Chapter 6 — Other Common Embedded Features
Chapter 6 — Other Common Embedded Features
6.1 Overview
As previously discussed in Chapter
4, ASC 815-15 outlines specific criteria that an entity must consider
when determining whether an embedded feature should be bifurcated from its host
contract. Chapter 5 addresses the application
of ASC 815-15 to embedded features that are commonly observed but unique to debt
host contracts. This chapter discusses the application of the guidance to other
types of common embedded features observed in debt, equity, lease, or other host
contracts. Although the concepts and examples discussed represent those that are
most commonly observed in practice, they are not intended to be all-inclusive with
respect to the types of instruments and embedded features that could exist.
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
6.3 Conversion Features in an Equity Host
6.3.1 Background
An equity instrument often contains features that require or permit the
instrument to be converted into another form of the issuer’s equity. The most
common scenario is a preferred stock agreement that contains a feature allowing
holders to convert their preferred shares into common stock (1) at the option of
one of the parties to the contract, (2) upon the occurrence of certain events,
or (3) after a certain period of time. As discussed in greater detail below,
equity conversion features generally do not require bifurcation from an equity
host contract because such features are considered clearly and closely related
to the host contract.
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 original issuance price of the preferred stock plus accrued
and unpaid dividends) 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. (An instrument issued in the form of an equity share [e.g., preferred
stock] should also be evaluated to determine 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.) For further discussion of how to evaluate embedded
redemption features in an equity host contract for bifurcation, see Section 6.5.
Example 6-4
Preferred Stock Settleable for Variable Number of
Shares Upon a Qualified Equity Financing
Tech Co. issues preferred stock that includes a feature
that calls for “conversion” into the issuer’s common
stock upon a qualified equity financing. The conversion
price is defined as 85 percent of the per-share price of
common stock in the qualified equity offering. Assume
that the preferred stock contains an equity host for the
purpose of performing the evaluation of embedded
features for bifurcation.
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
an equity host 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. Rather, this feature provides
the holder with a fixed payoff and therefore should be
evaluated under ASC 815-15 as a contingent redemption
option; it would not be evaluated as a conversion
feature even though it is settled in the issuer’s equity
shares.
See Example 6-10 for further
discussion of whether this feature would require
bifurcation.
6.3.2 Bifurcation Analysis
The table below presents an overview of the bifurcation analysis
of equity conversion features embedded in an equity host contract. As previously
noted, 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)
|
No
|
A conversion feature that allows a
hybrid instrument in the form of a share (e.g.,
preferred stock) to be converted into another type of
the entity’s equity (e.g., common stock) is considered
clearly and closely related to the equity host contract.
In addition, cash-settled conversion features are
similarly typically considered clearly and closely
related to an equity host since the monetary value of
the cash conversion is based on the value of the equity
shares.
|
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, equity
host contracts would not be 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, 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 conversion of a hybrid instrument in
the form of a share (e.g., preferred stock) into another
form of an entity’s equity may meet the definition of a
derivative if both the host contract and the instrument
issued are RCC. In addition, the feature may meet the
definition of a derivative if the conversion feature
could be settled in cash. See Section 6.3.4 for
further details.
|
Meets a scope exception
|
It depends
|
The issuer should evaluate whether the equity conversion
feature meets the scope exception for certain contracts
on own equity or share-based payment transactions.
Conversion features that can be cash settled in a manner
outside the issuer’s control would generally not qualify
for this scope exception.
|
6.3.3 Clearly-and-Closely-Related Analysis
A conversion feature that allows a hybrid instrument in the form of a share
(e.g., preferred stock) to be converted into another type of an entity’s equity
(e.g., common stock) is considered clearly and closely related to an equity host
contract. In addition, a conversion feature that can be settled in cash or
shares would also be considered clearly and closely related to the host contract
because the monetary value of the conversion, regardless of the form of
settlement, is based on the monetary value of the equity shares. Accordingly,
cash-settled conversion features are also typically considered clearly and
closely related to an equity host.
Because the “not clearly and closely related” criterion is
generally not met for conversion features in an equity host contract, most
entities would not be required to evaluate whether the conversion feature meets
the definition of a derivative. Despite that practicality, we discuss the
derivative considerations for illustrative purposes in the following
section.
6.3.4 Derivative Analysis
The table below presents the characteristics that would be
evaluated to determine whether an equity conversion feature embedded in an
equity host would meet the definition of a derivative. In a manner consistent
with conversion features in a debt host, the determination often comes down to
whether or not the feature meets the net settlement criterion.
Characteristics of a Derivative
|
Characteristic Present?
|
Analysis
|
---|---|---|
Underlying and notional amount or payment provision
|
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
|
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
equity host contract does not form part of the initial
net investment in the embedded feature).
|
Net settlement
|
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.
Shares of publicly traded entities may be considered
RCC; however, non-publicly-traded shares will never be
considered RCC (see Section 1.4.3.4
for further discussion of 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. See Section 6.2.4.3
for further discussion of net settlement considerations
for equity conversion features.
|
6.3.5 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 to an
entity that issues a contract that is settleable in its own equity. The issuer
of a convertible equity 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. In other words, a company that issues preferred
stock that is convertible into shares of common stock may potentially be
eligible for this scope exception, but the investor in the same convertible
preferred stock instrument would not be eligible for such exception.
See Deloitte’s Roadmap Contracts on an Entity’s Own
Equity for a comprehensive discussion of the relevant
guidance.
6.3.6 Scope Exception for Certain Share-Based Payment Transactions
As referenced in Section 6.2.6, ASC
815-10-15-74(b) indicates that a contract issued by an entity that is subject to
ASC 718 would not be subject to the guidance in ASC 815. Under ASC 718,
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.
6.4 Call, Put, and Other Redemption Features in Debt Hosts
6.4.1 Background
Debt host contracts often contain features that could permit the issuer to call
(or prepay) the outstanding amount or allow the holder to put (or accelerate the
repayment of) the outstanding amount. Such contracts might also contain features
that trigger an acceleration of the due date for the repayment of the instrument
upon the occurrence or nonoccurrence of a specified event or events (e.g., an
event of default or change of control). We discuss application issues related to
such features embedded in equity host contracts in Section 6.5.
Connecting the Dots
Recently, we have seen an increase in debt instruments
with features linked to environmental, social, and governance (ESG)
factors. In such instruments, the due date may be accelerated, deferred,
or triggered by the occurrence or nonoccurrence of a specified
environmental event or events. For ESG-linked debt instruments with this
type of feature, the determination of whether the feature requires
bifurcation often depends on whether the redemption feature is clearly
and closely related to the debt host under the four-step decision
sequence in ASC 815-15-25-42, as discussed in Section 6.4.3.
6.4.2 Bifurcation Analysis
The table below presents an overview of the bifurcation analysis
of redemption features 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 debtor should evaluate whether the redemption feature
is clearly and closely related to the debt host under
the four-step decision sequence in ASC 815-15-25-41.
|
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, 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 in fair value
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 an equity security within the scope of
ASC 321.
|
Meets the definition of a derivative (see Section 4.3.4)
|
Yes
|
A redemption feature embedded in a debt host meets the
definition of a derivative irrespective of whether the
debt host contract is RCC.
|
Meets a scope exception (see Section 4.3.5)
|
No
|
There is no specific scope exception for redemption
features embedded in a debt host.
|
As shown in the table above, the determination of whether a
redemption 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 records the hybrid instrument at fair
value, with changes in fair value recorded through earnings. Such features meet
the definition of a derivative and are not exempt from the scope of derivative
accounting.
6.4.3 Clearly-and-Closely-Related Analysis
ASC Master Glossary
Prepayable
Able to be settled by either party before its scheduled
maturity.
ASC 815-15
25-41 Call
(put) options that do not accelerate the repayment of
principal on a debt instrument but instead require a
cash settlement that is equal to the price of the option
at the date of exercise would not be considered to be
clearly and closely related to the debt instrument in
which it is embedded.
25-42 The following
four-step decision sequence shall be followed in
determining whether call (put) options that can
accelerate the settlement of debt instruments shall be
considered to be clearly and closely related to the debt
host contract:
Step 1: Is the
amount paid upon settlement (also referred to as the
payoff) adjusted based on changes in an index? If yes,
continue to Step 2. If no, continue to Step 3.
Step 2: Is the
payoff indexed to an underlying other than interest
rates or credit risk? If yes, then that embedded feature
is not clearly and closely related to the debt host
contract and further analysis under Steps 3 and 4 is not
required. If no, then that embedded feature shall be
analyzed further under Steps 3 and 4.
Step 3: Does the
debt involve a substantial premium or discount? If yes,
continue to Step 4. If no, further analysis of the
contract under paragraph 815-15-25-26 is required, if
applicable.
Step 4: Does a
contingently exercisable call (put) option accelerate
the repayment of the contractual principal amount? If
yes, the call (put) option is not clearly and closely
related to the debt instrument. If not contingently
exercisable, further analysis of the contract under
paragraph 815-15-25-26 is required, if applicable.
