Chapter 6 — Other Common Embedded Features

6.2 Conversion, Exchange, and Indexed Features in Debt Hosts

6.2.1 Background

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

6.2.2 Bifurcation Analysis

6.2.2.1 General

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

6.2.2.2 Equity Conversion Feature

Debt instruments often contain features that require or permit the debt to be converted into the debtor’s equity shares. The table below presents an overview of the bifurcation analysis of equity conversion features embedded in a debt host contract that are settleable in the debtor’s equity shares, including the shares of a substantive consolidated entity. The table does not apply to an embedded feature that economically represents a share-settled redemption or indexation feature whose monetary value does not vary on the basis of the debtor’s stock price (see Section 6.2.2.5). Further, an entity should always consider the terms and conditions of a specific feature in light of all the relevant accounting guidance before reaching a conclusion.

Bifurcation Condition	Condition Met?	Analysis
Not clearly and closely related (see Section 4.3.2)	Yes	A change in the debtor’s stock price is not clearly and closely related to a debt host.
Hybrid instrument not measured at fair value through earnings on a recurring basis (see Section 4.3.3)	It depends	From the issuer’s perspective, debt is not measured at fair value on a recurring basis unless the issuer elects the fair value option in ASC 815-15 or ASC 825-10. The fair value option cannot be elected for debt that contains a separately recognized equity component at inception. In the case of an outstanding share that qualifies for equity presentation but was determined to have a debt host contract, the instrument would not be recorded at fair value through earnings on a recurring basis. From the holder’s perspective, the determination of whether the hybrid instrument is measured at fair value, with changes recorded through earnings, will depend on whether the instrument is (1) an equity method investment, (2) considered a debt security within the scope of ASC 320 (and whether the holder has elected to apply the fair value option), or (3) an equity security within the scope of ASC 321.
Meets the definition of a derivative (see Section 4.3.4)	It depends	The entity should evaluate whether the equity conversion feature meets the net settlement characteristic in the definition of a derivative.
Meets a scope exception (see Section 4.3.5)	It depends	From the issuer’s perspective, the issuer should evaluate whether the equity conversion feature meets the scope exception for certain contracts on own equity or share-based payment transactions (see Section 2.3.11). From the holder’s perspective, a scope exception is not applicable.

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

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

ASC 815-15

Case U: Convertible Debt Instrument

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

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

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

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

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

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

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

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

6.2.2.3 Exchange Feature Involving Third-Party Stock

ASC 470-20 — SEC Materials — SEC Staff Guidance

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

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

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

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

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

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

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

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

The table below presents an overview of the bifurcation analysis of a feature that requires or permits a debt contract to be exchanged for shares of stock issued by a third party (other than shares of stock issued by a substantive consolidated entity). The table does not apply to a feature that economically represents a share-settled redemption or indexation feature whose monetary value does not vary on the basis of the third party’s stock price. An entity should always consider the terms and conditions of a specific feature in light of all the relevant accounting guidance before reaching a conclusion.

Bifurcation Condition	Condition Met?	Analysis
Not clearly and closely related (see Section 4.3.2)	Yes	The changes in the fair value of an equity interest are not clearly and closely related to a debt host.
Hybrid instrument not measured at fair value through earnings on a recurring basis (see Section 4.3.3)	It depends	From the issuer’s perspective, debt is not measured at fair value on a recurring basis unless the issuer elects the fair value option in ASC 815-15 or ASC 825-10. The fair value option cannot be elected for debt that contains a separately recognized equity component at inception. In the case of an outstanding share that qualifies for equity presentation but was determined to have a debt host contract, the instrument would not be recorded at fair value through earnings on a recurring basis. From the holder’s perspective, the determination of whether the hybrid instrument is measured at fair value, with changes recorded through earnings, will depend on whether the instrument is (1) an equity method investment, (2) considered a debt security within the scope of ASC 320 (and whether the holder has elected to apply the fair value option), or (3) an equity security within the scope of ASC 321.
Meets the definition of a derivative (see Section 4.3.4)	It depends	The entity should evaluate whether the feature meets the net settlement characteristic in the definition of a derivative.
Meets a scope exception (see Section 4.3.5)	No	There is no specific scope exception available for features that involve the exchange of debt for shares issued by a third party (other than shares of stock issued by a substantive consolidated entity).

