Chapter 5 — Common Embedded Features Unique to Debt Host Contracts

5.2 Features Related to an Interest Rate Embedded in a Debt Host

5.2.1 Background

This section discusses the analysis of whether an embedded feature that could adjust the payments on a debt host contract that is based solely on an interest rate or interest rate index should be separated as a derivative. Examples of contractual provisions in debt contracts that should be evaluated under the guidance discussed in this section include:

Interest payments that are leveraged on the basis of market interest rates (e.g., the contractual interest rate is a multiple of a specified interest rate).
Interest payments that move inversely with market interest rates (e.g., when market interest rates increase, the contractual interest rate decreases).
Interest payments that are based on a tenor of a specified interest rate that is different from the tenor of the interest payments (e.g., a constant maturity yield).
Choose-your-rate options (e.g., the debtor can elect to switch the basis of future variable- interest-rate payments to a different specified interest rate).
Caps, floors, or collars on interest payments indexed to a market interest rate.
Interest rate adjustments that are contingent on the level of interest rates.
Certain put and call options that are not otherwise required to be viewed as not clearly and closely related to the debt host contract.

This section does not address features that are contingent on, or indexed to, underlyings other than an interest rate or interest rate index. Similarly, this section also does not address features that are indexed to both interest rates and other underlyings.

For guidance on the evaluation of features that are indexed to underlyings other than an interest rate or interest rate index, see, for example, Sections 5.3 (credit-sensitive payments), 5.4 (inflation-indexed payments), 6.2.2.4 (equity-indexed payments), 5.6 (foreign currency features), 6.8 (commodity-indexed payments), 6.9 (revenue-indexed payments), and 6.10 (other payments contingent on underlyings other than interest rates, credit risk, or inflation).

5.2.2 Bifurcation Analysis

The table below presents an overview of the bifurcation analysis of an embedded feature that is based solely on an interest rate or interest rate index and could adjust the cash flows of a debt host contract. However, an entity should always consider the terms and conditions of a specific feature in light of all the relevant accounting guidance before reaching a conclusion.

Bifurcation Condition	Condition Met?	Analysis
Not clearly and closely related (see Section 4.3.2)	It depends	The entity must evaluate whether an interest-related feature is clearly and closely related to a debt host in accordance with the negative-yield test and the double-double test (ASC 815-15-25-26).
Hybrid instrument not measured at fair value through earnings on a recurring basis (see Section 4.3.3)	It depends	From the issuer’s perspective, debt is not measured at fair value on a recurring basis unless the issuer elects the fair value option in ASC 815-15 or ASC 825-10. The fair value option cannot be elected for debt that contains a separately recognized equity component at inception. From the holder’s perspective, if a loan or debt security is remeasured at fair value, with changes in fair value recorded in earnings, any derivative embedded in the interest would not need to be accounted for separately since the accounting for the interest would already be the same as that of a freestanding derivative.
Meets the definition of a derivative (see Section 4.3.4)	Yes	An interest-rate-related feature that adjusts the payments of a debt host contract meets the definition of a derivative.
Meets a scope exception (see Chapter 2 and Section 4.3.5)	No	No scope exception is available for features that are based solely on an interest rate or an interest rate index.

As shown in the table above, an entity’s determination of whether it must bifurcate as a derivative an embedded feature that is based solely on an interest rate or interest rate index and could adjust the payments of a debt host contract tends to focus on whether the feature is considered clearly and closely related to the debt host contract unless the entity is remeasuring the instrument at fair value on a recurring basis through earnings. Typically, such features meet the definition of a derivative and are not exempt from derivative accounting.

5.2.3 Clearly-and-Closely-Related Analysis

5.2.3.1 General

ASC 815-15

25-26 For purposes of applying the provisions of paragraph 815-15-25-1, an embedded derivative in which the only underlying is an interest rate or interest rate index (such as an interest rate cap or an interest rate collar) that alters net interest payments that otherwise would be paid or received on an interest-bearing host contract that is considered a debt instrument is considered to be clearly and closely related to the host contract unless either of the following conditions exists:

The hybrid instrument can contractually be settled in such a way that the investor (the holder or the creditor) would not recover substantially all of its initial recorded investment (that is, the embedded derivative contains a provision that permits any possibility whatsoever that the investor’s [the holder’s or the creditor’s] undiscounted net cash inflows over the life of the instrument would not recover substantially all of its initial recorded investment in the hybrid instrument under its contractual terms).
The embedded derivative meets both of the following conditions:
1. There is a possible future interest rate scenario (even though it may be remote) under which the embedded derivative would at least double the investor’s initial rate of return on the host contract (that is, the embedded derivative contains a provision that could under any possibility whatsoever at least double the investor’s initial rate of return on the host contract).
2. For any of the possible interest rate scenarios under which the investor’s initial rate of return on the host contract would be doubled (as discussed in (b)(1)), the embedded derivative would at the same time result in a rate of return that is at least twice what otherwise would be the then-current market return (under the relevant future interest rate scenario) for a contract that has the same terms as the host contract and that involves a debtor with a credit quality similar to the issuer’s credit quality at inception.

25-27 Even though the conditions in (a) and (b) in the preceding paragraph focus on the investor’s rate of return and the investor’s recovery of its investment, the existence of either of those conditions would result in the embedded derivative not being considered clearly and closely related to the host contract by both parties to the hybrid instrument. Because the existence of those conditions is assessed at the date that the hybrid instrument is acquired (or incurred) by the reporting entity, the acquirer of a hybrid instrument in the secondary market could potentially reach a different conclusion than could the issuer of the hybrid instrument due to applying the conditions in the preceding paragraph at different points in time.

25-28 An embedded derivative that alters net interest payments based on changes in a stock price index (or another non-interest-rate index) is not addressed in paragraph 815-15-25-26.

ASC 815-15-25-26 addresses whether an embedded feature whose only underlying is an interest rate or interest rate index should be considered clearly and closely related to a debt host contract.

There are two conditions in ASC 815-15-25-26: one that focuses on the investor’s recovery of its investment and one that focuses on the investor’s rate of return. If either of these conditions is met, neither party to the hybrid instrument would consider the embedded derivative feature clearly and closely related to the host contract.

ASC 815-15-25-26 indicates that when an entity assesses whether it meets these conditions, it should not consider the likelihood that a condition will be satisfied — the condition is met if there is any possibility whatsoever that it will be met.

5.2.3.2 Features That Are Indexed to Both Interest Rates and Other Underlyings

Because ASC 815-15-25-26 only applies to embedded features “in which the only underlying is an interest rate or interest rate index,” it does not apply to features that are indexed to, or contingent on, something other than an interest rate or an interest rate index, including features that are indexed to both an interest rate or interest rate index and other underlyings. An embedded put, call, or other redemption feature whose exercise is contingent on the occurrence or nonoccurrence of a specified uncertain, future event (e.g., an IPO or a change in control) would always have a second underlying (the occurrence or nonoccurrence of the specified event). Therefore, the redemption feature would only be subject to evaluation under ASC 815-15-25-26 if the event is solely related to an interest rate or an interest rate index (e.g., an embedded call option that may only be exercised when SOFR is at or above 5 percent).

Although an embedded feature that has a payoff that is indexed to both interest rates and another underlying (e.g., an event of default, a stock price, commodity price, or the entity’s stock market capitalization) is not subject to an evaluation under ASC 815-15-25-26, such a feature would not be considered clearly and closely related to a debt host contract unless either (1) the other underlying is based on the issuer’s credit risk (see Section 5.3) or inflation (see Section 5.4) or (2) the feature is a contingent redemption feature that otherwise does not have to be separated under the guidance on such features (see Section 6.4.2).

5.2.3.3 Negative-Yield Test

Under the negative-yield test (i.e., ASC 815-15-25-26(a)), an embedded interest rate feature is not clearly and closely related to its debt host contract if it could contractually cause the debt to be settled in such a way that the investor would not recover substantially all of its initial recorded investment. In other words, this test might be passed if it is contractually possible that the creditor could be forced to accept a negative yield on its investment.

The debtor performs the negative-yield test as of the date on which it initially recognizes the debt and does not subsequently reassess whether the test is passed. The investor (or creditor) performs the test as of the date it recognizes the debt investment, regardless of whether it acquires the debt investment in a secondary market or upon initial issuance. Like the debtor, the investor would not perform subsequent reassessment. It is possible that the investor’s application of the negative-yield test would produce a different result from the debtor’s initial evaluation if the investor acquires the debt investment in a secondary market and the market conditions or terms at that time have changed from the time of initial issuance.