ASC 815-15-25-41 and 25-42 address whether embedded call or put
options are clearly and closely related to a debt host contract and apply to all
features that can accelerate the settlement of a debt instrument regardless of
(1) whether such acceleration is optional or mandatory and (2) how such features
are described in the debt’s contractual terms. As shown in the decision tree
below, ASC 815-15-25-42 identifies four steps that should be performed in the
analysis of whether a feature that can accelerate the settlement of a debt
instrument is clearly and closely related to a debt host contract.
In practice, a discount or premium that is 10 percent or more is considered
“substantial” in the analysis performed under step 3. In determining whether a
substantial premium or discount exists, an entity should compare the debt’s
initial net carrying amount to the potential payoff if the embedded call, put,
or other redemption feature is triggered. Accordingly, an entity should base its
analysis on the amount allocated to the debt for accounting purposes rather than
the total cash proceeds (e.g., if debt was issued with detachable warrants, the
amount allocated to the warrants could cause a discount on the debt).
Nevertheless, an entity should not consider a discount that results from one of
the following in its determination of whether the debt involves a substantial
discount or premium under ASC 815-15-25-42:
-
Third-party debt issuance costs that have been deducted from the initial carrying amount.
-
A discount that results from the separation of an embedded derivative under ASC 815-15.
An entity should consider the payoff of the embedded feature being analyzed in
determining whether the debt instrument was issued at a substantial premium or
discount. For example, if a debt instrument that was issued at par contains a
put option that allows the investor to redeem the instrument at 112 percent of
par value, the debt instrument would be considered to involve a substantial
premium. Similarly, if a debt instrument was issued at 90 percent of par and is
redeemable at par, the debt is considered to involve a substantial discount.
However, unpaid accrued interest does not form part of the analysis of whether a
substantial premium or discount exists.
Importantly, the debtor performs the tests as of the date on
which it initially recognizes the debt and does not subsequently reassess the
tests. The investor (or creditor) performs the tests 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 and would similarly
not perform subsequent reassessment. Accordingly, it is possible that the
investor’s application of the tests would have a different result than the
initial evaluation performed by the debtor 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.
The following table outlines and illustrates the application of the four steps in
ASC 815-15-25-42:
Steps
|
Examples of Terms That Would Result in a “Yes” Answer
|
Examples of Terms That Would Result in a “No” Answer
|
---|---|---|
“Step 1: Is the amount paid upon settlement (also
referred to as the payoff) adjusted based on changes in
an index? If yes, continue to Step 2. If no, continue to
Step 3.”
|
|
|
“Step 2: Is the payoff indexed to an underlying other
than interest rates or credit risk? If yes, then that
embedded feature is not clearly and closely related to
the debt host contract and further analysis under Steps
3 and 4 is not required. If no, then that embedded
feature shall be analyzed further under Steps 3 and
4.”
|
|
|
“Step 3: Does the debt involve a substantial premium or
discount? If yes, continue to Step 4. If no, further
analysis of the contract under paragraph 815-15-25-26 is
required, if applicable” (see Section
5.2.3).
|
|
|
“Step 4: Does a contingently exercisable call (put)
option accelerate the repayment of the contractual
principal amount? If yes, the call (put) option is not
clearly and closely related to the debt instrument. If
not contingently exercisable, further analysis of the
contract under paragraph 815-15-25-26 is required, if
applicable” (see Section
5.2.3).
|
|
|
As noted in steps 2, 3, and 4 of the decision sequence in ASC 815-15-25-42, an
entity might be required to consider the applicability of ASC 815-15-25-26 to an
embedded call, put, or other redemption feature. ASC 815-15-25-26 applies to
embedded derivatives “in which the only underlying is an interest rate or
interest rate index . . . that alters net interest payments that otherwise would
be paid or received on an interest-bearing [debt] host contract” (see Section
5.2.3.1). An option that can be exercised only upon the occurrence or
nonoccurrence of a specified event (e.g., an IPO or a change in control at the
issuer) would always have a second underlying (the occurrence or nonoccurrence
of the specified event). The existence of this second underlying would exclude
such a contract from the scope of ASC 815-15-25-26 unless the event is solely
related to interest rates (e.g., a call that may only be exercised when LIBOR is
at or above 5 percent) because the underlying would never be only an interest
rate or interest rate index (see Section 5.2.3.2).
Example 6-5
Debt That Is Puttable Upon a Change in Control
Entity A issues a 10-year note at par, which becomes
puttable to the issuer at 102 percent of par plus
accrued interest, if a change in control occurs at
A.
As shown in the table below, A must apply the four-step
decision sequence in ASC 815-15-25-42 to evaluate
whether the embedded put option is clearly and closely
related to the debt host.
Example
|
Indexed Payoff? (Steps 1 and 2)
|
Substantial Discount or Premium? (Step 3)
|
Contingently Exercisable? (Step 4)
|
Embedded Option Clearly and Closely
Related?
|
---|---|---|---|---|
Debt issued at par is puttable at 102 percent
of par, plus accrued interest, in the event of a
change in control at A.
|
No. The amount paid upon settlement is not
“adjusted based on changes in an index.” The
payoff amount is fixed at 102 percent of par, plus
accrued interest.
|
No. The debt is issued at par and puttable for
a premium that is not substantial.
|
N/A. Analysis is not required because the
answer to step 3 is no (i.e., no substantial
discount or premium).
|
Yes. The embedded put option is clearly and
closely related to the debt host.
ASC 815-15-25-26 does not apply because the
change in control is considered a second
underlying that is not an interest rate or an
interest rate index.
|
Example 6-6
Interest Make-Whole Premium That Becomes Payable Upon
Exercise of Call Option
Entity X has issued a debt security, which includes a
call option that permits X to prepay the outstanding
amount of principal and accrued interest at any time
before the debt’s maturity. If X calls the debt security
before its maturity date, it is required to also pay an
interest make-whole premium equal to the present value
of the debt’s remaining interest cash flows discounted
at a fixed spread over the current U.S. Treasury rate as
of the date on which the debt is settled. However, X
could not be required to pay an interest make-whole
premium in excess of 5 percent of the principal
amount.
The interest make-whole premium is considered an integral
component of the call option; it is not a distinct
embedded feature that requires separate evaluation under
ASC 815-15. When assessing whether the call option is
clearly and closely related to its host, the issuer
first should look to the four-step decision sequence in
ASC 815-15-25-42.
Example
|
Indexed Payoff? (Steps 1 and 2)
|
Substantial Discount or Premium? (Step 3)
|
Contingently Exercisable? (Step 4)
|
Embedded Option Clearly and Closely
Related?
|
---|---|---|---|---|
Debt security issued at par is callable at par
plus an interest make-whole premium that may not
exceed 5 percent of the principal amount.
|
Yes. The amount paid upon settlement is
adjusted on the basis of changes in the
then-current U.S. Treasury rate. The calculation
of the interest make-whole premium includes the
U.S. Treasury rate.
The payoff is not, however, indexed to an
underlying other than interest rates or credit
risk.
|
No. The debt was issued at par and the interest
make-whole premium cannot exceed 5 percent of the
principal amount.
|
N/A. Analysis is not required because the
answer to the question in step 3 is no (i.e., no
substantial discount or premium).
|
Yes. The embedded call option, including the
interest make-whole provision, is clearly and
closely related to the debt host.
ASC 815-15-25-26 applies since the interest
make-whole premium is indexed to an interest
rate.
Under ASC 815-15-25-26(a), there is no
circumstance in which the investor would not
contractually recover its initial investment if
the issuer exercises the call option because the
repayment amount will exceed the principal amount,
and the debt was issued at par.
ASC 815-15-25-26(b) does not apply. ASC
815-15-25-37 states that this condition does “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.”
|
ASC 815-15
55-13 The following table
demonstrates the application of the four-step decision
sequence in paragraph 815-15-25-42 for determining
whether call options and put options that can accelerate
the settlement of debt instruments should be considered
to be clearly and closely related to the debt host
contract under the criterion in paragraph
815-15-25-1(a).
