Chapter 6 — Other Common Embedded Features

6.2 Conversion, Exchange, and Indexed Features in Debt Hosts

6.2.1 Background

This section discusses the analysis of whether equity-like features — including features that involve conversion into an issuer’s equity shares or third-party stock as well as payment features indexed to a stock price or stock price index — should be separated from a debt host contract and accounted for as derivatives under ASC 815-15. See Section 6.3 for discussion of these types of features in equity host contracts.

6.2.2 Bifurcation Analysis

6.2.2.1 General

The bifurcation analysis differs depending on whether the equity feature economically is an equity conversion feature settleable in the debtor’s equity shares, an exchange feature settleable in the equity shares of a third party, or a payment feature indexed to a stock price or stock price index. The analysis of a feature that economically represents a share-settled redemption or indexation feature whose monetary value does not vary on the basis of a stock price is discussed in Section 6.4. Such features do not represent conversion or exchange options since their monetary value is not indexed to the fair value of the shares delivered upon settlement.

6.2.2.2 Equity Conversion Feature

Debt instruments often contain features that require or permit the debt to be converted into the debtor’s equity shares. The table below presents an overview of the bifurcation analysis of equity conversion features embedded in a debt host contract that are settleable in the debtor’s equity shares, including the shares of a substantive consolidated entity. The table does not apply to an embedded feature that economically represents a share-settled redemption or indexation feature whose monetary value does not vary on the basis of the debtor’s stock price (see Section 6.2.2.5). 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 change in the debtor’s stock price 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. In the case of an outstanding share that qualifies for equity presentation but was determined to have a debt host contract, the instrument would not be recorded at fair value through earnings on a recurring basis. From the holder’s perspective, the determination of whether the hybrid instrument is measured at fair value, with changes recorded through earnings, will depend on whether the instrument is (1) an equity method investment, (2) considered a debt security within the scope of ASC 320 (and whether the holder has elected to apply the fair value option), or (3) an equity security within the scope of ASC 321.
Meets the definition of a derivative (see Section 4.3.4)	It depends	The entity should evaluate whether the equity conversion feature meets the net settlement characteristic in the definition of a derivative.
Meets a scope exception (see Section 4.3.5)	It depends	From the issuer’s perspective, the issuer should evaluate whether the equity conversion feature meets the scope exception for certain contracts on own equity or share-based payment transactions (see Section 2.3.11). From the holder’s perspective, a scope exception is not applicable.

As shown in the table above, the analysis of whether an equity conversion feature should be bifurcated from a debt host contract under ASC 815-15 usually centers on whether the feature meets (1) the net settlement characteristic in the definition of a derivative and, if so, (2) the scope exception in ASC 815-10-15-74(a) for certain contracts issued by the reporting entity that are both indexed to its own stock and classified in stockholders’ equity in its statement of financial position. This scope exception would not be applicable to the holder of the same contract.

A conversion feature might begin or cease to meet the bifurcation criteria under ASC 815-15 after the initial recognition of the instrument in which it is embedded. For instance, the assessment of whether a feature meets the scope exception for own equity may change if the issuer authorizes the issuance of additional shares (see Section 5.4 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity). The accounting analysis might also change if a conversion feature becomes RCC because a market develops for the underlying shares (see Section 1.4.3.4.5). The issuer must monitor such changes on an ongoing basis.

ASC 815-15

Case U: Convertible Debt Instrument

55-217 In a convertible debt instrument, an investor receives a below-market interest rate and receives the option to convert its debt instrument into the equity of the issuer at an established conversion rate. The terms of the conversion require that the issuer deliver shares of stock to the investor.

55-218 This instrument essentially contains a call option on the issuer’s stock. Under the provisions of this Subtopic, the accounting by the issuer and investor can differ. The issuer’s accounting depends on whether a separate instrument with the same terms as the embedded written option would be a derivative instrument pursuant to Section 815-10-15. Assuming the option is indexed to the issuer’s own stock and a separate instrument with the same terms would be classified in stockholders’ equity in the statement of financial position, the written option is not considered to be a derivative instrument for the issuer under paragraph 815-10-15-74(a) and should not be separated from the host contract.

55-219 In contrast, if the terms of the conversion allow for a cash settlement rather than delivery of the issuer’s shares at the investor’s option, the exception in paragraph 815-10-15-74(a) for the issuer does not apply because the contract would not be classified in stockholders’ equity in the issuer’s statement of financial position. In that circumstance, the issuer should separate the embedded derivative from the host contract and account for it pursuant to the provisions of this Subtopic because both of the following conditions exist:

An option based on the entity’s stock price is not clearly and closely related to an interest-bearing debt instrument.
The option would not be considered an equity instrument of the issuer (see paragraph 815-40-25-4(a)(2)).

55-220 Similarly, if the convertible debt is indexed to another entity’s publicly traded common stock, the issuer should separate the embedded derivative from the host contract and account for it pursuant to the provisions of this Subtopic because both of the following conditions exist:

An option based on another entity’s stock price is not clearly and closely related to an investment in an interest-bearing note.
The option would not be considered an equity instrument of the issuer.

55-221 The exception in paragraph 815-10-15-74 does not apply to the investor’s accounting. Therefore, in both circumstances described, the investor should separate the embedded option contract from the host contract and account for the embedded option contract pursuant to the provisions of this Subtopic because the option contract is based on the price of another entity’s equity instrument and thus is not clearly and closely related to an investment in an interest-bearing note. However, if the terms of conversion do not allow for a cash settlement and if the common stock delivered upon conversion is privately held (that is, is not readily convertible to cash), the embedded derivative would not be separated from the host contract because it would not meet the criteria for net settlement as discussed beginning in paragraph 815-10-15-99.

