (see Section 4.4.2.4). An entity cannot impute terms that are not clearly present in the hybrid instrument (see Section 4.3.2.5).

4.4.2.2 Identification of the Terms of a Non-Option Embedded Derivative in a Hybrid Instrument

ASC 815-15

30-4 In separating a non-option embedded derivative from the host contract under paragraph 815-15-25-1, the terms of that non-option embedded derivative shall be determined in a manner that results in its fair value generally being equal to zero at the inception of the hybrid instrument. Because a loan and an embedded derivative can be bundled in a structured note that could have almost an infinite variety of stated terms, it is inappropriate to necessarily attribute significance to every one of the note’s stated terms in determining the terms of the non-option embedded derivative. If a non-option embedded derivative has stated terms that are off-market at inception, that amount shall be quantified and allocated to the host contract because it effectively represents a borrowing. (This paragraph does not address the bifurcation of the embedded derivative by a holder who has acquired the hybrid instrument from a third party after the inception of that hybrid instrument.) The non-option embedded derivative shall contain a notional amount and an underlying consistent with the terms of the hybrid instrument. Artificial terms shall not be created to introduce leverage, asymmetry, or some other risk exposure not already present in the hybrid instrument. Generally, the appropriate terms for the non-option embedded derivative will be readily apparent. Often, simply adjusting the referenced forward price (pursuant to documented legal terms) to be at the market for the purpose of separately accounting for the embedded derivative will result in that non-option embedded derivative having a fair value of zero at inception of the hybrid instrument.

Example 12: Separating a Non-Option Embedded Derivative

55-160 This Example illustrates the application of paragraph 815-15-30-4 and assumes that the illustrative non-option embedded derivative is a plain-vanilla forward contract with symmetrical risk exposure and that the hybrid instrument was newly entered into by the parties to the contract. Assume that the hybrid instrument is not a derivative instrument in its entirety.

55-161 Entity A plans to advance Entity X $900 for 1 year at a 6 percent interest rate and concurrently enter into an equity-based derivative instrument in which it will receive any increase or pay any decrease in the current market price ($200) of XYZ Corporation’s common stock. Those two transactions (that is, the loan and the derivative instrument) can be bundled in a structured note that could have almost an infinite variety of terms. The following presents 5 possible contractual terms for the structured note that would be purchased by Entity A for $900:

Note 1: Entity A is entitled to receive at the end of 1 year $954 plus any excess (or minus any shortfall) of the current per-share market price of XYZ Corporation’s common stock over (or under) $200.
Note 2: Entity A is entitled to receive at the end of 1 year $955 plus any excess (or minus any shortfall) of the current per-share market price of XYZ Corporation’s common stock over (or under) $201.
Note 3: Entity A is entitled to receive at the end of 1 year $755 plus any excess (or minus any shortfall) of the current per-share market price of XYZ Corporation’s common stock over (or under) $1.
Note 4: Entity A is entitled to receive at the end of 1 year $1,054 plus any excess (or minus any shortfall) of the current per-share market price of XYZ Corporation’s common stock over (or under) $300.
Note 5: Entity A is entitled to receive at the end of 1 year $1,060 plus any excess (or minus any shortfall) of the current per-share market price of XYZ Corporation’s common stock over (or under) $306.

55-162 All of these five terms of a structured note will provide the same cash flows, given a specified market price of XYZ Corporation’s common stock. If the market price of XYZ Corporation’s common stock at the end of 1 year is still $200, Entity A will receive $954 under all 5 note terms. If the market price of XYZ Corporation’s common stock at the end of 1 year increases to $306, Entity A will receive $1,060 under all 5 note terms.

55-163 For simplicity in constructing this Example, it is assumed that an equity-based cash-settled forward contract with a strike price equal to the stock’s current market price has a zero fair value. In many circumstances, a zero-value forward contract can have a strike price greater or less than the stock’s current market price.

55-164 The differences in the terms for these five notes are totally arbitrary because those differences have no effect on the ultimate cash flows under the structured note; thus, those differences are nonsubstantive and should have no influence on how the terms of an embedded derivative are identified. Therefore, the separation of the hybrid instrument into an embedded derivative and a host debt instrument should be the same for all five terms described above for the structured note (because they are merely different descriptions of the same ultimate cash flows). That bifurcation would generally result in the structured note being accounted for as a debt host contract with an initial carrying amount of $900 and a fixed annual rate of interest of 6 percent and an embedded forward contract with a $200 forward price, which results in an initial fair value of zero. Instead, if the five notes were bifurcated based on all their contractual terms, such bifurcation would be the equivalent of simply marking an arbitrary portion of a debt instrument to market based on nonsubstantive arbitrary differences in those contractual terms — an inappropriate outcome.

An embedded derivative that does not involve any optionality (i.e., an embedded forward or swap) is separated from the host contract in a manner such that its fair value is zero when the hybrid instrument is first recognized (i.e., it is assumed that the entity received or paid no amount for the embedded feature). All of the proceeds of the hybrid instrument are allocated to the host contract; none are allocated to the embedded derivative upon initial recognition (see Section 4.4.3.1).