Example 5-1

Bond With Leverage Feature

Company X invests in a $10 million 10-year bond that pays a fixed rate of 6 percent for the first two years and then pays a variable rate calculated as 14 percent minus the product of 2.5 times three-month SOFR, without a floor, for the remaining term of the bond.

Company X makes this investment as part of the initial issuance of the bond and must perform the negative-yield test as of the initial recognition date, the same date on which the bond issuer performs the test. Company X and the issuer should reach the same conclusion when applying the negative-yield test.

If three-month SOFR were to increase significantly, the bond might have a negative return, which would effectively erode the bond’s principal. Because there is a possibility that X may not recover substantially all of its initial investment, the negative yield test is passed. Company X and the bond issuer should, therefore, separately account for the embedded interest rate derivative unless the entire hybrid financial instrument is recognized at fair value, with changes in fair value recognized in earnings.

In practice, the phrase “substantially all” in ASC 815-15-25-26(a) is interpreted to mean at least 90 percent of the original investment. The negative-yield test is performed on an undiscounted basis. If, at inception, there is any contractual possibility whatsoever that the undiscounted contractual net cash flows received by the creditor over the life of the instrument will not be at least 90 percent of the investment recorded by the investor at inception, the negative-yield test is passed and the entity would consider the feature not to be clearly and closely related to the debt host. Otherwise, an embedded feature that is based only on an interest rate or interest rate index would be considered clearly and closely related to its host provided that it does not pass the double-double test (ASC 815-15-25-26(b); see Section 5.2.3.4).

ASC 815-15

25-29 The condition in paragraph 815-15-25-26(a) applies only to those situations in which the investor (creditor) could be forced by the terms of a hybrid instrument to accept settlement at an amount that causes the investor not to recover substantially all of its initial recorded investment. That condition does not apply to a situation in which the terms of a hybrid instrument permit, but do not require, the investor to settle the hybrid instrument in a manner that causes it not to recover substantially all of its initial recorded investment, provided that the issuer does not have the contractual right to demand a settlement that causes the investor not to recover substantially all of its initial net investment.

If scenarios exist in which the investor contractually would not recover substantially all of its initially recorded investment but the creditor could not be forced to accept such a settlement or could prevent such a scenario from occurring, the negative-yield test is not passed. The negative-yield test only applies to scenarios in which the creditor could be forced to accept a settlement under which it would not recover substantially all of its initial recorded investment. If the creditor has a right, but not an obligation, to settle the debt at an amount that is less than substantially all of its initially recorded investment (e.g., an embedded put option held by the creditor that has an exercise price at a significant discount to the initial investment), the negative-yield test is not passed.

Further, the negative-yield test does not reflect the risk that the debtor might breach the contract (i.e., the test is not met merely because of the risk that the debtor may default on its obligation to repay the debt). The negative-yield test only applies to scenarios in which the creditor contractually is at risk of not recovering substantially all of its initial recorded investment.

ASC 815-15

Example 10: Interest-Rate-Related Underlyings — Recovering Substantially All of an Initial Recorded Investment

Case A: Note A

55-130 If an investor in a 10-year note has the contingent option at the end of Year 2 to put it back to the issuer at its then fair value (based on its original 10-year term), the condition in paragraph 815-15-25-26(a) would not be met even though the note’s fair value could have declined so much that, by exercising the option, the investor ends up not recovering substantially all of its initial recorded investment. See paragraph 815-15-25-29.

Case B: Note B

55-131 An investor purchased from an A-rated issuer for $10 million a structured note with a $10 million principal, a 9.5 percent interest coupon, and a term of 10 years at a time when the current market rate for 10-year A-rated debt is 7 percent. Assume that the terms of the note require that, at the beginning of the third year of its term, the principal on the note be reduced to $7.1 million and the coupon interest rate be reduced to zero for the remaining term to maturity if interest rates for A-rated debt have increased to at least 8 percent by that date. That structured note would meet the condition in paragraph 815-15-25-26(a) for both the issuer and the investor because the investor could be forced to accept settlement that causes the investor not to recover substantially all of its initial recorded investment. That is, if increases in the interest rate for A-rated debt trigger the modification of terms, the investor would receive only $9 million, comprising $1.9 million in interest payments for the first 2 years and $7.1 million in principal repayment, thus not recovering substantially all of its $10 million initial net investment.

Case C: Note C

55-132 The investor purchases for $10,000,000 a structured note with a face amount of $10,000,000, a coupon of 4.9 percent, and a term of 10 years. The current market rate for 10-year debt is 7 percent given the A credit quality of the issuer. The terms of the structured note require that if the interest rate for A-rated debt has increased to at least 10 percent at the end of 2 years, the coupon on the note be reduced to zero, and the investor purchase from the issuer for $10,000,000 an additional note with a face amount of $10,000,000, a zero coupon, and a term of 3.5 years.

55-133 The structured note contains an embedded derivative that shall be accounted for separately unless a fair value election is made pursuant to paragraph 815-15-25-4.

55-134 The requirement that, if interest rates increase and the embedded derivative is triggered, the investor purchase the second $10,000,000 note for an amount in excess of its fair value (which is about $7,100,000 based on a 10 percent interest rate) generates a result that is economically equivalent to requiring the investor to make a cash payment to the issuer for the amount of the excess. As a result, the cash flows on the original structured note and the excess purchase price on the second note shall be considered in concert. The cash inflows ($10,000,000 principal and $1,780,000 interest) that will be received by the investor on the original note shall be reduced by the amount ($2,900,000) by which the purchase price of the second note is in excess of its fair value, resulting in a net cash inflow ($8,880,000) that is not substantially all of the investor’s initial net investment on the original note.

55-135 As demonstrated by this Case, if an embedded derivative requires an asset to be purchased for an amount that exceeds its fair value, the amount of the excess — and not the cash flows related to the purchased asset — shall be considered when analyzing whether the hybrid instrument can contractually be settled in such a way that the investor would not recover substantially all of its initial recorded investment under paragraph 815-15-25-26(a). Whether that purchased asset is a financial asset or a nonfinancial asset (such as gold) is not relevant to the treatment of the excess purchase price. It is noted that requiring the investor to make a cash payment to the issuer is also economically equivalent to reducing the principal on the note.

55-136 The note described could have been structured to include terms requiring that the principal of the note be substantially reduced and the coupon reduced to zero if the interest rate for A-rated debt increased to at least 10 percent at the end of 2 years. That alternative structure would clearly have required that the embedded derivative be accounted for separately, because that embedded derivative’s existence would have resulted in the possibility that the hybrid instrument could contractually be settled in such a way that the investor would not recover substantially all of its initial recorded investment.

Example 5-2

Evaluation of Interest Rate Swaps Included in Securitization Vehicles

A securitization vehicle (i.e., an SPE) holds prepayable fixed-rate mortgage loans with a principal amount of $100,000 and issues variable-rate notes (beneficial interests) with a principal amount of $100,000 to investors. Concurrently with issuing its beneficial interests, the SPE enters into a pay-fixed, receive-variable interest rate swap with a third party. The notional amount of the swap declines according to a planned amortization schedule to approximate prepayment forecasts for the underlying loans as of the securitization date. A good-faith estimate was used to develop the planned amortization schedule; this estimate was reasonable given the facts and circumstances that existed at hedge inception.

To assess the negative-yield test in ASC 815-15-25-26(a), a holder of a variable-rate note must consider whether the note can contractually be settled in such a way that the holder would not recover substantially all of its initial recorded investment in the note. In doing so, it must consider all possible interest rate scenarios, even those that are considered remote. In this example, an unexpected decline in interest rates could cause the fixed-rate loans held by the SPE to be prepaid at a faster rate than had been expected as of the securitization date. Because the notional amount of the interest rate swap amortizes according to the original prepayment expectations, the unexpected loan prepayments could cause the notional amount of the swap to exceed the outstanding principal amount of the underlying loans.

If, for example, the swap contract requires the SPE to make net payments to the swap counterparty because of a decline in interest rates, the cash flows generated by fixed-rate loans remaining in the SPE may not be sufficient for the SPE to make payments to the counterparty and pay off the principal on the outstanding notes. In this scenario, it is possible that the investor would not recover substantially all of its initial recorded investment in its notes; accordingly, the notes would pass the negative-yield test and the holder of the variable-rate notes would conclude that the notes contain an embedded derivative that is not clearly and closely related to the host.

The holder then would have to assess whether the embedded derivative satisfies the remaining conditions of ASC 815-15-25-1 to determine whether the embedded derivative needs to be bifurcated from its host.

5.2.3.4 Double-Double Test

Under the double-double test (i.e., ASC 815-15-25-26(b)), an embedded interest rate feature is not clearly and closely related to its debt host contract if there is a potential scenario in which the investor could achieve a rate of return on the host contract that at least doubles its initial rate of return and is twice what would otherwise be the market return.