The description of the accounting for an equity conversion feature in a debt host in ASC 815-15-55-217 through 55-221 contains certain unstated, simplified assumptions that are not always applicable. Therefore, an entity cannot rely solely on those paragraphs in its accounting analysis for an equity conversion feature and must also consider other guidance in ASC 815. In particular, it is assumed in ASC 815-15-55-218 that the debtor can apply the scope exception in ASC 815-10-15-74(a) to the conversion feature, but this is not always an appropriate assumption (see Section 1.4.3.4.5). Further, it is assumed in ASC 815-15-55-219 that the hybrid instrument is not accounted for at fair value, with changes in fair value recognized in net income. However, if the hybrid instrument is accounted for at fair value, with changes in fair value recognized in earnings, bifurcation would not be appropriate (see Section 4.3.3).

6.2.2.3 Exchange Feature Involving Third-Party Stock

ASC 470-20 — SEC Materials — SEC Staff Guidance

Comments Made by SEC Observer at Emerging Issues Task Force (EITF) Meetings

SEC Observer Comment: Debt Exchangeable for the Stock of Another Entity

S99-1 The following is the text of the SEC Observer Comment: Debt Exchangeable for the Stock of Another Entity.

An issue has been discussed involving an enterprise that holds investments in common stock of other enterprises and issues debt securities that permit the holder to acquire a fixed number of shares of such common stock. These types of transactions are commonly affected through the sale of either debt with detachable warrants that can be exchanged for the stock investment or debt without detachable warrants (the debt itself must be exchanged for the stock investment — also referred to as “exchangeable” debt). Those debt issues differ from traditional warrants or convertible instruments because the traditional instruments involve exchanges for the equity securities of the issuer. There have been questions as to whether the exchangeable debt should be treated similar to traditional convertibles as specified in Subtopic 470-20 or whether the transaction requires separate accounting for the exchangeability feature. The SEC staff believes that Subtopic 470-20 does not apply to the accounting for debt that is exchangeable for the stock of another entity and therefore separation of the debt element and exchangeability feature is required.

A debt instrument may contain a feature that requires or permits its exchange into the shares of a third party. For example, a debt instrument may give the holder the option to require that the issuer deliver a fixed number of shares of a third party’s common stock in lieu of repaying the debt’s principal amount at maturity. From the holder’s perspective, the economic characteristics and risks of an investment in such a debt instrument are similar to those of an investment in convertible debt. However, the issuer should not analyze the exchange feature as an equity conversion feature that potentially could qualify for the scope exception for certain contracts on own equity since it is not settled in the debtor’s equity shares.

In consolidated financial statements, a debt instrument issued by a parent entity or its subsidiary that is exchangeable into the subsidiary’s equity shares is analyzed in a manner similar to a contract that is convertible into the parent’s equity shares, provided that the subsidiary is a substantive entity (see Section 2.6.1 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity). This is true irrespective of whether the instrument is issued by the parent or subsidiary. Therefore, the exchange feature would be analyzed as an equity conversion feature involving the company’s own stock under ASC 815-15 (see Section 6.3.1).

In the subsidiary’s separate financial statements, the parent’s equity is not considered equity of the subsidiary. Therefore, a debt instrument that is issued by a subsidiary and exchangeable into the parent’s equity shares would not be analyzed as an instrument that is convertible into the issuer’s equity shares in the subsidiary’s separate financial statements (see Section 2.6.2 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity). In the parent’s consolidated financial statements, however, the same instrument would be analyzed as a debt instrument that is convertible into the issuer’s equity shares, as discussed above.

Equity shares issued by an equity method investee are not considered part of the entity’s own equity. Therefore, debt instruments that are exchangeable into the shares of an equity method investee are analyzed as an exchange feature that is settleable in third-party stock under ASC 815-15.

The table below presents an overview of the bifurcation analysis of a feature that requires or permits a debt contract to be exchanged for shares of stock issued by a third party (other than shares of stock issued by a substantive consolidated entity). The table does not apply to a feature that economically represents a share-settled redemption or indexation feature whose monetary value does not vary on the basis of the third party’s stock price. 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	The changes in the fair value of an equity interest are 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. In the case of an outstanding share that qualifies for equity presentation but was determined to have a debt host contract, the instrument would not be recorded at fair value through earnings on a recurring basis. From the holder’s perspective, the determination of whether the hybrid instrument is measured at fair value, with changes recorded through earnings, will depend on whether the instrument is (1) an equity method investment, (2) considered a debt security within the scope of ASC 320 (and whether the holder has elected to apply the fair value option), or (3) an equity security within the scope of ASC 321.
Meets the definition of a derivative (see Section 4.3.4)	It depends	The entity should evaluate whether the feature meets the net settlement characteristic in the definition of a derivative.
Meets a scope exception (see Section 4.3.5)	No	There is no specific scope exception available for features that involve the exchange of debt for shares issued by a third party (other than shares of stock issued by a substantive consolidated entity).

As shown in the table above, the determination of whether an exchange feature settleable in third-party stock must be bifurcated as a derivative tends to focus on whether the feature meets the net settlement characteristic in the definition of a derivative (unless the entity records the hybrid instrument at fair value, with changes in fair value recorded through earnings). Such features are not clearly and closely related to a debt host contract and are not exempt from the scope of derivative accounting.

6.2.2.4 Equity-Indexed Payment Features

The table below presents an overview of the bifurcation analysis of an equity-indexed payment feature embedded in a debt host contract (e.g., a debt contract with principal or interest payments indexed to the S&P 500 Index). 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	The changes in the fair value of an equity interest are not clearly and closely related to a debt host.
Hybrid instrument not measured at fair value through earnings (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. In the case of an outstanding share that qualifies for equity presentation but was determined to have a debt host contract, the instrument would not be recorded at fair value through earnings on a recurring basis. From the holder’s perspective, the determination of whether the hybrid instrument is measured at fair value, with changes recorded through earnings, will depend on whether the instrument is (1) an equity method investment, (2) considered a debt security within the scope of ASC 320 (and whether the holder has elected to apply the fair value option), or (3) an equity security within the scope of ASC 321.
Meets the definition of a derivative (see Section 4.3.4)	Yes	An equity-indexed payment feature meets the definition of a derivative.
Meets a scope exception (see Section 4.3.5)	No	There is no specific scope exception available for an equity-indexed payment feature embedded in a debt host.