Accordingly, an entity cannot necessarily rely on the stated terms of the embedded feature for separation purposes. If the stated terms imply that the embedded feature would have some fair value at inception, those terms are redefined and calibrated so that the embedded feature instead has zero fair value at inception. For example, a stated forward price might need to be increased or decreased for separation purposes with an equal and offsetting adjustment to the manner in which the terms of the host contract are identified. The purpose of this requirement is to ensure that the host contract component in a hybrid financial instrument is not attributed to an embedded derivative. If a non-option embedded derivative were to be separated on terms that result in an initial fair value other than zero (i.e., on “off-market” terms), the amount attributed to the embedded derivative effectively represents a component of the host contract (e.g., a debt element since the off-market element is “repaid” upon contract settlement).

4.4.2.3 Identification of the Terms of an Option-Based Embedded Derivative

ASC 815-15

30-6 The terms of an option-based embedded derivative shall not be adjusted to result in the embedded derivative being at the money at the inception of the hybrid instrument. In separating an option-based embedded derivative from the host contract under paragraph 815-15-25-1, the strike price of the embedded derivative shall be based on the stated terms documented in the hybrid instrument. As a result, the option-based embedded derivative at inception may have a strike price that does not equal the market price of the asset associated with the underlying. The guidance in this paragraph addresses both of the following:

The bifurcation of the option-based embedded derivative by a holder who has acquired the hybrid instrument from a third party either at inception or after inception of that hybrid instrument
The bifurcation of the option-based embedded derivative by the issuer when separate accounting for that embedded derivative is required.

An embedded derivative that involves optionality is separated on the basis of the stated terms of the hybrid instrument (e.g., the strike price specified in the hybrid instrument). Under ASC 815-15-30-6, an entity is not permitted to identify terms of an option-based embedded derivative that are different from those in the hybrid instrument. For example, an entity cannot adjust the manner in which the option is identified so as to achieve an intrinsic option value of zero at inception. Economically, an embedded derivative that involves optionality is different from a non-option embedded derivative because it is possible that the option will never be exercised.

4.4.2.4 Multiple Embedded Derivative Features

ASC 815-15

25-7 If a hybrid instrument contains more than one embedded derivative feature that would individually warrant separate accounting as a derivative instrument under paragraph 815-15-25-1, those embedded derivative features shall be bundled together as a single, compound embedded derivative that shall then be bifurcated and accounted for separately from the host contract under this Subtopic unless a fair value election is made pursuant to paragraph 815-15-25-4.

25-8 An entity shall not separate a compound embedded derivative into components representing different risks (for example, based on the risks discussed in paragraphs 815-20-25-12[f] and 815-20-25-15[i]) and then account for those components separately.

25-9 If a compound embedded derivative comprises multiple embedded derivative features that all involve the same risk exposure (for example, the risk of changes in market interest rates, the creditworthiness of the obligor, or foreign currency exchange rates), but those embedded derivative features differ from one another by including or excluding optionality or by including a different optionality exposure, an entity shall not separate that compound embedded derivative into components that would be accounted for separately.

25-10 If some of the embedded derivative features in a hybrid instrument are clearly and closely related to the economic characteristics and risks of the host contract, those embedded derivative features shall not be included in the compound embedded derivative that is bifurcated from the host contract and separately accounted for.

If a hybrid contract contains more than one embedded feature that requires bifurcation under ASC 815-15-25-1, those embedded derivatives must be bundled together as a single compound embedded derivative. For example, an entity cannot separate multiple embedded derivatives and designate only some as hedging instruments. The compound embedded derivative that is separated should not include embedded features that are evaluated separately and do not qualify for separation (e.g., features that are considered clearly and closely related to the host contract or qualify for a derivative scope exception).

4.4.3 Measurement

4.4.3.1 Initial Measurement (Including Allocation)

ASC 815-10

30-1 All derivative instruments shall be measured initially at fair value.

ASC 815-15

30-2 The allocation method that records the embedded derivative at fair value and determines the initial carrying value assigned to the host contract as the difference between the basis of the hybrid instrument and the fair value of the embedded derivative shall be used to determine the carrying values of the host contract component and the embedded derivative component of a hybrid instrument if separate accounting for the embedded derivative is required by this Subtopic. (Note that Section 815-15-25 allows for a fair value election for hybrid financial instruments that otherwise would require bifurcation.)

30-3 The objective is to estimate the fair value of the derivative features separately from the fair value of the nonderivative portions of the contract. Estimates of fair value shall reflect all relevant features of each component. For example, an embedded purchased option that expires if the contract in which it is embedded is prepaid would have a different value than an option whose term is a specified period that is not subject to truncation.

An entity is required to use a “with-and-without” method to allocate the cost basis between a bifurcated derivative and the host contract. Under this method, (1) a portion of the basis of the hybrid instrument (e.g., debt proceeds allocable to a hybrid debt instrument) equal to the fair value of the derivative component is allocated to the bifurcated derivative and then (2) the remaining carrying amount of the hybrid instrument is allocated to the host contract. Application of this method will not result in recognition of an immediate gain or loss in earnings related to the derivative because the initial carrying amount of the derivative will be its fair value.