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

6.2.2.4 Equity-Indexed Payment Features

The table below presents an overview of the bifurcation analysis of an equity-indexed payment feature embedded in a debt host contract (e.g., a debt contract with principal or interest payments indexed to the S&P 500 Index). An entity should always consider the terms and conditions of a specific feature in light of all the relevant accounting guidance before reaching a conclusion.

Bifurcation Condition	Condition Met?	Analysis
Not clearly and closely related (see Section 4.3.2)	Yes	The changes in the fair value of an equity interest are not clearly and closely related to a debt host.
Hybrid instrument not measured at fair value through earnings (see Section 4.3.3)	It depends	From the issuer’s perspective, debt is not measured at fair value on a recurring basis unless the issuer elects the fair value option in ASC 815-15 or ASC 825-10. The fair value option cannot be elected for debt that contains a separately recognized equity component at inception. In the case of an outstanding share that qualifies for equity presentation but was determined to have a debt host contract, the instrument would not be recorded at fair value through earnings on a recurring basis. From the holder’s perspective, the determination of whether the hybrid instrument is measured at fair value, with changes recorded through earnings, will depend on whether the instrument is (1) an equity method investment, (2) considered a debt security within the scope of ASC 320 (and whether the holder has elected to apply the fair value option), or (3) an equity security within the scope of ASC 321.
Meets the definition of a derivative (see Section 4.3.4)	Yes	An equity-indexed payment feature meets the definition of a derivative.
Meets a scope exception (see Section 4.3.5)	No	There is no specific scope exception available for an equity-indexed payment feature embedded in a debt host.

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

6.2.2.5 Share-Settled Redemption Features

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

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

Example 6-1

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

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

Example 6-2

Debt Indexed to S&P 500 Index

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

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

6.2.3 Clearly-and-Closely-Related Analysis

6.2.3.1 Equity Conversion or Exchange Features

ASC 815-15

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

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

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

6.2.3.2 Equity-Indexed Payment Feature

ASC 815-15

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

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

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

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

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

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

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

Case H: Equity-Indexed Note

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

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

Case I: Variable Principal Redemption Bond

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

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

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

Case P: Specific Equity-Linked Bond

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

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

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

Example 6-3

Debt With Principal Amount That Is Indexed to Stock Price

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

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

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

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

6.2.4 Derivative Analysis

6.2.4.1 Equity Conversion or Exchange Feature

The table below presents an analysis of whether an equity conversion or exchange feature meets the definition of a derivative (see Section 1.4). Note, however, that an entity should always consider the terms and conditions of a specific feature in light of the applicable accounting guidance before reaching a conclusion.

Characteristics of a Derivative	Characteristic Present?	Analysis
Underlying and notional amount or payment provision (see Section 1.4.1)	Yes	An equity conversion or exchange feature has both an underlying (the fair value of the equity instruments that would be issued upon conversion and, if applicable, the occurrence or nonoccurrence of any exercise contingency) and a notional amount (the number of shares that would be issued upon conversion).
Initial net investment (see Section 1.4.2)	Yes	The initial net investment in an embedded feature is its fair value (i.e., the amount that would need to be paid to acquire the equity conversion feature on a stand-alone basis without the host contract). Generally, an equity conversion or exchange feature has an initial net investment that is smaller than would be required for a direct investment that has the same exposure to changes in the stock price (since the investment in the debt host contract does not form part of the initial net investment for the embedded feature).
Net settlement (see Section 1.4.3)	It depends	The net settlement characteristic is met if either (1) the equity conversion or exchange feature can be explicitly net settled (e.g., its fair value can be settled net in shares or net in cash) or (2) the shares that would be issued upon conversion are RCC. The net settlement characteristic is not met if the equity conversion or exchange feature must be gross physically settled and the shares that would be delivered upon conversion are not RCC.