As shown in the table above, an equity-indexed payment feature typically must be bifurcated as a derivative unless the entity records the instrument at fair value, with changes recorded through earnings.

6.2.2.5 Share-Settled Redemption Features

A financial instrument may contain a term that is described as an equity conversion or exchange feature but economically represents a share-settled redemption or indexation provision whose monetary value does not vary on the basis of a stock price or stock price index. The number of equity shares is variable and is calculated to be equal in value to a fixed or specified monetary amount (e.g., the principal amount plus accrued and unpaid interest) or a monetary amount that is indexed to an unrelated underlying (e.g., the price of gold).

Even if the terms of the instrument refer to the share-settled feature as an equity conversion or exchange feature, the entity should not analyze it as such since it does not have the economic payoff profile of an equity conversion or exchange feature. Instead, the entity should (1) evaluate the feature as a put, call, redemption, or other indexed feature, as applicable, and (2) determine whether the feature must be separated as a derivative instrument under ASC 815-15. (If the instrument is issued in the form of an equity share [e.g., preferred stock], the issuer should also evaluate whether the feature results in the requirement to classify the instrument as a liability under ASC 480-10; see Chapter 6 of Deloitte’s Roadmap Distinguishing Liabilities From Equity.)

Example 6-1

Debt Settleable for Variable Number of Shares Upon a Qualified Equity Financing

A debt instrument includes a feature that must be “converted” into the debtor’s common stock upon a qualified equity financing. The conversion price is defined as (1) the outstanding amount of principal and interest divided by (2) the price of a share of common stock in the qualified equity offering. Although the contract refers to the feature as a conversion feature and it must be settled in shares of common stock, the instrument should not be analyzed as a debt instrument with an equity conversion feature because the monetary value of the shares delivered upon conversion is unrelated to the fair value of the issuer’s equity shares. Instead, under ASC 815-15, this feature should be evaluated as a contingent redemption option; it would not be evaluated as a conversion feature even though it is settled in the debtor’s equity shares.

Example 6-2

Debt Indexed to S&P 500 Index

A debt instrument with a principal amount of $1 million contains a “conversion” feature that requires the issuer to settle, at the holder’s option, the instrument in a variable number of common shares equal in value to $1 million adjusted for changes in the S&P 500 Index. Under ASC 815-15, this feature would not be analyzed as an equity conversion feature. Instead, it should be evaluated as a payment feature indexed to the S&P 500 Index.

A share-settled redemption or indexation feature meets the net settlement characteristic in the definition of a derivative irrespective of whether the shares that will be delivered upon settlement are RCC. Because the monetary amount of the obligation does not depend on the share price, neither party is required to deliver an asset (1) that is associated with the underlying and (2) whose principal amount, stated amount, face value, number of shares, or other denomination is equal to the notional amount. In the evaluation of whether the net settlement criterion in ASC 815-10-15-107(b) has been met, the assets being delivered to the holder upon the feature’s settlement are treated as shares of the issuer. Such shares are not associated with the embedded feature’s underlying because the monetary value of the shares to be delivered does not vary on the basis of the share price. In other words, the holder is indifferent to changes in the value of any of the equity shares until the feature is settled. Therefore, the net settlement criterion is met regardless of whether the underlying shares are RCC.

6.2.3 Clearly-and-Closely-Related Analysis

6.2.3.1 Equity Conversion or Exchange Features

ASC 815-15

25-51 The changes in fair value of an equity interest and the interest rates on a debt instrument are not clearly and closely related. Thus, for a debt security that is convertible into a specified number of shares of the debtor’s common stock or another entity’s common stock, the embedded derivative (that is, the conversion option) shall be separated from the debt host contract and accounted for as a derivative instrument provided that the conversion option would, as a freestanding instrument, be a derivative instrument subject to the requirements of this Subtopic. (For example, if the common stock was not readily convertible to cash, a conversion option that requires purchase of the common stock would not be accounted for as a derivative instrument.) That accounting applies only to the holder (investor) if the debt is convertible to the debtor’s common stock because, under paragraph 815-10-15-74(a), a separate option with the same terms would not be a derivative instrument for the issuer.

A conversion or exchange feature whose value varies on the basis of changes in the equity instruments that would be issued upon conversion is not clearly and closely related to a debt host because the economic characteristics and risks of an equity instrument differ from those of a debt instrument. Such a feature is not clearly and closely related to a debt host irrespective of whether it is considered indexed to the entity’s own equity under ASC 815-40.

The accounting for an equity conversion feature in a debt host in ASC 815-15-25-51 is premised on certain unstated, simplified assumptions that are not always applicable. Therefore, an entity cannot rely solely on that paragraph in its accounting analysis for an equity conversion feature and must also consider other guidance in ASC 815. For example, it is assumed in the second sentence in ASC 815-15- 25-51 that the hybrid instrument is not accounted for at fair value, with changes in fair value recognized in net income. However, if the hybrid instrument is accounted for at fair value, with changes in fair value recognized in earnings, bifurcation would not be required (see Section 4.3.3). Further, it is assumed in the final sentence in ASC 815-15-25-51 that the equity conversion feature meets the scope exception in ASC 815-10-15-74(a) for the issuer, which is not always an appropriate assumption (see Section 1.4.3.4.5).