Example 4-12

Initial Recognition of Embedded Derivative in a Debt Contract

Company ABC issues $100 million of 10-year, 4 percent fixed-rate convertible debt in $1,000 denominations. Each $1,000 bond is convertible into 20 common shares of ABC stock. Assume that the conversion option meets the definition of a derivative instrument and must be bifurcated and accounted for separately. At issuance, the fair value of the conversion option is $100 per $1,000 bond or $10 million in aggregate. The issuer would initially recognize the conversion option liability at $10 million and the host debt instrument at $90 million.

Preferred stock issued with a bifurcated embedded feature could similarly result in the initial recognition of preferred stock at a discount or premium. Application of the guidance in ASC 480-10-S99-3A creates additional complexities, as highlighted in the following example. For further details on the SEC’s guidance on temporary equity, see Chapter 9 of Deloitte’s Roadmap Distinguishing Liabilities From Equity.

Example 4-13

Initial Carrying Amount of Redeemable Preferred Stock With a Bifurcated Embedded Derivative

Issuer A issues preferred stock for net proceeds of $100. The stock is redeemable by the holder at any time for $98. Further, the stock contains a call option with an exercise price indexed to a foreign currency. Assume that A concludes that it should bifurcate the embedded call option. If the initial amount allocated to the embedded derivative is $5 (an asset), the initial carrying amount of the host contract after separation of the embedded derivative is $105. Therefore, the initial carrying amount presented in temporary equity is $105. Even though the redemption value is $98, A cannot reduce the amount of temporary equity to this amount because the SEC precludes reductions in the amount of temporary equity recorded for a redeemable equity instrument below the initial carrying amount unless an exception applies (see Section 9.5.2.5 of Deloitte’s Roadmap Distinguishing Liabilities From Equity).

It is also possible that an embedded derivative would need to be bifurcated from a host contract that has no initial cost basis (such as a lessor’s operating lease or a supply contract). In such an instance, there would be no allocation of the “remaining carrying amount” and the entity would instead simply record the host contract at an offsetting amount. Unlike the bifurcated embedded derivative, the host contract would not be subject to recurring fair value measurement. Instead, it would follow generally accepted accounting principles applicable to that type of contract.

Example 4-14

Initial Recognition of a Bifurcated Embedded Derivative From an Operating Lease

Lessor L enters into an operating lease of a building with Lessee P. Lessee P is required to make lease payments of $1,000 per month to L during the lease’s five-year term; however, if the price of oil exceeds $100 per barrel, P must make an additional lease payment of $200 per month for as long as the price of oil exceeds $100. Lessor L concludes that it should bifurcate the oil price payment feature from its operating lease, and the initial amount allocated to the embedded derivative is $8 (an asset). Since there is no initial basis for the lessor’s operating lease, L would simply record an offsetting entry for $8 as a lease liability. That liability would be released over the life of the lease and treated as a reduction of lease payments received.

At the 2014 AICPA Conference on Current SEC and PCAOB Developments, then SEC Professional Accounting Fellow Hillary Salo discussed situations in which entities enter into financing arrangements in which the total net proceeds received for an issued hybrid instrument are less than the fair value of the related financial liabilities that must be measured at fair value. These scenarios can occur if an entity wishes to align itself with a strategic investor or needs financing because of financial difficulties. For example, an entity that wants to align itself with a specific investor may issue $15 million of convertible debt at par and be required to bifurcate an in-the-money conversion option with a fair value of $20 million.

When a reporting entity issues a hybrid instrument and must recognize related financial liabilities (e.g., an embedded derivative that must be bifurcated) at fair values that exceed the total net proceeds received, the entity should perform a detailed analysis of the financing transaction. Its analysis should include:

Verifying that the financial liabilities that must be measured at fair value are appropriately valued under ASC 820.
Determining whether the transaction was conducted at arm’s length and whether the parties involved are related parties under ASC 850.
Evaluating all elements of the transaction to determine whether there are any other rights or privileges received that should be recognized as an asset under other applicable guidance.

If, after performing this analysis, the entity concludes that the amount of financial liabilities measured at fair value still exceeds the total net proceeds received, it should recognize the excess as a loss in earnings. In addition, the entity should disclose the nature of the transaction in the financial statement footnotes, including (1) the reasons why the entity entered into the transaction and (2) the benefits received. If, however, the entity determines that the transaction was not conducted at arm’s length or was executed with a related party, it should consider consulting with the SEC staff or the entity’s accounting advisers before reaching a conclusion about the appropriate accounting treatment.

4.4.3.2 Subsequent Measurement

ASC 815-10

35-1 All derivative instruments shall be measured subsequently at fair value.

When an entity is required to bifurcate an embedded derivative from a hybrid instrument, it accounts for the host contract under the requirements that apply to such contracts. The accounting for the host contract is based on the contractual cash flows that remain after separation of the cash flows attributable to the embedded derivative. The embedded derivative is accounted for at fair value, with changes in fair value recognized in earnings (unless it is designated as a hedging instrument in a qualifying cash flow hedge or net investment hedge under ASC 815, in which case fair value changes are recognized in OCI). Importantly, although the bifurcated embedded derivative is remeasured, the host contract is not subject to recurring fair value measurement; instead, the accounting depends on the applicable framework for the host contract.

