Chapter 6 — Other Common Embedded Features

6.6 Features Related to Interest Rate, Credit Risk, or Inflation-Indexed Payments Embedded in an Equity Host

6.6.1 Background

In a manner similar to the types of features discussed in Sections 5.2, 5.3, and 5.4, interest rate, credit-risk, or inflation-indexed features may also be embedded in an equity host contract (e.g., preferred stock), although such features are less common.

6.6.2 Bifurcation Analysis

The table below presents an overview of the bifurcation analysis of an embedded feature that is based on an interest rate, interest rate index, inflation index, or the issuer’s credit risk and could adjust the cash flows of an equity 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	Typically, yes	The economic risks and characteristics associated with an equity host contract typically would not be clearly and closely related to the economic risks and characteristics of a stated or adjusted interest rate or inflation index or the creditworthiness of the issuer.
Hybrid instrument not measured at fair value through earnings on a recurring basis	It depends	From the issuer’s perspective, equity host contracts are not measured at fair value on a recurring basis since they are not eligible for the fair value option in ASC 815-15 or ASC 825-10. Legal form equity contracts that require liability classification (and thus are potentially subject to recurring fair value measurement) would not typically be considered equity hosts in the evaluation of embedded features. From the holder’s perspective, the determination of whether the hybrid instrument is measured at fair value, with changes in fair value recorded through earnings, depends 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	Yes	An interest-rate-, credit-risk-, or inflation-rate-related feature that adjusts the payments of an equity host contract meets the definition of a derivative for the same reasons that such a feature embedded in a debt host meets the definition of a derivative (see Sections 5.2.4, 5.3.4, and 5.4.4, respectively).
Meets a scope exception	No	No scope exception is available for features that are based solely on an interest rate or interest rate index, an issuer’s creditworthiness, or an inflation index.

As shown in the table above, an entity will typically conclude that an embedded feature requires bifurcation if it is based solely on an interest rate or interest rate index, an issuer’s creditworthiness, or an inflation index and could adjust the payments of an equity host contract. Such features generally meet the definition of a derivative and are not exempt from derivative accounting. From the investor’s perspective, an equity security recorded under ASC 321 would be recorded at fair value, with changes in fair value recorded through earnings, in which case bifurcation would not be required. Accordingly, the determination of whether bifurcation is required may vary depending on whether it is from the perspective of the issuer or of the investor/holder.

Example 6-11

Preferred Stock With a Dividend Adjustment Feature

Company C issued preferred stock on January 15, 20X2, that pays cumulative quarterly dividends at a 5 percent annual rate. If a business combination transaction is consummated after December 31, 20X2, the stated percentage for the dividend payment will increase by 1 percent (i.e., the “dividend rate adjustment”) in each month after the transaction. The preferred stock is redeemable at the option of the investor and therefore subject to remeasurement in accordance with the temporary equity guidance in ASC 480-10-S99-3A. Assume that C has asserted that the fair value of the dividend rate adjustment is less, by more than a nominal amount, than what would have been required to invest in a freestanding contract with a feature similar to the dividend rate adjustment feature.

The following analysis summarizes the evaluation of whether the dividend rate adjustment requires bifurcation from the equity host contract:

From the Issuer’s Perspective

Not clearly and closely related — Condition met. The economic characteristic of the dividend rate adjustment is not clearly and closely related to the equity host since an equity host would typically absorb variability rather than be protected from variability related to adverse events.
Not remeasured at fair value — Condition met. The preferred stock would not be subject to recurring fair value measurements, with changes in fair value recorded through earnings. (Importantly, even though the preferred stock is subject to remeasurement, the changes in its redemption value would typically be recorded through equity as dividends rather than through earnings.)
Meets the definition of a derivative — Condition met. To meet the definition of a derivative in accordance with ASC 815-10-15-83, the dividend rate adjustment must have all of the following:
- Underlying, notional amount, payment provision — The dividend rate adjustment has an underlying (i.e., the occurrence of a business combination transaction) and the payment of additional dividends (i.e., 1 percent for each month after December) as a payment provision.
- Initial net investment — As noted above, the fair value of the dividend rate adjustment is less, by more than a nominal amount, than what would have been required to invest in a freestanding contract with terms that are similar to those of the embedded feature. Thus, the condition above is met.
- Net settlement — The dividend rate adjustment results in a one-way delivery of cash to the holder of C’s preferred stock. Therefore, the dividend rate adjustment provides for contractual net settlement.
On the basis of the above analysis, the dividend rate adjustment has all the characteristics of a derivative instrument and therefore meets the bifurcation requirement in ASC 815-15-25-1(c).

Because all of the criteria in ASC 815-15-25-1 are met, the dividend rate adjustment requires bifurcation from the preferred stock as a derivative instrument.

From the Holder’s Perspective

From the perspective of the preferred stockholder, the only consideration that would be different from the analysis above is that in some cases the hybrid instrument may be recorded at fair value through earnings. The holder would account for its investment in C’s preferred stock as a debt security within the scope of ASC 320 since the preferred stock is redeemable at the option of the investor.2 If the holder accounts for its investment in C’s preferred stock at fair value, with changes in fair value recorded through earnings (i.e., as a trading security or under the fair value option), it would not bifurcate the dividend rate adjustment since the criterion in ASC 815-15-25-1(b) would not be met. Importantly, if the holder classifies the investment as an available-for-sale debt security, changes in fair value would be recorded through OCI and, therefore, the holder would be required to bifurcate the dividend rate adjustment from the host contract and record changes in its fair value through earnings.

Footnotes

The definition of a debt security in ASC 320 specifically includes investments in preferred stock that are redeemable at the investor’s option. In this example, it would not be appropriate to account for the preferred stock as an equity security within the scope of ASC 321.

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