6.2.3.2 Equity-Indexed Payment Feature

ASC 815-15

25-49 The changes in fair value of an equity interest and the interest yield on a debt instrument are not clearly and closely related. Thus, an equity-related derivative instrument embedded in an equity-indexed debt instrument (whether based on the price of a specific common stock or on an index that is based on a basket of equity instruments) shall be separated from the host contract and accounted for as a derivative instrument.

Example 7: Clearly and Closely Related Criterion — Characterizing a Debt Host

55-117 This Example illustrates the application of the clearly and closely related criterion in paragraph 815-15-25-1(a) to the determination of what is the host contract and what is the embedded derivative composing the illustrative hybrid instrument. This Example has the following assumptions:

An entity (Entity A) issues a 5-year debt instrument with a principal amount of $1,000,000 indexed to the stock of an unrelated publicly traded entity (Entity B).
At maturity, the holder of the instrument will receive the principal amount plus any appreciation or minus any depreciation in the fair value of 10,000 shares of Entity B, with changes in fair value measured from the issuance date of the debt instrument.
No separate interest payments are made.
The market price of Entity B shares to which the debt instrument is indexed is $100 per share at the issuance date.

55-118 The instrument is not itself a derivative instrument because it requires an initial net investment equal to the notional amount. The host contract is a debt instrument because the instrument has a stated maturity and because the holder has none of the rights of a shareholder, such as the ability to vote the shares and receive distributions to shareholders. The embedded derivative is an equity-based derivative that has as its underlying the fair value of the stock of Entity B. As a result of the host instrument being a debt instrument and the embedded derivative having an equity-based return, the embedded derivative is not clearly and closely related to the host contract and must be separated from the host contract and accounted for as a derivative by both the issuer and the holder of the hybrid instrument. (Paragraph 815-15-25-4 allows for a fair value election for hybrid financial instruments that otherwise would require bifurcation. Hybrid financial instruments that are elected to be accounted for in their entirety at fair value cannot be used as a hedging instrument in a Topic 815 hedging relationship.)

Example 8: Clearly and Closely Related Criterion — Debt Instrument Incorporating Equity-Based Return

55-119 This Example illustrates the application of the clearly and closely related criterion in paragraph 815-15-25-1(a). Even though an overall hybrid instrument that provides for repayment of principal may include a return based on the market price (the underlying as defined) of XYZ Corporation common stock, the host contract does not involve any existing or potential residual interest rights (that is, rights of ownership) and thus would not be an equity instrument. The host contract would instead be considered a debt instrument, and the embedded derivative that incorporates the equity-based return would not be clearly and closely related to the host contract.

Case H: Equity-Indexed Note

55-189 An equity-indexed note is a bond for which the return of interest, principal, or both is tied to a specified equity security or index, for instance, the Standard and Poor’s 500 S&P 500 Index. This instrument may contain a fixed or varying coupon rate and may place all or a portion of principal at risk.

55-190 An equity-indexed note essentially combines an interest-bearing instrument with a series of forward exchange contracts or option contracts. Often, a portion of the coupon interest rate is, in effect, used to purchase options that provide some form of floor on the potential loss of principal that would result from a decline in the referenced equity index. Because forward or option contracts for which the underlying is an equity index are not clearly and closely related to an investment in an interest-bearing note, those embedded derivatives should be separated from the host contract and accounted for by both parties pursuant to the provisions of this Subtopic.

Case I: Variable Principal Redemption Bond

55-191 A variable principal redemption bond’s principal redemption value at maturity depends on the change in an underlying index over a predetermined observation period. A typical circumstance would be a bond that guarantees a minimum par redemption value of 100 percent and provides the potential for a supplemental principal payment at maturity as compensation for the below-market rate of interest offered with the instrument.

55-192 Assume that a supplemental principal payment will be paid to the investor, at maturity, if the final S&P 500 closing value (determined at a specified date) is less than its initial value at date of issuance and the 10-year U.S. Treasury constant maturities is greater than 2 percent as of a specified date. In all circumstances, the minimum principal redemption will be 100 percent of par.

55-193 A variable principal redemption bond essentially combines an interest-bearing investment with an option that is purchased with a portion of the bond’s coupon interest payments. Because the embedded option entitling the investor to an additional return is partially contingent on the S&P 500 index closing above a specified amount, it is not clearly and closely related to an investment in a debt instrument. Therefore, the embedded option should be separated from the host contract and accounted for by both parties pursuant to the provisions of this Subtopic.

Case P: Specific Equity-Linked Bond

55-207 A specific equity-linked bond pays a coupon slightly below that of traditional bonds of similar maturity; however, the principal amount is linked to the stock market performance of an equity investee of the issuer. The issuer may settle the obligation by delivering the shares of the equity investee or may deliver the equivalent fair value in cash.

55-208 A specific equity-linked bond can be viewed as combining an interest-bearing instrument with, depending on its terms, a series of forward exchange contracts or option contracts based on an equity instrument. Often, a portion of the coupon interest rate is used to purchase options that provide some form of floor on the loss of principal due to a decline in the price of the referenced equity instrument. The forward or option contracts do not qualify for the exception in paragraph 815-10-15-59(b) because the shares in the equity investee owned by the issuer meet the definition of a financial instrument. Because forward or option contracts for which the underlying is the price of a specific equity instrument are not clearly and closely related to an investment in an interest-bearing note, the embedded derivative should be separated from the host contract and accounted for by both parties pursuant to the provisions of this Subtopic.

In a manner similar to an equity conversion or exchange feature (see Section 6.2.4.1), a feature that adjusts the contractual payments on the basis of a stock price or stock price index is not clearly and closely related to a debt host. Accordingly, a contractual provision in a debt host that involve payments that are indexed to a stock price or stock price index must be bifurcated as a derivative if the other bifurcation conditions in ASC 815-15-25-1 are also met.