For example, if debt was issued at par and contains an embedded redemption feature that must be bifurcated as a derivative liability under ASC 815-15, the allocation of value to the derivative liability creates a debt discount upon issuance (see Section 4.3.6 of Deloitte’s Roadmap Issuer’s Accounting for Debt). In that instance, the application of the interest method to a debt host contract depends on the amount of proceeds and subsequent contractual cash flows that are attributed to the debt host contract.

ASC 480-10-S99-3A does not specifically address the subsequent measurement of hybrid instruments recorded outside of permanent equity after any embedded derivative or derivatives have been separated from the host contract. We believe there are two possible subsequent measurement alternatives that would be acceptable when consistently applied as illustrated in the example below.

Example 4-15

Subsequent Measurement of Host Contract

A convertible preferred stock instrument is redeemable for cash at the greater of (1) the conversion value and (2) the original issue price plus accrued cumulative unpaid dividends. The issuer has concluded that the conversion option must be bifurcated as a derivative under ASC 815-15 (including a portion of the cash-settled redemption feature equal to the difference between the conversion value and the original issue price plus accrued and cumulative unpaid dividends). The instrument is not currently redeemable, but it is probable that it will become redeemable.

The two acceptable views regarding subsequent measurement of the preferred stock instrument are as follows:

View A — The entity could accrete or immediately adjust the host contract to the redemption amount on the basis of the original issue price plus accrued cumulative unpaid dividends. Under this approach, the value of the host contract upon remeasurement would not reflect the possibility of a redemption based on the conversion value because the conversion spread would be recognized separately as a derivative liability.
View B — The entity could adjust the carrying amount of the host contract to an amount equal to the instrument’s maximum redemption value less the current carrying amount of the bifurcated derivative liability.

Importantly, the application of Views A and B could result in differences in the total amounts assigned to the sum of the host contract plus the bifurcated feature. For example, if the fair value of the bifurcated conversion feature increased, there may or may not be a change in the carrying amount of the host contract under View B, depending on whether the hybrid instrument’s redemption value increases by the same amount as the increase in the bifurcated conversion option’s fair value. In many cases, the redemption value of the hybrid instrument would not include the time value of the conversion option. In addition, if the redemption value of the hybrid instrument increases partly because of increases in the intrinsic value of the conversion option, that portion of the increase in fair value would not result in a change in the carrying amount of the host contract. In that case, the fair value of the bifurcated conversion feature would be the same regardless of whether the entity applies View A or View B but the value assigned to the host contract could be different.

4.4.4 Reassessment

4.4.4.1 General

ASC 815-10

25-2 If a contract that did not meet the definition of a derivative instrument at acquisition by the entity meets the definition of a derivative instrument after acquisition by the entity, the contract shall be recognized immediately as either an asset or liability with the offsetting entry recorded in earnings.

25-3 If a contract ceases to be a derivative instrument pursuant to this Subtopic and an asset or liability had been recorded for that contract, the carrying amount of that contract becomes its cost basis and the entity shall apply other generally accepted accounting principles (GAAP) that are applicable to that contract prospectively from the date that the contract ceased to be a derivative instrument. If the derivative instrument had been designated in a cash flow hedging relationship and a gain or loss is recorded in accumulated other comprehensive income, then the guidance in Sections 815-30-35 and 815-30-40 shall be applied accordingly.

30-3 A contract recognized under paragraph 815-10-25-2 because it meets the definition of a derivative instrument after acquisition by an entity shall be measured initially at its then-current fair value.

ASC 815-40

35-8 The classification of a contract (including freestanding financial instruments and embedded features) shall be reassessed at each balance sheet date. If the classification required under this Subtopic changes as a result of events during the period (if, for example, as a result of voluntary issuances of stock the number of authorized but unissued shares is insufficient to satisfy the maximum number of shares that could be required to net share settle the contract [see discussion in paragraph 815-40-25-20]), the contract shall be reclassified as of the date of the event that caused the reclassification. There is no limit on the number of times a contract may be reclassified.

50-3 Contracts within the scope of this Subtopic may be required to be reclassified into (or out of) equity during the life of the instrument (in whole or in part) pursuant to the provisions of paragraphs 815-40-35-8 through 35-13. An issuer shall disclose contract reclassifications (including partial reclassifications), the reason for the reclassification, and the effect on the issuer’s financial statements.

An entity should continually reassess whether an embedded feature qualifies as a derivative and, if so, for any derivative scope exception. For example, an entity is required to reassess whether the net settlement characteristic in the definition of a derivative is met (see Section 4.3.4). If an embedded feature begins or ceases to meet the definition of a derivative or any scope exception, the analysis of whether the feature should be separated and accounted for as a derivative under ASC 815 is affected.