Both the debtor and the investor (or creditor) evaluate whether the double-double test is passed as of the date on which the instrument is initially recognized. Neither the debtor nor the investor subsequently reassesses whether the test is passed. If the investor purchases the debt in a secondary market, it performs the double-double test as of the date it recognized the debt investment. The investor’s application of this test could produce a different result from that of the debtor if the investor purchased the investment in a secondary market and the market conditions or terms at the time of the secondary purchase have changed from the time of initial issuance.

The double-double test is performed in two steps:

Step 1 — The entity determines whether there is a possible future interest rate scenario, no matter how remote, in which the embedded feature would at least double the investor’s initial rate of return on the host contract. In making this assessment, the entity must differentiate between the return on the host contract and the return on the hybrid instrument. The initial rate of return on the host contract excludes the effects of the embedded feature. If no such scenario exists, the embedded feature would be considered clearly and closely related to its host provided that it does not pass the negative-yield test (ASC 815-15-25-26(a)). If any such scenario exists, the entity must proceed to step 2 below.
Step 2 — The entity determines whether, for any of the scenarios identified in the first step for which the investor’s initial rate of return on the host contract would be doubled, the embedded derivative would at the same time result in a rate of return that is at least twice what otherwise would be the then-current market return (under the relevant future interest rate scenario) for a contract that has the same terms as the host contract and that involves a debtor with a credit quality similar to the issuer’s credit quality at inception. If such a high return is possible, the embedded feature would not be considered clearly and closely related to its host contract. If such a high return is not possible for a feature that is based solely on an interest rate or interest rate index and the embedded feature also does not pass the negative-yield test (ASC 815-15-25-26(a)), the embedded feature is considered clearly and closely related to the host contract.

Example 5-3

Debt With Interest Step-Up Feature

Company A invests in 30-year variable-rate debt issued by Company B. The debt is indexed to the three-month SOFR rate plus 4 percent. As of the date of issuance, the three-month SOFR rate was 2 percent. The debt’s terms also specify that if the three-month SOFR rate increases to 5 percent, the debt issuer is required to pay 23 percent for the remaining term of the bonds.

Company A makes its investment as part of the initial issuance of B’s variable-rate debt. Accordingly, both A and B would perform the double-double test as of the same date and should reach the same conclusion.

If B were to issue 30-year variable-rate debt without any embedded derivatives (i.e., the interest rate reset feature), it would pay a coupon of three-month SOFR plus 6 percent. Consequently, the initial rate of return on the host contract is 8 percent (three-month SOFR of 2 percent plus 6 percent). Company A must determine whether the embedded derivative could at least double its initial rate of return on the host contract, which was 8 percent as of the issuance date, in any of the possible interest rate environments. When three-month SOFR increases to 5 percent, the 23 percent interest rate feature more than doubles the initial rate of return of 8 percent on the host contract; therefore, step 1 of the double-double test is satisfied.

To apply step 2 of the double-double test, A must determine whether, for any of the possible interest rate scenarios under which its initial rate of return on the host contract would be doubled (i.e., when three-month SOFR is at 5 percent or higher), the embedded derivative would at the same time result in a rate of return that is at least twice what otherwise would be the then-current market return on a contract with the same terms as the host contract. When three-month SOFR increases to 5 percent, the rate of return on a contract with the same terms as the host contract (and involving a debtor with a credit quality similar to B’s credit quality at debt inception) would be 11 percent (three-month SOFR of 5 percent plus 6 percent). Therefore, step 2 of the double-double test is also satisfied because when three-month SOFR increases to 5 percent, the 23 percent return generated by the embedded derivative feature in the debt is more than twice the 11 percent return (three-month SOFR of 5 percent plus 6 percent) on the contract with the same terms as the host contract.

Both A and B would be required to account for the embedded derivative separately unless the entire hybrid financial instrument is recognized at fair value, with changes in fair value recognized in earnings. Note that ASC 815-15-25-26 indicates that when an entity assesses whether it meets one of the conditions, it should not consider the probability that the condition will be satisfied; the condition should be considered satisfied if there is any possibility whatsoever that the condition will be met. Therefore, the probability that the three-month SOFR rate will increase to 5 percent or higher is not relevant to the analysis of whether the condition is met. However, an entity should consider such probability when valuing any bifurcated embedded derivative.

ASC 815-15

25-37 The conditions in paragraph 815-15-25-26(b) do not apply to an embedded call option in a hybrid instrument containing a debt host contract if the right to accelerate the settlement of the debt can be exercised only by the debtor (the issuer or the borrower). This guidance does not affect the application of the condition in paragraph 815-15-25-26(a) or the application of paragraphs 815-15-25-41 through 25-43. In addition, this guidance does not apply to other embedded derivative features that may be present in the same hybrid instrument.

25-38 The conditions in paragraph 815-15-25-26(b) apply only to situations that meet the two conditions specified in paragraph 815-15-25-26(b)(1) through (b)(2) and for which the investor has the unilateral ability to obtain the right to receive the high rate of return specified in those paragraphs. If the embedded derivative is an option rather than a forward contract, it is important to analyze whether the investor is the holder of that option. For an embedded call option, the issuer or borrower (and not the investor) is the holder, and thus only the issuer (borrower) can exercise the option. Consequently, the investor does not have the unilateral ability to obtain the right to receive the high rate of return, which is contingent on the issuer’s exercise of the embedded call option.

If scenarios exist in which the investor could double its initial return but the debtor could prevent any such scenarios from occurring, the double-double test does not apply. For example, the double-double test does not apply if the debtor has a right, but not an obligation, to settle the debt at an amount that would pass the double-double test (e.g., an embedded call option held by the debtor that has an exercise price that potentially could double the investor’s initial return). The double-double test is passed only if scenarios exist in which the debtor contractually could not prevent a settlement that would pass the double-double test. ASC 815-15-55-25 (below) contains six examples that illustrate this concept.

ASC 815-15

55-25 Application of the guidance in paragraphs 815-15-25-37 through 25-39 to specific debt instruments is provided in the following table.

Instrument	Paragraph 815-15-25-26(b) Applicable to the Embedded Call Option?	Comments
1. An unsecured commercial loan that includes a prepayment option that permits the loan to be prepaid by the borrower at a fixed amount at any time at a specified premium over the initial principal amount of the loan.	No.	The commercial loan is prepayable only at the option of the borrower.
2. A fixed-rate debt instrument issued at a discount that is callable at par value at any time during its 10-year term.	No.	The fixed-rate debt instrument is callable at par value only by the issuer.
3. A fixed-rate 10-year bond that contains a call option that permits the issuer to prepay the bond at any time after issuance by paying the investor an amount equal to all the future contractual cash flows discounted at the then-current Treasury rate plus 45 basis points. The spread over the Treasury rate for the borrower at the issuance of the bond was 300 basis points.	No.	The fixed-rate 10-year bond is callable only at the option of the issuer.
4. A 5-year debt instrument issued at par that has a quarterly coupon equal to 15 percent minus 3 times 3-month LIBOR and that includes a call provision that allows the issuer to call the debt at any time at a specified premium over par.	No.	The instrument is callable only by the issuer, so the embedded call option feature will not be subject to the conditions in paragraph 815-15-25-26(b). However, the conditions in the paragraph are still applicable to the levered index feature of the debt.
5. A fixed rate debt instrument is issued at par and is callable at any time during its 10-year term. If the debt is called, the investor receives the greater of the par value of the debt or the market value of 100,000 shares of XYZ common stock (an unrelated entity).	No.	The instrument is callable only by the issuer, so the embedded call option feature will not be subject to the conditions in paragraph 815-15-25-26(b). However, the embedded call option is not considered clearly and closely related to the debt host contract because the payoff is based on an equity price.
6. A mortgage-backed security is issued, whereby cash flows associated with principal payments (including full or partial prepayments and related penalties) received on the related mortgage loans are passed through to the mortgage-backed security investors.	Not applicable (see comments).	Although the related mortgage loans are prepayable, and thus each contain a separate embedded call option, the mortgage-backed security itself does not contain an embedded call option. While the mortgage-backed security investor is subject to prepayment risk, the mortgage-backed security issuer has the obligation (not the option) to pass through cash flows from the related mortgage loans to the mortgage-backed security investors. Therefore, mortgage-backed securities are not within the scope of this guidance. Paragraphs 815-15-25-33 through 25-36 address the application of paragraph 815-15-25-26(b) to securitized interests in prepayable financial assets.