Example 6-3

Debt With Principal Amount That Is Indexed to Stock Price

Company ABC issues $100 million of five-year debt. The debt pays an annual coupon of 6 percent and is indexed to the price of 1 million shares of Company XYZ’s common stock. Company XYZ is listed on the New York Stock Exchange and, on the date on which the debt is issued, its stock price is $100 per share. At debt maturity, if XYZ’s common stock has appreciated in value to $200 per share, ABC will pay $200 million; however, if the value of XYZ’s stock has depreciated to $50 per share at maturity, ABC will pay $50 million.

Although the return on the debt is linked to an equity instrument (XYZ’s stock), the host contract is considered a debt host because the instrument is legal form debt with a stated maturity and no shareholder rights.

The embedded equity forward is not clearly and closely related to the debt host; therefore, the embedded derivative must be bifurcated and accounted for at fair value unless the entity elects to measure the entire hybrid financial instrument at fair value, with changes in fair value recognized in earnings.

If ABC was required to deliver XYZ’s shares to the investor instead of adjusting the amount of cash paid at maturity of the debt, ABC would need to assess whether XYZ’s shares are RCC (i.e., whether the 1 million shares significantly affect the market price of XYZ) to determine whether the embedded equity forward meets the definition of a derivative instrument. See the next section for more information.

6.2.4 Derivative Analysis

6.2.4.1 Equity Conversion or Exchange Feature

The table below presents an analysis of whether an equity conversion or exchange feature meets the definition of a derivative (see Section 1.4). 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	An equity conversion or exchange feature has both an underlying (the fair value of the equity instruments that would be issued upon conversion and, if applicable, the occurrence or nonoccurrence of any exercise contingency) and a notional amount (the number of shares that would be issued upon conversion).
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 equity conversion feature on a stand-alone basis without the host contract). Generally, an equity conversion or exchange 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 stock price (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	The net settlement characteristic is met if either (1) the equity conversion or exchange feature can be explicitly net settled (e.g., its fair value can be settled net in shares or net in cash) or (2) the shares that would be issued upon conversion are RCC. The net settlement characteristic is not met if the equity conversion or exchange feature must be gross physically settled and the shares that would be delivered upon conversion are not RCC.

Generally, an analysis of whether an equity conversion or exchange feature meets the definition of a derivative focuses on whether it meets the net settlement characteristic (see Section 1.4.3).

6.2.4.2 Equity-Indexed Payment Feature

The table below presents an analysis of whether an equity-indexed payment feature 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 equity-indexed payment feature has both an underlying (a stock price or stock price index) and a notional amount (the debt’s principal amount) 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 equity-indexed payment feature on a stand-alone basis without the host contract). Generally, an equity-indexed payment 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 stock price or stock price index (since the investment in the debt host contract does not form part of the initial net investment in the embedded feature).
Net settlement (see Section 1.4.3)	Yes	A feature that adjusts the payments of a debt host contract on the basis of a stock price or stock price index meets the net settlement condition since 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. (If the feature must be settled by delivery of the underlying shares of stock, however, the considerations in Section 6.2.4.3.3 apply.)

As shown in the table above, an equity-indexed payment feature embedded in a debt host contract typically meets the definition of a derivative. Because such a feature is not clearly and closely related to a debt host and does not qualify for any scope exception, it must be bifurcated as a derivative unless the entity records the hybrid instrument at fair value, with changes in fair value recorded through earnings.

6.2.4.3 Net Settlement Analysis

6.2.4.3.1 Background

An equity conversion or exchange feature embedded in a debt host contract does not meet the definition of a derivative instrument on a stand-alone basis unless it satisfies the net settlement characteristic in that definition. In evaluating whether an embedded conversion or exchange feature can be explicitly net settled, the entity should consider all of the debt instrument’s terms (e.g., redemption and liquidation features). Different considerations apply in the following situations:

The feature must or may be settled in cash (see the next section).
The feature must or may be settled net in shares (see Section 6.2.4.3.3).
The feature requires physical settlement in stock that is not restricted (see Section 6.2.4.3.4).
The feature requires physical settlement in restricted stock (see Section 6.2.4.3.5).

These considerations do not apply to an equity-indexed payment feature that adjusts the payments of a debt host contract on the basis of a stock price or stock price index unless it is settled by delivery of the feature’s underlying shares of stock. Such a feature meets the net settlement characteristic irrespective of whether it is settled in cash or other assets (including those that are not RCC) since neither party is required to deliver an asset whose principal amount, stated amount, face value, number of shares, or other denomination is equal to the feature’s notional amount (see Section 1.4.3.2).

6.2.4.3.2 Features That Must or May Be Settled in Cash Upon Settlement

A conversion or exchange feature that must be net cash settled or can be settled in cash at either party’s election meets the net settlement characteristic. Convertible debt instruments often specify that, upon conversion, the issuer or investor may elect to have the instrument settle in an amount of cash that is equal to the value of the shares that would be received upon conversion (in exchange for the convertible instrument) instead of having shares delivered. For example, conversion features embedded in convertible instruments in the form of Instruments A, B, C, or X1 (see Section 2.3.2.2 of Deloitte’s Roadmap Issuer's Accounting for Debt) meet the net settlement characteristic in the definition of a derivative irrespective of whether the underlying shares are RCC, since such instruments either require or permit the conversion value or the conversion spread to be settled in cash.

In other cases, a conversion or exchange feature that is embedded in a debt host meets the net settlement characteristic even if, according to the feature’s stated terms, physical delivery of shares that are not RCC is required. For example, a convertible instrument may be redeemable by the holder and, upon redemption, the holder may receive cash equal to the greater of (1) the face value plus accrued interest or (2) the value of the shares that would be received had the holder exercised the conversion option (this alternative is sometimes described as cash equal to the fair value of the convertible instrument, which is presumably equal to the combined fair value of the debt host and embedded conversion option). The conversion option, by its terms, may only be settled physically. However, the redemption feature permits net cash settlement of the conversion option; therefore, the conversion option meets the net settlement characteristic.