Instrument
|
Indexed Payoff? (Steps 1 and 2)
|
Substantial Discount or Premium? (Step 3)
|
Contingently Exercisable? (Step 4)
|
Embedded Option Clearly and Closely
Related?
|
---|---|---|---|---|
1. Debt that is issued at a substantial
discount is callable at any time during its
10-year term. If the debt is called, the investor
receives the par value of the debt plus any unpaid
and accrued interest.
|
No.
|
Yes.
|
No.
|
The embedded call option is clearly and closely
related to the debt host contract because the
payoff is not indexed, and the call option is not
contingently exercisable.
|
2. Debt that is issued at par is callable at
any time during its 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).
|
Yes, based on an equity price.
|
N/A. Analysis not
required.
|
N/A. Analysis not
required.
|
The embedded call option is not clearly and
closely related to the debt host contract because
the payoff is indexed to an equity price.
|
3. Debt that is issued at par is puttable if
the Standard and Poor’s S&P 500 Index
increases by at least 20 percent. If the debt is
put, the investor receives the par amount of the
debt adjusted for the percentage increase in the
S&P 500.
|
Yes, based on an equity index (S&P
500).
|
N/A. Analysis not
required.
|
N/A. Analysis not
required.
|
The embedded put option is not clearly and
closely related to the debt host contract because
the payoff is indexed to an equity price.
|
4. Debt that is issued at a substantial
discount is puttable at par if London Interbank
Offered Rate (LIBOR) either increases or decreases
by 150 basis points.
|
No.
|
Yes.
|
Yes, contingent on a movement
of LIBOR of at least 150 basis points.
|
The put option is not clearly
and closely related to the debt host contract
because the debt was issued at a substantial
discount and the put option is contingently
exercisable.
|
5. Debt that is issued at a substantial
discount is puttable at par in the event of a
change in control.
|
No.
|
Yes.
|
Yes, contingent on a change in
control.
|
The put option is not clearly
and closely related to the debt host contract
because the debt was issued at a substantial
discount and the put option is contingently
exercisable.
|
6. Zero coupon debt is issued at a substantial
discount and is callable in the event of a change
in control. If the debt is called, the issuer pays
the accreted value (calculated per amortization
table based on the effective interest rate
method).
|
No.
|
Yes.
|
Yes, contingent on a change in
control, but since the debt is callable at
accreted value, the call option does not
accelerate the repayment of principal.
|
The call option is clearly and closely related
to the debt host contract. Although the debt was
issued at a substantial discount and the call
option is contingently exercisable, the call
option does not accelerate the repayment of
principal because the debt is callable at the
accreted value.
|
7. Debt that is issued at par
is puttable at par in the event that the issuer
has an initial public offering.
|
No.
|
No.
|
N/A. Analysis not required.
|
The embedded put option is clearly and closely
related to the debt host contract because the debt
was issued at par (not at a substantial discount)
and is puttable at par. Paragraph 815-15-25-26
does not apply.
|
8. Debt that is issued at par
is puttable if the price of the common stock of
Entity XYZ (an entity unrelated to the issuer or
investor) changes by 20 percent. If the debt is
put, the investor will be repaid based on the
value of Entity XYZ’s common stock.
|
Yes, based on an equity price (price of Entity
XYZ’s common stock).
|
N/A. Analysis not required.
|
N/A. Analysis not required.
|
The embedded put option is not clearly and
closely related to the debt host contract because
the payoff is indexed to an equity price.
|
9. Debt is issued at a slight discount and is
puttable if interest rates move 200 basis points.
If the debt is put, the investor will be repaid
based on the S&P 500.
|
Yes, based on an equity index (S&P
500).
|
N/A. Analysis not required.
|
N/A. Analysis not required.
|
The embedded put option is not clearly and
closely related to the debt host contract because
the payoff is based on an equity index.
|
Connecting the Dots
As discussed in Section 4.4.4.1,
when a contract is modified, it must be reassessed to identify and
evaluate any embedded derivatives for potential bifurcation. This
analysis is more complex in a modification of a debt instrument that is
accounted for as a troubled debt restructuring. See Section 11.4.4.5 of Deloitte’s Roadmap
Issuer’s Accounting for
Debt for additional details.
6.4.4 Derivative Analysis
6.4.4.1 General
The table below presents an analysis of whether a redemption
feature embedded in a debt host contract meets the definition of a
derivative. 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 redemption feature has both an underlying (interest
rates and, if applicable, the occurrence or
nonoccurrence of any exercise contingency and any
other underlyings that adjust the redemption amount)
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 redemption feature on a
stand-alone basis without the host contract).
Generally, a redemption feature has an initial net
investment that is smaller than would be required
for a direct investment that pays the redemption
amount (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
|
The potential settlement that would occur upon the
exercise of the redemption feature in a debt host
contract always meets the net settlement condition
because neither party is required to deliver an
asset that is associated with the underlying.
|
As shown in the table above, a redemption 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 considered clearly and closely related to
the debt host contract unless the entity records the hybrid instrument at
fair value, with changes in fair value recorded through earnings.
6.4.4.2 Net Settlement Analysis
ASC 815-10
Net Settlement of a Debt Instrument Through
Exercise of an Embedded Put Option or Call
Option
15-107 The potential
settlement of the debtor’s obligation to the
creditor that would occur upon exercise of a put
option or call option embedded in a debt instrument
meets the net settlement criterion as discussed
beginning in paragraph 815-10-15-100 because neither
party is required to deliver an asset that is
associated with the underlying. Specifically:
-
The debtor does not receive an asset when it settles the debt obligation in conjunction with exercise of the put option or call option.
-
The creditor does not receive an asset associated with the underlying.
15-108 The guidance in the
preceding paragraph shall be applied under both of
the following circumstances:
-
When applying paragraph 815-15-25-1(c) to a put option or call option (including a prepayment option) embedded in a debt instrument
-
When analyzing the net settlement criterion (see guidance beginning in paragraph 815-10-15-100) for a freestanding call option held by the debtor on its own debt instrument and for a freestanding put option issued by the debtor on its own debt instrument.
15-109 The guidance in
paragraph 815-10-15-107 shall not be applied under
either of the following circumstances:
-
To put or call options that are added to a debt instrument by a third party contemporaneously with or after the issuance of a debt instrument. (In that circumstance, see paragraph 815-10-15-6.)
-
By analogy to an embedded put or call option in a hybrid instrument that does not contain a debt host contract.
ASC 815-10-15-107 through 15-109 indicate that the potential settlement of a
debtor’s obligation to the creditor that would occur upon the exercise of a
put or call option (including a prepayment option) embedded in a debt
instrument meets the net settlement condition in ASC 815-10-15-100, which
states, in part, that “neither party is required to deliver an asset that is
associated with the underlying and that has a principal amount, stated
amount, face value, number of shares, or other denomination that is equal to
the notional amount.”
Accordingly, a call, put, or other redemption feature that
is embedded in a debt host meets the net settlement characteristic in the
definition of a derivative irrespective of whether the debt host contract is
RCC. For instance, such a feature is considered to meet the net settlement
characteristic even if it is embedded in a loan or debt security that does
not have an observable price. Further, a call, put, or other redemption
feature embedded in a debt host meets the net settlement characteristic even
if it is settled in a form other than cash.
Traditionally, the settlement of a debt obligation upon the exercise of a put
or call results in the creditor’s receipt of cash in exchange for tendering
the debt obligation. However, in some circumstances, the debtor either is
required or has the option to settle the redemption by delivering a number
of shares of its own stock with a value equal to a predetermined dollar
amount. An embedded redemption feature in a hybrid financial instrument with
a debt host that may be settled with the issuer’s shares always meets the
net settlement characteristic under the guidance in ASC 815-10-15-107 on put
or call options in debt host contracts. In the evaluation under ASC
815-10-15-107(b) of a share-settled put, call, or redemption feature
embedded in a debt host contract, the assets being delivered to the holder
upon the settlement of the feature are 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. The guidance in ASC 815-10-15-107 through 15-109 does not apply to
calls, puts, and other redemption features that are embedded in equity host
contracts.
Example 6-7
Notes That Are Automatically Converted Into Shares
Upon a Qualifying Equity Offering
Company XYZ issues $1 million of notes to an investor
group. According to the terms of the notes, XYZ is
required to pay interest semiannually at a rate of 8
percent per annum. Principal on the notes is due at
maturity, which is two years after issuance. Upon a
qualifying equity offering (one in which XYZ raises
at least $10 million of equity), the notes are
automatically converted into shares sold in the
qualifying equity offering. The conversion price
equals 80 percent of the price per share of the
qualifying equity offering. For example, if XYZ
issued $10 million of Series D preferred stock at
$10 per share, the notes would be converted into
Series D preferred stock at $8 per share.
The automatic conversion upon a
qualifying equity offering is economically a
contingent redemption of the notes for $1.25 million
(i.e., $10,000,000 ÷ $8). However, the investors do
not receive $1.25 million in cash; rather, the
redemption feature is settled in shares of XYZ with
a value of $1.25 million.
The redemption feature would not be
considered clearly and closely related to the debt
host because it is a contingent redemption and
involves a significant premium relative to the
amount paid by the investors — $1.25 million
compared with $1 million (see ASC 815-15-25-42). ASC
815-15-25-26 is not applicable because this is a
contingent redemption whose underlying is an event
(i.e., not an interest rate or interest rate
index-only underlying). Assuming that the debt is
not remeasured at fair value, with changes in fair
value recognized in earnings, XYZ would be required
to bifurcate the redemption option because a
separate instrument with the same terms would be
subject to derivative accounting under ASC 815.
In the evaluation of the net
settlement condition under ASC 815-10-15-107(b), the
assets being delivered to the holder of the debt
instrument are shares of the issuer, which are not
associated with any underlying because the value of
the shares to be delivered is a fixed dollar amount.
In other words, even though the shares to be issued
to the investor group are related to the event that
triggers redemption (i.e., the shares delivered are
the same shares issued in the qualifying equity
offering) and an event is considered an underlying,
the holder is indifferent to changes in the value of
any of the issuer’s equity shares during the time
between debt issuance and the triggering of the
redemption feature because the holder will receive a
fixed dollar amount once the redemption is
triggered. Therefore, with respect to the condition
in ASC 815-10-15-107(b), the shares are not
associated with any underlying, regardless of
whether the underlying shares are RCC.