5.2.3.5 Interest Rate Caps, Floors, and Collars

ASC 815-15

25-32 Floors or caps (or collars, which are combinations of caps and floors) on interest rates and the interest rate on a debt instrument are considered to be clearly and closely related unless the conditions in either paragraph 815-15-25-26(a) or 815-15-25-26(b) are met, in which circumstance the floors or the caps are not considered to be clearly and closely related.

Caps, floors, or collars on floating-rate interest payments are considered clearly and closely related to a debt host contract unless either the negative-yield test or the double-double test (ASC 815-15-25-26) is passed.

Example 5-4

Debt With Embedded Floor

Company A issues five-year variable-rate debt to the public that is indexed to the SOFR rate (SOFR plus 1 percent). SOFR is currently 6 percent. The investors required that A pay not less than 5 percent at any time during the term of the debt. The agreement that A will not pay an interest rate less than 5 percent on its variable-rate debt represents a floor. If A had issued five-year variable-rate debt without a floor, it would have paid SOFR plus 2 percent.

The floor would not pass the negative-yield test (ASC 815-15-25-26(a)) because it could not result in a failure of the investor to recover substantially all of its initial investment. In addition, the floor would not pass the double-double test (ASC-815-25-26(b)) because it could not result in a rate of return that is more than double the initial rate of return of 8 percent (SOFR at inception plus 2 percent). The floor, when in-the-money, will only result in a rate of 5 percent.

Example 5-5

Debt With Embedded Cap

On January 1, 20X1, Company X purchases a bond at par that pays SOFR. The bond also incorporates an interest rate cap provision under which if SOFR equals or exceeds 8 percent as of any interest rate reset date, X will receive a return of 10 percent. On the date on which X purchased the bond, it also could have purchased at par a variable-rate bond not containing a cap that pays SOFR minus 1 percent from a debtor that has the same credit quality as the issuer of X’s bond. As of January 1, 20X1, SOFR is 5 percent.

Since the bond containing the cap cannot contractually be settled such that X would not recover substantially all of its initial recorded investment in the bond, the negative-yield test in ASC 815-15-25-26(a) is not passed. To perform the first step of the double-double test (ASC 815-15-25-26(b)), X must determine whether there are any interest rate scenarios, no matter how remote, under which the embedded derivative (the cap) would at least double its initial rate of return on the host contract. This analysis is summarized in the following table:

A SOFR Interest Rate Range	B Return Reflecting the Effect of Cap	C Initial Rate of Return on Host (SOFR Minus 1%)	D Initial Rate of Return on Host Doubled	Is the ASC 815-15-25-26(b)(1) Test Met — Is B > D?
0–7.99%	0–7.99%	4%	8%	No
8% and up	10%	4%	8%	Yes

Since the first step suggests that there is a possible scenario in which X could double its initial rate of return on the host contract, X must perform the second step in ASC 815-15-25-26(b) to determine whether the embedded cap is clearly and closely related to the debt host contract. For this test, X must determine, for any of the possible interest rate scenarios identified above under which X’s initial rate of return on the host contract would be doubled, whether the embedded cap would simultaneously result in a rate of return that is at least twice what otherwise would be the then-current market return (under the relevant future interest rate scenario) for a contract that (1) has the same terms as the host contract and (2) involves a debtor with a credit quality similar to the issuer’s credit quality at inception. Company X’s analysis for this test can be summarized as follows:

A Interest Rate Scenario Identified in the ASC 815-15-25-26(b)(1) Test for Which the Cap Would at Least Double the Investor’s Initial Rate of Return on the Host Contract	B Return Reflecting the Effect of the Cap Under the Interest Rate Scenario in A	C Current Market Rate for a Contract Having the Same Terms as the Host Contract Under the Interest Rate in A (SOFR Minus 1%)	Is the ASC 815-15-25-26(b)(2) Test Met — Is B at Least Twice C for Any Scenario?
8% and up	10%	7% and up	No

Since the second step suggests that there is no possible scenario in which the investor would achieve a rate of return that is at least twice what otherwise would be the then-current market return, the double-double test in ASC 815-15-25-26(b) is not passed, and the embedded cap is considered clearly and closely related to the debt host contract.

Example 5-6

Debt With SOFR-Indexed Interest Rate Adjustment

On January 1, 20X0, an entity issues a variable-rate debt instrument at par, maturing on January 1, 20X5. The interest rate is three-month SOFR plus 0.40 percent as long as three-month SOFR remains at or above 6.00 percent. In periods in which three-month SOFR drops below 6.00 percent, the interest rate on the debt is calculated as follows: three-month SOFR plus 0.40 percent – [2 × (6.00% – 3-month SOFR)]. The following table illustrates the interest rate on the debt under certain conditions:

Three-Month SOFR	Interest Rate on Debt
7.00%	7.40%
5.00%	3.40%
3.00%	(2.60%)

For the embedded derivative to be considered clearly and closely related to the debt host, it must not be contractually possible for the hybrid instrument to be settled in such a way that the investor would not recover substantially all of its initial recorded investment. In this example, it is possible for the investor in the debt to incur an unlimited negative return, thus not recovering substantially all of its original investment. Therefore, the negative-yield test in ASC 815-15-25-26(a) is passed, and the embedded floor would not be considered clearly and closely related to the debt host.

By contrast, assume that the agreement contained a provision that guaranteed a cumulative minimum rate of return to the investor over the life of the debt. For example, the agreement could contain a minimum interest rate clause such that negative interest accrues if the defined interest rate is less than zero; however, the accrued negative interest could only be applied to (1) future interest payments required under this debt or (2) the principal amount only to the extent of interest previously paid under the debt agreement, provided that any accrued interest remains at the debt’s maturity. In this scenario, the instrument could not contractually be settled in such a way that the investor would not recover substantially all of its initial recorded investment. Therefore, the negative-yield test in ASC 815-15-25-26(a) would not be passed, and the leveraged interest rate terms and floor would be considered clearly and closely related to the debt (provided that under ASC 815-15-25-26(b)’s double-double test, those embedded features are clearly and closely related to the debt host). A cap on a leveraged interest rate index would be similarly analyzed under ASC 815-15-25-26 through 25-29.

5.2.3.6 Interest Rate Tenor Mismatch (Including Constant Maturity Rates)

The contractual interest rate of many debt securities is based on a reference index. It is not uncommon for the contractual terms of some securities to require the contractual interest rate to reset more frequently than the term of the index the securities are referenced to. One example is a debt security whose interest rate resets every six months to a 10-year index (i.e., a constant maturity rate). Such an interest rate index should be evaluated under ASC 815-15-25-26.

Connecting the Dots

LIBOR, and other IBOR reference rates, are no longer expected to exist as a result of reference rate reform. The Alternative Reference Rate Committee1 has indicated that SOFR is the recommended replacement rate for U.S. dollar LIBOR rates. As entities have been modifying contracts to designate fallback language to determine the replacement rate upon LIBOR’s cessation, and as entities have been issuing new contracts to reference SOFR, questions have emerged regarding whether certain SOFR conventions could create embedded derivatives that should be evaluated for potential bifurcation. In a speech at the 2020 AICPA Conference on Current SEC and PCAOB Developments, then SEC Professional Accounting Fellow Jillian Pearce discussed a preclearance submission in which the SEC staff did not object to a view that certain SOFR-based interest rate features did not require bifurcation from a debt host contract. The preclearance applied to the following four SOFR interest rate reset features:

Term SOFR rates.
Compounded SOFR in arrears rate.
Compounded SOFR in advance rate.
For adjustable-rate residential mortgages: average SOFR in-advance rate that resets every 6 months and resets 45 days before the beginning of the interest period on the basis of the trailing 30 or 90 days SOFR average.

According to Ms. Pearce, the SEC staff did not believe that it was necessary to evaluate such features in the context of the guidance in ASC 815-15-25-26; rather, “the SOFR interest rate reset features evaluated in the consultation were terms of the host contract.”

We understand that the SEC staff reached this view partially because of its belief that relief was needed for entities with such features during the LIBOR to SOFR transition period as well as the general expectation that SOFR markets will develop to include features similar to the existing LIBOR features.

The outcome of this preclearance should not be analogized to any other fact patterns or other features. Entities are encouraged to consult with their accounting advisers if they believe that any of their debt agreements contain the specific SOFR interest rate reset features subject to the preclearance.

Example 5-7

Debt With Interest Rate Tenor Mismatch

Assume that a 30-year note has an initial yield of 4 percent and that the contractual interest rate resets semiannually to a 10-year index interest rate plus 100 basis points rather than to the six-month rate. The initial yield on a security that resets to the six-month rate, but that otherwise has terms that are identical to those of the 30-year note, is 3 percent.