A conversion or exchange feature that is embedded in a debt host is considered to meet the net settlement characteristic in the definition of a derivative even if the ability to net cash settle the feature is contingent on the occurrence or nonoccurrence of an event (e.g., an IPO or a change of control). For example, the terms of a convertible debt instrument might specify that an equity conversion feature must be settled in shares, which are not RCC. However, the terms may also specify that if an IPO were to occur, the holder may elect to have the instrument settle in an amount of cash that is equal to the fair value of the shares that would otherwise be received upon conversion instead of having shares delivered. In this scenario, the conversion feature meets the net settlement characteristic because it can be explicitly net cash settled upon an IPO.

Sometimes, a conversion or exchange feature embedded in a debt host can be effectively net cash settled through the conversion and subsequent redemption of the shares that are delivered upon conversion. If the shares that will be delivered upon the settlement of a conversion or exchange feature have redemption or liquidation terms that apply in scenarios other than an ordinary liquidation, the issuer should carefully evaluate those terms to determine whether the embedded feature can be effectively net cash settled. For example, a debt instrument may be convertible by the holder into preferred stock (which is not RCC) upon a change of control. If the terms of the preferred stock permit the holder to redeem it for cash or other assets upon a change of control, the conversion feature meets the net settlement characteristic in the definition of a derivative. If, however, the holder is required, upon conversion, to own preferred shares that are not RCC for a substantive period before they can be redeemed and the investor is exposed to changes in the value of the preferred shares, the net settlement characteristic is not met.

6.2.4.3.3 Net-Share-Settled Features

ASC 815-10

15-102 The net settlement criterion as described in paragraph 815-10-15-83(c) and related paragraphs in this Subsection is met if a contract provides for net share settlement at the election of either party. Therefore, if either counterparty could net share settle a contract, then it would be considered to have the net settlement characteristic of a derivative instrument regardless of whether the net shares received were readily convertible to cash as described in paragraph 815-10-15-119 or were restricted for more than 31 days as discussed beginning in paragraph 815-10-15-130. While this conclusion applies to both investors and issuers of contracts, issuers of those net share settled contracts shall consider whether such contracts qualify for the scope exception in paragraph 815-10-15-74(a). See Example 5 (paragraph 815-10-55-90).

Example 5: Net Settlement Under Contract Terms — Net Share Settlement

55-90 This Example illustrates the concept of net share settlement. Entity A has a warrant to buy 100 shares of the common stock of Entity X at $10 a share. Entity X is a privately held entity. The warrant provides Entity X with the choice of settling the contract physically (gross 100 shares) or on a net share basis. The stock price increases to $20 a share. Instead of Entity A paying $1,000 cash and taking full physical delivery of the 100 shares, the contract is net share settled and Entity A receives 50 shares of stock without having to pay any cash for them. (Net share settlement is sometimes described as a cashless exercise.) The 50 shares are computed as the warrant’s $1,000 fair value upon exercise divided by the $20 stock price per share at that date.

A conversion or exchange feature that can be settled net in shares meets the net settlement characteristic even if the shares are not RCC. For example, a convertible debt instrument might specify that, upon conversion, the outstanding amount of principal and interest will be settled in cash, and the conversion spread in shares. In this scenario, the conversion feature is net share settled and meets the net settlement characteristic of a derivative.

6.2.4.3.4 Physically Settled Features

ASC 815-10

15-130 A security that is publicly traded but for which the market is not very active is readily convertible to cash if the number of shares or other units of the security to be exchanged is small relative to the daily transaction volume. That same security would not be readily convertible if the number of shares to be exchanged is large relative to the daily transaction volume.

A conversion or exchange feature that is embedded in a debt host and that requires physical settlement in equity shares upon settlement meets the net settlement characteristic if the shares that would be issued upon settlement are RCC (see Section 1.4.3.4). If the terms of the shares that would be delivered upon conversion permit the holder to redeem them for cash upon conversion, the feature meets the net settlement characteristic even if the shares are not currently RCC (see Section 1.4.3.2). An equity conversion feature that is embedded in a debt host and fails to meet any of the conditions for equity classification in ASC 815-40-25 (e.g., sufficient authorized and unissued shares; see Section 6.2.4.3.2) would typically possess the net settlement characteristic because it would be presumed that the entity would be required to net cash settle the feature.

A share of a company’s stock is considered to be RCC if the share price is quoted in an active market that can rapidly absorb the smallest increment of shares available for exchange under the contract without any significant impact on the quoted price. Typically, shares traded in a public market are RCC unless the smallest number of shares that can be exchanged under the contract is large relative to the daily trading volume of the shares (see below) or the costs of converting the shares into cash (e.g., sales commissions on the quoted price) are in excess of 10 percent of the stock price at the inception of the contract (see Section 1.4.3.4.2). However, shares are not considered RCC if the sale or transfer of the issued shares is restricted for a period of 32 days or more from the date on which a conversion feature is exercised (see Section 1.4.3.4.3).

ASC 815-10

Example 7: Net Settlement — Readily Convertible to Cash — Effect of Daily Transaction Volumes

55-99 The following Cases illustrate consideration of the relevance of daily transaction volumes to the characteristic of net settlement in deciding whether, from the investor’s perspective, the convertible bond contains an embedded derivative that must be accounted for separately:

Single bond with multiple conversion options (Case A)
Multiple bonds each having single conversion option (Case B).

55-100 The Cases illustrate that the form of the financial instrument is important; paragraph 815-10-15-123 explains that individual instruments cannot be combined for evaluation purposes to circumvent compliance with the criteria beginning in paragraph 815-10-15-119. Further, paragraph 815-10-15-111(c) explains that contracts shall be evaluated on an individual basis, not on an aggregate-holdings basis.