Unlike the evaluation of whether the embedded feature is a derivative, the evaluation of whether an embedded feature is clearly and closely related to its host contract is performed at the inception of the contract only and is not subject to reassessment.

If separation of an embedded derivative is required after the initial recognition of a hybrid instrument, the feature is bifurcated and recognized at fair value at the time it begins to meet the bifurcation criteria (see Section 4.3). In the case of a hybrid instrument, a portion of the current carrying amount of the hybrid instrument equal to the current fair value of the feature as of the reclassification date is reallocated to the embedded derivative in a manner consistent with the allocation guidance in ASC 815-15-30-2 (see Section 4.4.3.1).

If a contract is modified or exchanged, an entity should reperform its analysis of whether any embedded features must be separated from the hybrid instrument under ASC 815-15. Even if the modification or exchange is not treated as an extinguishment of the original instrument for accounting purposes, reperformance of the analysis may be necessary because the contractual arrangement has been changed. If separation of an embedded derivative is required after the initial recognition of an instrument, the feature is bifurcated and recognized at fair value at the time it begins to meet the bifurcation criteria. A portion of the current carrying amount of the instrument equal to the current fair value of the feature as of the reclassification date is reallocated to the embedded derivative in a manner consistent with the allocation guidance in ASC 815-15-30-2.

Conversely, if separation of an embedded feature is no longer required after the initial recognition of a hybrid instrument, the embedded derivative is recombined with its host contract at its current fair value at the time it ceases to meet the bifurcation criteria. However, special guidance applies to bifurcated equity conversion features (see Section 4.4.4.3).

Example 4-16

Reassessment of Embedded Features in a Preferred Stock Arrangement

Entity A issues convertible preferred stock that contains a debt host contract it is evaluating for potential bifurcation of the embedded features under ASC 815-15. The conversion feature embedded in the debt host contract does not initially meet the definition of a derivative since (1) the feature cannot be contractually net settled and (2) neither the preferred stock nor the shares issuable upon the stock’s conversion are publicly traded (and therefore are not RCC as defined by ASC 815-10). After the initial issuance of the preferred stock, A successfully completes an IPO, and the level of market trading is sufficient to rapidly absorb the shares issuable upon conversion of the preferred stock without significantly affecting the stock price (i.e., the shares become RCC). Accordingly, before considering the applicability of any derivative scope exceptions, A would be required to bifurcate the embedded conversion feature upon the IPO, even though the terms of the convertible preferred stock itself are not amended.

4.4.4.2 Conversion Feature Ceases to Qualify for the Own Equity Scope Exception

ASC 815-40

35-9 . . . If an embedded feature no longer qualifies for the derivatives scope exception under this Subtopic, the feature shall be separated from its host contract and accounted for as a derivative instrument in accordance with Subtopic 815-10 and Subtopic 815-15 (if all of the criteria in paragraph 815-15-25-1 are met).

If separation of an embedded equity conversion feature is required after the initial recognition of a convertible instrument, the feature is bifurcated and recognized at fair value at the time it begins to meet the bifurcation criteria (see Section 4.3). A portion of the current carrying amount of the instrument equal to the current fair value of the embedded derivative feature as of the reclassification date is reallocated to the embedded derivative in a manner consistent with the allocation guidance in ASC 815-15-30-2 (see Section 4.4.3.1). The entity also should provide the disclosures required by ASC 815-40-50-3.

4.4.4.3 Conversion Feature Ceases to Be Bifurcated as a Derivative

ASC 815-15

35-4 If an embedded conversion option in a convertible debt instrument no longer meets the bifurcation criteria in this Subtopic, an issuer shall account for the previously bifurcated conversion option by reclassifying the carrying amount of the liability for the conversion option (that is, its fair value on the date of reclassification) to shareholders’ equity. Any debt discount recognized when the conversion option was bifurcated from the convertible debt instrument shall continue to be amortized.

40-1 If a holder exercises a conversion option for which the carrying amount has previously been reclassified to shareholders’ equity pursuant to paragraph 815-15-35-4, the issuer shall recognize any unamortized discount remaining at the date of conversion immediately as interest expense.

40-4 If a convertible debt instrument with a conversion option for which the carrying amount has previously been reclassified to shareholders’ equity pursuant to the guidance in paragraph 815-15-35-4 is extinguished for cash (or other assets) before its stated maturity date, the entity shall do both of the following:

The portion of the reacquisition price equal to the fair value of the conversion option at the date of the extinguishment shall be allocated to equity.
The remaining reacquisition price shall be allocated to the extinguishment of the debt to determine the amount of gain or loss.

50-3 An issuer shall disclose both of the following for the period in which an embedded conversion option previously accounted for as a derivative instrument under this Subtopic no longer meets the separation criteria under this Subtopic:

A description of the principal changes causing the embedded conversion option to no longer require bifurcation under this Subtopic
The amount of the liability for the conversion option reclassified to stockholders’ equity.

ASC 815-40

35-10 . . . An embedded derivative that qualifies for the derivatives scope exception upon reassessment under this Subtopic that was separated from its host contract and accounted for as a derivative instrument in accordance with Subtopic 815-10 shall be reclassified to equity. The previously bifurcated embedded derivative shall not be recombined with its host contract.