Because the interest rate resets semiannually to a point further out than the next reset date on the interest rate curve (i.e., a 10-year rate versus a six-month rate), there are possible future interest rate scenarios under which the initial rate of return on the host contract and the then-current market rate would be doubled. The application of the double-double test (ASC 815-15-25-26(b)) is shown in the table below.

Step 1: Is there a possible interest rate scenario (even though it may be remote) under which the embedded derivative would at least double the investor’s initial rate of return on the host contract?

Yes. It is possible that the 10-year index rate could be more than double the investor’s initial rate of return on the host contract, which is 3 percent.

Step 2: For any of the possible interest rate scenarios under which the investor’s initial rate of return on the host contract would be doubled, could the embedded derivative at the same time result in a rate of return that is at least twice what otherwise would be the then-current market return (under the relevant future interest rate scenario) for a contract that has the same terms as the host contract and that involves a debtor with a credit quality similar to the issuer’s credit quality at inception?

Yes. It is possible that the 10-year index rate could be more than double the six-month rate on the same date; therefore, the embedded derivative could result in a rate of return that is at least twice the then-current market return for a contract that has the same terms as the host contract, which resets to the current six-month rate. Note that it is irrelevant whether it is probable that the 10-year rate will rise to more than twice the six-month rate.

Because both conditions of the double-double test in ASC 815-15-25-26(b) are met, the embedded interest rate index is not considered clearly and closely related to the debt host of the 30-year note. If the instrument contains a cap that is less than double the initial rate of return on the host contract, however, the conditions in ASC 815-15-25-26(b) would not be met.

5.2.3.7 Choose-Your-Rate Option

Variable-rate credit facilities often include an option for the debtor to change the interest rate index that is used as the basis for calculating interest rate payments on outstanding debt (e.g., an option to switch from one specified interest rate to another specified interest rate). Such a feature is clearly and closely related to its debt host contract unless the negative-yield test or the double-double test (ASC 815-40-15-26) is passed.

5.2.3.8 Examples

ASC 815-15-55 contains additional illustrative examples of the application of ASC 815-15-25-26.

5.2.4 Derivative Analysis

The table below presents an analysis of whether an embedded feature that is based solely on an interest rate or interest rate index and could adjust the payments of a debt host contract meets the definition of a derivative (see Section 4.3.4). However, an entity should always consider the terms and conditions of a specific feature in light of the applicable accounting guidance before reaching a conclusion.

Characteristics of a Derivative	Characteristic Present?	Analysis
Underlying and notional amount or payment provision (see Section 1.4.1)	Yes	An embedded feature that could adjust the payments of a debt host contract solely on the basis of an interest rate or interest rate index typically has both an underlying (i.e., the interest rate or interest rate index) and a notional amount (i.e., the amount on which the interest rate adjustment is based, such as the debt’s outstanding amount) or payment provision (e.g., a fixed cash payment contingent on an interest rate or interest rate index).
Initial net investment (see Section 1.4.2)	Yes	The initial net investment in an embedded feature is its fair value (i.e., the amount that would need to be paid to acquire the interest-rate-related feature on a stand-alone basis without the host contract). Generally, an embedded feature that could adjust the cash flows of a debt host contract solely on the basis of an interest rate or interest rate index has an initial net investment that is smaller than would be required for a direct investment that has the same exposure to changes in interest rates (since the investment in the debt host contract does not form part of the initial net investment for the embedded feature).
Net settlement (see Section 1.4.3)	Yes	An embedded feature that adjusts the payments of a debt host contract solely on the basis of an interest rate or interest rate index meets the net settlement condition (neither party is required to deliver an asset that is associated with the underlying and whose principal amount, stated amount, face value, number of shares, or other denomination is equal to the feature’s notional amount).

As shown in the table above, an embedded feature that is based solely on an interest rate or interest rate index and could adjust the payments of a debt host contract typically meets the definition of a derivative. Therefore, the analysis of whether it must be bifurcated as a derivative tends to focus on whether the feature is considered clearly and closely related to the debt host contract unless the entity is remeasuring the debt at fair value on a recurring basis through earnings.

Footnotes

The Alternative Reference Rates Committee (ARRC) was formed by the Federal Reserve Board and the New York Fed to guide the transition from LIBOR to SOFR.

5.3 Credit-Risk-Related Features Embedded in a Debt Host

5.3.1 Background

Examples of contractual provisions in debt contracts that could adjust payments on the basis of a measure of credit risk include:

A provision that requires the debtor to pay additional interest (e.g., 2 percent per annum) upon the debtor’s event of default.
A feature that adjusts interest payments on the basis of a measure of the debtor’s creditworthiness (e.g., a table that specifies different margins over a specified interest rate on the basis of a measure of the debtor’s working capital).
A feature that adjusts principal or interest payments on the basis of the credit risk of a third party.

This section does not address features that could accelerate the repayment of the outstanding amount of the debt host contract in cash upon the occurrence or nonoccurrence of a specified event such as an event of default. Such features should be evaluated as contingent redemption features (see Section 6.4).

5.3.2 Bifurcation Analysis

The table below presents an overview of the bifurcation analysis of a credit-risk-related feature embedded in a debt host contract. However, an entity should always consider the terms and conditions of a specific feature in light of all the relevant accounting guidance before reaching a conclusion.

Bifurcation Condition	Condition Met?	Analysis
Not clearly and closely related (see Section 4.3.2)	It depends	A credit-sensitive payment that is based solely on the creditworthiness of the debtor is clearly and closely related to a debt host. However, the creditworthiness of a third party is not clearly and closely related to a debt host.
Hybrid instrument not measured at fair value through earnings on a recurring basis (see Section 4.3.3)	It depends	From the issuer’s perspective, debt is not measured at fair value on a recurring basis unless the issuer elects the fair value option in ASC 815-15 or ASC 825-10. The fair value option cannot be elected for debt that contains a separately recognized equity component at inception. From the holder’s perspective, if a loan or debt security is remeasured at fair value, with changes in fair value recorded in earnings, any derivative embedded in the interest would not need to be accounted for separately since the accounting for the interest would already be the same as that of a freestanding derivative.
Meets the definition of a derivative (see Section 4.3.4)	Yes	A credit-risk-related feature that adjusts the payments of a debt host contract meets the definition of a derivative.
Meets a scope exception (see Chapter 2 and Section 4.3.5)	It depends	Typically, no specific scope exception is available for a credit-risk-related feature that is based on the debtor’s creditworthiness(see Section 4.3.5). However, in some situations the scope exception for financial guarantee contracts may apply (see Section 2.3.4).

As shown in the table above, an entity’s determination of whether an embedded credit-risk-related feature must be bifurcated as a derivative tends to focus on whether the feature is considered clearly and closely related to the debt host contract (see the next section) unless the entity is remeasuring the hybrid instrument at fair value on a recurring basis through earnings. If the credit-risk-related feature is based on the credit risk of a third party, the entity should also evaluate whether the feature can be net settled (see Section 5.3.4) and whether it qualifies for the scope exception for financial guarantee contracts (see Section 2.3.4).

5.3.3 Clearly-and-Closely-Related Analysis

ASC 815-15

25-46 The creditworthiness of the debtor and the interest rate on a debt instrument shall be considered to be clearly and closely related. Thus, for debt instruments that have the interest rate reset in the event of any of the following conditions, the related embedded derivative shall not be separated from the host contract:

Default (such as violation of a credit-risk-related covenant)
A change in the debtor’s published credit rating
A change in the debtor’s creditworthiness indicated by a change in its spread over U.S. Treasury bonds.

25-47 If an instrument incorporates a credit risk exposure that is different from the risk exposure arising from the creditworthiness of the obligor under that instrument, such that the value of the instrument is affected by an event of default or a change in creditworthiness of a third party (that is, an entity that is not the obligor), then the economic characteristics and risks of the embedded credit derivative are not clearly and closely related to the economic characteristics and risks of the host contract, even though the obligor may own securities issued by that third party. This guidance shall be applied to all other arrangements that incorporate credit risk exposures that are unrelated or only partially related to the creditworthiness of the issuer of that instrument. This guidance does not affect the accounting for a nonrecourse debt arrangement (that is, a debt arrangement in which, in the event that the debtor does not make the payments due under the loan, the creditor has recourse solely to the specified property pledged as collateral).

A credit-sensitive payment is considered clearly and closely related to a debt host contract under ASC 815-15-25-46 and 25-47 if it is triggered by, and directionally consistent with, a measure of the debtor’s creditworthiness, such as one or more of the following:

The debtor’s failure to pay amounts due on a timely basis (e.g., additional interest on late payments).
The debtor’s failure to comply with credit-risk-related debt covenants (e.g., additional interest that becomes payable if there is a material adverse change in the debtor’s creditworthiness).
A change in the debtor’s published credit rating (e.g., additional interest that becomes payable upon a credit rating downgrade).
A change in observable interest rate spreads over a risk-free interest rate (e.g., U.S. Treasury rates) for debt instruments with similar credit risk (e.g., an interest rate that varies on the basis of observable credit spreads on identical or similar debt securities issued by the debtor or other similar debtors).
A change in another measure of the debtor’s creditworthiness (e.g., a specified interest margin that varies on the basis of a measure of the debtor’s working capital).