From XYZ’s perspective, the embedded redemption
feature related to the automatic conversion upon a
qualifying equity offering must be bifurcated from
the host contract and accounted for as a derivative
liability because all three criteria for bifurcation
are met.
From the perspective of the
investors in XYZ’s notes, whether the embedded
redemption feature requires bifurcation will depend
on whether the investor has classified the debt
security as a trading security or under the fair
value option. If the investor records the full
investment at fair value, with changes recorded
through earnings, bifurcation of the embedded
feature would not be required.
Example 6-8
Convertible Debt With a Share-Settled Redemption
Feature
An entity has issued a debt instrument with a
principal amount of $10 million that is
automatically converted into the issuer’s equity
shares upon an IPO. The conversion price is the
lower of 80 percent of the stock price in the IPO or
$50. Although the conversion price in this scenario
is reduced to the IPO price if the IPO price is
below $50, the potential adjustment is not a
down-round feature because the associated settlement
has a monetary value equal to a fixed monetary
amount ($10,000,000 ÷ 80% = $12,500,000). The entity
should evaluate this share-settled redemption
feature in a manner similar to how it evaluates a
put or call option embedded in a debt host contract
to determine whether the feature must be separated
as a derivative under ASC 815-15.
6.5 Call, Put, and Other Redemption Features in Equity Hosts
6.5.1 Background
Redemption features in an equity host can take many potential forms, including
put and call options and share-settled redemption options. Such redemption
features could be exercisable (1) at the option of the holder or the issuer or
(2) automatically upon the occurrence of certain contingent events. An entity
should understand the specific terms and provisions of the redemption feature
before evaluating whether it is clearly and closely related to the equity host.
We discuss application issues related to such features embedded in debt host
contracts in Section
6.4.
Equity host contracts often contain a provision related to
liquidation preference, which stipulates the amount of cash or other assets a
holder of the equity shares would receive upon the final liquidation or winding
up of the entity (i.e., an “ordinary liquidation”). The existence of a
liquidation preference provision does not in itself represent an embedded
feature that must be evaluated for possible bifurcation. However, if redemption
would occur upon certain “deemed liquidation events” that do not result in the
cessation of the entity’s operations, such as a change of control or sale of the
issuer, the entity would be required to evaluate the provision as a possible
embedded derivative.
6.5.2 Bifurcation Analysis
The table below presents an overview of the bifurcation analysis
of redemption features embedded in an equity host contract. 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
|
Yes
|
Put and call options are not considered
clearly and closely related to an equity host contract
since the risks and rewards of a fixed settlement upon
redemption are not clearly and closely related to the
risks and rewards of an equity interest. In the
evaluation of this criterion, an entity should consider
the payoff profile of the settlement (see Section
4.2.2) rather than the form of settlement
(i.e., cash versus shares).
|
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
|
It depends
|
The determination of whether a
redemption feature embedded in an equity host meets the
definition of a derivative often depends on whether the
feature meets the net settlement criterion —
specifically, whether the underlying instrument (e.g.,
preferred stock) is RCC. The gross exchange of an equity
host instrument that is not RCC for cash does not
inherently meet the net settlement criterion.
|
Meets a scope exception
|
No
|
From the issuer’s perspective, the
issuer should evaluate whether the redemption feature
meets the scope exception for certain contracts on an
issuer’s own equity. For example, a redemption feature
that allows the issuer to call an equity instrument at a
fixed price (i.e., a physically settled reacquisition of
its own equity) may meet this exception if the option
doesn’t fail any of the criteria in ASC 815-40 (see
Section 2.3.11).
From the holder’s perspective, a scope exception is not
applicable.
|
6.5.3 Clearly-and-Closely-Related Analysis
ASC 815-15
25-20 A put option that
enables the holder to require the issuer of an equity
instrument (which has been deemed to contain an equity
host contract in accordance with paragraphs
815-15-25-17A through 25-17D) to reacquire that equity
instrument for cash or other assets is not clearly and
closely related to that equity instrument. Thus, such a
put option embedded in a publicly traded equity
instrument to which it relates shall be separated from
the host contract by the holder of the equity instrument
if the criteria in paragraph 815-15-25-1(b) through (c)
are also met. That put option also shall be separated
from the host contract by the issuer of the equity
instrument except in those circumstances in which the
put option is not considered to be a derivative
instrument pursuant to paragraph 815-10-15-74(a) because
it is classified in stockholders’ equity. A purchased
call option that enables the issuer of an equity
instrument (such as common stock) to reacquire that
equity instrument would not be considered to be a
derivative instrument by the issuer of the equity
instrument pursuant to that paragraph. Thus, if the call
option were embedded in the related equity instrument,
it would not be separated from the host contract by the
issuer. However, for the holder of the related equity
instrument, the embedded written call option would not
be considered to be clearly and closely related to the
equity instrument, if the criteria in paragraph
815-15-25-1(b) through (c) were met, and shall be
separated from the host contract.
Put and call options are not considered clearly and closely
related to an equity host contract because the economic risks and
characteristics of redemption features are not the same as the economic risks
and characteristics of an equity instrument. In determining whether a put or
call option is considered clearly and closely related to an equity host, an
entity should consider the payoff profile of the settlement (see Section 4.2.2) rather
than whether the redemption is settled in cash or shares.
For example, a share-settled redemption that results in the
delivery of a variable number of shares on the basis of a fixed value would be
evaluated as a redemption feature (and not as a conversion feature). A
share-settled redemption feature would not be considered clearly and closely
related to an equity host contract, even though the contract is settled by
delivery of the entity’s equity shares. Since the share-settled redemption would
be based on a fixed monetary value payable in a variable number of shares, the
economic risks and characteristics of such feature does not expose the holder to
the variability of the underlying equity. Inversely, a cash conversion feature
would typically be considered clearly and closely related to an equity host
because the conversion value exposes the holder to similar risks and
characteristics as those of an equity holder.
6.5.4 Derivative Analysis
ASC 815-10
15-107 The potential
settlement of the debtor’s obligation to the creditor
that would occur upon exercise of a put option or call
option embedded in a debt instrument meets the net
settlement criterion as discussed beginning in paragraph
815-10-15-100 because neither party is required to
deliver an asset that is associated with the underlying.
Specifically:
-
The debtor does not receive an asset when it settles the debt obligation in conjunction with exercise of the put option or call option.
-
The creditor does not receive an asset associated with the underlying.
15-109 The guidance in
paragraph 815-10-15-107 shall not be applied under
either of the following circumstances:
-
To put or call options that are added to a debt instrument by a third party contemporaneously with or after the issuance of a debt instrument. (In that circumstance, see paragraph 815-10-15-6.)
-
By analogy to an embedded put or call option in a hybrid instrument that does not contain a debt host contract.
As outlined in ASC 815-10-15-107 and ASC 815-10-15-109, it would
be inappropriate to analogize the guidance on net settlement of a “debtor’s
obligation to the creditor that would occur upon exercise of a put option or
call option embedded in a debt instrument” to “a hybrid instrument that does not
contain a debt host.”
The table below presents an analysis of whether a redemption
feature embedded in an equity host contract meets the definition of a
derivative. 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 redemption feature has both an
underlying (the fair value of the shares to be redeemed)
and a notional amount (the number of shares to be
redeemed) 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 redemption feature on a stand-alone basis
without the host contract). Generally, a redemption
feature has an initial net investment that is smaller
than would be required for a direct investment that pays
the redemption amount (since the investment in the
equity 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 equity
contract is RCC (see below).
|
As presented in the table above, the determination of whether a
redemption feature meets the definition of a derivative is generally focused on
the net settlement characteristic.
Importantly, as noted in ASC 815-10-15-109, redemption features
embedded in equity host contracts do not inherently meet the net settlement
criterion since the issuer is delivering assets associated with an underlying.
Whether the redemption feature meets the net settlement characteristic in the
definition of a derivative generally depends on whether the hybrid contract
qualifies as RCC. A publicly traded equity instrument that may be sold in
increments that can be rapidly absorbed by the market without significantly
affecting the price would be RCC. By contrast, equity shares of a private
company that are not publicly traded would not be considered RCC, and the
redemption feature would typically not meet the definition of a derivative. (See
Section 1.4.3
for further discussion of how to determine whether an instrument is RCC.)
Example 6-9
Redemption Feature in a Preferred Stock
Agreement
Company ABC issues convertible preferred
stock, which is not publicly traded, to investors. The
convertible preferred stock contains a provision that
allows holders to redeem the preferred stock for cash in
the event of a deemed liquidation event, which is
defined in the underlying agreement as “a sale, merger,
acquisition, or change in control” of ABC. Upon the
occurrence of a deemed liquidation event, the preferred
stockholders are entitled to be paid out of the assets
of ABC that are available for distribution to its
stockholders an amount per share equal to the applicable
original issuance price, plus any dividends declared but
unpaid (the “deemed liquidation contingent redemption
feature”).