If a previously bifurcated embedded conversion option ceases to meet the ASC 815-15 bifurcation criteria, any previously recognized gains and losses should not be reversed. Instead, the carrying amount of the embedded derivative (i.e., the feature’s fair value as of the date of the reclassification) should be reclassified to shareholders’ equity (see Section 6.4 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity). The entity also should provide the disclosures required by ASC 815-15-50-3 and ASC 815-40-50-3.

Example 4-17

Reassessment of an Embedded Feature That May No Longer Meet the Definition of a Derivative

Entity B issues convertible preferred stock that contains a debt host it is evaluating for potential bifurcation of the embedded features under ASC 815-15. The conversion feature embedded in the debt host contract meets the definition of a derivative since the feature requires gross settlement by delivery of shares that are RCC as defined by ASC 815-10. The scope exception for contracts indexed to an entity’s own equity does not apply because the convertible preferred stock’s conversion feature includes adjustments that are precluded under ASC 815-40. Accordingly, the conversion feature is bifurcated and accounted for separately as if it were a freestanding derivative.

After the initial issuance of the convertible preferred stock, all of B’s common stock is acquired by a private equity partnership, and the stock is no longer publicly traded. Accordingly, B should reevaluate whether the embedded conversion feature still requires bifurcation upon the acquisition, even though the terms of the convertible preferred stock itself are not amended. If the conversion feature requires gross settlement (i.e., an exchange of preferred stock for nonpublic common stock), it would typically no longer meet the definition of a derivative and therefore no longer require bifurcation after the private equity acquisition.

Example 4-18

Convertible Debt With a Conversion Option That No Longer Requires Bifurcation

On January 1, 20X5, Company ABC issues a 10-year note that has a $1,000 par value, accrues interest at an annual rate of 4 percent, and is convertible into 100 shares of ABC common stock. The fair value of one share of ABC’s common stock is $4.50 on the issue date. Upon conversion, ABC must settle the accreted value of the note in cash and has the option to settle the conversion spread in either cash or common stock (commonly referred to as Instrument C2). After considering its potential share requirements for other existing commitments, ABC concludes that it cannot assert that it has a sufficient number of authorized but unissued common shares available to share settle the conversion option; accordingly, the conversion option does not qualify for equity classification under ASC 815-40. After applying ASC 815-40 and ASC 815-15-25-1, ABC concludes that the conversion option must be bifurcated and accounted for as a separate derivative.

At inception, on January 1, 20X5, ABC records the entry below to bifurcate the embedded derivative. The fair value of the conversion option on that date is $50.

Journal Entry: January 1, 20X5

As of each quarterly reporting date, ABC determines that continued bifurcation of the conversion option is required. For each quarterly reporting period, the derivative (which is not designated as a hedging instrument) is marked to fair value, with the changes in fair value recognized in earnings. Company ABC also recognizes its contractual interest expense on the note, and the debt discount created by the bifurcation of the embedded conversion option is amortized to interest expense. The following journal entries reflect the cumulative activity booked during the year ended December 31, 20X5 (each journal entry represents the sum of the quarterly journal entries):

Journal Entry: Year Ended December 31, 20X5

As of December 31, 20X5, the carrying amounts of the debt host contract and the conversion liability are $955 and $200, respectively.

On January 1, 20X6, ABC obtains shareholder approval to increase the number of its authorized common shares to a level sufficient for it to assert that it has the ability to share settle the conversion option. On the basis of this approval, ABC concludes that the conversion option now qualifies for equity classification under ASC 815-40 and that the bifurcated derivative liability no longer needs to be accounted for as a separate derivative under ASC 815-15-25-1.

Company ABC believes that no modification of terms occurred. Rather, an event extraneous to the note (obtaining shareholder approval to increase authorized common shares) has caused the embedded conversion option to no longer meet the conditions for bifurcation.

Company ABC records the following entry on January 1, 20X6 (assume no changes in fair values from December 31, 20X5, to January 1, 20X6).

Journal Entry: January 1, 20X6

Note that the debt discount will continue to be amortized over the remaining term of the debt since this discount reflects the issuer’s economic borrowing costs related to the convertible debt instrument. Company ABC also would be required to provide the disclosures described in ASC 815-15-50-3 and ASC 815-40-50-3.

4.4.5 Inability to Reliably Identify and Measure Embedded Derivative

4.4.5.1 Recognition and Measurement

ASC 815-15

30-1 An entity shall measure both of the following initially at fair value: . . .

b. An entire hybrid instrument if an entity cannot reliably identify and measure the embedded derivative that paragraph 815-15-25-1 requires be separated from the host contract.

35-2 If an entity cannot reliably identify and measure the embedded derivative that paragraph 815-15-25-1 requires be separated from the host contract, the entire contract shall be measured subsequently at fair value with gain or loss recognized in earnings. Paragraph 815-20-25-71(a)(4) states that the entire contract shall not be designated as a hedging instrument pursuant to Subtopic 815-20.