However, a provision that requires an adjustment on the basis of the creditworthiness of a third party (e.g., the third party’s default) is not clearly and closely related to a debt host contract.

Debt contracts often contain provisions that require the debtor to pay additional interest upon the occurrence of an “event of default.” To determine whether such a provision is clearly and closely related to the debt host, the entity must evaluate how the debt terms define an event of default. The table below discusses common situations that may be described as events of default and whether such triggering events would be considered clearly and closely related to a debt host.

Triggering Event	Clearly and Closely Related?
Any representation or warranty made by the debtor is not correct	Yes
The debtor’s failure to perform or comply with financial or nonfinancial covenants	Yes, unless the covenants include items that do not affect the issuer’s credit risk
The debtor’s bankruptcy or insolvency	Yes
Cross default on the debtor’s other indebtedness	Yes, unless the default on the other indebtedness arises from events that are not credit-related
Invalidity or failure of debtor to maintain loan or collateral documents	Yes
The debtor’s nonpayment of principal or interest when due	Yes
Judgments or orders against the debtor exceeding a specific amount	Yes
Revocation of the debtor’s license or permit to perform business operations that results in a material adverse effect	Yes
Criminal events of the debtor	Yes
A change of control of the debtor	No
Key-person event	Depends on facts and circumstances
The debtor suffers a credit rating downgrade	Yes
An observable increase in the debtor’s current interest rate spread over a risk-free interest rate	Yes

Example 5-8

Debt With Interest Rate Adjustment

Company ABC, which is rated BBB, issues $100 million in 8 percent fixed-rate bonds. The bonds include a provision that requires the interest rate to reset to 10 percent if ABC’s credit rating is downgraded to a single B at any time during the term of the bonds. The embedded derivative that resets the interest rate of the bonds is clearly and closely related to the debt host because it is based on the issuer’s credit rating.

However, if ABC’s bonds include a provision that requires the interest rate to reset to 10 percent if Company XYZ’s (an unrelated party’s) credit rating is downgraded to a single B at any time during the term of the bonds, the reset feature is not clearly and closely related to the debt host.

ASC 815-15

Case A: Credit-Linked Note

55-103 Entity A issues to an investor a fixed-rate, 10-year, $10 million credit-linked note that provides for periodic interest payments and the repayment of principal at maturity. However, upon default of a specified reference security (an Entity X subordinated debt obligation) the redemption value of the note may be zero or there may be some claim to the recovery value of the reference security (depending on the terms of the specific arrangement). Generally, the term reference security refers to the security whose credit rating or default determines the cash flows under a credit derivative. Usually, the terms of credit-linked notes explicitly reference Committee on Uniform Security Identification Procedures (CUSIP) numbers of securities in the marketplace. In an event of default of the specified reference security, there is no recourse to the general credit of the obligor (Entity A). In exchange for accepting the default risk of the reference security, the note entitles the investor to an enhanced yield. The transaction results in the investor selling credit protection and Entity A buying credit protection.

55-104 The credit-linked note includes an embedded credit derivative. The credit risk exposure of the reference security (Entity X) and the risk exposure arising from the creditworthiness of the obligor (Entity A) are not clearly and closely related. Thus, the economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the debt host contract and, accordingly, the criterion in paragraph 815-15-25-1(a) is met.

55-105 Paragraph 815-15-25-6 explains that the fair value election for hybrid financial instruments that otherwise would require bifurcation does not apply to hybrid financial instruments that are described in paragraph 825-10-50-8, which include insurance contracts as discussed in Section 944-20-15, other than financial guarantees and investment contracts.

55-106 Consideration should be given to whether the embedded derivative could possibly not be subject to this Topic as a financial guarantee under paragraph 815-10-15-58 and, in that circumstance, the embedded derivative would not warrant bifurcation.

Case M: Credit-Sensitive Bond

55-200 A credit-sensitive bond has a coupon rate of interest that resets based on changes in the issuer’s credit rating.

55-201 A credit-sensitive bond can be viewed as combining a fixed-rate bond with a conditional exchange contract (or option contract) that entitles the investor to a higher rate of interest if the credit rating of the issuer declines. Because the creditworthiness of the debtor and the interest rate on a debt instrument are clearly and closely related, the embedded derivative should not be separated from the host contract.

Example 5-9

EBITDA-Indexed Rate Reset Provision

Company A issues term loans of $150 million, which pay a floating rate of interest. The floating interest rate is adjusted quarterly and is based on an interest rate index plus a spread over the interest rate index. At each interest repricing date, A may elect to choose bank prime or SOFR as the interest rate index. The spread above the interest rate index is based on A’s debt to EBITDA ratio at the end of the most recent quarter.

As A pays down or issues debt and its operating income increases or decreases from the previous period, the overall interest rate payments fluctuate. The spread above the interest rate index on A’s debt fluctuates on the basis of A’s operating income and outstanding debt balance. The economic characteristics of these terms may be determined to be directly related to A’s creditworthiness and, in such case, would be clearly and closely related to the debt host.

If, however, it is determined that the terms were not directly related to A’s creditworthiness, they would not be considered clearly and closely related to the debt host, and there may be an embedded derivative that should be accounted for. For example, if the spread above the interest rate index increased as EBITDA increased, the feature related to EBITDA would not be directly related to the debtor’s creditworthiness and, therefore, would not be considered to be clearly and closely related to the debt host.

5.3.4 Derivative Analysis

The table below presents an analysis of whether a credit-risk-related embedded feature that could adjust the payments on a debt host contract meets the definition of a derivative (see Section 4.3.4). However, an entity should always consider the terms and conditions of a specific feature in light of the applicable accounting guidance before reaching a conclusion.

Characteristics of a Derivative	Characteristic Present?	Analysis
Underlying and notional amount or payment provision (see Section 1.4.1)	Yes	A credit-risk-related feature that could adjust the payments of a debt host contract generally has both an underlying (e.g., an event of default or the issuer’s credit rating) and a notional amount (i.e., the amount on which the adjustment is based, such as the debt’s outstanding amount) or payment provision (e.g., a fixed cash payment).
Initial net investment (see Section 1.4.2)	Yes	The initial net investment in an embedded feature is its fair value (i.e., the amount that would need to be paid to acquire the credit-risk-related feature on a stand-alone basis without the host contract). Generally, a credit-risk-related feature has an initial net investment that is smaller than would be required for a direct investment that has the same exposure to changes in credit risk (since the investment in the debt host contract does not form part of the initial net investment for the embedded feature).
Net settlement (see Section 1.4.3)	Yes	A credit-risk-related embedded feature that adjusts the payments of a debt host contract meets the net settlement condition (neither party is required to deliver an asset that is associated with the underlying and whose principal amount, stated amount, face value, number of shares, or other denomination is equal to the feature’s notional amount).

As shown in the table above, a credit-risk-related embedded feature that could adjust the payments of a debt host contract on the basis of the debtor’s creditworthiness meets the definition of a derivative. Therefore, the analysis of whether such a feature must be bifurcated as a derivative tends to focus on whether the feature is considered clearly and closely related to the debt host contract unless the entity is remeasuring the hybrid instrument at fair value on a recurring basis through earnings.

5.4 Features Indexed to Inflation in a Debt Host

5.4.1 Background

This section discusses the analysis of whether an inflation-indexed payment feature embedded in a debt host contract should be separated as a derivative (e.g., inflation-linked bonds). The discussion does not address features that could accelerate the repayment of the outstanding amount of the debt in cash upon the occurrence or nonoccurrence of a specified event (e.g., an acceleration feature that is triggered by a specified measure of inflation). Such features should be evaluated as contingent redemption features (see Section 4.4.4).

5.4.2 Bifurcation Analysis

The table below presents an overview of the bifurcation analysis of an inflation-indexed payment feature embedded in a debt host contract. However, an entity should always consider the terms and conditions of a specific feature in light of all the relevant accounting guidance before reaching a conclusion.

