Chapter 6 — Other Common Embedded Features

6.9 Revenue-Based Payments

6.9.1 Background

This section discusses payment features that are based on specified volumes of sales or service revenues. For example, some instruments require payments that are indexed to revenues from the sale of goods or services or from royalty income. In practice, we most commonly observe revenue-based payments in lease contracts, but it is also possible for such a feature to be embedded in a debt or equity host.

6.9.2 Bifurcation Analysis

The table below presents an overview of the bifurcation analysis of a payment feature indexed to specified volumes of sales or service revenues of one of the parties to the 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	Revenue-based payments are not clearly and closely related to a lease host contract (see discussion in Section 6.9.3). Revenue-based payments linked to specified volumes of sales or service revenues are also not clearly and closely related to a debt or equity host.
Hybrid instrument not measured at fair value through earnings on a recurring basis (see Section 4.3.3)	It depends	From the perspective of the lessor and the lessee, a lease host contract is not recorded at fair value through earnings on a recurring basis. From the issuer’s perspective, legal form 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 (1) an outstanding share that qualifies for equity presentation but was determined to have a debt host contract or (2) an equity host contract, the issuer would not measure the instrument at fair value, with changes in fair value recorded through earnings, on a recurring basis. From the perspective of a holder of a debt or equity host contract, the determination of whether the hybrid instrument is measured at fair value, with changes in fair value recorded through earnings, will depend on whether the instrument is (1) considered a debt security in the scope of ASC 320 (and the related classification of the debt security) or (2) an equity security in the scope of ASC 321.
Meets the definition of a derivative (see Section 4.3.4)	Yes	Payment features that are based on specified volumes of sales or service revenues meet the definition of a derivative (see Section 6.9.4).
Meets a scope exception (see Section 4.3.5)	It depends	ASC 815-10-15-59 and 15-60 contains a scope exception for non-exchange-traded contracts with payments based on specified volumes of sales or service revenues of one of the parties to the contract. See Section 2.3.5.3 for discussion of this scope exception.

As shown in the table above, the determination of whether a revenue-based payment feature requires bifurcation as an embedded feature will vary on the basis of the nature of the host contract, whether the hybrid instrument is remeasured at fair value through earnings, and whether the revenue-based payment feature is exempt from the scope of derivative accounting if a specific scope exception is met.

6.9.3 Clearly-and-Closely-Related Analysis

As indicated above, revenue-based payment features are most commonly identified in lease host contracts. An example of such a provision would be a scenario in which a lessee’s monthly lease payment is composed of a base component plus a sales component (e.g., a base fee of $100,000 plus 10 percent of the lessee’s total sales from that month). Aside from the likely application of a derivative scope exception, if an entity were to determine whether the payment feature is clearly and closely related to the lease host contract, it would conclude that the underlying nature and economics of the revenue-based payment is not clearly and closely related to the risks and rewards of a lease host. That is, the economic risks and rewards of a lease contract typically would not expose the lessee or lessor to the variability of the revenue of one party to the contract.

The economic characteristics and risks of a payment feature indexed to specified volumes or sales or service revenues would also not be considered clearly and closely related to the economic characteristics and risks of a debt instrument (i.e., interest rates, credit risk, and inflation rates). Similarly, revenue-based payment features are not generally considered to be clearly and closely related to an equity host because the risks and economics of such features do not align with the risks and economics of an equity holder. Although there may be a correlation between an entity’s revenues and its equity value, the economic risks and characteristics would typically not be sufficiently aligned so as to be considered clearly and closely related.

In practice, we would generally not expect an entity to perform this evaluation because revenue-indexed features will often meet the scope exception in ASC 815-10-15-59(d). Accordingly, an entity may not even need to consider whether the revenue-based payment is clearly and closely related to the host because the scope exception alone would indicate that bifurcation is not required (see Example 2-13 for illustration of this scope exception).

6.9.4 Derivative Analysis

The table below presents an analysis of whether a payment feature indexed to specified volumes of sales or service revenues 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 feature that could adjust the payments of a contract on the basis of specified volumes of sales or service revenues has both an underlying (specified volumes of sales or service revenues) and a notional amount (e.g., the debt’s outstanding amount, number of shares) or a 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 feature on a stand-alone basis without the host contract). Generally, a feature that adjusts the payments of a contract on the basis of specified volumes of sales or service revenues 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 value of the specified volumes of sales or service revenues (since the investment in the host contract does not form part of the initial net investment in the embedded feature).
Net settlement (see Section 1.4.3)	Yes	Adjustments to the payments of a host contract on the basis of specified volumes of sales or service revenues meet the net settlement condition because the feature is cash settled (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 payment feature indexed to specified volumes of sales or service revenues typically meets the definition of a derivative. However, such a feature often qualifies for a scope exception. Section 2.3.5.3 includes a variety of examples for which this scope exception applies.

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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.