In determining whether the deemed
liquidation contingent redemption feature requires
bifurcation from the host contract, ABC considers the
guidance in ASC 815-15-25-1. Because the redemption of
an equity instrument for cash is not considered clearly
and closely related to the host contract and the
convertible preferred stock is not a hybrid instrument
remeasured at fair value, ABC considers whether the
deemed liquidation contingent redemption feature meets
the definition of a derivative in accordance with ASC
815-10-15-83.
The settlement of the deemed liquidation
contingent redemption feature requires the gross
exchange of the preferred stock (which is not RCC since
it is not publicly traded) in return for cash or other
assets. In other words, the deemed liquidation
contingent redemption feature does not allow for net
settlement, and the net settlement criterion in the
definition of a derivative is not met. (As noted in ASC
815-10-15-109, redemption features embedded in equity
host contracts do not inherently meet net settlement.)
Because the deemed liquidation contingent redemption
feature would not meet the definition of a derivative if
it were freestanding, the embedded feature should not be
bifurcated from the host contract.
Example 6-10
Evaluating Whether a Share-Settlement Feature Embedded
in an Equity Host Requires Bifurcation
Assume the same facts as in Example
6-4, in which the terms of the preferred
stock provide for “conversion” into Tech Co.’s common
stock upon a qualified equity financing at a price equal
to 85 percent of the per-share price of common stock in
the qualified equity offering. Since the preferred stock
in this example contains an equity host, the
determination of whether the issuer would be required to
bifurcate this feature would typically focus on whether
the net settlement criterion of the definition of a
derivative is met.
Importantly, as noted in ASC 815-10-15-109, redemption
features embedded in equity host contracts do not
inherently meet the net settlement criterion since the
issuer is delivering assets associated with an
underlying. Whether the redemption feature would meet
the net settlement criterion generally depends on
whether the preferred stock qualifies as RCC. A publicly
traded equity instrument that may be sold in increments
that can be rapidly absorbed by the market without
significantly affecting the price would be RCC. By
contrast, equity shares of a private company that are
not publicly traded would not be considered RCC, and the
share-settled redemption feature would typically not
meet the definition of a derivative. (See
Section 1.4.3 for further
discussion of how to determine whether an instrument is
RCC.)
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
2
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.
6.7 Embedded Commitments (Including PIK Interest/Dividend Features)
6.7.1 Background
A credit facility or tranche debt financing might include both an initial term
loan and commitments to obtain additional term loans on specified future dates.
Further, some debt and preferred stock instruments contain a paid-in-kind (PIK)
interest or dividend feature, respectively, which requires or permits the issuer
to pay interest or dividends in the form of additional debt or stock that has
the same terms as the original instrument. In substance, a PIK interest feature
in a debt host is a loan commitment since it permits or requires the issuer to
issue additional debt with specified terms to settle future interest payments.
Similarly, a PIK dividend feature in an equity host is a commitment to issue
additional equity interests.
Note that the discussion in this section only applies if the
entity has determined that the host contract and the PIK commitments represent
one combined unit of account (see Section 3.3 of Deloitte’s Roadmap
Distinguishing
Liabilities From Equity for further discussion of unit of
account considerations). If the commitments represent separate units of account
(e.g., the commitments are legally detachable and separately exercisable from
the host contract), they should be evaluated as freestanding commitments and
would be subject to other guidance.
6.7.2 Bifurcation Analysis
The table below presents an overview of the bifurcation analysis
of a PIK commitment embedded in a debt or 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 (see Section 4.3.2)
|
It depends
|
A loan commitment is not clearly and
closely related to a debt host contract if it includes
features that are not clearly and closely related to a
debt instrument. Similarly, a commitment to issue
additional equity shares would not be clearly and
closely related to an equity host contract if it
includes features that are not clearly and closely
related to an equity instrument.
|
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, 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,
depends on whether the instrument is considered a debt
security within the scope of ASC 320 (and the related
classification of the debt security) or an equity
security within the scope of ASC 321.
|
Meets the definition of a derivative (see Section 4.3.4)
|
It depends
|
The evaluation of whether a PIK
commitment 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 Section 4.3.5)
|
It depends
|
A debtor should evaluate whether the
commitment qualifies for the loan commitment scope
exception (see Section 2.3.9).
This scope exception is not available if the commitment
is held by the potential creditor or investor, nor would
it be available for a PIK dividend feature embedded in
an equity instrument.
|
6.7.3 Clearly-and-Closely-Related Analysis
A loan commitment is not clearly and closely related to a debt
host contract if it includes features that are not clearly and closely related
to a debt instrument. For example, if a commitment requires an entity to issue
(1) debt that is convertible into the debtor’s equity shares or (2) both debt
and warrants on the debtor’s equity shares, the commitment would not be clearly
and closely related to a debt host contract since the debtor’s stock price is
not clearly and closely related to a debt host. Similarly, a commitment to issue
term debt would not be clearly and closely related to a preferred stock
agreement with an equity host since the risks and rewards of holding debt are
not consistent with those of an equity holder. However, a commitment to issue
additional equity shares could be clearly and closely related to an equity host
contract. The clearly-and-closely-related analysis will depend on the specifics
of the embedded PIK features and the nature of the host contract.
6.7.4 Derivative Analysis
The table below presents an analysis of whether a loan or equity
commitment meets the definition of a derivative (see Section 4.3.4). 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 loan commitment has both an underlying
(interest rates and, if applicable, the occurrence or
nonoccurrence of any exercise contingency and other
underlyings) and a notional amount (the committed amount
of debt/equity) 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 commitment on
a stand-alone basis).
Generally, an embedded loan commitment
feature has an initial net investment that is smaller
than the committed amount of debt or equity.
|
Net settlement (see Section
1.4.3)
|
It depends
|
The entity should evaluate whether the
debt or equity that would be issued upon settlement of
the PIK feature is RCC or whether the PIK feature
explicitly provides for net settlement on the basis of
contractual terms.
|
Generally, an analysis of whether an embedded PIK commitment
meets the definition of a derivative focuses on whether it meets the net
settlement characteristic in the definition of a derivative (see Section 1.4.3). If the
PIK 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 of whether the feature meets the net settlement characteristic
depends on whether the debt or equity that would be funded is RCC (e.g.,
publicly traded instruments that may be sold in increments that can be rapidly
absorbed by the market without significantly affecting the price). If the
underlying debt or equity shares are not RCC, the embedded PIK 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.
If the net settlement criterion is met, some PIK interest
features may qualify for a scope exception, which is discussed further in the
section below.
6.7.5 Scope Exception for Loan Commitments
ASC 815-10-15-69 through 15-71 contain a scope exception related to the
derivative accounting requirements in ASC 815 for “a commitment to originate a
loan” for the holder of the commitment (i.e., the potential borrower; see
Section 2.3.9). (The investor or potential lender in a
loan commitment is never eligible for this derivative scope exception.)
For the holder of the commitment, this scope exception applies irrespective of
whether (1) the commitment is contingent and (2) the loan is revolving or
nonrevolving. Commitments to issue debt securities (e.g., tranche debt
issuances) also qualify for this scope exception. ASC 310-10-20 defines a loan
as a “contractual right to receive money on demand or on fixed or determinable
dates that is recognized as an asset in the creditor’s statement of financial
position. Examples include but are not limited to accounts receivable (with
terms exceeding one year) and notes receivable.” We informally discussed with
members of the SEC staff the application of this scope exception to commitments
to issue debt securities. The staff concurred that it is appropriate to apply
the loan commitment exception to an entity’s commitment to receive funds in
exchange for the initial issuance of a debt security that will be an obligation
of the entity.
In a typical loan commitment, the potential creditor writes an option to the
potential debtor that permits the potential debtor to obtain debt on
prespecified terms at its request. Therefore, the loan commitment scope
exception does not apply to an option written by the potential debtor to the
potential creditor under which the potential creditor could force the potential
debtor to enter into a loan but does not give the potential debtor a right to
elect to borrow money from the potential creditor.
ASC 815 does not clearly address whether the scope exception for loan commitments
is available if the loan to be funded contains an embedded feature that will
need to be bifurcated as a derivative once the loan is funded. It may therefore
be prudent for an entity to further evaluate whether the loan commitment meets
the definition of a derivative in ASC 815. If the loan commitment does not meet
the net settlement characteristic in the definition of a derivative (e.g., it
requires delivery of an underlying loan that is not RCC and the commitment
cannot otherwise be net settled), the debtor may conclude that the loan
commitment should not be accounted for as a derivative even if the scope
exception for loan commitments is considered inapplicable.
6.8 Payment Features Indexed to Commodities or Other Nonfinancial Items
6.8.1 Background
This section discusses the analysis of whether payment features that are indexed
to the price or value of a commodity or other nonfinancial item (e.g., a
commodity-indexed principal or interest payment or a participating mortgage
feature) should be separated from their host contract and accounted for as
derivatives under ASC 815-15.