Bifurcation Condition	Condition Met?	Analysis
Not clearly and closely related (see Section 4.3.2)	It depends	The rate of inflation in the economic environment for the currency in which the debt is denominated is clearly and closely related to the debt host unless the feature is leveraged (see Section 4.4.2.3). The rate of inflation in other economic environments is not clearly and closely related to a debt host.
Hybrid instrument not measured at fair value through earnings on a recurring basis (see Section 4.3.3)	It depends	From the issuer’s perspective, debt is not measured at fair value on a recurring basis unless the issuer elects the fair value option in ASC 815-15 or ASC 825-10. The fair value option cannot be elected for debt that contains a separately recognized equity component at inception. From the holder’s perspective, if a loan or debt security is remeasured at fair value, with changes in fair value recorded in earnings, any derivative embedded in the interest would not need to be accounted for separately since the accounting for the interest would already be the same as that of a freestanding derivative.
Meets the definition of a derivative (see Section 4.3.4)	Yes	An inflation-indexed payment feature that adjusts the payments of a debt host contract meets the definition of a derivative (see Section 4.4.2.4).
Meets a scope exception (see Chapter 2 and Section 4.3.5)	No	No specific scope exception is available for inflation-indexed payment features embedded in debt host contracts (see Section 4.3.5).

As shown in the table above, an entity’s determination of whether an inflation-indexed feature that could adjust the payments of a debt host contract must be bifurcated as a derivative tends to focus on whether the feature is considered clearly and closely related to the debt host contract unless the entity is remeasuring the hybrid instrument at fair value on a recurring basis through earnings. Typically, such features meet the definition of a derivative and are not exempt from the scope of derivative accounting.

5.4.3 Clearly-and-Closely-Related Analysis

ASC 815-15

25-50 The interest rate and the rate of inflation in the economic environment for the currency in which a debt instrument is denominated shall be considered to be clearly and closely related. Thus, nonleveraged inflation- indexed contracts (debt instruments, capitalized lease obligations, pension obligations, and so forth) shall not have the inflation-related embedded derivative separated from the host contract.

Under ASC 815-15-25-50, the indexation of principal or interest payments to an inflation rate (e.g., U.S. CPI or U.K. retail price index) is considered clearly and closely related to a debt host contract if (1) the inflation rate is appropriate for the economic environment for the currency in which the debt is denominated and (2) the feature is not leveraged (e.g., interest payments that are computed on the basis of two times CPI would not be considered clearly and closely related to a debt host contract). For example, payments indexed to an unleveraged measure of U.S. CPI would be considered clearly and closely related to USD-denominated debt. Conversely, the rate of inflation in a different economic environment (e.g., EUR-denominated debt that has principal or interest payments indexed to U.S. CPI) is not clearly and closely related to the debt host.

Example 5-10

Debt With Embedded Inflation Index Feature

A U.S. company issues USD-denominated bonds. On the basis of an embedded inflation index, the bond issuer is required to pay the change in the Mexican CPI every two years. The embedded inflation-indexed derivative is not clearly and closely related to the bond because it is not the rate of inflation of the United States, the economic environment in which the bond was issued. However, if the bond issuer was required to pay the change in U.S. CPI every two years, the embedded derivative would be clearly and closely related and, therefore, would not need to be accounted for separately.

ASC 815-15

Case N: Inflation Bond

55-202 An inflation bond has a contractual principal amount that is indexed to the inflation rate but cannot decrease below par; the coupon rate is typically below that of traditional bonds of similar maturity.

55-203 An inflation bond can be viewed as a fixed-rate bond for which a portion of the coupon interest rate has been exchanged for a conditional exchange contract (or option contract) indexed to the consumer price index, or other index of inflation in the economic environment for the currency in which the bond is denominated, that entitles the investor to payment of additional principal based on increases in the referenced index. Such rates of inflation and interest rates on the debt instrument are considered to be clearly and closely related. Therefore, the embedded derivative should not be separated from the host contract.

5.4.4 Derivative Analysis

The table below presents an analysis of whether an inflation-indexed feature that could adjust the cash flows of a debt host contract meets the definition of a derivative (see Section 4.3.4). However, an entity should always consider the terms and conditions of a specific feature in light of the applicable accounting guidance before reaching a conclusion.

Characteristics of a Derivative	Characteristic Present?	Analysis
Underlying and notional amount or payment provision (see Section 1.4.1)	Yes	An inflation-indexed payment feature that could adjust the payments of a debt host contract has both an underlying (i.e., the applicable measure of inflation, such as the change in CPI) and a notional amount (i.e., the amount on which the adjustment is based, such as the debt’s outstanding amount) or payment provision (e.g., a fixed cash payment).
Initial net investment (see Section 1.4.2)	Yes	The initial net investment in an embedded feature is its fair value (i.e., the amount that would need to be paid to acquire the inflation-indexed feature on a stand-alone basis without the host contract). Generally, an inflation-indexed feature has an initial net investment that is smaller than would be required for a direct investment that has the same exposure to changes in the inflation rate (since the investment in the debt host contract does not form part of the initial net investment for the embedded feature).
Net settlement (see Section 1.4.3)	It depends	A feature that adjusts the payments of a debt host contract on the basis of an inflation index meets the net settlement condition (neither party is required to deliver an asset that is associated with the underlying and whose principal amount, stated amount, face value, number of shares, or other denomination is equal to the feature’s notional amount).

As shown in the table above, an inflation-indexed feature embedded in a debt host contract typically meets the definition of a derivative. Therefore, the analysis of whether such a feature must be bifurcated as a derivative tends to focus on whether the feature is considered clearly and closely related to the debt host contract unless the entity is remeasuring the hybrid instrument at fair value on a recurring basis through earnings.

5.5 Term Extension Features in a Debt Host

5.5.1 Background

Term extension features embedded in a debt host contract include those that give either party the right to extend the debt’s remaining term or automatically extend the term upon the occurrence of a specified event.

5.5.2 Bifurcation Analysis

The table below presents an overview of the bifurcation analysis of a term extension feature embedded in a debt host contract. However, an entity should always consider the terms and conditions of a specific feature in light of all the relevant accounting guidance before reaching a conclusion.

Bifurcation Condition	Condition Met?	Analysis
Not clearly and closely related (see Section 4.3.2)	It depends	A term extension feature is not clearly and closely related to a debt host unless the interest rate is concurrently reset to a current market rate and the debt initially did not involve a significant discount.
Hybrid instrument not measured at fair value through earnings on a recurring basis (see Section 4.3.3)	It depends	From the issuer’s perspective, debt is not measured at fair value on a recurring basis unless the issuer elects the fair value option in ASC 815-15 or ASC 825-10. The fair value option cannot be elected for debt that contains a separately recognized equity component at inception. From the holder’s perspective, if a loan or debt security is remeasured at fair value, with changes in fair value recorded in earnings, any derivative embedded in the interest would not need to be accounted for separately since the accounting for the interest would already be the same as that of a freestanding derivative.
Meets the definition of a derivative (see Section 4.3.4)	It depends	The evaluation of whether a term extension feature meets the definition of a derivative depends on whether it meets the net settlement characteristic in the definition of a derivative.
Meets a scope exception (see Chapter 2 and Section 4.3.5)	Generally, yes	A term extension feature embedded in a debt host contract often qualifies for the loan commitment scope exception. However, this scope exception is not available if the term extension option is held by the creditor.

As shown in the table above, a term extension feature in a debt host would not be bifurcated if (1) the feature is considered clearly and closely related to the debt host contract (see the next section), (2) the entity is remeasuring the hybrid instrument at fair value on a recurring basis through earnings, (3) the feature does not meet the definition of a derivative, or (4) the feature meets the scope exception for loan commitments.

5.5.3 Clearly-and-Closely-Related Analysis

ASC 815-15

25-44 An embedded derivative that either (a) unilaterally enables one party to extend significantly the remaining term to maturity or (b) automatically extends significantly the remaining term triggered by specific events or conditions is not clearly and closely related to the interest rate on a debt instrument unless the interest rate is concurrently reset to the approximate current market rate for the extended term and the debt instrument initially involved no significant discount. Thus, if there is no reset of interest rates, the embedded derivative is not clearly and closely related to the host contract. That is, a term-extending option cannot be used to circumvent the restriction in paragraph 815-15-25-26 regarding the investor’s not recovering substantially all of its initial recorded investment.

Under ASC 815-15-25-44, a term extension feature is clearly and closely related to a debt host only if (1) the interest rate is adjusted to the approximate current market rate of interest for the extended term at the time the term is extended and (2) the debt did not initially involve a significant discount.

Example 5-11

Debt With Extension Option

Company XYZ issues five-year, variable-rate debt that pays three-month SOFR plus 250 basis points on a quarterly basis. At the end of five years, XYZ has an option to extend the debt for another three years and, if the option is exercised, XYZ will continue to pay three-month SOFR plus 250 basis points for the extended term.