In the unusual situation in which an entity cannot reliably identify and measure an embedded feature that is required to be separated as a derivative, the entity must record the entire hybrid instrument at fair value and recognize changes in fair value through earnings. In practice, this provision is rarely applied. Note that under no circumstance can such an instrument be designated as a hedging instrument under ASC 815-20.

4.4.5.2 Presentation

ASC 815-15

45-1 In each statement of financial position presented, an entity shall report hybrid financial instruments measured at fair value under the election and under the practicability exception in paragraph 815-15-30-1 in a manner that separates those reported fair values from the carrying amounts of assets and liabilities subsequently measured using another measurement attribute on the face of the statement of financial position. To accomplish that separate reporting, an entity may do either of the following:

Display separate line items for the fair value and non-fair-value carrying amounts
Present the aggregate of the fair value and non-fair-value amounts and parenthetically disclose the amount of fair value included in the aggregate amount.

If an entity accounts for a hybrid instrument at fair value, it must report the related fair value amounts separately on the face of the balance sheet under ASC 815-15-45-1.

4.4.5.3 Disclosure

ASC 815-15

50-1 For those hybrid financial instruments measured at fair value under the election and under the practicability exception in paragraph 815-15-30-1, an entity shall also disclose the information specified in paragraphs 825-10-50-28 through 50-32.

50-2 An entity shall provide information that will allow users to understand the effect of changes in the fair value of hybrid financial instruments measured at fair value under the election and under the practicability exception in paragraph 815-15-30-1 on earnings (or other performance indicators for entities that do not report earnings).

If an entity accounts for a hybrid instrument at fair value because it cannot reliably identify and measure an embedded derivative (see Section 4.4.5.1), it must provide the disclosures that are required for financial liabilities for which the fair value option in ASC 825-10 has been elected (see Chapter 12 of Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the Fair Value Option)).

4.4.6 Fair Value Election for Hybrid Financial Instruments

4.4.6.1 Eligibility

ASC 815-15

25-4 An entity that initially recognizes a hybrid financial instrument that under paragraph 815-15-25-1 would be required to be separated into a host contract and a derivative instrument may irrevocably elect to initially and subsequently measure that hybrid financial instrument in its entirety at fair value (with changes in fair value recognized in earnings and, if paragraph 825-10-45-5 is applicable, other comprehensive income). A financial instrument shall be evaluated to determine that it has an embedded derivative requiring bifurcation before the instrument can become a candidate for the fair value election.

25-5 The fair value election shall be supported by concurrent documentation or a preexisting documented policy for automatic election. That recognized hybrid financial instrument could be an asset or a liability and it could be acquired or issued by the entity. The fair value election is also available when a previously recognized financial instrument is subject to a remeasurement event (new basis event) and the separate recognition of an embedded derivative. The fair value election may be made instrument by instrument. For purposes of this paragraph, a remeasurement event (new basis event) is an event identified in generally accepted accounting principles, other than the recording of a credit loss under Topic 326, or measurement of an impairment loss through earnings under Topic 321 on equity investments, that requires a financial instrument to be remeasured to its fair value at the time of the event but does not require that instrument to be reported at fair value on a continuous basis with the change in fair value recognized in earnings. Examples of remeasurement events are business combinations and significant modifications of debt as defined in Subtopic 470-50.

25-6 The fair value election shall not be applied to the hybrid instruments described in paragraph 825-10-50-4.

Under ASC 815-15-25-1, an entity may be required to bifurcate and separately account for an embedded derivative contained within a hybrid instrument. In lieu of such separation, ASC 815-15-25-4 allows an entity to account for the entire hybrid instrument at fair value, provided that the instrument is a financial asset or financial liability, with changes recognized in earnings and, if applicable, OCI. The fair value measurement election applies to hybrid financial instruments that are issued as well as those that are purchased.

The fair value election in ASC 815-15 originated from the guidance in FASB Statement 155, which was issued before FASB Statement 159 (which provided the pre-Codification fair value option guidance now contained in ASC 825-10; see Section 4.4). The fair value election in ASC 815-15 can be made on an instrument-by-instrument basis, or an entity can elect this option for all qualifying hybrid financial instruments on some other basis, such as an entity-wide policy decision or a type-of-instrument basis. In all scenarios, the fair value election under ASC 815-15 must be supported with appropriate concurrent documentation that eliminates any question regarding whether the entity elected to apply fair value measurement to a particular instrument.

In ASC 815-15-25-5, the term “concurrent documentation” is analogous to the “contemporaneous documentation” requirements for hedge accounting in ASC 815. Therefore, the fair value election for hybrid financial instruments must be documented (1) at the time a hybrid financial instrument is acquired or issued or (2) when a previously recognized hybrid financial instrument is subject to a remeasurement (new basis) event. If the documentation does not exist at that time, the fair value option may not be elected.