We have generally observed payment features indexed to commodities or other
nonfinancial assets as potential embedded derivatives in debt host instruments,
although it would be possible for such a feature to be incorporated into an
equity or lease host. Regardless of whether the nature of the host contract is
debt, equity, or a lease, the price or value of a commodity or other
nonfinancial item would typically not be clearly and closely related to the host
contract. As illustrated in the table in the section below, the determination of
whether a feature requires bifurcation generally depends on whether the hybrid
instrument is measured at fair value or if the feature meets a derivative scope
exception.
6.8.2 Bifurcation Analysis
The table below presents an overview of the bifurcation analysis of a payment
feature indexed to the price or value of a commodity or other nonfinancial item.
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)
|
Typically, yes
|
The price or value of a commodity or
other nonfinancial item is typically not clearly and
closely related to a debt, equity, or lease 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 within the scope of ASC 320 (and the
related classification of the debt security) or (2) an
equity security within the scope of ASC 321.
|
Meets the definition of a derivative
(see Section 4.3.4)
|
Yes
|
Payments indexed to the price or value
of a commodity or other nonfinancial item meet the
definition of a derivative (see Section 6.8.4).
|
Meets a scope exception (see Section
4.3.5)
|
It depends
|
ASC 815 contains a scope exception
related to certain non-exchange-traded contracts with
payments that are based on the price or value of a
unique nonfinancial item of one of the parties to the
contract, provided that the asset is not RCC (see
Section 2.3.5.2).
|
As shown in the table above, an entity’s determination of whether a payment
feature indexed to a commodity or other nonfinancial item must be bifurcated as
a derivative tends to focus on whether the feature is exempt from the scope of
derivative accounting (see Section 2.3.5.2) and whether the
host contract is measured at fair value, with changes recorded through earnings.
Such a feature is not clearly and closely related to a debt, equity, or lease
host and typically meets the definition of a derivative (see Section 6.8.4).
6.8.3 Clearly-and-Closely-Related Analysis
ASC 815-15
25-48 The changes in fair
value of a commodity (or other asset) and the interest
yield on a debt instrument are not clearly and closely
related. Thus, a commodity-related derivative instrument
embedded in a commodity-indexed debt instrument shall be
separated from the noncommodity host contract and
accounted for as a derivative instrument.
Case J: Crude Oil Knock-In Note
55-194 An illustrative crude
oil knock-in note has a 1 percent coupon and guarantees
repayment of principal with upside potential based on
the strength of the oil market.
55-195 A crude oil
knock-in note essentially combines an interest-bearing
instrument with a series of option contracts. A
significant portion of the coupon interest rate is, in
effect, used to purchase options that provide the
investor with potential gains resulting from increases
in specified crude oil prices. Because the option
contracts are indexed to the price of crude oil, they
are not clearly and closely related to an investment in
an interest-bearing note. Therefore, the embedded option
contract should be separated from the host contract and
accounted for by both parties pursuant to the provisions
of this Subtopic.
Case K: Gold-Linked Bull Note
55-196 An illustrative
gold-linked bull note has a fixed 3 percent coupon and
guarantees repayment of principal with upside potential
if the price of gold increases.
55-197 A
gold-linked bull note can be viewed as combining an
interest-bearing instrument with a series of option
contracts. A portion of the coupon interest rate is, in
effect, used to purchase call options that provide the
investor with potential gains resulting from increases
in gold prices. Because the option contracts are indexed
to the price of gold, they are not clearly and closely
related to an investment in an interest-bearing note.
Therefore, the embedded option contracts should be
separated from the host contract and accounted for by
both parties pursuant to the provisions of this
Subtopic.
A feature that adjusts the payments of a debt, equity, or lease contract on the
basis of the price or value of a commodity or other nonfinancial item is
typically not clearly and closely related to the respective debt, equity, or
lease host. This determination applies irrespective of whether the entity owns
the commodity or other nonfinancial item.
ASC 815-15-25-48 discusses the concept that changes in the fair value of a
commodity (or other asset) would not be clearly and closely related to the
interest yield in a debt instrument. Similarly, the changes in a commodity’s
fair value would not be clearly and closely related to (1) the value of an
issuer’s equity shares if the hybrid instrument contains an equity host or (2)
the economic risks and characteristics of a lease contract if the contract is a
lease host.
6.8.4 Derivative Analysis
The table below presents an analysis of whether a payment
feature indexed to a commodity or other nonfinancial item 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 the price or value of a
commodity or other nonfinancial item has both an
underlying (the item’s price or value) and a notional
amount (e.g., the outstanding amount due under a debt or
lease agreement).
|
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 indexed to a commodity or other nonfinancial
asset 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 price or value of the
nonfinancial asset (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 that are indexed to the price or value of a
commodity or other nonfinancial item meet 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 nonfinancial item,
however, the considerations in Section
6.2.4.3 apply.)
|
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 within the scope of ASC 320 (and the
related classification of the debt security) or (2) an
equity security within 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
2-16 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.
6.10 Other Payment Provisions in Contracts
6.10.1 Background
Debt instruments often contain provisions under which payments are (1) made upon
the occurrence or nonoccurrence of a specified event (e.g., the issuer is late
in filing financial statements) or (2) indexed to a variable (e.g., the
creditor’s costs associated with a specified event) for which the accounting is
not specifically addressed in ASC 815. While features of this nature are
generally observed in a debt host, it is possible for such a feature to be
embedded in an equity or lease host. In a manner consistent with the assessment
of other features discussed in this chapter, an entity must consider the
specific facts and circumstances when determining whether the feature requires
bifurcation from its host contract.
For example, payment provisions may require the issuer of a debt
instrument (i.e., the debtor) to:
- Pay additional interest if the debt is not freely tradable by its holders by a specified date after issuance (e.g., the debtor must pay 0.25 percent of additional interest if the debt is not freely tradable six months after issuance).
- Pay additional interest if it has not filed in a timely manner any report or document that must be filed with the SEC (e.g., 0.25 percent of additional interest).
- Pay additional interest if it fails to meet one or more specified ESG targets (e.g., the debtor must pay additional interest of 0.50 percent if it does not use the debt proceeds to invest in renewable energy projects or fails to achieve 40 percent female representation on the debtor’s board of directors within three years of debt issuance).
- Receive an interest rate reduction if it meets specified ESG targets (e.g., the stated interest rate is reduced by 0.25 percent if the debtor achieves a specified reduction in greenhouse gas emissions within three years of debt issuance).
- Reimburse the creditor for increased costs as result of a specified event (e.g., a change in law or hedge disruption event).
- Reimburse the creditor for taxes on interest payments.
Because payment provisions that are contingent on filing with the SEC on time or
on the ability to freely trade an instrument do not pertain to the filing or
maintenance of either an effective registration statement or an exchange
listing, they do not meet the definition of a registration payment arrangement
(see Section 2.3.14).
Example 6-12
Debt That Requires Additional Interest to Be Paid if Resale Is
Restricted
A debt instrument was issued in accordance with an
exemption from registration under the Securities Act of
1933. The terms of a debt contract require the issuer to
pay additional interest at a rate equal to 0.50 percent
per annum if, or for as long as, a restrictive legend on
the debt has not been removed, the debt is assigned a
restricted CUSIP number, or the debt is not otherwise
freely tradable.
Example 6-13
Debt That Requires Additional Interest to Be Paid Upon the
Occurrence of Certain Events
The terms of a debt contract require the
issuer to pay additional interest at a rate equal to
0.50 percent per annum of the principal amount
outstanding for each day during which (1) the debtor has
failed to file any document or report that the debtor is
required to file with the SEC under Section 13 or 15(d)
of the Securities Exchange Act of 1934 or (2) the debt
is not otherwise freely tradable (e.g., eligible for
sale and transfer under SEC Rule 144) as a result of
restrictions in U.S. securities laws (e.g., a
registration requirement under the Securities Act of
1933) or the terms of the debt indenture.
6.10.2 Bifurcation Analysis
The table below presents an overview of the bifurcation analysis of a payment
provision that is contingent on the occurrence or nonoccurrence of a specified
event (e.g., late filings) or is indexed to a variable (e.g., the creditor’s
costs associated with a specified event) for which the accounting is not
specifically addressed in ASC 815.
Bifurcation Condition
|
Condition Met?
|
Analysis
|
---|---|---|
Not clearly and closely related (see
Section 4.3.2)
|
It depends
|
Payments that are contingent on, or
indexed to, (1) an underlying other than interest rates,
(2) the debtor’s creditworthiness, or (3) inflation are
considered not clearly and closely related to a debt
host. Other contingent payment provisions should be
carefully evaluated to determine whether they are
clearly and closely related to the host contract.