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

6.2.4.2 Equity-Indexed Payment Feature

The table below presents an analysis of whether an equity-indexed payment feature meets the definition of a derivative. Note, however, that an entity should always consider the terms and conditions of a specific feature in light of the applicable accounting guidance before reaching a conclusion.

Characteristics of a Derivative	Characteristic Present?	Analysis
Underlying and notional amount or payment provision (see Section 1.4.1)	Yes	An equity-indexed payment feature has both an underlying (a stock price or stock price index) and a notional amount (the debt’s principal amount) or payment provision.
Initial net investment (see Section 1.4.2)	Yes	The initial net investment in an embedded feature is its fair value (i.e., the amount that would need to be paid to acquire the equity-indexed payment feature on a stand-alone basis without the host contract). Generally, an equity-indexed payment feature has an initial net investment that is smaller than would be required for a direct investment that has the same exposure to changes in the stock price or stock price index (since the investment in the debt host contract does not form part of the initial net investment in the embedded feature).
Net settlement (see Section 1.4.3)	Yes	A feature that adjusts the payments of a debt host contract on the basis of a stock price or stock price index meets the net settlement condition since neither party is required to deliver an asset that is associated with the underlying and whose principal amount, stated amount, face value, number of shares, or other denomination is equal to the feature’s notional amount. (If the feature must be settled by delivery of the underlying shares of stock, however, the considerations in Section 6.2.4.3.3 apply.)

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

6.2.4.3 Net Settlement Analysis

6.2.4.3.1 Background

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

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

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

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

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

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

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

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

6.2.4.3.3 Net-Share-Settled Features

ASC 815-10

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

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

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

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

6.2.4.3.4 Physically Settled Features

ASC 815-10

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

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

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

ASC 815-10

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

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

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

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

Case A: Single Bond With Multiple Conversion Options

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

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

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

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

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

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

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

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

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

Case B: Multiple Bonds Each Having Single Conversion Option

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

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

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

6.2.4.3.5 Features Physically Settled in Restricted Stock

ASC 815-10

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

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

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

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

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

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

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

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

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

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

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

6.2.4.3.6 Ongoing Assessment

ASC 815-10

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

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

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

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

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

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

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

6.2.5 Scope Exception for Certain Own Equity Contracts

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

6.2.6 Scope Exception for Certain Share-Based Payment Transactions

ASC 815-10

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

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

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

Connecting the Dots

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

Footnotes

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

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.”	The principal amount is adjusted for changes in the price of gold. The principal amount is adjusted for changes in a stock market index. The principal amount is adjusted to reflect changes in inflation rates (e.g., CPI). The principal amount is adjusted on the basis of the issuer’s earnings or EBITDA.	The payoff is a fixed principal amount plus accrued interest. The payoff is a fixed principal amount plus a premium that decreases ratably as the instrument approaches maturity.
“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.”	Commodity-linked payoff (see Section 6.8.3). Equity-linked payoff (see Section 6.2.2.4), such as debt that is callable by the issuer at par plus 5 percent of the change in S&P 500. Payoff linked to a credit risk exposure that is different from the borrower’s credit risk exposure (see Section 5.3.3).	Payoff directly linked to changes in the borrower’s credit rating (see Section 5.3.3). Nonleveraged inflation-indexed contracts where the inflation rate is in the economic environment for the currency in which the debt is denominated (see Section 5.4.3).
“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).	Fixed-rate debt issued at a 12 percent discount to par and contingently puttable at par. Fixed-rate debt issued at par that is contingently puttable for 110 percent of par.	Debt puttable at par issued at a 6 percent discount to par. Debt issued at a 3 percent discount to par that is callable upon an IPO at par plus accrued and unpaid interest.
“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).	Convertible debt with a redemption feature that permits the investor to put the debt if an IPO occurs. Debt with a redemption option that is exercisable by either the investor or the issuer upon a change in control. Debt with a redemption option that is exercisable upon a change in interest of at least 150 basis points.	The embedded option is exercisable at any time. The embedded option is exercisable at the anniversary date of the issuance of the debt.

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

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

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.