A remeasurement event, as prescribed in ASC 825-10-25-5, may provide the entity with another opportunity to elect to measure the entire hybrid financial instrument at fair value provided that concurrent documentation is prepared to support that election.3

For the following reasons, the fair value election in ASC 815-15 applies to a narrower population (scope) of items than the fair value option in ASC 825-10:

The fair value election in ASC 815-15 applies only to hybrid financial instruments for which bifurcation of an embedded derivative would otherwise be required. An entity that elects the fair value option in ASC 825-10 is not required to determine that an embedded derivative would need to be accounted for separately under ASC 815-15.
ASC 815-15-25-6 prohibits the fair value election for any hybrid instrument that is discussed in ASC 825-10-50-8, which describes 15 items for which public business entities are not required to provide fair value disclosures. The scope of ASC 825-10-50-8 is more restrictive than the scope of the fair value option in ASC 825-10-15-4 and 15-5 (see Section 12.2.1 of Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the Fair Value Option).

Like ASC 825, ASC 815-15 allows the fair value election for an eligible item only upon (1) initial recognition or (2) the occurrence of a subsequent remeasurement event (i.e., a subsequent remeasurement of the entire instrument at fair value under other U.S. GAAP). Therefore, under both ASC 815-15 and ASC 825, an entity is prohibited from making the fair value election upon determining that an embedded derivative that was previously not bifurcated under ASC 815-15 subsequently must be bifurcated (e.g., a hybrid financial instrument containing an embedded derivative that meets the net settlement condition in ASC 815-10-15-83(c) after initial recognition).

There are no situations in which an entity could make the fair value election for a hybrid instrument under ASC 815-15 but would be prohibited from electing the fair value option for the same instrument under ASC 825-10. In addition, regardless of whether the entity applies the fair value accounting guidance in ASC 815-15 or ASC 825, the hybrid financial instrument cannot be designated as a hedging instrument under ASC 815-20. Furthermore, the documentation and disclosure requirements related to the fair value election in ASC 815-15 are the same as those related to the fair value option in ASC 825-10.

Since the fair value election under ASC 815-15 applies to a narrower population of items than does the fair value option under ASC 825, entities can effectively disregard the fair value election guidance in ASC 815-15-25-4. While ASC 815-15 requires an entity to first determine that a hybrid financial instrument contains an embedded derivative for which bifurcation would otherwise be required under ASC 815-15, entities can bypass this assessment because — regardless of whether such bifurcation is required — the hybrid financial instruments that are eligible for the fair value election in ASC 815-15 are also eligible for the fair value option in ASC 825-10 (and the fair value option in ASC 825 can be elected regardless of whether an entity has identified an embedded derivative for which bifurcation would otherwise be required). In practice, an entity may elect to apply the fair value option simply to avoid having to separately value an embedded derivative if the entity expects it to be easier to determine the fair value of the hybrid contract as a whole.

The disclosure requirements applicable to a hybrid financial instrument for which the fair value election is made under ASC 815-15 are consistent with those in ASC 825-10. Regardless of whether fair value accounting is elected under ASC 815-15 or ASC 825-10, an entity is subject to the applicable incremental disclosure requirements for (1) derivatives in ASC 815 and (2) items for which the fair value option has been elected in ASC 825-10. We believe that the guidance on fair value elections in ASC 815-15 (which was derived from FASB Statement 155) was retained in U.S. GAAP because that guidance was available (and may have been used) before the effective date of FASB Statement 159 (codified in ASC 825). Thus, entities may still have hybrid financial instruments that are being recognized at fair value in their entirety in accordance with ASC 815-15 because those instruments were issued before the effective date of the fair value option guidance in ASC 825-10.

4.4.6.2 Measurement

ASC 815-15

30-1 An entity shall measure both of the following initially at fair value:

A hybrid financial instrument that under paragraph 815-15-25-1 would be required to be separated into a host contract and a derivative instrument that an entity irrevocably elects to initially and subsequently measure in its entirety at fair value (with changes in fair value recognized in earnings) . . .

35-1 If an entity irrevocably elected to initially and subsequently measure a hybrid financial instrument in its entirety at fair value, changes in fair value for that hybrid financial instrument shall be recognized in earnings. Paragraph 815-20-25-71(a)(3) states that the entire contract shall not be designated as a hedging instrument pursuant to Subtopic 815-20.

If an entity elects the fair value option in ASC 815-15 for a hybrid financial instrument, no embedded feature should be separated as a derivative (see Section 4.3.3). The accounting for the hybrid financial instrument is the same as if the fair value option in ASC 825-10 had been applied (see Chapter 12 of Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the Fair Value Option)).

4.4.6.3 Presentation and Disclosure

For guidance on the presentation and disclosure of embedded derivatives, see Chapter 7.

Footnotes

For more information about Instrument C, see remarks of then SEC Professional Accounting Fellow Robert Comerford at the 2003 AICPA Conference on Current SEC Developments.

If a debt instrument has been refinanced or modified in such a way that it is substantially different from the original instrument (i.e., an extinguishment of the original instrument), a remeasurement under ASC 825 has occurred and the fair value option could be elected (or no longer applied if it was previously elected). See ASC 825-10-25-5 for specific examples. A modification of a debt instrument that is not an extinguishment would not be considered a remeasurement event. See Section 12.3.2.2.4 of Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the Fair Value Option).

Confidential and Proprietary — for Use Solely by Authorized Personnel

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.