Although the debt continues to vary on the basis of three-month SOFR if the term of the debt is extended, the interest rate does not reset to current market rates because the credit spread is not adjusted. At the end of the original five-year term, the current market rate for an issuer with the creditworthiness of XYZ may be different than three-month SOFR plus 250 basis points (e.g., the current market rate for XYZ debt could be SOFR plus 750 basis points), even if the creditworthiness of XYZ has not changed. Therefore, because XYZ has the option to extend the maturity of the debt significantly and the interest rate in its entirety does not reset to market, the term-extending option is not clearly and closely related to the debt host.

The analysis of whether a term extension feature is clearly and closely related to a debt host is different from the analysis of whether an embedded prepayment (or call) option is clearly and closely related to a debt host even though economically such features may be similar.

Example 5-12

Bonds With Extension Options

Entity ABC issues two series of bonds that are publicly traded. One bond has a five-year term and a 6 percent fixed coupon rate and grants the bondholder an option to extend the debt for another three years at a 6 percent fixed interest rate. The second bond has an eight-year term and a 6 percent fixed coupon rate and grants the bondholder an option to put the debt back to ABC at the end of five years. Although these two bonds are economically similar, they are analyzed differently under ASC 815. The first bond is analyzed as a five-year debt host contract with an embedded term extension feature; the second bond is analyzed as an eight-year debt host contract with an embedded put option.

The term-extending option in the first bond extends the maturity of the debt significantly but does not reset the interest rate to a market rate. The term-extending option, therefore, is not clearly and closely related to the debt host and may need to be bifurcated from the host contract and accounted for separately if it meets the other criteria in ASC 815-15-25-1. The embedded put option in the second bond would not be evaluated under the guidance on term extension options. Instead, it would be evaluated under the guidance on embedded put options (see Section 6.4).

5.5.4 Derivative Analysis

The table below presents an analysis of whether a term extension feature embedded in a debt host contract meets the definition of a derivative (see Section 4.3.4). Note, however, that an entity should always consider the terms and conditions of a specific feature in light of the applicable accounting guidance before reaching a conclusion.

Characteristics of a Derivative	Characteristic Present?	Analysis
Underlying and notional amount or payment provision (see Section 1.4.1)	Yes	A term extension feature in a debt host contract has both an underlying (interest rates and, if applicable, the occurrence or nonoccurrence of any exercise contingency) and a notional amount (the principal amount subject to extension) or payment provision.
Initial net investment (see Section 1.4.2)	Yes	The initial net investment in an embedded feature is its fair value (i.e., the amount that would need to be paid to acquire the term extension feature on a stand-alone basis without the debt host contract). Generally, a term extension feature has an initial net investment that is smaller than would be required for a direct investment in the amount of debt that is subject to the term extension (since the investment in the debt host contract does not form part of the initial net investment for the embedded feature).
Net settlement (see Section 1.4.3)	It depends	Typically, the entity would evaluate whether the debt contract that will be extended is RCC (see below).

Generally, the analysis of whether an embedded term extension feature meets the definition of a derivative focuses on whether the feature meets the net settlement characteristic. If a term extension feature does not contain an explicit net settlement provision or a market mechanism to facilitate net settlement (both of which would be uncommon), the evaluation depends on whether the instrument whose maturity is being extended is RCC (e.g., publicly traded debt that may be sold in increments that can be rapidly absorbed by the market without significantly affecting the price). If the underlying debt is not RCC, the embedded term extension feature should not be bifurcated as a derivative because it does not permit net settlement and therefore does not meet the definition of a derivative.

5.6 Foreign Currency in a Debt Host

5.6.1 Background

This section discusses the analysis of whether a feature whose value changes on the basis of changes in one or more foreign currency exchange rates should be separated from a debt host contract and accounted for as a derivative. For example, some debt instruments contain an option to convert principal, interest payments, or both at a fixed foreign currency exchange rate. Further, the terms of some debt instruments (e.g., dual currency bonds) have principal and interest payments denominated in different currencies.

This section does not apply to a feature that does not present an exposure to the risk of changes in the exchange rate of foreign currency that is different from the currency in which the debt is denominated, such as certain currency conversion convenience clauses (see Section 5.6.5). Further, it does not apply to debt merely by virtue of its denomination in a currency that is different from the debtor’s functional currency unless the debt contains one or more features that are denominated in a currency that is different from that in which the debt was denominated (e.g., a foreign currency option).

5.6.2 Bifurcation Analysis

The table below presents an overview of the bifurcation analysis of a foreign currency feature embedded in a debt host contract. Further, an entity should always consider the terms and conditions of a specific feature in light of all the relevant accounting guidance before reaching a conclusion.

Bifurcation Condition	Condition Met?	Analysis
Not clearly and closely related (see Section 4.3.2)	Yes	A feature that presents an exposure to changes in the exchange rate of foreign currency that is different from the debt’s currency of denomination is not clearly and closely related to a debt host.
Hybrid instrument not measured at fair value through earnings on a recurring basis (see Section 4.3.3)	It depends	From the issuer’s perspective, debt is not measured at fair value on a recurring basis unless the issuer elects the fair value option in ASC 815-15 or ASC 825-10. The fair value option cannot be elected for debt that contains a separately recognized equity component at inception. From the holder’s perspective, if a loan or debt security is remeasured at fair value, with changes in fair value recorded in earnings, any derivative embedded in the interest would not need to be accounted for separately since the accounting for the interest would already be the same as that of a freestanding derivative.
Meets the definition of a derivative (see Section 4.3.4)	Yes	A feature that presents an exposure to changes in a foreign currency exchange rate meets the definition of a derivative.
Meets a scope exception (see Chapter 2 and Section 4.3.5)	It depends	The entity should evaluate whether the foreign currency feature is exempt from derivative accounting under ASC 815-15-15-5.

As shown in the table above, an entity’s determination of whether a foreign currency feature must be bifurcated from a debt host contract and accounted for as derivative tends to focus on whether the feature meets a scope exception related to derivative accounting unless the entity is remeasuring the hybrid instrument at fair value on a recurring basis through earnings. Typically, such features meet the definition of a derivative and are not clearly and closely related to a debt host (see the next section).

5.6.3 Clearly-and-Closely-Related Analysis

A feature that presents an exposure to changes in the exchange rate of foreign currency that is different from the debt’s currency of denomination is not clearly and closely related to a debt host. As noted in ASC 815-15-55-212, for example, a “foreign currency option is not clearly and closely related to issuing a loan.” However, this guidance does not apply to a feature that does not present an exposure to the risk of changes in the exchange rate of foreign currency that is different from the currency in which the debt is denominated (see Section 5.6.5).

5.6.4 Derivative Analysis

The table below presents an analysis of whether a foreign currency feature embedded in a debt host contract meets the definition of a derivative. Note, however, that an entity should always consider the terms and conditions of a specific feature in light of the applicable accounting guidance before reaching a conclusion.

Characteristics of a Derivative	Characteristic Present?	Analysis
Underlying and notional amount or payment provision (see Section 1.4.1)	Yes	An embedded feature that presents an exposure to changes in a foreign currency exchange rate that is based on a currency that is different from the debt’s currency of denomination has both an underlying (the foreign currency rate) and a notional amount (e.g., the debt’s outstanding amount).
Initial net investment (see Section 1.4.2)	Yes	The initial net investment in a feature that presents an exposure to changes in a foreign currency exchange rate that is based on a currency that is different from the debt’s currency of denomination is its fair value (i.e., the amount that would need to be paid to acquire the feature on a stand-alone basis without the host contract). This feature has an initial net investment that is smaller than would be required for a direct investment that has the same exposure to changes in foreign currency exchange rates.
Net settlement (see Section 1.4.3)	Yes	A foreign currency feature meets the net settlement condition because it is net cash settled.

As shown in the table above, a foreign currency feature embedded in a debt host contract meets the definition of a derivative. Therefore, the analysis of whether such a feature must be bifurcated as a derivative tends to focus on whether the feature is exempt from the scope of derivative accounting unless the entity is remeasuring the hybrid instrument at fair value on a recurring basis through earnings.

5.6.5 Convenience Clauses That Do Not Present a Foreign Currency Exposure

Sometimes, debt contracts contain a convenience clause that permits or requires principal or interest payments or both to be made in a currency that is different from that in which the debt is denominated. The amount of the payment is determined by applying the current spot foreign currency exchange rate at the time of payment to the amount owed in the debt’s currency of denomination. For example, the terms of a debt instrument denominated in USD might specify that payments may be made in one or more currencies at the current spot exchange rate at the time of payment. Such a clause does not represent a foreign currency feature that should be evaluated for bifurcation since its monetary value does not vary on the basis of a foreign currency exchange rate.