It could also be possible for a payment
provision to be identified in an equity or lease host. A
feature in either of those host types that would be
triggered by, for example, an ESG event, missed filings
with the SEC, or board diversity targets would generally
not have the same risks and rewards as an equity or
lease host contract and would not be clearly and closely
related to the host contract. Given the unique nature of
such provisions, an entity should further evaluate the
specific facts and circumstances.
|
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 in fair value
recorded through earnings, will depend on whether the
instrument is (1) considered a debt security within the
scope of ASC 320 (and the related classification of the
debt security) or (2) an equity security within the
scope of ASC 321.
|
Meets the definition of a derivative
(see Section 4.3.4)
|
Yes
|
Generally, a feature that creates the
requirement to make a cash payment (1) upon the
occurrence of a specified event or (2) on the basis of a
variable associated with a specific event would meet the
definition of a derivative (see Section 6.10.4).
|
Meets a scope exception (see Section
4.3.5)
|
Generally, no
|
Although the entity should evaluate
whether any specific scope exception is available (see
Section 2.3),
often a scope exception would not be available.
|
6.10.3 Clearly-and-Closely-Related Analysis
If an embedded feature is not addressed in ASC 815, an entity must apply judgment and consider the purpose of the clearly-and-closely-related criterion (e.g., whether the feature bears a close economic relationship to the host contract or is dissimilar) and analogous guidance for other types of features. Paragraphs 305 and 306 of the Basis for Conclusions of FASB Statement 133 state, in part:
The . . . criterion [that the economic characteristics of the derivative
and the host contract are not clearly and closely related to one another]
focuses on whether an embedded derivative bears a close economic
relationship to the host contract. . . . Applying the approach will require
judgment, which may lead to different accounting for similar instruments. To
reduce that possibility, [ASC 815] provides examples illustrating how to
apply the approach.
Generally, payments that are contingent on (or indexed to) an
underlying other than (1) interest rates (see Section
5.2), (2) the debtor’s creditworthiness (see Section 5.3), or (3)
inflation (see Section
5.4) are considered not clearly and closely related to a debt
host.
The following types of payment features are typically considered not clearly and
closely related to a debt, equity, or lease host:
- Additional interest features that are triggered if debt or equity is not freely tradeable by a specified date or if the issuer does not file financial statements on time with the SEC.
- Additional interest features in a debt or equity host that are triggered if specified ESG targets are or are not met.
- Interest rate reductions that apply if specified ESG targets are met.
- Reimbursement of creditor-related costs.
- Reimbursement of taxes that the creditor owes to the government on interest paid.
We have observed various other types of contingent payment provisions in
different types of host contracts in practice. Such embedded features should be
carefully evaluated to determine whether the relevant economic risks and
characteristics are clearly and closely related to the economic risks and
characteristics of the respective host contract. Given the absence of
authoritative guidance on less commonly observed embedded features, we encourage
consultation with an entity’s accounting advisers.
6.10.4 Derivative Analysis
The table below presents an analysis of whether a payment
provision meets the definition of a derivative (see Section 4.3.4) if it is either (1)
contingent on the occurrence or nonoccurrence of a specified event (e.g., late
filings) or (2) indexed to a variable (e.g., the creditor’s costs associated
with a specified event) for which the accounting is not specifically addressed
in ASC 815. 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
on the basis of a specified event or variable has both
an underlying (the specified event or variable) and a
notional amount (e.g., the debt’s outstanding amount,
number of shares) 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 feature on a
stand-alone basis without the host contract). Generally,
a feature that adjusts the payments of a contract 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 event
or variable (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
|
A feature that adjusts the payments of a
host contract on the basis of a specified event or
variable meets 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 that is contingent on a specified
event or indexed to a specified variable typically meets the definition of a
derivative.
6.10.5 Contingent Interest Rate Features in ESG-Linked Debt Instruments
It is becoming increasingly common for entities to issue debt instruments whose
interest or principal payments are indexed to certain ESG targets. We have
observed in practice that such features generally meet the requirements for
bifurcation because they are not considered clearly and closely related to a
debt host.
Specifically, a debt instrument with an ESG-linked feature may
indicate that the contractual interest rate will (1) be reduced by a certain
amount if the borrower achieves predefined targets, such as reaching carbon
neutral by a specified date, (2) be increased if the borrower fails to achieve
those targets, or (3) vary on the basis of changes in an index tied to specified
environmental metrics. As previously discussed in Section 5.2.3, 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. The guidance
does not address features that are indexed to or contingent on something other
than an interest rate or interest rate index, including features that are
indexed to both an interest rate or interest rate index and other underlyings
(e.g., environmental targets or key performance indicators). Under the existing
guidance, generally, only certain features that are based on a market interest
rate, an entity’s credit risk, or inflation are viewed as clearly and closely
related to a debt host contract. Accordingly, an ESG-linked feature that adjusts
the contractual interest rate is generally not considered clearly and closely
related to the host contract, and bifurcation of that feature may be required
unless a specific scope exception is available.
Given the wide variety of environmentally linked terms and the evolving nature of
these instruments, entities are strongly encouraged to discuss their accounting
analysis with their advisers.
Changing Lanes
On July 23, 2024, the FASB issued a proposed ASU that would revise the
application of certain derivative scope exceptions. If finalized, the
proposed amendments would refine the scope of ASC 815 to exclude certain
“contracts with underlyings based on operations or activities specific
to one of the parties to the contract.” Contracts with ESG-linked
features may qualify for this scope exception. The Board will consider
stakeholder feedback on the proposed ASU after the comment letter period
ends on October 21, 2024.
In addition, as of the date of this publication, the
FASB’s research agenda still includes a project on the “definition of a
derivative.” One of the objectives of that research project is to
identify potential application guidance specific to certain
arrangements, including financial instruments with ESG-linked features.
Although this remains a separate research agenda project, some of these
objectives may be addressed by the proposed ASU on derivative scope
refinements discussed above. Stakeholders should monitor the status of
the research project for developments.
6.10.6 Additional Considerations
Before reaching a conclusion about the accounting for a payment provision, an
entity should always consider the terms and conditions of a specific feature in
light of all the relevant accounting guidance (e.g., whether a scope exception
on derivative accounting is available; see Chapter
2). An entity is not required to recognize a derivative related
to normal contractual remedies for a breach of contract whose occurrence the
entity can prevent. For example, an entity is not required to separate an
indemnification clause that holds each party harmless against damages, losses,
or claims resulting from the breach of contract or gross negligence.
The fair value of a payment feature embedded in debt host might
be minimal, depending on the likelihood that the feature will be triggered and,
if so, on its potential amount (e.g., a feature in which a minor adjustment must
be made to the interest rate upon an event whose likelihood of occurring is
remote). In practice, therefore, entities sometimes determine and document that
they are not required to make accounting entries upon debt issuance to recognize
a feature that must be bifurcated as a derivative under ASC 815-15. Any such
conclusion must be appropriately supported on the basis of materiality. A
determination that a feature has a minimal fair value at inception does not
negate the requirement to account for it as a derivative. Accordingly, if an
entity makes such a determination, it should also monitor its facts and
circumstances in each reporting period to evaluate whether the feature’s fair
value or a change to it is significant and therefore must, under U.S. GAAP
requirements, be reflected in the entity’s financial statements. For instance,
if a feature that must be bifurcated as a derivative liability is determined to
have a fair value that is not materially different from zero when the debt is
issued and the fair value increases to $50,000 during the next reporting period,
the change in fair value from zero to $50,000 should be reflected as a loss
during that reporting period; the change cannot be recognized as a debt discount
after the issuance of the debt.
The entity should also consider the appropriate level of aggregation in
identifying and evaluating embedded features (see Section 4.2.2). The terms of a debt contract might contain a cap
on the total amount of additional interest that would be paid under additional
interest provisions. For example, the debt terms might specify that in no event
will additional interest be paid at a rate in excess of 0.50 percent regardless
of the number of events or circumstances giving rise to the requirement to pay
such additional interest. This means that the total amount of additional
interest that might have to be paid on the debt is not necessarily simply the
sum of the additional interest that might need to be paid under each of the
provisions that triggers such additional interest payments. For instance, if one
or more additional interest features have been triggered such that the total
amount of additional interest payable is equal to the cap, there would be no
incremental amount payable if another such feature is triggered. In this
circumstance, the potential payoff of each additional interest provision and the
payoffs under the other provisions to which the cap applies are interdependent.
Under the payoff profile approach for identifying embedded features (see
Section 4.2.2), it is appropriate to
evaluate such additional interest features as one combined embedded feature
rather than as separate embedded features for each of the triggers. As a
consequence, an additional interest feature that would have been considered
clearly and closely related to a debt host if it had been evaluated on a
stand-alone basis (e.g., an additional interest feature triggered by a change in
the issuer’s creditworthiness; see Section
5.3) might have to be combined with other additional interest
features that are not considered clearly and closely related to a debt host in
the evaluation of whether the combined feature is clearly and closely related to
the debt host.
6.11 Illustrative Example: Convertible Preferred Stock With Multiple Features (Debt and Equity Host Considerations)
The comprehensive example below applies the guidance in ASC
815-15-25-1 to convertible preferred stock that has multiple embedded features that
must be evaluated for bifurcation.
Example 6-14
Overview and Background
Entity R, a private company, issues redeemable convertible
preferred stock at par to multiple investors with the
following features:
- Redemption option — After the third anniversary of the issuance, investors may redeem the security for an amount of cash equal to the greater of (1) the face value of the security or (2) the fair value of the underlying common stock.
- Conversion option — Investors may convert the security at any time into the issuer’s common stock on a one-for-one basis.