Case A: Single Bond With Multiple Conversion Options

55-101 Investor A holds a convertible bond classified as an available-for-sale security under Topic 320. The bond has all of the following additional characteristics:

It is not exchange-traded and can be converted into common stock of the debtor, which is traded on an exchange.
It has a face amount of $100 million and is convertible into 10 million shares of common stock.
It may be converted in full or in increments of $1,000 immediately or at any time during the next 2 years.
If it were converted in a $1,000 increment, Investor A would receive 100 shares of common stock.

55-102 Assume further that the market condition for the debtor’s stock is such that up to 500,000 shares of its stock can be sold rapidly without the share price being significantly affected.

55-103 The embedded conversion option meets the criteria in paragraph 815-10-15-83(a) through (b) but does not meet the criteria in paragraphs 815-10-15-100 and 815-10-15-110, in part because the option is not traded and it cannot be separated and transferred to another party.

55-104 It is clear that the embedded equity conversion feature is not clearly and closely related to the debt host instrument.

55-105 The bond may be converted in $1,000 increments and those increments, by themselves, may be sold rapidly without significantly affecting price, in which case the criteria discussed beginning in paragraph 815-10- 15-119 would be met. However, if the holder simultaneously converted the entire bond, or a significant portion of the bond, the shares received could not be readily converted to cash without incurring a significant block discount.

55-106 From Investor A’s perspective, the conversion option should be accounted for as a compound embedded derivative in its entirety, separately from the debt host, because the conversion feature allows the holder to convert the convertible bond in 100,000 increments and the shares converted in each increment are readily convertible to cash under the criteria discussed beginning in paragraph 815-10-15-119. Investor A need not determine whether the entire bond, if converted, could be sold without affecting the price.

55-107 Because the $100 million bond is convertible in increments of $1,000, the convertible bond is essentially embedded with 100,000 equity conversion options, each with a notional amount of 100 shares. Each of the equity conversion options individually has the characteristic of net settlement discussed beginning in paragraph 815-10-15-119 because the 100 shares to be delivered are readily convertible to cash. Because the equity conversion options are not clearly and closely related to the host debt instrument, they must be separately accounted for. However, because an entity cannot identify more than 1 embedded derivative that warrants separate accounting, the 100,000 equity conversion options must be bifurcated as a single compound derivative. (Paragraphs 815-15-25-7 through 25-10 say an entity is not permitted to account separately for more than one derivative feature embedded in a single hybrid instrument.)

55-108 There is a substantive difference between a $100 million convertible debt instrument that can be converted into equity shares only at one time in its entirety and a similar instrument that can be converted in increments of $1,000 of tendered debt; the analysis of the latter should not presume equality with the former.

Case B: Multiple Bonds Each Having Single Conversion Option

55-109 Investor B has 100,000 individual $1,000 bonds that each convert into 100 shares of common stock. Assume those bonds are individual instruments but they were issued concurrently to Investor B.

55-110 From Investor B’s perspective, the individual bonds each contain an embedded derivative that must be separately accounted for. Each individual bond is convertible into 100 shares, and the market would absorb 100 shares without significantly affecting the price of the stock.

As discussed in Section 1.4.3.4.3, the evaluation of whether an embedded feature is RCC is performed on the basis of the smallest increment in which it can be settled under its contractual terms. ASC 815-10-55-101 through 55-108 contain an illustration of a $100 million bond that is convertible into 10 million shares of stock when the market can rapidly absorb 500,000 shares without a significant effect on the share price. If the terms of that bond permit the holder to convert the bond in $1,000 increments for 100 shares each, the embedded conversion feature would be considered RCC under ASC 815-10-55-119 even though the aggregate number of shares that would be issued if the holder converted the entire bond could not be readily converted to cash without incurring a significant block discount. If, under the above terms, the bond could only be converted at one time in its entirety, the equity conversion feature would not meet the net settlement characteristic since the stock market could not rapidly absorb 10 million shares of stock without a significant effect on the share price.

6.2.4.3.5 Features Physically Settled in Restricted Stock

ASC 815-10

15-131 Shares of stock in a publicly traded entity to be received upon the exercise of a stock purchase warrant do not meet the characteristic of being readily convertible to cash if both of the following conditions exist:

The stock purchase warrant is issued by an entity for only its own stock (or stock of its consolidated subsidiaries).
The sale or transfer of the issued shares is restricted (other than in connection with being pledged as collateral) for a period of 32 days or more from the date the stock purchase warrant is exercised.

15-132 Restrictions imposed by a stock purchase warrant on the sale or transfer of shares of stock that are received from the exercise of that warrant issued by an entity for other than its own stock (whether those restrictions are for more or less than 32 days) do not affect the determination of whether those shares are readily convertible to cash. The accounting for restricted stock to be received upon exercise of a stock purchase warrant shall not be analogized to any other type of contract.

15-133 Newly outstanding shares of common stock in a publicly traded company to be received upon exercise of a stock purchase warrant cannot be considered readily convertible to cash if, upon issuance of the shares, the sale or transfer of the shares is restricted (other than in connection with being pledged as collateral) for more than 31 days from the date the stock purchase warrant is exercised (not the date the warrant is issued), unless the holder has the power by contract or otherwise to cause the requirement to be met within 31 days of the date the stock purchase warrant is exercised.

15-134 In contrast, if the sale of an actively traded security is restricted for 31 days or less from the date the stock purchase warrants are exercised, that limitation is not considered sufficiently significant to serve as an impediment to considering the shares to be received upon exercise of those stock purchase warrants as readily convertible to cash.