The below evaluation of the embedded
features will contemplate two scenarios — one in which the
preferred stock has an equity host and one in which it has a
debt host (see Section
4.3.2.3.2 for details on the determination of
the host contract nature). In both scenarios, the preferred
stock qualifies for equity classification in accordance with
ASC 480 in R’s financial statements.
As stated above, after the third anniversary, the redemption
option allows the holder to put the security to the issuer
for cash equal to the greater of (1) the security’s face
value or (2) the underlying common stock’s fair value.
Effectively, this “greater of” redemption option gives the
holder of the security the ability to either net cash settle
the conversion option or obtain a return of the originally
invested amount. When the embedded features are identified
under an economic payoff approach, the right to redeem the
preferred stock for cash equal to the fair value of the
underlying common stock would be attributed to a conversion
feature rather than a redemption feature. Entity R would
separately evaluate the redemption feature as only the right
to redeem the security for cash equal to the security’s face
value.
The preferred stock cannot contractually be settled in such a
way that the holder would not recover substantially all of
its initial recorded investment. Further, there is no
potential scenario in which the holder could achieve a rate
of return on the preferred stock that at least doubles its
initial rate of return and is twice what would otherwise be
the market return.
In this scenario, the preferred stock contains two payoff
profiles that should be evaluated as embedded features: (1)
the holder’s right to redeem the security at its face value
for cash (the “redemption feature”) and (2) the holder’s
right to convert the security into equity that can be
settled in cash or in shares (the “conversion feature”). The
redemption feature and the conversion feature must be
analyzed separately under ASC 815-15-25-1.
First Criterion: Not
Clearly and Closely Related
Both R and the investor would apply the
not-clearly-and-closely-related criterion to the redemption
and conversion features, as described separately below.
Redemption Feature
- Equity host — If the host contract is an equity host, the redemption feature that enables the holder to require the issuer to reacquire that equity instrument for cash (at face value) is not considered clearly and closely related to that equity host under ASC 815-15-25-20. Evaluation of the additional bifurcation criteria would be required.
- Debt host — If R concludes
that the host contract is a debt host, it would look
to ASC 815-15-25-26 and ASC 815-15-25-41 through
25-43 in determining whether the redemption feature
is clearly and closely related to that debt host, as
follows:
- Consider the four-step
decision sequence in ASC 815-15-25-42:
-
“Step 1: Is the amount paid upon settlement (also referred to as the payoff) adjusted based on changes in an index? If yes, continue to Step 2. If no, continue to Step 3.”Answer: No. The redemption is at the security’s face value and is not adjusted on the basis of changes in an index.
-
“Step 2: Is the payoff indexed to an underlying other than interest rates or credit risk? If yes, then that embedded feature is not clearly and closely related to the debt host contract and further analysis under Steps 3 and 4 is not required. If no, then that embedded feature shall be analyzed further under Steps 3 and 4.”Answer: Not applicable because of the answer in step 1.
-
“Step 3: Does the debt involve a substantial premium or discount? If yes, continue to Step 4. If no, further analysis of the contract under paragraph 815-15-25-26 is required, if applicable.”Answer: No substantial premium or discount exists in the consideration of any premium or discount that exists upon both (1) issuance and (2) settlement of this feature. Accordingly, further evaluation under ASC 815-15-25-26 is required.
-
“Step 4: Does a contingently exercisable call (put) option accelerate the repayment of the contractual principal amount? If yes, the call (put) option is not clearly and closely related to the debt instrument. If not contingently exercisable, further analysis of the contract under paragraph 815-15-25-26 is required, if applicable.”Answer: Not applicable because of the answer in step 3.
-
- Evaluate the guidance in ASC
815-15-25-26:
-
Does the feature pass the negative yield and double-double tests (see Sections 5.2.3.3 and 5.2.3.4 for the applicable guidance)?Answer: On the basis of the background information provided, the preferred stock cannot contractually be settled in such a way that the holder would not recover substantially all of its initial recorded investment. There is also no potential scenario in which the holder could achieve a rate of return on the preferred stock through the redemption feature that at least doubles its initial rate of return and is twice what would otherwise be the market return. The upside provided by the redemption equal to the fair value of the underlying common stock is evaluated as a potential cash settlement of the conversion option. Thus, the feature would not pass the negative yield or double-double test.
-
- Consider the four-step
decision sequence in ASC 815-15-25-42:
In accordance with the steps above, including evaluating the
guidance in ASC 815-15-25-26, the redemption feature is
clearly and closely related to the host contract, so
bifurcation of the redemption feature from a debt host would
not be required. Evaluation of the additional bifurcation
criteria is not necessary.
Conversion Feature
- Equity host — If the host contract is more akin to equity, the conversion feature and host contract would be clearly and closely related and this condition would not be met. Because all three criteria must be met for bifurcation, further evaluation would not be needed to conclude that no bifurcation is required.
- Debt host — If the host contract is more akin to debt, guidance in ASC 815-15-25-51 would be applicable, which indicates that conversion options are generally not clearly and closely related to debt hosts. In that case, R and the investor would conclude that the conversion feature is not clearly and closely related to the debt host and further analysis of the other criteria would be necessary to determine whether the feature requires bifurcation.
Second Criterion: Not
Remeasured at Fair Value
From R’s perspective, the preferred stock issued is not
eligible to be measured at fair value, with changes in fair
value recognized in earnings. ASC 815 and ASC 825 prohibit
this election for equity instruments issued by an entity
that are classified in stockholders’ equity (or mezzanine
equity) in the issuer’s statement of financial position.
From R’s perspective, the second criterion is met.
From the investors’ perspective, provided
that the preferred stock investment is not accounted for
under the equity method, the preferred stock would be
classified as a debt security in accordance with ASC 320
because of the provision that allows the holder to redeem
the shares. Depending on how the debt security is classified
(i.e., trading, AFS, or HTM) and whether the investor has
elected to apply the fair value option, the debt security
may or may not be recorded at fair value, with changes in
fair value recorded through earnings. If the investment is
already recorded at fair value, with changes recognized
through earnings, the second criterion would not be met and
neither of the embedded features would be bifurcated from
the host contract. If the investment is not recorded
at fair value, with changes recorded through earnings (e.g.,
an AFS-classified debt security for which the fair value
option has not been elected), the second criterion would be
met.
Third Criterion:
Derivative on a Stand-Alone Basis
To be bifurcated, an embedded feature in a hybrid instrument
must, on a freestanding basis, meet the definition of a
derivative in ASC 815-10-15-83. The determination of whether
the definition is met often focuses on the definition’s
third component (i.e., the net settlement characteristic).
Usually, the other two components of the definition of a
derivative (i.e., (1) an underlying and a notional amount or
payment provision and (2) no or little initial net
investment) are met for an embedded feature in a hybrid
financial instrument.
Redemption Feature
- Equity host — Whether the redemption feature meets the net settlement characteristic in the definition of a derivative generally depends on whether the hybrid contract is publicly traded and RCC. For R, the preferred stock is not publicly traded and is not considered RCC. Therefore, this criterion is not met under this specific fact pattern because the redemption feature does not meet the definition of a derivative.
- Debt host — Evaluation is not required since the redemption feature is clearly and closely related to the host contract.
Conversion Feature
- Equity host — Evaluation is not required since the conversion feature is clearly and closely related to the host contract.
- Debt host — Because the conversion feature may be net-cash-settled, the holder is effectively able to realize the change in the conversion option’s fair value without physically settling the option in shares. As a result, the conversion feature is considered net-settleable and meets the definition of a derivative. There are no applicable scope exceptions from derivative accounting; specifically, since the conversion feature is settled in cash at the option of the holder, the conversion feature would not be eligible for the scope exception for contracts in an entity’s own equity under ASC 815-40. This exception would have never been applicable to the investor, regardless of the ability to settle the conversion feature in cash. As a result, the third criteria is met for the conversion feature.
Conclusion
As shown above, under the guidance in ASC 815-15-25-1, R’s
determination of whether the conversion and redemption
features require bifurcation depends largely on (1) the
nature of the host contract and (2) whether the evaluation
is performed from the issuer’s or holder’s perspective.
If the host contract has an equity host, the redemption
feature will not require bifurcation because the feature on
its own does not meet the definition of a derivative (since
R is a private company and its equity securities are not
RCC). The conversion feature would similarly not require
bifurcation because the conversion feature and the equity
host contract are clearly and closely related.
If the host contract has a debt host, the redemption feature
would not require bifurcation because the feature is clearly
and closely related to the host contract. However, from the
issuer’s perspective, the conversion feature would require
bifurcation because (1) the conversion feature would not be
clearly and closely related to the host contract, (2) the
preferred stock is not measured at fair value, and (3) the
conversion feature meets the definition of a derivative
because it can be settled net in cash at the holder’s
option. From the holder’s perspective, the determination of
whether the conversion feature requires bifurcation depends
on how the ASC 320 debt security is classified.
As indicated in this example, the facts and circumstances
surrounding a particular transaction significantly affect
the determination of whether bifurcation of a particular
feature is required.