15-135 The guidance that a restriction for more than 31 days prevents the shares from being considered readily convertible to cash applies only to stock purchase warrants issued by an entity for its own shares of stock, in which case the shares being issued upon exercise are newly outstanding (including issuance of treasury shares) and are restricted with respect to their sale or transfer for a specified period of time beginning on the date the stock purchase warrant is exercised.

15-136 However, even if the sale or transfer of the shares is restricted for 31 days or less after the stock purchase warrant is exercised, an entity still must evaluate both of the following criteria:

Whether an active market can rapidly absorb the quantity of stock to be received upon exercise of the warrant without significantly affecting the price
Whether the other estimated costs to convert the stock to cash are expected to be not significant. (The assessment of the significance of those conversion costs shall be performed only at inception of the contract.)

Thus, the guidance in paragraph 815-10-15-122 shall be applied to those stock purchase warrants with sale or transfer restrictions of 31 days or less on the shares of stock.

15-137 If the shares of an actively traded common stock to be received upon exercise of the stock purchase warrant can be reasonably expected to qualify for sale within 31 days of their receipt, such as may be the case under SEC Rule 144, Selling Restricted and Control Securities, or similar rules of the SEC, any initial sales restriction is not an impediment to considering those shares as readily convertible to cash, as that phrase is used in paragraph 815-10-15-119. (However, a restriction on the sale or transfer of shares of stock that are received from an entity other than the issuer of that stock through the exercise of another option or the settlement of a forward contract is not an impediment to considering those shares readily convertible to cash, regardless of whether the restriction is for a period that is more or less than 32 days from the date of exercise or settlement.)

As indicated in ASC 815-10-15-133, the shares that would be delivered upon the settlement of a conversion feature are not considered RCC if (1) their sale or transfer is restricted for a period of 32 days or more from the date on which the feature is exercised and (2) the holder does not have “the power by contract or otherwise to cause the requirement to be met within 31 days.” If the shares to be delivered are actively traded and can reasonably be expected to qualify for sale within 31 days, however, they may be considered RCC even if their sale or transfer is restricted (see ASC 815-10-15-137). However, the guidance on restricted stock does not apply to exchange features that restrict the sale or transfer of third-party stock that would be delivered upon settlement of an exchange feature (see ASC 815-10-15-132).

6.2.4.3.6 Ongoing Assessment

ASC 815-10

Case B: Initial Public Offering Makes Shares Readily Convertible to Cash After Contract Inception

55-87 A nontransferable forward contract on a nonpublic entity’s stock that provides only for gross physical settlement is generally not a derivative instrument because the net settlement criteria are not met. If the entity, at some point in the future, accomplishes an initial public offering of its shares and the original contract is still outstanding, the shares to be delivered would be considered to be readily convertible to cash (assuming that the shares under the contract could be rapidly absorbed in the market without significantly affecting the price).

Case C: Increased Trading Activity Makes Shares Readily Convertible to Cash After Contract Inception

55-88 A nontransferable forward contract on a public entity’s stock provides for delivery on a single date of a significant number of shares that, at the inception of the contract, would significantly affect the price of the public entity’s stock in the market if sold within a few days. As a result, the contract does not satisfy the readily-convertible-to-cash criterion. However, at some later date, the trading activity of the public entity’s stock increases significantly. Upon a subsequent evaluation of whether the shares are readily convertible to cash, the number of shares to be delivered would be minimal in relation to the new average daily trading volume such that the contract would then satisfy the net settlement characteristic.

Case D: Delisting Makes Shares Not Readily Convertible to Cash After Contract Inception

55-89 A nontransferable forward contract on a public entity’s stock meets the net settlement criteria (as discussed beginning in paragraph 815-10-15-119) in that, at inception of the contract, the shares are expected to be readily convertible to cash when delivered under the contract. Assume that there is no other way that the contract meets the net settlement criteria. The public entity subsequently becomes delisted from the stock exchange, thus causing the shares to be delivered under the contract to no longer be readily convertible to cash.

An entity should continually reassess whether an embedded feature meets the net settlement characteristic in the definition of a derivative. ASC 815-10-55-87 through 55-89 highlight that such reassessment might be required for the stock underlying a contract upon (1) its IPO, (2) a change in its market activity, or (3) its delisting.

6.2.5 Scope Exception for Certain Own Equity Contracts

As discussed in Section 2.3.11, ASC 815-10-15-74 describes a scope exception that can potentially be applied by an entity that issues a contract that is settleable in its own equity. The issuer of a convertible debt instrument should evaluate whether this scope exception may be applicable; however, this scope exception would never be available to the investor in the same instrument. See Deloitte’s Roadmap Contracts on an Entity’s Own Equity for a comprehensive discussion of the relevant guidance.

6.2.6 Scope Exception for Certain Share-Based Payment Transactions

ASC 815-10

15-74 Notwithstanding the conditions of paragraphs 815-10-15-13 through 15-139, the reporting entity shall not consider the following contracts to be derivative instruments for purposes of this Subtopic: . . .

b. Contracts issued by the entity that are subject to Topic 718. If any such contract ceases to be subject to Topic 718 in accordance with paragraphs 718-10-35-9 through 35-14, the terms of that contract shall then be analyzed to determine whether the contract is subject to this Subtopic. An award that ceases to be subject to Topic 718 in accordance with those paragraphs shall be analyzed to determine whether it is subject to this Subtopic. . . .

Share-based payment arrangements generally remain within the scope of ASC 718 throughout their lives, provided that they are not modified after they are issued to grantees.

Connecting the Dots

Convertible instruments granted to nonemployees in a share-based payment transaction remain within the scope of ASC 718 after vesting. A convertible instrument could become subject to the guidance in U.S. GAAP that applies to financial instruments only if (1) the instrument is modified after vesting and (2) the nonemployee is no longer providing goods or services or is no longer a customer (see ASC 718-10-35-10).

Footnotes

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

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.